Investments Ch 14 Flashcards
DERIVATIVES INTRODUCTION
DERIVATIVES INTRODUCTION
- A derivative is a financial security whose value is derived from the
value of an underlying security or asset (e.g., coffee, oil). - Derivatives are contracts or agreements between two parties.
- A futures contract is an agreement between two parties to
buy or sell a security or a specific commodity (e.g., coffee or
lumber) of a specified quality at a future time, place, and unit
price. - A swap contract is an agreement between two parties to
exchange cash flows at regular intervals in the future.
THE FUTURES MARKET
THE FUTURES MARKET
- Commodity and other futures contract prices constantly change.
- The spot price is the price of a commodity or asset to be
delivered today. The spot price is also called the cash price. - A futures price is the price of the commodity or asset at some
time in the future. - The difference between the spot and futures price is known as
the basis.
FORWARD VS. FUTURES CONTRACT
FORWARD VS. FUTURES CONTRACT
- A forward contract is an agreement between two parties to buy or
sell a specific asset at a specified future time, which is agreed to
today. - Not standardized, are negotiated private agreements between
the parties - A futures contract is similar to a forward contract, but it has several
important differences. - Standardized agreement between two parties
- Trade on organized exchange
THE FUTURES MARKET
- A futures contract consists of one buyer and one seller, and the
contract specifies all details, including:
THE FUTURES MARKET
- A futures contract consists of one buyer and one seller, and the
contract specifies all details, including: - Time of delivery (usually specified by a delivery month)
- Place of delivery
- Quality and details of the commodity
- Unit price
FUTURES EXAMPLE
Beibei is a speculator in the futures market. He believes that coffee
prices will increase in the future. Beibei decides to buy a coffee futures contract, which has the following characteristics:
- Contract Size: 37,500 pounds
- Futures Price - 6 months: $1.2515 per pound
By entering into the contract, Beibei has agreed to buy 37,500 pounds of coffee at a price of $1.2515 six months from now
FUTURES EXAMPLE
Beibei is a speculator in the futures market. He believes that coffee
prices will increase in the future. Beibei decides to buy a coffee futures contract, which has the following characteristics:
- Contract Size: 37,500 pounds
- Futures Price - 6 months: $1.2515 per pound
By entering into the contract, Beibei has agreed to buy 37,500 pounds of coffee at a price of $1.2515 six months from now
FUTURES EXAMPLE AT MATURITY
Assume that the spot rate of coffee six months from now at maturity is $1.36.
Since Beibei has locked in a price of $1.2515, he has made a nice
profit.
He will pay $46,931.25 ($1.2515 x 37,500) and the coffee will be worth
$51,000 ($1.36 x 37,500). Beibei’s profit is $4,068.75.
If the spot had decreased to $1.20 per pound, Beibei would have a
loss of $1,931.25 ($1.2515 - $1.20 = $.0515 per pound).
CHARACTERISTICS OF FUTURES CONTRACTS
- Futures contracts, by definition, are standardized. These
agreements have specific/characteristics which include:
CHARACTERISTICS OF FUTURES CONTRACTS
- Futures contracts, by definition, are standardized. These
agreements have specific/characteristics which include: - Contract size
- Contract value (also called notional value)
- Price limits
- Margin requirements
- Mark-to-market
- Settlement price
- Margin call
FUTURES POSITION
FUTURES POSITION
- Investors can take long or short positions in futures contracts and
can be hedgers or speculators. - Purchasing a contract is termed a long position (take delivery).
- Selling a contract is called a short position (make delivery).
LEVERAGE COMPARISON
LEVERAGE COMPARISON
- Buy $500,000 of SPY (S&P 500 ETF). This investment has zero
leverage and requires $500,000 of capital. - Buy $500,000 of SPY (S&P 500 ETF) on margin. This investment
provides a 2-to-1 leverage. It controls the same asset as the first
choice but with only $250,000 of capital. - Take the long position in an S&P 500 Futures contract. This
investment provides more than 20 times leverage with only $23,000
of capital. It has approximately the same exposure to the S&P 500
index as the SPY ETF.
MARGIN TRADING
- Initial margin deposit:
- Maintenance margin:
MARGIN TRADING
- Initial margin deposit:
- An amount deposited with the broker
- Margin requirements range from 2% to 10% of the value of the
contract - Maintenance margin:
- The minimum amount of deposit required at all times
- Margin call occurs if value drops below allowed amount
- Mark-to-the-market - occurs daily, which is cash settlement based
on the price movement of the underlying asset
DAILY SETTLEMENT: EXAMPLE (1 OF 2)
On Monday morning, an investor takes a long position in a British
Pound futures contract that matures in three weeks. At the close of
trading on Monday, the account gains $200.
* At Tuesday close, the account has further gains of $100.
* At Wednesday close, the account loses $250.
