Futures Contracts Flashcards
What are the market participants and what do they do?
Hedgers - Hedgers use futures markets for protection against negative price movements.
Speculators – aim to make money from higher or lower prices by taking a view of future price direction.
Arbitrage traders – profit from mispriced instruments by entering and executing a trade.
Define: Futures market
a place where market participants
(buyers and sellers) meet to determine the future price of something (underlying asset) today.
Define: Futures contract
Instruments which give the holder the opportunity to buy/sell a particular commodity or financial instrument at a predetermined price in the future
How are future contracts used?
Used to fix the value of a commodity or financial instrument for the future.
List: Two basic futures positions
Long futures position
Short futures position
Explain: Long futures position
Buying a futures contract
This will lead to a long position in the market as well
Side note: Hedge against an INCREASE in the price of the underlying
What does it mean when a long futures position is in-the-money?
when the underlying spot price price (S) > contract strike price (X) (receives margin)
What does it mean when a long futures position is out-of-the-money?
when the underlying spot price price (S) < contract strike price (X) (pays margin)
What does it mean when a long futures position is at-the-money?
when the underlying spot price price (S) = contract strike price (X) (neutral)
Explain: Short futures position
Selling short a futures contract
This will lead to a short position in the market as well
Side note: Hedge against a DECREASE in the price of the underlying
What does it mean when a short futures position is in-the-money?
when the underlying spot price price (S) < contract strike price (X) (receives margin)
What does it mean when a short futures position is out-of-the-money?
when the underlying spot price price (S) > contract strike price (X) (pays margin)
What does it mean when a short futures position is at-the-money?
when the underlying spot price price (S) = contract strike price (X) (neutral)
List: The two ways to execute a futures contract
Offsetting
Making or taking delivery of the underlying instrument (mostly for agricultural commodities)
Explain: Offsetting
entering into an opposite position of what you have
(same expiry month, same underlying instrument)
How to close a long futures position?
sell a long futures contract
How to close a short futures position?
buy back a short futures contract
Define: In-the-money
(a) a call option where the asset price is greater than the strike price
(b) a put option where the asset price is less than the strike price.
Define: Out-of-the-money
(a) a call option where the asset price is less than the
strike price
(b) a put option where the asset price is greater than the strike price.
Define: At-the-money
Where the underlying spot price is equal to the contract strike price (neutral)
Define: Spot price
The price for immediate delivery.
Define: Strike price (exercise price)
The price at which the asset may be bought or sold in an option contract.
Define: Contango
is the market condition wherein the price of a
forward or futures contract is trading above the expected spot price at contract maturity – Normal market conditions
Define: Backwardation
is the market condition wherein the price of a
forward or futures contract is trading below the expected spot price at contract maturity – NOT normal market conditions
Define: Initial margin
The amount that must be deposited at the time the contract is entered into
Define: Variation margin
An extra margin required to bring the balance in a margin account up to the initial margin when there is a margin call.
What happens when the delivery period for a futures contract approaches?
the futures price converges to the spot price of the underlying asset
What happens when the delivery period for a futures contract is reached?
the futures price equals or is very close to the spot price
Why is the futures price equals or is very close to the spot price when the delivery period is reached?
the carry cost is reduced over time, causing the
market to “arbitrage” the difference between the futures price and the spot price
Explain: Cash settlement
The movement on the underlying is payable in cash
Explain: Physical settlement
The physical underlying asset is exchanged
Define: Futures prices (X)
is the price at which you agree to buy or sell
How is the futures prices determined?
It is determined by supply and demand of the underlying in the same way as a spot price
Define: Hedging
is the process where we reduce or offset the probability of loss from fluctuations in the prices of commodities, currencies, or securities.
Define: Hedge ratio
The ratio of the size of a position in a hedging instrument to the size of the position being hedged.
What are the uses of hedging?
it can be used in protecting one’s capital against effects of inflation through investing in high-yield financial instruments, real estate, or precious metals.
Define: Hedge effectiveness
the proportion of the variance that is eliminated by hedging
What are we seeking to get with the hedge effectiveness?
seeking a 100% hedge or as close as possible
What is h*?
optimal hedge ratio
What is h* called when it comes to shares?
Beta
What does beta (h*) measure?
measures sensitivity of a share in relation to the market
What is the correlation between a portfolio and the market?
+1 (tracker fund)
What is the beta value (h*) for an all share index (ALSI)?
1
Define: Basis risk
the uncertainty as to the difference between the spot price and the futures price
When are we exposed to basis risk?
When using different futures contracts to hedge other assets
Profit or loss:When is profit or loss made?
When the position is closed
Profit or loss: When will the money in the variation account translate into a profit or loss?
The money in the variation margin account will translate into a profit/loss when the position is closed out
Rolling positions: When can profit or loss be made?
The profit/loss can only be made on current open positions (long or short)
Rolling positions: When does the profit or loss position resets?
Once the position is “rolled” to a following contract month, the P/L position resets and will be calculated on the new contract month
Buying or selling the spread: List the two types of spreads
Calendar spreads
Inter-commodity spreads
Buying or selling the spread: Explain calendar spreads
The difference between two contract months
Buying or selling the spread: Explain inter-commodity spreads
The difference between two different
commodities/assets
Buying or selling the spread: How do you choose the positions of two assets (A & B) when buying the spread?
a long position is taken in asset A while a short position is taken in asset B
