Midterm 1 Flashcards
Anticipatory Hedge
Hedgers expect to need to buy/sell the commodity in the future
Ex)
Plane company needs fuel
Farmer needs to sell his crop
Arbitrage
The strategy of simultaneously buying and selling an asset to make a risk free profit. Arbitrageurs keep market prices honest by jumping on arbitrage opportunities which drives the price to the market value.
Backwardation
The agreed upon futures price is below the expected future spot price.
Typically occurs in an inverted market.
Basis
Basis = Spot price of asset to be hedged - Futures price of contract used
The basis changes over time
If the basis (the gap between the spot price and futures price) is increasing, it is strengthening
If the basis (the gap between the spot price and futures price) is decreasing, it is weakening
Basis Risk
The uncertainty associated with moving spot prices and futures prices. These prices do not always move in tandem leaving the hedger exposed to a potential change in basis.
This can strengthen or weaken the hedger’s position.
Bootstrapping
Plotting out the interest rates for zero coupon bonds by analyzing many zero coupon bonds with different expiry dates from the same issuer.
Business Risk
The risk associated with external factors affecting business operations. For example, extreme weather or equipment failure.
These risks can be insured.
(as opposed to financial risks - the risk of prices changing ex) the price of wheat)
Carry Arbitrage
The possibility of locking in a price by opening a long underlying and a short futures position, and profiting by holding on to or “carrying” the asset.
This can be done in the opposite direction as well. This opportunity keeps prices “fair”
Cash Settlement
Futures contract that is settles via cash payment
For example betting on the S&P won’t require you to deliver 500 stocks if you are holding the contract at expiration.
Clearing House
A clearing house is an intermediary between buyers and sellers of financial instruments. It is an agency or separate corporation of a futures exchange responsible for settling trading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery, and reporting trading data.
Close Out
Closing out is the inverse transaction of opening a position.
If you are long, you must purchase a short contract to close out and vice versa.
Collateral
You must supply collateral for borrowing. This is the margin you must keep in your account to keep your position. If you do not have sufficient collateral in your account, a margin call will be issued.
Consumption Asset
An asset that is consumable
For example: crude oil, cattle.
As opposed to financial assets.
Contango
The agreed upon futures price is above the expected future spot price.
This typically occurs in a normal market because of carrying costs (you must be compensated for holding an asset and bearing the carrying costs).
Contract Price
The price of the underlying asset as if it were delivered.
For example, if oil is $80 / BOE and the contract size is 1000 barrels, the contract price is $80,000
Convenience Yield
The benefit of holding an underlying asset. This is basically the opposite of a holding cost.
Cross Hedge
Hedging an underlying asset by using a similar asset that in theory should have similar price movements to the hedged asset.
This is required when the hedged asset isn’t sold in futures markets.
Ex) jet fuel cross hedged with crude oil
Daily Settlement
Resets the futures contract value to zero at the current futures price every day. This continues until spot and future price converge at maturity.
Contracts are marked to market every day.
Default Risk
The risk associated with not having enough capital in the margin account to maintain the loan. If your account dips below the maintenance margin, it must be topped up to the initial margin to avoid a margin call.
Exchange
Exchange markets trade fixed contracts, with more liquidity than over-the-counter markets.
Financial Risk
Risks associated with the changing prices of commodities used in business operations. For example, the changing price of wheat is a financial risk to a farmer.
These can be hedged using derivatives.
Financial Settlement
As opposed to physical delivery. Contracts are settled via financial transaction
Forward Price
Agreed upon PREDETERMINED price of an asset in a forward contract at a date in time.
Used to hedge against price changes in the commodity.
F0 = S0 * e^rt if the asset is expected to grow at the risk free rate.
Forward Rate Agreement
An OTC forward contract used to lock in interest rates for future loans.
Works as a “notional loan.”
Forwards
A customized contract between two parties to lock in the price or rate of a commodity in the future. Typically traded in over-the-counter exchanges.
These contracts are more customizable but less liquid than future contracts.
Futures
Fixed derivative contracts that trade on exchanges to lock in future commodity prices.
These contracts are less customizable but trade in a liquid market as opposed to forward contracts.
Futures Price
The agreed upon price for a futures contract at a point in time in the future.
If you are long on a futures contract, you win when the spot price at expiration turns out to be higher than the agreed upon futures price.
Gambling
Gambling is a zero-sum game where no wealth is created or destroyed.
