Markets and Mechanics of Trading

Question 1

What is the Spot Market?

Answer 1

The spot market or cash market is a public financial market in which financial instruments or commodities are traded for immediate delivery

Question 2

What are the features of the spot market?

Answer 2

1) Instant trading in actual commodity
2) Low cost of trading
3) Price is a function of the number of agents
4) Very Good price transparency

Question 3

What are the risks of the spot market?

Answer 3

1) For Sellers, price and income is risky

2) For Buyers, quality, quantity and cost are risky

Question 4

What is a forward market?

Answer 4

Buyer and seller agree a fixed price and quantity for the future.

Question 5

What are the features of a forward market?

Answer 5

1) Delay of the Physical trade
2) Private contract must be made
3) Contract determines price, time quantity, quality etc.
4) Price is agreed - thus certain

Question 6

What are the problems related to forward markets?

Answer 6

1) No centralised market
2) Have to search for a buyer/seller - time consuming
3) Imbalance of buyers/sellers
4) No information is traded
5) No central regulation/enforcement (go to courts)
6) Other interests excluded

Question 7

Why are the physical goods not generally traded on the futures market?

Answer 7

Contracts are traded and CLOSED OUT leaving stakeholders with no commitment to the market.

Question 8

Why must the contracts be standardised?

Answer 8

1) They act as a medium of exchange
2) No disputes over details
3) Bought and sold with no further commitments
4) Allows for Centralised point of trading/information
5) Can be traded over several months (until maturity)

Question 9

How do future markets operate?

Answer 9

1) Market governed by Clearing house
2) Brokers are licensed
3) Brokers take orders from buyers/sellers

Question 10

What do the Clearing house do?

Answer 10

1) Oversees activities and records them
2) Controls finances
3) Arbitrates in disputes
4) Maintains supply/demand balance

Question 11

What is closing out?

Answer 11

When you buy/sell back original contract (with same quantity of same good), leaving a net of 0 to the market.

Question 12

What are the costs/fees for trading?

Answer 12

1) Broker’s fee

2) Margins

Question 13

What is an initial margin?

Answer 13

‘Good faith’ or deposit payment. To ensure that the trader didn’t default is investments went against them. 2-10% of contract value and is paid back once deal ends.

Question 14

What is a maintenance margin?

Answer 14

Lowest point that a trader’s account can fall before before they must pay more funds. The lower the good faith account falls, it will need topping up.

Question 15

Why must there be a link between Spot and futures markets?

Answer 15

Or else it will be a gambling market

Question 16

What is the cost of carry?

Answer 16

Cost of carrying commodity forwards through time. Function of: Warehouse, insurance costs and finance (interest rates) costs

Question 17

What is the basis?

Answer 17

Futures price - spot price.

Question 18

What is the spread?

Answer 18

Futures(t+i) - Future(t)

Question 19

How might arbitrageurs make riskless profit?

Answer 19

At maturity date, futures price > spot price, then can buy in spot market and sell in futures and make delivery. Reverse arbitrage in other direction.

Question 20

What is cash and carry arbitrage?

Answer 20

When the basis/spread exceeds the cost of carry so arbitrageurs can sell futures/deferred and buy spot/nearby, raising spot/nearby price, lowering futures/deferred (making conditions hold).

Question 21

What is the convenience yield?

Answer 21

The benefit of holding onto physical good rather than the contract.

Question 22

Why might marginal yield be high?

Answer 22

1) Stocks are low
2) Pipeline stocks have high value
3) Merchants wish to hold stocks to meet longstanding customers demand
4) processors hold stocks to avoid disruption

Question 23

How do merchants use futures?

Answer 23

They use futures price as a forecast for the future spot price, the basis is a guide to expected returns to storage and use this to determine when to enter the market.

Question 24

How does the demand for storage shift?

Answer 24

More/less production than normal leads to a rightward/leftward shift as there are higher/lower supplies available for current and future consumption expected production for next period is lower/higher and expected stocks carried forward will be higher/lower

Question 25

What is a Contango market?

Answer 25

Futures price > Spot Price or Distant future > Nearby Future

Question 26

What is backwardation or an inverted market?

Answer 26

Where there is a convenience yield large enough so that Spot price + cost of carry > futures

Question 27

What do hedgers do?

Answer 27

To offset risk in spot market they trade in futures, i.e. sells futures when they plant crop, so if spot falls, so does the futures price, they the sell crop in spot market and buy futures (closing out). The loss made in spot is offset by the gain in futures market.