* At Thursday close the account again falls, this time $900.
* At Friday close, the account loses $200.
* Initial Margin Requirement - $1,500
* Margin Maintenance - $1,000
DAILY SETTLEMENT: EXAMPLE (1 OF 2)
On Monday morning, an investor takes a long position in a British
Pound futures contract that matures in three weeks. At the close of
trading on Monday, the account gains $200.
* At Tuesday close, the account has further gains of $100.
* At Wednesday close, the account loses $250.
* At Thursday close the account again falls, this time $900.
* At Friday close, the account loses $200.
– Initial Margin Requirement - $1,500
– Margin Maintenance - $1,000
DAILY SETTLEMENT: EXAMPLE (2 OF 2
SETTLING FUTURES CONTRACTS
Cash Settlement
Offsetting Trade
SETTLING FUTURES CONTRACTS
Cash Settlement
* Some types of futures contracts, such as the S&P 500 contract, call
for cash settlement. It would be impractical to deliver the underlying
securities in the index.
Offsetting Trade
* An offsetting trade is completed by entering into a position that is
opposite of the currently held position.
TAXATION OF FUTURES CONTRACT
TAXATION OF FUTURES CONTRACT
- A futures contract is classified as an IRC Section 1256 contract.
- Sec. 1256 contracts include any regulated futures contract,
any foreign currency contract, any non-equity option contract,
any dealer equity option contract, and any dealer securities
futures contract. - Any gain or loss on a section 1256 contract is treated as:
—40% short-term capital gain or loss, and
—60% long-term capital gain or loss
SWAPS
SWAPS
- A swap is an over-the-counter agreement between two or more
parties to exchange future sets of cash flows. - The agreement specifies the dates of payments and the
methodology that is to be used to determine the payments. - The future payments may be fixed or floating based on changes in
interest rates, exchange rates, or other variables. - Common swap types include interest rate swaps, currency swaps,
and equity swaps
INTEREST RATE SWAPS
INTEREST RATE SWAPS
- Financial institutions use interest rate swaps to mange risk.
- Financial institutions must constantly manage interest rate risk due
to a mismatch in the maturity structure of assets and liabilities.
—Rate paid on deposits (short term) are variable
—Rates received on investments (long term) are fixed
NTEREST RATE SWAPS EXAMPLE
* Example: Suppose an investor agrees to pay the fixed rate and receive the floating rate on a $100 million notional amount. The fixed rate is 5% and the floating rate is SOFR + 200 basis points.
- In one year, SOFR is 6%, the payments are as follows:
- The investor pays $5 million (0.05 × $100 million)
- The investor receives $8 million (0.06 + 0.02) × $100 million
- These payments are netted, so the investor receives $2 million
- In two years, SOFR is 2%, the payments are as follows:
- The investor pays $5 million (0.05 × $100 million)
- The investor receives $4 million (0.02 + 0.02) × $100 million
- These payments are netted, so the investor pays $1 million
NTEREST RATE SWAPS EXAMPLE
* Example: Suppose an investor agrees to pay the fixed rate and receive the floating rate on a $100 million notional amount. The fixed rate is 5% and the floating rate is SOFR + 200 basis points.
- In one year, SOFR is 6%, the payments are as follows:
—The investor pays $5 million (0.05 × $100 million)
—The investor receives $8 million (0.06 + 0.02) × $100 million
—These payments are netted, so the investor receives $2 million - In two years, SOFR is 2%, the payments are as follows:
—The investor pays $5 million (0.05 × $100 million)
—The investor receives $4 million (0.02 + 0.02) × $100 million
—These payments are netted, so the investor pays $1 million
CURRENCY SWAPS
CURRENCY SWAPS
- Currency swaps involve the exchange of principal and interest
payments in one currency for principal and interest payments in
another currency. - The swap identifies the currencies as well as the principal amounts
in each currency. - The amounts are equivalent based on the exchange rate.
- In addition, the counterparties exchange the principal in each
currency at the effective date of the agreement and exchange the
principal back at the expiration of the agreement
The futures price of an asset is increased by:
higher cost of carrying.
Rationale
Carrying cost generally results in a relatively higher futures price compared to the spot price for a commodity.
Which of the following types of contracts are traded on exchanges in the United States?
Futures contracts.
Rationale
Executive contacts are generally employments contracts between corporations and executives. Forward contracts are negotiated agreements between two parties. Spot contracts are agreements to buy or sell at current prices. None of these contracts are traded on exchanges. Futures contracts are standardized agreements that are traded on exchanges.
Futures trading in the U.S. is regulated by:
The Commodity Futures Trading Commission (CFTC).