Derivatives markets are not gambling because hedgers profit by having certainty, even if they lose on their contracts.
Hedger
Participants in the derivatives markets who hedge their risks. These are people or firms that will need to buy or sell commodities in the future and use derivatives to hedge their risk
Imperfect Hedge
As opposed to a “perfect hedge” where hedgers completely erase their risk and are impartial to changes in the market
Imperfect hedges leave hedgers in a situation where they either win or lose.
Investment Asset
Assets (tangible or intangible) that investors buy in hopes to make a profit by investing in them.
Inverted Market
The price in this market is expected to fall as time passes. For example, if the futures price of oil is lower than the current spot price, it is considered an inverted market.
Secured Overnight Financing Rate (SOFR)
Benchmark rate used in Forward Rate Agreement’s.
Replacing LIBOR after an insider trading scandal.
Limit Order
An order restriction on the maximum price to buy an asset
or
An order restriction on the minimum price to sell an asset
Long Hedge
A situation where a hedger must take a long position on a futures contract in order to hedge.
This occurs when they expect to need to buy the asset in the future.
May also be referred to as an input hedge, a buyers hedge, a buy hedge, a purchasers hedge, or a purchasing hedge.
Long Position
When an asset is purchased with the expectation that the price will rise in the future.
The holder owns a positive amount of the asset.
Margin Account
In futures trading, you must keep money in your margin account in order to take part in margin trading
Margin Call
Occurs when the balance in your margin account falls below the maintenance margin.
You must top up your account to the initial margin, or else the broker will sell your assets until you reach that mark.
Market Order
A buy or sell order to transact at the market price. This can be risky if there is a high volume of trades placed at the exact same time.
A good way to get the fair price but has less certainty as opposed to a limit order.
Marking to Market
The process of daily settlement of futures contracts every day at the closing price for the day and revaluing futures contracts to determine the profit or loss.
Normal Market
The futures price is above the current spot price. The asset is expected to keep or rise in value as time passes.
For example, gold is expected to be worth more tomorrow than it is today.
Notice
The short party gives notice of intention to deliver. This can be done anytime within the delivery period (which lasts from the first notice day until the last notice day).
Offset
A method of exiting a position. The most simple way would be to sell your assets, but there are other methods intended to avoid liabilities such as taxes.
You can hedge your position to lock in your profits without having to realize capital gains.
Open Interest
The total number of long or short positions of an asset.
OTC (Over-The-Counter)
Creates personalized forward contracts between parties.
broker-dealer network.
Perfect Hedge
All risk is eliminated. Parties with a perfect hedge are impartial to changes in the market.
Physical Delivery / Settlement
A futures contract that results in physical delivery at expiration.
For example, crude oil contracts require a physical transaction of x amount of barrels of oil at expiration.
Price Convergence
As time passes, the spot price converges (moves towards) the futures price and eventually they are equal at expiry.
Quantity / Volume Risk
This is the risk associated with the hedger being wrong about the quantity of an asset to be hedged.
For example, a farmer can overestimate his crop yield for the year.
Rolling the Hedge
CLARIFY
Short Hedge
A hedge where you take the short position. Used by hedgers who expect to need to sell a commodity in the future and want to reduce their exposure to price risk.
Short Position
Owning a negative amount of an asset. You are betting on the price to fall in the future if you have a short position.
Short Squeeze
Occurs when an asset that is largely shorted rises in price. This prompts short parties to buy the asset to reduce exposure which drives the price up even further.
Speculators
Participants in the derivatives market who are not looking to buy/sell commodities, but they want to profit off of their investments.
Spot Price
The futures price for a contract that expires in the exact moment. Basically the price of an asset at a point in time.
Spread
Spreading is an arbitrage strategy where arbitrageurs instantaneously take a long and a short position to make a profit by exploiting mispricing in the market.
Stack and Roll
CLARIFY
Strengthening Basis
Occurs when the spot price rises more than the futures price, therefore increasing or strengthening the basis.
Synthetic
A strategy to emulate a futures contract by purchasing a call and a put option at the same strike price to effectively create a futures contract that locks in the price of an asset at a point in time.
Treasury Bond
Loan issued and backed by the government.
Volume
The total amount of contracts exchanged. As opposed to open interest which only considers the amount of open positions.
Weakening Basis
When the spot price increases less than the futures price. This effectively decreases or weakens the basis.
