Financial Derivatives: Forwards & Futures

Question 1

From what underlying assets is value derived?

Answer 1

• shares
• currencies
• precious metals
• agricultural products

Question 2

What are financial derivatives?

Answer 2

• an agreement or right to buy or sell something for a pre-set price within a specified period of time
• derive their value from other underlying assets

Question 3

What are the types of derivatives?

Answer 3

1. forward contracts
2. futures (standardized forward contracts)
3. options (right to buy or sell something)
4. swaps

Question 4

What is a forward contract?

Answer 4

• one party agrees to buy, another agrees to sell
• price agreed today (F = forward rate)
• agreed price will not change when actual price (S = spot rate) changes
• entering in a forward contract results in an obligation

Question 5

When are forward contracts most commonly used?

Answer 5

very common in commodities as they can be tailor-made to fit your needs

Question 6

What is a forward contract long hedge?

Answer 6

Protection from price appreciation
- I am buying something and I don’t want it to be more expensive

Question 7

What is a forward contract short hedge?

Answer 7

Protection from price depreciation
- I am selling something so I want to make as much money as possible

Question 8

How are forward contracts tailor-made

Answer 8

• they are often made via an intermediary through “over the counter” sale
• the bank matches various buy and sell positions
• the contract is tailor-made between two parties to fit their needs
• therefore the contract is non-transferable

Question 9

How can you speculate with a forward contract?

Answer 9

You can use a forward contract to speculate when you have no position in the underlying asset

Question 10

What are futures contracts?

Answer 10

Standardized forward contracts
- standard maturities
- standard size/quantities
- tradable on an exchange

Question 11

How is delivery and payment organized in futures contracts?

Answer 11

• in the future at a realized spot price
• in the meantime it is marked-to-market (settled daily)

Question 12

When are futures contracts commonly used?

Answer 12

For commodities and agricultural produce

Question 13

What is the biggest futures market?

Answer 13

Chicago Mercantile Exchange

Question 14

How are futures marked to market?

Answer 14

Price fluctuations are settled every day via an account at the exchange.
- traders deposit a margin in the account

Question 15

Why are futures marked-to-market?

Answer 15

• to ensure both parties honor the contract
• to minimize risk of default

Question 16

What is clearing?

Answer 16

Clearing means settling contracts

Question 17

What are the futures safe guards?

Answer 17

• margin deposited by traders
• margin call - demand to deposit (additional) margin
• margin increases with contract size and price volatility of underlying assets
• defaults in futures contracts are extremely rare