Chapter 24 - Derivatives: Futures, Forwards and Options

Question 1

Derivatives

Answer 1

Financial instrument designed to manage risk (hedging)

Question 2

Hedging

Answer 2

Engaging in a financial transaction that reduces or eliminates risk

Question 3

Hedging positions (2)

Answer 3

1. Long position: profit increases when price increases (buying or owning an asset). You are long = risk of price going down.
2. Short position: profit increases when price decreases (item is a production input of your business). You are short = risk of price going up

You hedge a long position by entering a short one (vice versa)

Question 4

Forward contract

Answer 4

An agreement to enter a transaction at some future date, agreeing on date, price, etc. so it eliminates future price uncertainty

Question 5

Zero-sum game

Answer 5

For every winner, there’s a loser, but ex-ante it reduces risk for both

Question 6

Forwards: selling profits

Answer 6

Selling a forward contract opens a short position, which is more valuable the lower the spot price in the future.

Pshort=F-St

Question 7

Forwards: buying profits

Answer 7

Buying a forward contract opens a long position, more valuable the higher the spot price in the future

Plong= St-F

Question 8

Forwards: pros (1) & cons (2)

Answer 8

Pro: not standardized, flexible
Con:
1. Hard to find counter party: lack of liquidity/depth in secondary market
2. Subject to default risk of the counterparts. Traded OTC

Question 9

Future contract

Answer 9

Exchange traded contracts that specify an agreement to exchange an asset at a future date at a price specified today.

Question 10

Future standardize what? (3)

Answer 10

Futures standardize: contract size, delivery date, quality

Question 11

What does future standardization overcome?

Answer 11

Standardization overcomes the problem of mark t liquidity that forwards have

Question 12

Delivery of futures

Answer 12

The delivery almost never happens. You can close your position with another offsetting position
E.g. if you’re long, you can enter a short position

Question 13

Future prices

Answer 13

Future prices will converge to the spot price at the delivery date

FT=ST - because otherwise there is an arbitrage position

Question 14

Payoffs in futures (2)

Answer 14

1. Long side
   Ft-Fo
2. Short side
   Fo-Ft

Fo (received) Ft (buying)

Question 15

What happens with payoff if contract is kept until delivery for futures?

Answer 15

Ft=FT=ST