Futures Markets

Question 1

What are futures markets?

Answer 1

Where futures contracts are traded.
Futures contracts= agreement between buyer and seller that an asset will be bought/sold for an agreed price on a set day in the future

Question 2

What are the functions of the futures exchange?

Answer 2

• central place for large amounts of buyers and sellers
• enforce trading rules and standards
• settle disputes

Question 3

Who are the participants in futures markets?

Answer 3

Traders- buy and sell contracts for themselves

Brokers- take customer orders

Question 4

Who are hedgers?

Answer 4

Derivative users who seek to reduce risks. They lock in favourable contract prices as an insurance policy for their business.

Question 5

Who are speculators?

Answer 5

Derivative users who seek to profit from price changes. Their activity helps provide liquidity to the market. Their only purpose is to make profits from the market

Question 6

Who are arbitrageurs?

Answer 6

Derivative users who seek to exploit price differences on the same instrument or similar assets.

Question 7

What are derivatives?

Answer 7

A large number of financial instruments whose value is based on the prices of securities, commodities, money or other external variables. They are contracts which give the right to buy or sell a quantity of the underlying.

Question 8

What is an options derivative?

Answer 8

Contracts that allow the buyer the right, not the obligation, to buy/sell the asset at an agreed price on a certain date

Question 9

What is a forwards derivative?

Answer 9

Buy or sell assets at a specified price on a future date. They are non-standardised so allow for hedging. They are customised so can be any commodity, amount and timer period. Over the counter.

Question 10

What is a futures derivative?

Answer 10

A deal between 2 investors to buy or sell a standardised quantity and quality of a commodity at a predetermined place and time in the future. Exchange trade based instruments on a regulated exchange. A clearing house is the formal counter party.

Question 11

What are over the counter derivatives?

Answer 11

Contracts that are traded directly between 2 parties without going through an exchange.

Question 12

What are the advantages and disadvantages of over the counter derivatives?

Answer 12

Advantages
-Contracts are tailor made
-can arrange deals without a specific margin or deposit
Disadvantages
-risk that the counterparty wont honour the transaction
-may take a long time
-difficult to reverse

Question 13

What are exchange traded derivatives?

Answer 13

Contracts that are standardised like futures and options contracts that are transacted on an organised exchange

Question 14

What are the advantages and disadvantages of exchange traded derivatives?

Answer 14

Advantages
-counterparty risk is reduced
-high regulation
-positions can be reversed
Disadvantages 
-standardisation can be restrictive

Question 15

What is a margin in the trading futures?

Answer 15

For a new trade traders must deposit money called a margin which acts as a deposit.
If the equity in the traders account falls below the maintenance margin level (minimum amount required at all times) then there is a margin call and the trader must deposit enough to reach the initial margin again.

Question 16

What is meant by a long position?

Answer 16

Long position is the term to buy. To be long means you’re trying to protect the purchase price of the commodity that you plan to obtain from raising prices

Question 17

What is meant by a short position?

Answer 17

Short position is the term to sell. To be short means you’re trying to protect the commodity in your possession from falling prices.

Question 18

What is contago?

Answer 18

A situation where the futures price of a commodity is above the expected spot price . The nearby price is lower than the distant contract price so prices increase into the future

Question 19

What is backwardation?

Answer 19

When the futures price of a commodity is below the expected spot price. The nearby price is higher than the distant contract prices so prices decrease into the future

Question 20

What terms are agreed in futures contracts?

Answer 20

• Quality (for contracts of commodity products)
• Delivery date (when the contract must be completed)
• Price limits (smallest allowable price movement)
• Position limits (limit on the number of contracts a speculator may hold for a particular delivery month)
• Settlement (when settlement must occur)

Question 21

What are call options?

Answer 21

Give the buyer the right to buy an underlying security at the strike price. An option writer who sells a call option believes the underlying stock price won’t exceed the option’s strike price

Question 22

What are put options?

Answer 22

Give the buyer the right to sell at the strike price. They want the stock price to go down. The put option writer believes the underlying stock’s price wont go below the strike price.

Question 23

What is meant by ‘the underlying’?

Answer 23

The underlying can be almost anything that is actively traded in a market where the current price is continuously available and indisputable. For example:

• equity options
• index options
• bond options
• commodity options
• currency options

Question 24

What are the benefits of trading options?

Answer 24

• Risk management
• Hedging= option contract can be used to reduce or eliminate the risk of an asset losing value
• Leveraged speculation= a given amount of money can be used to make a greater bet on the price of the underlying
• Arbitrage= seek profit from discrepancies in prices in different markets
• Income= large investors write options for income

Question 25

What is a swap?

Answer 25

A derivative contract through which 2 parties exchange financial instruments.

• interest rate swaps
• commodity swaps
• currency swaps
• debt-equity swaps
• credit default swaps

Question 26

What is a warrant?

Answer 26

Derivative that gives the right but not the obligation to buy or sell a share at a certain price before expiration