Lesson 4.3: Futures and Forwards

Question 1

In May, an investor purchased a futures contract to purchase 5,000 bushels of wheat at $4.30 per bushel for December delivery. On settlement date, the spot price of wheat is $4.20 per bushel. For the investor, this:

Answer 1

represents a loss of $500

Unlike options, both parties to a futures contract are obligated to perform. That is, the buyer must accept delivery of the contract (in this case, 5,000 bushels of wheat). In practical matters, instead of having a truck show up at the door, the wheat would be sold at its spot price to a user. Therefore, the investor would lose 10 cents per bushel, which on 5,000 bushels is $500. It was the seller of the contract who had a successful hedge because, instead of having to sell at the $4.20 spot price, the wheat is sold at the strike price of $4.30.

Question 2

One way in which futures contracts differ from options contracts is that:

Answer 2

both parties are obligated on futures contracts whereas only the seller is obligated on an options contract.

Unlike options contracts, where only the seller of the option is obligated to perform (if the option is exercised), both parties to a futures contract are obligated to fulfill the terms.

Question 3

The long party in a futures contract has entered the contract as:

Answer 3

a buyer

Long is the industry term describing the buyer of a futures contract. The long is committed to buying the underlying asset at the pre-agreed-upon price on the specified future date.

Short is the industry term describing the seller of the futures contract. The short is committed to delivering the underlying asset in exchange for the pre-agreed-upon price on the specified future date. Market maker is a term used for securities, not futures, and liquidity provider is a concept that is not tested (as is the case with many incorrect answer choices).

Question 4

Forward contracts

Answer 4

are a one-to-one investment where the buyer and seller set the terms of the deal. Lack of standardization makes exchange trading forward contracts an impossibility.

Question 5

In contrast with a typical forwards contract, futures contracts have

Answer 5

standardized terms

Futures are contracts that trade on exchanges and have standardized terms, in contrast with forwards contracts, which are customized instruments. A futures clearinghouse reduces counterparty risk by guaranteeing the performance of buyers and sellers. Because futures contracts trade on organized exchanges and have standardized terms, they are more liquid than forwards contracts.

Question 6

A speculator, believing that a drought in the Midwest will lead to a weak corn crop, would probably:

Answer 6

take a long position in corn futures

A weak corn crop means a shortage in the supply. That will lead to an increase in prices. When one is speculating that prices will go up, the best position is a long one. So, why not the long forwards? Those who purchase forward contracts anticipate accepting delivery of the asset. This individual is merely speculating and has no interest in taking physical possession of the commodity and paying for transportation, silage, and insurance until the commodity is sold. If the person in the question had been a user of corn (a cereal maker, for example), then the forward contract would have been a better choice.

Question 7

News reports indicate that the wheat crop scheduled to be harvested in three months will be much larger than normal. To hedge, a wheat farmer would most likely:

Answer 7

take a short position in wheat futures

A bumper crop means lower prices for the producers (farmers). The appropriate protection is a short hedge—selling wheat futures. Think of it this way: if you thought a stock’s price was going to decline, you would sell that stock short. Here, believing that wheat prices will decline, you take a short position in that commodity futures contract. There is no such thing as wheat stock, and the wheat has already been planted; it is too late to switch crops.

Question 8

Nonsecurities derivatives include futures and forwards. Among the differences between futures and forwards is that futures contracts:

Answer 8

are rarely exercised, while forwards generally are

In the vast majority of the cases, futures contracts are closed out prior to expiration. That is one reason they are more popular with speculators than forwards. Because forwards are generally delivered, they are the preferred tool by producers, and it is futures that are standardized and CFTC regulates, not forwards.

Question 9

All of the following statements regarding futures contracts are correct:

Answer 9

A) a short position will increase in value if the underlying commodity or asset declines in value.
B) purchasing a contract for future delivery is considered taking a long position.
C) futures contracts can be written on financial assets or commodities.

In almost all cases, the holder of the futures contract will purchase an offsetting contract canceling the original position or sell the contract prior to expiration.

In isolated cases, delivery of the commodity may be made but is not required. Futures contracts can be written on financial assets such as currencies and stock indexes, as well as on commodities such as agricultural products or precious metals. As with anyone taking a short position, the value goes up when the price of the underlying asset declines. And, just as purchasing a stock or bond, a long position represents one of ownership.

Question 10

Which has no active secondary market?

Answer 10

Forward contracts

One of the disadvantages when investing in forward contracts is that there is no active secondary market. Because each contract is between one buyer and one seller and there is no standardization, no exchange trading is possible.

Question 11

Which type of contract obligates both parties to act?

I. Forward contract
II. Futures contract
III. Options contract
IV. Warrant

Answer 11

I & II

It is only in the case of forward and futures contracts that both parties are obligated to fulfill the terms of the contract. Only the seller of an options contract is obligated, and in the case of a warrant, it is the issuer of the warrant who is obligated to deliver the underlying shares if the owner exercises.

Question 12

Which of these would be specified in an exchange-traded futures contract?