Rationale
The mission of the Commodity Futures Trading Commission (CFTC) is to foster open, transparent, competitive, and financially sound markets, to avoid systemic risk, and to protect the market users and their funds, consumers, and the public from fraud, manipulation, and abusive practices related to derivatives and other products that are subject to the Commodity Exchange Act. In carrying out this mission and to promote market integrity, the Commission polices the derivatives markets for various abuses and works to ensure the protection of customer funds. Further, the agency seeks to lower the risk of the futures and swaps markets to the economy and the public.
Which of the following is an advantage of interest rate swaps?
The ability to manage interest rate risk.
Rationale
An interest rate swap is an exchange of cash flows based on interest payments and is used to manage interest rate risk.
Elsie entered into a “forward contract” to sell 100 shares of MMN stock at a price of $9 per share in exactly nine months. Now, the nine-month period has expired. MMN stock is trading at $12 per share.
What are the economic consequences for Elsie?
She has lost $300.
She has lost $900.
She has gained $300.
She has gained $1,200.
She has lost $300.
Rationale
Elsie has lost $300 [($9 - $12) x 100 shares].
Which of the following is marked-to-market daily?
A fixed-rate loan.
A futures contract.
An option contract.
A forward contract.
A futures contract.
Rationale
Futures contracts are marked-to-market on a daily basis to help eliminate default risk.
Which of the following is NOT correct regarding derivative securities?
Derivatives can be used for speculation and hedging.
The use of leverage is both an advantage and a disadvantage of derivatives.
The value of a derivative is tied to the value of an underlying security or asset.
Most types of derivatives are suitable investments for unsophisticated investors.
Most types of derivatives are suitable investments for unsophisticated investors.
Rationale
The use of leverage exponentiates both gains and losses, which can be an advantage or a disadvantage. This exponentiation of gains and losses, along with their relative complexity, makes most types of derivatives unsuitable for small unsophisticated investors.
The financial institution that guarantees both sides of a futures contract is most likely known as a:
Clearing house.
Rationale
The clearing house is the institution that guarantees both sides of a futures contract.
An individual buyer and seller of lumber may enter into a customizable sales transaction that will occur nine months from today. This type of contract is typically called a:
Buy/Sell agreement.
Forward contract.
Lumber contract.
Sales contract.
Forward contract.
Rationale
A forward contract is a customizable contract to buy/sell a specified commodity in the future at a predetermined price.
Beau entered into a “forward contract” to buy 100 shares of ABC stock at a price of $8 per share in exactly nine months. Now, the nine-month period has expired. ABC stock is trading at $11 per share. What are the economic consequences for Beau?
He has lost $800.
He has gained $1,100.
He has lost $300.
He has gained $300
He has gained $300.
Rationale
Beau has gained $300 [($11 - $8) x 100 shares].
Which of the following is most accurate?
Speculators always take the “other” side of trades made by hedgers.
Limit orders can only be used to exit a market position.
Price move limits remain the same regardless of market conditions.
Mark-to-market settlement of futures positions is based on end of trading day or trading session prices.
Mark-to-market settlement of futures positions is based on end of trading day or trading session prices.
Rationale
Option a is incorrect because futures contracts are “anonymous” transactions cleared, therefore it is impossible for participants to know what kind of transaction (i.e. hedge, speculation, offset) is the counterparty to their trade.
Option b is incorrect because all order types can be utilized to enter or exit a market position.
Option c is incorrect because limits are set by the Exchange and help to regulate dramatic price swings. When a futures contract settles at its limit price, the limit may be expanded to facilitate transactions on the next trading day. This may help futures prices return to a more normal trading range.
A futures contract price is adjusted daily during the term of the contract, up or down, depending on current market conditions.
This adjustment is called:
SEC requirements for futures contracts.
Mark-to-market.
The “cheapest to deliver” option on a futures contract.
Initial margin requirements changing on a daily basis.
Mark-to-market.
Rationale
This is mark-to-market.
In order for Kylie to buy a coffee futures contract, she is required to deposit a certain amount of money. What are these funds called?
Mark-to-market.
Cheapest to deliver.
Initial margin.
Open interest.
Initial margin.
Rationale
The initial margin is the amount of money that is required of the buyer and seller to help ensure that traders meet their financial obligations under the futures contract.
A corn farmer who wants to hedge the price of corn should enter into what type of contract?
Buy a corn futures contract.
Sell a corn futures contract.
Long position in an option index.
Short position in an option index.
Sell a corn futures contract.
Rationale
A corn farmer would enter into a short (sell) futures contract because they wants to sell their corn.
The risk of unexpected change in the difference between currency futures prices and currency spot prices is called:
Basis risk.
Foreign currency risk.
Exchange rate risk.
Interest rate risk.
Basis risk.
Rationale
Basis reflects the relationship between the spot price and the futures price. It is found by subtracting the futures price from the cash price. Basis risk is the risk of unexpected changes in the futures and spot prices.
Which of the following factors are important when selecting a futures contract to trade?
