Chapter 2 - Basic Features of Forward Agreements and Futures Contracts

Question 1

What is cash settlement?

Answer 1

A feature of certain types of futures
and option contracts that allow
delivery or exercise to be conducted
with an exchange of cash rather
than by delivery of a physical asset
in exchange for payment. Stock
index futures contracts are the most
predominant type of cash-settled
contract.

Question 2

What is a daily price limit?

Answer 2

In a futures contract, the maximum
amount the price is allowed to rise or
fall in one day.

Question 3

What is a delivery notice?

Answer 3

When a short futures position holder
wants to make delivery he/she notifies his/her broker who in turn tenders a delivery notice to the clearing corporation which then allocates the notice to a broker that has an account who is long that particular futures contract. Allocation by the clearing corporation and the broker is often done on a first-in first-out basis (FIFO).

Question 4

What is a delivery price?

Answer 4

The price that the purchaser of a
forward-based contract agrees to pay to the seller of the contract upon delivery.

Question 5

What is a first notice day?

Answer 5

The day that the futures contract
delivery process begins. Long position holders who maintain their positions on and after first notice day may have to accept delivery of the underlying asset from the seller of the contract.

Question 6

What is a long position?

Answer 6

For forward-based derivatives, the
party that agrees to buy the asset has
the long position in the contract. For
option-based derivatives, the party
that pays the premium has the long
position in the contract.

Question 7

What is maintenance margin?

Answer 7

The minimum balance for margin
required during the life of a futures
contract.

Question 8

What is margin?

Answer 8

An amount of money deposited by
both buyers and sellers of futures
contracts to ensure performance of the terms of the contract (the delivery or taking of delivery of the commodity or offset of the contract). Margin is not a payment of equity, merely a performance bond or good faith deposit.

Question 9

What is marking-to-market?

Answer 9

The process in a futures market in
which the daily price changes are paid by the parties incurring losses to the parties earning profits.

Question 10

What is an offsetting transaction?

Answer 10

A futures or option transaction that
is the exact opposite of a previously
established long or short position.

Question 11

What is original margin?

Answer 11

The required deposit when a futures
contract is entered into.

Question 12

What is the settlement price?

Answer 12

The settlement price is determined
at the end of each trading day by the
“Pit Committee” of the Exchange. The
price usually represents the average of futures prices for trades made toward the end of the day.

Question 13

What is a short position?

Answer 13

For forward-based derivatives, the
party that agrees to sell the asset has
the short position in the contract. For
option-based derivatives, the party
that receives the premium has the
short position in the contract.

Question 14

What is a warehouse receipt?

Answer 14

Even if an individual decides to take
delivery, what is received/delivered in
the case of most physical commodities is a warehouse receipt which the seller endorses over to the buyer. The receipt is issued by a storage point authorized by the exchange which confirms the presence and ownership of the
underlying asset.

Question 15

Discuss why forward markets were developed.

Answer 15

Forward markets were developed to help producers and consumers reduce or eliminate price uncertainty.

Question 16

Describe the similarities and differences between futures contracts and forward agreements.

Answer 16

All forward-based derivatives represent contracts between counterparties whereby one agrees to buy and one
agrees to sell an underlying asset at a predetermined future date at a price known as the delivery price.
The delivery price and the forward price are the same at the onset of the contract; therefore, a forward initially
has no value. It develops value as the forward price deviates from the delivery price agreed to in the forward
agreement.
Forward agreements…
- are tailored to the specific needs of the counterparties;
- have payoffs that occur only at the end of the contract;
- are not easily transferable because they are custom designed;
- have no third-party guarantor.
Futures contracts…
- are standardized by the exchange where they trade;
- have payoffs that occur on a daily basis (marking-to-market);
- are easily transferable because they are standardized;
- have a clearinghouse acting as a third-party guarantor.

Question 17

Calculate the value of a forward agreement at any point in time.

