Chapter 4: Principles of Exchange-Traded Derivatives Flashcards
How is the price of a future derived?
Price of asset plus the cost of holding the position, e.g. financing
What is the Cost of Carry and what makes it up (4)?
Cost of holding the physical asset until expiry date
finance costs
security costs
storage costs
insurance
What is the fair value of a future?
cash price + cost of carry
If a future cost more than this, it would make more sense to purchase and hold the physical asset
How is the fair value of an equity index future calculated?
As other costs are negligible, only the net finance costs need to be considered
What is the formula for net finance costs for equity index futures?
interest - present value of dividends
How does the IASB define the fair value of a future?
The price at which it can be traded between two market participants at any given time
What is a contago?
A market where the net cost of carry to hold the asset to delivery are higher than cash prices
What is backwardation?
Markets where there is a net benefit to holding the asset to delivery, where futures prices are lower then cash prices
When is backwardation most common?
When long term interest rates are higher than short term rates
In commodity markets when there is high demand for immediate delivery
What is convergence in futures?
Cost of carry tends to zero as expiry approaches
This means that cash and futures prices eventually meet
What is basis & its formula?
Measure of the difference between cash and futures prices
Basis = cash price - futures price
What is the basis in contango markets?
Contango is where futures > cash
Thus negative
What is the basis in backwardation markets?
Cash > futures
Thus positive
How does basis differ towards expiry in contango vs backwardation markets?
In contango markets (eg, equity index), the basis strengthens towards
expiry.
In backwardation markets (eg, STIR and bond futures), the basis weakens towards expiry.
What should a trader do if they expect the basis to strengthen?
Buy near dated instrument
Sell far dated instrument
What should a trader do if they expect the basis to weaken?
Sell near dated instrument
Buy far dated instrument
How does the gap differ between contango and backwardation markets for a strengthening basis?
Contago - narrowing gap
Backwardation - widening gap
What is basis risk?
That a future will move differently to that of its underlying asset
What is the only way to eliminate basis risk?
Hold future till expiry, futures and cash prices will converge
What is a cash and carry arbitrage?
Where a future is trading above its fair value
Buy the underlying asset, sell the future