Volatility.
Contract size (dollar value of the contract).
Liquidity.
All of the above.
All of the above.
Rationale
All of the factors are important in selecting a futures contract to trade
Which of the following regarding futures contracts is least accurate?
A futures contract is essentially a standardized and marketable forward contract.
Futures markets use a clearing house to mitigate default risk.
Futures contracts can be used to lock in the future selling price of a commodity regardless of future changes in spot market prices.
The basis in futures is similar to a basis point in bonds.
The basis in futures is similar to a basis point in bonds.
Rationale
A futures contract is essentially a standardized marketable forward contract traded on an exchange.
The clearing house helps to eliminate default risk for the parties to the futures contract.
Buying or selling a futures contract fixes the price at which a good is bought or sold, regardless of changes in the spot price.
Basis reflects the relationship between the spot price and the futures price. It is found by subtracting the futures price from the cash price.
Liquidity can be defined as the ability to transact quickly and efficiently without a substantial impact to the price of the underlying asset.
Which of the following transactions is the LEAST liquid?
Buying or selling an exchange-traded fund (ETF).
Buying or selling an E-mini S&P 500 futures contract.
Buying or selling a car.
Buying or selling a house.
Buying or selling a house.
Rationale
Buying and selling homes are very illiquid transactions. There are numerous factors for this, including substantial transaction costs (agent fees), difficulty in ascertaining an accurate market price and complications in verifying the capability of the buyer to complete the transaction.
All other transactions are more liquid.
If the S&P 500 index futures price is undervalued relative to the spot S&P 500 index price, an arbitrage exists if the investor were to:
Buy the S&P 500 futures.
Sell short all the stocks in the S&P 500 and buy call options on the S&P 500 index.
Sell short all the stocks in the S&P 500 and buy the S&P 500 index futures.
Sell the S&P 500 index futures and buy all the stocks in the S&P 500.
Sell short all the stocks in the S&P 500 and buy the S&P 500 index futures.
Rationale
On a relative basis, the S&P 500 index is overpriced and the S&P futures is underpriced.
Therefore, an investor should sell the index and buy the futures.
Which of the following best describes a futures contract?
The right to buy or sell a specified quantity of a particular asset during a given period at the spot price.
A standardized obligation to buy or sell a specified quantity of a particular asset during a given period for a given price.
An option to buy or sell a specified quantity of a particular asset during a given period for a given price.
A standardized obligation to buy or sell a particular asset in a specified quality at a future time, place, and unit price.
A standardized obligation to buy or sell a particular asset in a specified quality at a future time, place, and unit price.
Rationale
A futures contract is a standardized obligation to buy or sell a particular asset in a specified quality at a future time, place, and unit price.
Which of the following regarding margin requirements for futures contracts is least accurate?
Margin requirements for futures contracts are generally significantly lower than requirements for equities.
The maintenance margin is always smaller than the initial margin.
The maintenance margin is only required for sellers of futures contracts.
The initial margin is the money placed with the clearing house when the trade is initially executed.
The maintenance margin is only required for sellers of futures contracts.
Rationale
The maintenance margin is required for both buyers and sellers of future contracts.
The futures exchange specifies which of the following contract terms for futures contracts on commodities?
Option Quality Quantity Delivery Date Price
a √ √ √ √
b √ x √ x
c √ √ √ x
d x √ √ √
Option a.
Option b.
Option c.
Option d.
Option c.
Rationale
The futures exchange specifies all terms of the contract except price.
Swaps and forward contracts are negotiated directly by the counterparties to the agreement and are:
Spot contracts.
Without default risk.
Over-the-counter contracts.
Standardized agreements offered by an exchange.
Over-the-counter contracts.
Rationale
Swaps and forward contracts are traded in the over-the-counter market between private companies. They are not void of default risk.
Which of the following regarding basis is least accurate?
The basis is the difference between the spot price and the futures price.
The hedger bears the basis risk.
A short hedger suffers losses when the basis decreases.
The basis increases when the futures price increases by more than the spot price.
A short hedger suffers losses when the basis decreases.
Rationale
Losses to a short hedger occur when basis increases, not decreases.
Which of the following regarding futures contracts is least accurate?
Futures contracts are available for Treasury bonds.
Futures contracts are available for stock indexes.
Futures contracts are available for silver.
Futures contracts are available for common stocks.
futures contracts are available for common stocks.
Rationale
Futures contracts are not available for common stocks.
Bank 1 promises to pay Bank 2 a fixed rate of interest on a $20 million dollar principal amount. In exchange for this, Bank 2 promises to Bank 1 a floating rate of interest on the same $20 million dollar principal.
What is this called?
A call options contract.
A put option contract.
An interest rate swap.
A futures market transaction.
An interest rate swap.
Rationale
This is an example of a plain vanilla interest rate swap.
