Chapter 13 Flashcards
Financial Futures
A standardized agreement to deliver or receive a specified amount of a specified financial instrument at a specified price and date.
Are traded on organized exchanges, which establish and enforce rules.
Interest Rate Futures
Debt securities such as T-bills, Treasury notes, Treasury bonds, and Eurodollar CDs.
Settlement dates occur March, June, September, and December.
Stock Index Futures
Allows for the buying and selling of a stock index for a specified price at a specified date.
Futures Exchanges
Provide an organized marketplace where standardized futures contracts can be traded.
Clear, settle, and guarantee all transactions.
Over-the-Counter Market
A financial intermediary finds a counterparty or serves as the counterparty.
More personalized and can be tailored to specific preferences.
Speculators
Take positions to profit from expected changes in the futures prices.
Day traders attempt to capitalize on price movements during a single day.
Position traders maintain their futures positions for longer periods of time.
Hedgers
Take positions in financial futures to reduce their exposure to future movements in interest rates or stock prices.
Trading Process
A customer must establish a margin deposit with a broker before a transaction can be executed.
Brokers commonly require margin deposits above those required by the exchanges.
To buy or sell futures contracts, customers open accounts at brokerage firms that execute futures transactions.
Market Order
The trade is executed at the prevailing price.
Limit Order
The trade is executed if the price is within the limit specified by the customer.
Roles of the Futures Exchange
Facilitates the trading process but does not itself take buy or sell positions on futures contracts.
Interest Rate Futures Contracts
Specify a face value of the underlying securities, a maturity of the underlying securities, and the settlement date.
There is a minimum price fluctuation for each contract.
Valuing Interest Rate Futures
The price of an interest rate futures contract reflects the expected price of the underlying security on the settlement date.
Speculating in Interest Rate Futures
Speculators who anticipate future movements in interest rates can anticipate the direction of Treasury security values and therefore how valuations of interest rate futures will change.
Impact of Leverage
The return from speculating in interest rate futures should reflect the degree of financial leverage involved.
Cross-Hedging
The use of a futures contract on one financial instrument to hedge a position in a different financial instrument.
Trade-Off from Using a Short Hedge
A financial institution that hedges may be able to reduce the variability of its earnings over time.
Single Stock Futures
Agreements to buy or sell a specified number of shares of a specified stock on a specified future date.
Stock Index Futures
The securities underlying the stock index futures contracts are not actually deliverable, so settlement occurs through a cash payment.
Can be closed out before the settlement date by taking an offsetting position.
Valuing Stock Index Futures
Highly correlated with the value of the underlying stock index.
The underlying security tends to change by a much greater degree than the cost of carry, so changes in financial futures prices are primarily attributed to changes in the values of the underlying securities.
Test of Suitability of Stock Index Futures
Can be measured by the sensitivity of the portfolio’s performance to market movements over a period prior to taking a hedge position.
Speculating in Stock Index Futures
Can be traded to capitalize on expectations about general stock market movements.
Speculators who expect the market to perform well (poorly) before the settlement date may consider purchasing (selling) index futures.
Dynamic Asset Allocation with Stock Index Futures
Investors switch between risky and low-risk investment positions.
Stock index futures allow portfolio managers to alter their risk-return position without restructuring their existing portfolios.
Arbitrage with Stock Index Futures
Securities firms capitalize on discrepancies between prices of index futures and stocks.
Index arbitrage involves the buying or selling of stock index futures with a simultaneous opposite position in the stocks that the index comprises.
Market Risk
Refers to fluctuations in the value of the instrument because of market conditions.
Basis Risk
The risk that the position being hedged by the futures contracts is not affected in the same manner as the instrument underlying the futures contract.
Liquidity Risk
Refers to potential price distortions due to a lack of liquidity.
Credit Risk
The risk that a loss will occur because a counterparty defaults on the contract.
Exists for over-the-counter transactions in which a firm or individual relies on the creditworthiness of a counterparty.
Prepayment Risk
Refers to the possibility that the assets to be hedged may be prepaid earlier than their designated maturity.
Operational Risk
The risk of losses as a result of inadequate management or controls.
Systemic Risk
The intertwined relationships among firms may cause one trader’s financial problems to be passed on to other traders.