Answer 17

At any point in time, the value of a forward agreement is equal to the difference between the delivery price of
the forward agreement and the current price of a forward agreement with identical terms. This includes the
asset underlying the contract and the maturity date.
At maturity, this value is equal to the difference between the delivery price and the spot price of the underlying
asset because, at maturity, the current price of a forward agreement with identical terms (in this case,
immediate delivery) is the same as the spot price of the asset.

Question 18

Explain how delivery works.

Answer 18

For futures contracts that have a deliverable underlying interest (almost all commodity futures and some
financial futures), the window during which delivery can be made usually lasts from three weeks to one month.
The delivery process is initiated by the short futures holder who, at any time on or after first notice day, can
tender a delivery notice to the clearinghouse who in turn assigns it to a long futures holder. On delivery day, the
short delivers the underlying asset to the long in exchange for a certified cheque.
Some futures contracts call for cash settlement. When a cash-settled contract expires, an exchange of cash
is made between the long futures holder and the short futures holder. The amount of cash is based on each
individual participant’s entry price and the settlement price of the underlying interest. The most active cash-
settled contracts are stock index futures.

Question 19

Explain the concepts of offset, margin, leverage, marking-to-market, and trading limits.

Answer 19

• Offset
  Delivery is one way of settling the obligation of a futures contract. The other, more popular method is through
  an offsetting transaction. For those parties with long positions, the offset is accomplished by selling the same
  futures contract. For those parties with short positions, the offset is accomplished by buying the same futures
  contract. Once a position is offset, there is no obligation to make or take delivery.
• Margin
  A margin deposit, or performance bond, is required upon entry into a futures contract and is the same for both
  a long futures position and a short futures position. The amount of the deposit is known as original or initial
  margin. Maintenance margin refers to the minimum margin balance required in an account during the life of
  the contract.
• Leverage
  The amount of leverage is indicated by the size of the margin deposit relative to the full value of the
  underlying interest. Most futures contracts have initial margin requirements ranging from 3% to 10% of the
  full contract value. The use of leverage results in larger swings in a trader’s profit or loss for any given change
  in the price of the futures contract. This is why leverage is sometimes referred to as a double-edged sword. It
  should be clear that the degree of leverage any individual market participant takes on is his or her own choice.
  Leverage can be decreased by depositing more than the initial margin, and it can be avoided altogether by
  depositing the full value of the contract.
• Marking-to-market
  Marking-to-market is the daily transfer of funds from losing positions to winning positions based on the
  settlement price of the futures contract. If a losing position’s account falls under its maintenance margin level,
  the account must have funds deposited to restore the account back to the original margin level.
• Trading Limits
  Most, but not all, contracts have daily price limits on the amount by which prices can move, either up or down,
  during one day’s trading session. When these price limits are reached, trading does not necessarily stop.
  Trading can occur at the limit, below the upper limit (if the market has traded limit up), or above the lower
  limit (if the market has traded limit down).

Question 20

Calculate the profit or loss from a futures trade.

Answer 20

The profit or loss from a futures trade is calculated as the difference between the initial delivery price (also
known as the entry price) and the offsetting delivery price (also known as the offset price) multiplied by the
size of each contract and the number of contracts traded. It is recommended that the “buy” price be subtracted
from the “sell” price when calculating a profit or loss. This way, the “sign” (i.e., plus or minus) of the answer will
immediately inform you as to whether there has been a profit or a loss from the completed trade.

EXAMPLE…

If a trader buys 1 March S&P/TSX 60 Index futures contract ($200 × the index) at 1,080 and sells it one week
later at 1,090, the profit or loss will be calculated as follows:
(1,090 − 1,080) × $200 × 1 = + $2,000 = $2,000 profit

Question 21

Interpret a futures quotation page.

Answer 21

Refer to photo on phone.

Question 22

Why did forward markets develop?

Answer 22

Forward markets developed to help producers and consumers reduce or eliminate price uncertainty.