I. The quantity of the underlying asset
II. The quality of the underlying asset
III. The time of delivery of the underlying asset
IV. The location of delivery of the underlying asset

Answer 12

ALL

Typically, there are five standardized parts to an exchange-traded futures contract:

Quantity of the commodity (e.g., 5,000 bushels of corn or 100 oz. of gold)
Quality of the commodity (specific grade or range of grades may be acceptable for delivery, including price adjustments for different deliverable grades)
Delivery price (similar to exercise or strike price with options)
Time for delivery (e.g., December wheat to be delivered)
Location (approved for delivery)

Question 13

An investment adviser representative attends a seminar discussing derivative investments. It would be unlikely that there would be any mention of:

Answer 13

REITs are not derivatives, but options (both puts and calls), futures (and forwards), and warrants (and stock rights) are.

Question 14

A manufacturer of soybean oil is concerned that the price of soybeans will increase over the next six months. The best strategy to employ would probably be:

Answer 14

a long hedge.

The concern is that the price will go up. Just as with options, when we are concerned that the price of something will go up, we go long that item. With options, it would be a long call; with futures, it is simply hedging by going long (buying) the soybean futures. The soybean farmer who would be concerned about a decline in the price would go short soybean futures.

Question 15

A farmer who produces soybeans believes that this year’s crop will be the biggest ever. The farmer would most likely hedge this risk by:

Answer 15

going short soybean forwards.

A big crop means more supply and lower prices when the crop is harvested. Hedging involves taking an opposite position (benefiting if prices fall). If the farmer is correct, selling short at today’s price will enable delivery in the future at that higher price. Because this is a producer who will have product to deliver, forwards are likely to be more appropriate than futures.

Question 16

Forwards

Answer 16

It is only in the case of forward contracts that the buyer (and seller) are both obligated to complete the contract. Holders of options have the right to exercise but are not obligated to do so. The same is true of stock rights and warrants.

Question 17

A farmer entered into a forward contract to sell his produce at $2.25 per bushel. At the expiration date of the contract, the price was $2.00 per bushel. The farmer would receive

Answer 17

$2.25

The reason the farmer entered into this contract was to hedge against a drop in price. Because the strike price was higher than the market price at expiration, the farmer made a good deal, while the buyer of the contract lost.

Question 18

Not be considered a derivative?

Answer 18

ETFs are investment companies (exchange-traded funds) and are not included in the definition of derivative.

Question 19

Mark’s company, which is located in Oregon, makes unfinished wood furniture. His company sells this furniture directly to the public from a large warehouse. Theresa’s company, which is located in southern Georgia, grows cotton for t-shirt manufacturers. Which of the following statements correctly identify hedging strategies for Mark and Theresa?

I. Mark should buy lumber futures.
II. Theresa should sell cotton futures.
III. Mark should sell lumber futures.
IV. Theresa should buy cotton futures.

Answer 19

I & II

Mark is short lumber because he needs lumber to produce his products. A hedge position for Mark would be to go long lumber futures—that is, to purchase lumber futures. Theresa is long cotton because she owns cotton for manufacturing purposes. A hedge position for Theresa is to go short—that is, to sell cotton futures.

Question 20

A commodities speculator purchases a 1,000-bushel wheat futures contract at 50 cents per bushel. At expiration, the settlement price is 45 cents per bushel. This individual:

Answer 20

has a $50 loss

The simple math is as follows: The individual bought at 50 cents and sold at 45 cents, losing 5 cents per bushel. Multiply 5 cents ($0.05) by 1,000 bushels and the loss is $50. It is the seller who is obligated to deliver; the buyer of the contract must accept delivery (unless there was an offsetting transaction prior to expiration). This individual was long the futures contact, not long (the owner of) the wheat.

Question 21

Nonsecurities derivatives would include which of these?

I. Forward contracts
II. Futures contracts
III. Hedge funds
IV. REITs

Answer 21

I & II

Forward contracts and futures contracts are known as nonsecurities derivatives because they derive their value from something that is not a security. REITs and hedge funds are securities, not derivatives.

Question 22

Which investment would not be considered exchange-traded derivative?

Answer 22

Forwards are never traded on an exchange

Question 23

An investor goes short five soybean futures contracts on the Chicago Mercantile Exchange (CME). When the contract expires,

Answer 23

both the buyer and the seller are obligated to perform.

Among the ways in which futures differ from options is that both parties, long and short, are obligated to execute the contract. At expiration date, if not exercised before, the buyer must purchase at the contract price and the seller must deliver at the contract price. In the case of options, the buyer (long position) is the one who chooses to exercise or not, and it is the seller (short position) who becomes obligated to perform.

Question 24

A commodities speculator purchases a 1,000-bushel wheat futures contract for 75 cents per bushel. At expiration, the settlement price is 85 cents per bushel. This individual

Answer 24

has a $100 gain.

The simple math is this: The individual bought at 75 cents and sold at 85 cents, making 10 cents per bushel. Multiply 10 cents ($0.10) by 1,000 bushels and the gain is $100. It is the seller who is obligated to deliver; the buyer of the contract must accept delivery (unless there was an offsetting transaction prior to expiration). This individual was long the futures contract, not long (the owner of) the wheat.

Question 25

With respect to the specific commodity that is the subject of the contract, all of the following are standardized parts to an exchange-traded futures contract except

A) the market price.
B) the quality.
C) the quantity.
D) the time for delivery.

Answer 25

A) the market price.

It is the delivery price that is standardized, not the market price (which is continuously fluctuating). Exchange-traded futures contracts offer standardized quantities and qualities (grade of the commodity), as well as a standardized time for delivery.