Chapter 15- Commodities and Financial Futures

Question 1

Cash Market

Answer 1

• a market where a product or commodity changes hand s in exchange for a cash price paid when the transaction is completed
  - takes place on location, not an exchange

Question 2

Futures Market

Answer 2

• the organized market for the trading of futures contracts

Question 3

Futures Contract:

Answer 3

a commitment to deliver a certain amount of some specified item at some specified date in the future at a negotiated price

Question 4

Purpose of Futures Market-

Answer 4

• Price Discovery
• Risk Bearing/Sharing

Question 5

Futures Participants

Answer 5

• Speculators: 80 to 90% of them lose money
• Hedgers: Users of the product or producers of the product

Question 6

Futures Exchanges

Answer 6

• US exchanges use electronic trading and open cry auction”
  - futures are mostly electronic
  - options are mostly open outcry
• the exchange serves to guarantee the credibility of the parties involved

Question 7

Advantages of using a Futures Contract:

Answer 7

• potential for very high returns
• margin buying allows use of leverage ( the ability to obtain a given equity position at a reduced capital investment, thereby magnifying total return
• allows producers to hedge prices
  - don’t have to sell crops at harvest time when prices are often low

Question 8

Disadvantages of Futures Contract:

Answer 8

• high risk of losing more than the amount originally invested; no limit on exposure to loss

Question 9

Options vs. Futures Contract

(Options)

Answer 9

• right to buy
• strike price specified in option contract
• loss limited to price paid for option

Question 10

Options vs. Futures Contract

(Futures)`

Answer 10

Obligation to buy
Delivery price set by supply and demand
No limit on potential loss

Question 11

Trading Mechanics:

Answer 11

• bought and sold through brokerage offices
• same types of orders are used as stocks
  - market
  - limit
• long position- buying a contract
  - investor wants contract price to go up
• short position- selling a contract
  - investor wants contract price to go down
• long and short positions can be liquidated by executing and offsetting transaction
  - about 1-4% of futures contracts are settled

Question 12

Margin Trading:

Answer 12

• all futures contracts are traded on margin
• initial margin deposit is the
  amount deposited with broker at time of commodity transaction to cover any loss in market value of futures contract due to price movements- usually $10- 20,000 to open an account
  - margin requirements range from 2- 10%
• maintenance deposit
  - minimum amount of deposit requires at all times
  - margin call occurs if value drops below allowed amount
• mark- to- the- market occurs daily

Question 13

Factors in commodity price behavior

Answer 13

• weather and crop forecasts
• economic factors
• Political factors
• international pressures

Question 14

Components of a Commodities Contract

Answer 14

• the product
• the exchange
• size of the contract
• pricing units
• the delivery months

Question 15

Factors in Commodity Price Behavior

Answer 15

Weather and crop forecasts
Economic factors
Political factors
International pressures

Question 16

Commodity Price Behavior

Answer 16

• Because of leverage, small unit price changes can cause large total dollar changes in contract price
• To protect investors, daily price change limits are set:

Daily price limit: restriction on the day-to-day change in price

Maximum daily price range: the amount a commodity price can change during the day; usually equal to twice the daily price limit

Question 17

Financial Futures:

Answer 17

future contract in which the commodity is a financial asset, such as debt securities, foreign currencies or market baskets of common stocks

• often used by large institutional investors to hedge specific types of risk:
  - offset interest rate risk on debt instruments
  - minimize foreign currency rate risk on overseas business transactions
  - minimize market risk on common stock investments

Question 18

Speculating in Financial Futures

Answer 18

• leverage can provide high returns (or losses) enhances chance of return.
• “long” positions are used if investor speculates values will go up
• “short” positions are used if investor speculates values will go down

Question 19

Hedging with Financial Futures

Answer 19

• Effective Way of protecting stock or other securities holdings in a declining market
• stock-index futures used to hedge stock portfolios
• interest rate futures used to hedge bond portfolios
• foreign currency futures used to hedge significant exposure to foreign exchange rate risk

Question 20

Penny Stocks:

Answer 20

Trade at or under $5 a share

• less than $4 million in net tangible assets
• some are “legit”
• shell companies that do not provide a lot of information about what they do