Question 23

Two counterparties enter into a 3-month forward contract on gold with a delivery price of $1,580 per ounce.

i. What is the contract worth to both the buyer and seller at onset?

ii. With one month remaining on the contract, the spot price of gold is $1,685 per ounce, and 1-month gold
forwards are trading at $1,687.50 per ounce. What is the value of the contract in dollars per ounce to the
long holder?

a. −$107.50
b. −$105
c. $105
d. $107.50

Answer 23

i. At onset, forward contracts have no value to either party.

ii. d. $107.50

The original 3-month forward is now a 1-month forward. The value of the long holder’s position in the
contract is equal to the current 1-month gold forward price ($1,687.50) minus the forward contract’s
delivery price ($1,580).

Question 24

An oil refining company that anticipates needing 1,000 barrels of crude oil in six months is concerned that
crude oil prices may change significantly in the interim.

i. Is the refiner concerned that prices might rise or fall?

ii. How would the company hedge its price risk using crude oil futures?

a. Go short enough crude oil futures to cover the entire purchase.
b. Go long enough crude oil futures to cover the entire purchase.
c. Go long or short depending on the company’s outlook for crude oil prices.
d. Any of the above.

iii. If the refiner entered into a 6-month crude oil futures contract (1,000 barrels of crude oil per contract)
at $76 per barrel, what profit or loss would result if the refiner offset the contract at $78 per barrel?

a. $2,000 loss.
b. $2 loss.
c. $2 profit.
d. $2,000 profit.

Answer 24

i. Since the refiner needs to buy crude oil in six months, it is concerned that the price of crude oil will rise.

ii. b. Go long enough crude oil futures to cover the entire purchase.

A long position will protect the company from a rising crude oil price. If the price of crude oil rises, the
futures should show a profit, which will help to reduce the cost of the crude oil in the cash market.

iii. d. $2,000 profit.

($78 − $76) × 1,000 barrels per contract × 1 contract

Question 25

Questions i) to iv) below are based on lumber futures, details of which are as follows:

Trading unit = 110,000 board feet,
Minimum tick size = $0.10 per 1,000 board feet = $11 per contract,
Daily price limit $30 per 1,000 board feet

i. In dollar terms, what is the value of one lumber futures contract given a price of $640 per 1,000 board
feet?

a. $704
b. $70,400
c. $140,800
d. $640,000

ii. Given a current price of $640, at what minimum price above $640 could the next trade occur?

a. $640.10
b. $641.10
c. $650.00
d. $650.10

iii. Given a previous-day settlement price of $640, what is the lowest price at which lumber can trade at
during the current session?

a. $609.90
b. $610.00
c. $610.90
d. $620.00

iv. A trader sells 10 lumber futures at $640. If the trader offsets the position at $620, what is the profit or loss
on the trade?

a. $22,000 loss.
b. $20,000 loss.
c. $20,000 profit.
d. $22,000 profit.

Answer 25

i. b. $70,400

(110,000 ÷ 1,000) × $640
Because the price quotes are “per 1,000 board feet,” we must divide the contract size by 1,000 before
multiplying by the price of the contract.

ii. a. $640.10

The minimum tick size is $0.10.

iii. b. $610.00

The lower limit of a futures price on any given day is the previous day’s settlement price minus the daily
price limit.

iv. d. $22,000 profit.

($640 − $620) × (110,000 ÷ 1,000) × 10 contracts

Question 26

A speculator buys 1 lumber futures contract at $630 and deposits original margin of $7,000.

i. What percentage of the value of the futures contract has the speculator deposited as margin?

a. Less than 2%
b. 4.9%
c. 7.6%
d. 10.1%

ii. If the speculator sells the lumber contract at $660, what is his return on the original margin deposit?

a. −42.8%
b. −47.1%
c. 47.1%
d. 285%

iii. If the speculator wants to earn a return on margin of 110%, at what price must the contract be sold?

a. $675
b. $685
c. $700
d. $710

Answer 26

i. d. 10.1%

$7,000 ÷ ($630 × 110,000 ÷ 1,000)
At a price of $630, the futures contract has a “value” of $69,300. A margin deposit of $7,000 represents
10.1% of this value.

ii. c. 47.1%

(($660 − $630) × (110,000 ÷ 1,000) × 1) ÷ $7,000 = 0.4714 = 47.1%
Calculate the dollar profit or loss first, then divide by the margin deposit.

iii. c. $700

$630 + ($7,700 ÷ (110,000 ÷ 1,000))
A 110% return on a margin deposit of $7,000 represents a $7,700 profit (1.1 × $7,000). To earn a $7,700
profit on one long lumber futures contract, the price must rise by $70 per 1,000 board feet [$7,700 ÷
(110,000 ÷ 1,000)] to $700 ($630 + $70).

