FMP7 - Futures Markets

Question 1

Define and describe the key features and specifications of a futures contract, including the underlying asset, the contract price and size, trading volume, open interest, delivery, and limits

Answer 1

• Underlying asset: what is being traded
• Contract size: value of the contract
• Delivery: location and time of delivery of the contract
• Limits: exchanges define how much a price can change in one day
• Open interest: number of contracts in existence

Question 2

Explain the convergence of futures and spot prices

Answer 2

As time approaches delivery period, futures rate converges to spot rate, arbitrage by shorting futures if futures > spot at delivery

Question 3

Describe the role of an exchange in futures transactions

Answer 3

Works as a CCP

Question 4

Explain the differences between a normal and inverted market

Answer 4

Normal market when futures price increases with time to maturity, inverted market when futures decreases with time to maturity increasing

Question 5

Describe the mechanics of the delivery process and contrast it with cash settlement

Answer 5

As future gets towards delivery, short positions notify CCP how much and at what grade will be delivered. CCP notifies long position they will take delivery.

Question 6

Describe and compare different trading order types

Answer 6

• Market orders execute as quickly as possible for the best available price
• Limit orders execute at specified or more favourable price to the trader
• Stop-loss orders become market orders when asset reaches specified or less favourable price
• Stop-limit orders become limit orders when stop price is reached
• Market-if-touched becomes a market order if stop price is reached

Question 7

Describe the application of marking to market and hedge accounting for futures

Answer 7

Generally profit and loss accounted for at the end of each year, certain circumstances allow contracts to qualify for hedge accounting, where profit and loss all count in the final year of accounting in the contract

Question 8

Compare and contrast forward and futures contracts

Answer 8

Forwards tend to be on foreign exchange rates, futures on more range. Forward is OTC and subject to more credit risk, futures are exchanges.