Chapter 17: Futures Markets and Risk Management

Question 1

What is a futures contract?

Answer 1

An arrangement calling for future delivery of an asset at an agreed-upon price.

Question 2

What is a futures price?

Answer 2

The agreed-upon price to be paid on a futures contract at maturity.

Question 3

What is a long position?

Answer 3

The futures trader who commits to purchasing the asset (but will probably never purchase an asset).

Question 4

What is a short position?

Answer 4

The futures trader who commits to delivering the asset (but will probably never deliver an asset).

Question 5

What is the asset received at the end of a futures contract?

Answer 5

Although futures contracts are technically laying out the terms for delivery of an asset, delivery rarely occurs. Usually the parties to the contract close out the position and take gains and losses in cash.

Question 6

Who profits on futures?

Answer 6

The trader holding the long position (the willing purchaser) benefits when the price increases. Conversely, the short position loses on a price increase. Vice-versa is true when the price decreases.

Profit to long = spot price at maturity - original futures price
Profit to short = original futures price - spot price at maturity

Question 7

What is a single stock future?

Answer 7

A future contract on the shares of an individual company (listed on the electronic OneChicago market).

Question 8

What are some examples of futures contracts?

Answer 8

• Foreign Currencies (e.g. British pound, Canadian dollar, Japanese yen)
• Agricultural (e.g. corn, oats, soybeans, wheat, barley)
• Metals and Energy (e.g. copper, aluminium, gold, platinum, palladium)
• Interest Rate Futures (e.g. Eurodollars, Euroyen, Sterling, British gov’t bonds, Canadian gov’t bonds)
• Equity Indexes (e.g. Dow Jones Industrials, S&P Midcap 400, Titans 30)

Question 9

What is a clearinghouse?

Answer 9

Est. by exchanges to facilitate trading. The clearinghouse interposes itself as an intermediary between traders. The clearinghouse holds the middle position on the futures, selling for the long position holders and buying for the short position holders - the relationship is therefore only to the clearinghouse and not to one another.

Question 10

What are the benefits to a clearinghouse?

Answer 10

Traders can liquidate positions easily. You can easily reverse trade (switch from long-to-short or v.v.)

Question 11

What is the open interest on a futures contract?

Answer 11

It is the number of contracts outstanding. In this case, long and short positions are not counted separately, they are just a pair in one contract. When trading begins, open interest is zero, but increases as more contracts are entered.

Question 12

What is marking to market?

Answer 12

The daily settlement of obligations on futures positions.

Question 13

What is a maintenance margin?

Answer 13

An established value below which a trader’s margin may not fall. Reaching the maintenance margin triggers a margin call.

Question 14

What is a convergence property?

Answer 14

The convergence of futures prices and spot prices at the maturity of the futures contract.

Question 15

How are futures markets regulated?

Answer 15

In the US, by the federal Commodity Futures Trading Commission (CFTC). They set capital requirements, authorise trading in new contracts and oversee maintenance of daily trading records.

Question 16

How are pricing limits used on futures?

Answer 16

Typically an amount is set by which a future can change in a single day – this apparently prevents volatility, but in truth, they over no real protection against fluctuations. Price limits are often eliminated as contracts approach maturity (~30 days).

Question 17

How are futures taxed?

Answer 17

Tax gains and losses cannot be controlled, but typically 60% of gains or losses are treated as LT and the other 40% as ST.

Question 18

Why use a future rather than trading directly in the commodity?

Answer 18

Futures allow for far more leverage. Transaction costs are smaller, and traders are required to post considerably less margin than the value of the asset underlying the contract.

Question 19

What is basis?

Answer 19

The difference between the futures price and the spot price. On the maturity date of a contract, the basis must be zero; convergence property implies Fᵣ-Pᵣ=0.

Question 20

What is basis risk?

Answer 20

The risk attributable to uncertain movements in the spread between a futures price and a spot price.

Question 21

In futures, what is spread?

Answer 21

Taking a long position in a futures contract of one maturity and a short position in a contract of a different maturity, both on the same asset. Spread positions aim to exploit movements in relative prices rather than to profit from movement in the general level of prices.

Question 22

What is the spot-futures parity?

Answer 22

The notion that there should be a close relationship between the current price of an asset, and the futures price. This looks at the differences between the ‘spot’ strategy (buy the asset now) and the long futures position (invest money now to pay the futures price when the contract matures.

F₀/(1+r⒡)ᵀ = S₀ OR
F₀=S₀(1+r⒡)ᵀ