Question 27

If there are currently 30 open long futures positions and 30 open short futures positions in a particular futures
contract, what is the open interest?

a. 15
b. 30
c. 60
d. 900

Answer 27

b. 30

Open interest is the total number of contracts outstanding at any point in time. Since there are always two
sides to a contract, open interest is calculated by summing either the open long positions or the open short
positions. Both methods have to produce the same result.

Question 28

A speculator sells 5 S&P/TSX 60 Index futures ($200 × the index) at 1,120. At expiration, the index settles at a
level of 1,110. What is the speculator’s profit or loss?

a. $10,000 profit.
b. $2,000 profit.
c. $2,000 loss.
d. $10,000 loss.

Answer 28

a. $10,000 profit.

(1,120 − 1,110) × $200 × 5

Question 29

A hedger sells 5 May coffee futures (37,500 lbs. per contract) at $1.20 per lb. If the hedger tenders a delivery
notice on a day when May coffee futures settle at $1.30 per lb., what is the amount of the certified cheque
that the hedger will receive from the assigned long futures holder upon delivery?

a. $18,750
b. $45,000
c. $225,000
d. $243,750

Answer 29

d. $243,750

$1.30 × 37,500 × 5

The amount of the certified cheque is determined by the settlement price on the day the delivery is
tendered.

Question 30

A speculator buys 1 November canola futures (20 tonnes per contract) at $420 per tonne. If the speculator
sells the contract and ends up with a profit of $400, at what price was the contract offset?

a. $400
b. $440
c. $460
d. $820

Answer 30

b. $440

$420 + ($400 ÷ 20)

Since the contract represents 20 tonnes of canola, the price of the futures must rise by $20 per tonne
($400 ÷ 20) to produce a profit of $400.

Question 31

If a short futures holder decides to make delivery, what information about the deliverable asset must be
conveyed to the clearinghouse?

Answer 31

Within what is allowed by the terms of each contract, the short futures holder who decides to make delivery
must inform the clearinghouse of the exact grade of the asset being delivered, the location of delivery, and the
timing of delivery. (Because most deliverable futures contracts allow delivery notices to be submitted on any
day within a predetermined time period, the short indicates the exact timing of delivery by choosing the date
to submit the delivery notice within this time period. The actual timing of the delivery is usually a fixed number
of days following submission of the delivery notice.)

Question 32

On the back of this card are your mathematical notes from this chapter.

Answer 32

The value of a forward agreement at any point in time = the difference between the delivery price of the forward agreement and the current price of the forward agreement; at maturity, the value of a forward agreement at any point in time = the difference between the delivery and spot price.

Leverage Ratio = Contract Value / Original Margin

The amount received by cheque on delivery day is determined by the settlement price.

Open Interest = the total number of longs OR shorts; i.e., if open interest is 44,000 there are 44,000 outstanding longs and 44,000 outstanding shorts for that futures contract because each contract has two sides to it (the long and the short)

To find the profit figure that would give an investor a 110% return on margin, simply multiply the margin by 1.1; for example, 7000 x 1.1 = 7700

Value of One Contract = Price Per Unit x Trading Unit

The trading unit is how many of the price per units you need to fulfill one contract size - i.e. lumber priced per 1000 board feet but you need 110,000 board feed to trade 1 contract so the trading unit is 110

Profit/Loss of a futures trade is calculated as the difference between the initial delivery price (entry price) and the offsetting delivery price (offset price) multiplied by the size of each contract and the number of contracts traded —-> TIP: SUBTRACT THE BUY PRICE FROM THE SELL PRICE

Think these questions through - most of it is pretty basic algebra!