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Derivatives > Lecture 2_Futures > Flashcards

Lecture 2_Futures Flashcards

1
Q

What is the difference between stop order and limit order?

A
  1. Limit order = reservation - (Good case, I want to capture the best opportunity; the price is $50, I want to buy at a lower price - set limit order as $45)
  2. Stop order = stop loss - (Bad case, I want to buy the stock, but I am afraid that it will just go up and I will miss the opportunity. You stop the loss, and say that if it goes to $55, I will buy it.)

Stop price in a stop order triggers the market order. Not guaranteed at the stop price.

Limit order is not guaranteed to execute, if the price is too high/low

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2
Q

What is treasury bond futures quotes in?

A

1/32 $

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3
Q

What is the time of delivery for future contracts?

A

The month of delivery instead of the point in time

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4
Q

What is the settlement at delivery date for futures?

A

Usually settlement in underlying assets

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5
Q

What are the exceptions for settlements of future contracts?

A

Stock indices and Eurodollar bonds are settled in cash

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6
Q

How to think about future contracts?

A

Delayed purchase of products at a fixed price

i. e. purchase a MacBook at 1299 in 3 months; this contract give you that guarantee. In 3 months, you need to pay $1299 and they will deliver the MacBook.
i. e. future contract of Japanes Yen in March - I can buy Japanes Yen at 0.978. I need to pay $0.978 in the future to buy Japanes Yen.

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7
Q

What should be the relationship between spot and future in theory?

A

Future rate should converge to spot rate in theory - otherwise arbitrage opportunities can close up the gap.

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8
Q

What mechanisms are used in a speculative market like the futures?

A

Margin account: a certain amount of money that you set aside, where brokers can take your money away when you lose money; or add when you earn money.

Initial margin (how much you need to set aside initially) and maintenance margin (you are allowed to lose some money, but not too much).

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9
Q

What is trading on margin?

A

Essentially, you are borrowing money from the broker to trade. If put $100 in the margin account, you can buy $200 worth of stocks. You double your return/loss.

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10
Q

What are the two numbers for the margin account of a future contract?

A
  1. Initial margin - (initial deposit)

2. Maintenance margin - (the minimum amount in the margin account)

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11
Q

What would happen if the value of the margin account drops below the maintenance margin?

A

You will get a margin call

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12
Q

What are some occasions when you want to hedge with futures?

A
  1. Long hedge
  2. Short hedge
  3. Basis risk
  4. Optimal number of future contracts
  5. Hedging portfolio of stocks
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13
Q

How to do a long hedge with futures?

A
  1. Buy the security at spot rate in the future (S)
  2. Buy the future contract (F)
  3. Sell the security at future spot rate (S)

payoff = S + (F - S) = F

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14
Q

What is a perfect hedge?

A

When the gain/loss in the hedge completely offsets the loss/gain in the spot rate

payoff = S2 + F1 - F2; it is a perfect hedge if S2=F2: you can resell at the same price as you bought it

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15
Q

What is the basis risk?

A

When there is no perfect hedge, the risk is called basis risk.

The difference between S2 and F2: The price you need to buy/sell and the hedging price you sell/buy

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16
Q

What might cause the existence of basis risk?

A
  1. Mismatch of maturity of the contract and the payment date
  2. Future contracts may not be available (cross hedge)
  3. Uncertainty about the CF of the contracts that we are trying to hedge
17
Q

What is cross hedge?

A

Use assets that are close to what we are trying to hedge

18
Q

What do the notations mean? S1, S2, F1, F2

A

S is the spot rate of the asset; F is the price of the hedging instruments;
1 represents the price that is known now; 2 represents the price that is known in the future

19
Q

What is the rule if there is a basis risk? How do you choose the future contracts?

A
  1. Choose the future contracts that are highly correlated with the underlying assets
  2. Choose the maturity date that is later than the delivery date
20
Q

What is an example of an imperfect hedge?

A
  1. Receive yen in May, maturity of the contract is June.
  2. Sell at the spot rate - 2
  3. Sell at the future rate - 1
  4. Buy at the future rate - 2

Because of the mismatching, you cannot get the real product with the future contract, thus in step 4, you cannot buy/sell at the spot rate - 2.

21
Q

What is the logic behind calculating the optimal number of futures contracts?

A
  1. With perfect hedge, because the correlation is 1, you completely cover the exposed assets
  2. With imperfect hedge, because of the correlation is not 1, you need to minimize the variance/the risks
  3. Write out the payoff of the portfolio if hedged - change in price X quantity of spot is the same as the future
  4. Write out the change in the portfolio in terms of spot and future contracts; substitute h (you should get a equation with S, F, and h)
  5. Write out the variance equation - minimize the variance equation over h
22
Q

What is h?

A

h is the variance minimizing hedge ratio

The higher the h, the more future contracts are required.

Number of contracts = hedge ratio * number of spot / number of future

23
Q

What does higher hedge ratio indicate?

A

h is the beta when running the regression of spot (y) over future (x)

24
Q

How to use futures on stock index to hedge a portfolio of stocks?

A
  1. Write out the CAPM for the portfolio; write out the CAPM for the hedging stock index
  2. Write out the return of the whole portfolio including the hedges, with the return, and quantities
  3. Rearrange the formula to isolate market risk premium
  4. Set the beta equal to 0, to get rid of the market risk premium
25
Q

How to change the beta of the portfolio?

A
  1. Similar logic

Decrease beta, short future contracts (beta - beta’)*Va/Vf

increase beta, buy future contracts (beta’ - beta)*Va/Vf

This makes sense - by shorting the stock indices, you are offsetting the systematic risks that you are exposed to earlier.

Derivatives (3 decks)

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