Options, Futures and Other Derivatives Ch2

Question 1

Define a forward contract.

Answer 1

A forward contract is an agreement between two parties to buy or sell an asset at a specified price on a future date.

Question 2

Explain the difference between a forward contract and a futures contract.

Answer 2

A forward contract is customized, traded over-the-counter, and has counterparty risk, whereas a futures contract is standardized, exchange-traded, and has minimal counterparty risk due to clearinghouses.

Question 3

What is the role of the clearinghouse in futures markets?

Answer 3

Clearinghouses act as intermediaries, ensuring the performance of futures contracts by guaranteeing trades and managing margin requirements.

Question 4

Define the term “marginaling” in futures trading.

Answer 4

Marginaling is the process of adjusting margin accounts daily based on price changes in the underlying asset.

Question 5

Explain the concept of marking-to-market in futures trading.

Answer 5

Marking-to-market involves adjusting the margin account daily to reflect changes in the market value of the futures contract.

Question 6

What is the significance of initial margin in futures trading?

Answer 6

Initial margin is the minimum amount of cash or collateral required to open a futures position, ensuring that traders can meet potential losses.

Question 7

Explain the concept of variation margin in futures trading.

Answer 7

Variation margin is the amount of money transferred between the buyer and seller’s margin accounts daily to cover gains or losses on the futures contract.

Question 8

Define the term “basis risk” in futures contracts.

Answer 8

Basis risk refers to the risk that the relationship between the spot price and the futures price may change, resulting in potential losses for hedgers.

Question 9

What are the primary reasons for using futures contracts?

Answer 9

Hedging against price fluctuations, speculation for potential profits, and arbitrage opportunities across markets.

Question 10

Explain how futures contracts help in price discovery.

Answer 10

Futures markets provide information on future price expectations, which aids in determining the fair value of assets and commodities.

Question 11

Define the concept of backwardation in futures markets.

Answer 11

Backwardation occurs when the futures price is lower than the spot price, usually due to immediate demand or supply constraints.

Question 12

Explain the concept of contango in futures markets.

Answer 12

Contango occurs when the futures price is higher than the spot price, often observed in markets with ample supply and reduced demand.

Question 13

What are the advantages of using futures contracts over forward contracts?

Answer 13

Standardization, liquidity, reduced counterparty risk, and ease of trading due to exchange-trading are advantages of futures contracts over forwards.

Question 14

What role do speculators play in futures markets?

Answer 14

Speculators provide liquidity, take on risk, and aim to profit from price fluctuations, increasing market efficiency.

Question 15

Define the term “deliverable grade” in futures contracts.

Answer 15

Deliverable grade refers to the quality standards that the underlying asset must meet for physical delivery in a futures contract.

Question 16

Explain the process of convergence in futures markets.

Answer 16

Convergence refers to the gradual approach of futures prices towards the spot price as the contract approaches its expiration.

Question 17

What factors influence the basis in futures contracts?

Answer 17

Supply and demand dynamics, storage costs, interest rates, and market participants’ expectations affect the basis in futures contracts.

Question 18

Define the term “roll yield” in futures trading.

Answer 18

Roll yield is the return generated by rolling over futures contracts, potentially impacted by changes in the term structure of futures prices.

Question 19

Explain the concept of convenience yield in futures markets.

Answer 19

Convenience yield represents the non-monetary benefits of holding a physical asset, such as immediate access or production flexibility, impacting futures pricing.

Question 20

What is the role of the term structure of interest rates in futures markets?

Answer 20

The term structure reflects expectations of future interest rates, influencing the pricing and trading of interest rate futures contracts.

Question 21

Define the concept of a carry trade in futures markets.

Answer 21

A carry trade involves borrowing at a low interest rate to invest in an asset with a higher yield, potentially realized in futures markets.

Question 22

Provide the formula for the price of a forward contract.

Answer 22

Question 23

Explain the concept of arbitrage in forward markets using a formula.

Answer 23

Arbitrage opportunities can arise when the forward price doesn’t equal the no-arbitrage price.

Question 24

What is the formula to calculate the profit from a long forward position?

Answer 24

Question 25

Provide the formula for the profit from a short forward position.

Answer 25

Question 26

Define the cost of carry model and provide its formula.

Answer 26

Question 27

Explain the concept of convexity adjustment in forward contracts.

Answer 27

Convexity adjustment accounts for changes in interest rates, adjusting the forward price to account for deviations due to nonlinearity in the relationship between spot and forward prices.

Question 28

Define the formula for the price of a futures contract.

Answer 28

Question 29

Provide the formula for the mark-to-market calculation in futures contracts.

Answer 29

Mark-to-market =
Previous day’s settlement price
−
Current day’s settlement price
Previous day’s settlement price−Current day’s settlement price
This amount is then added or subtracted to the margin account.

Question 30

Explain the role of initial margin in futures contracts using a formula.

Answer 30

Initial margin serves as a security deposit, ensuring traders can meet potential losses.
Initial margin=Multiplier × Contract value

Question 31

Define the concept of the forward rate agreement (FRA) and provide its formula.

Answer 31

A forward rate agreement is an over-the-counter contract that allows parties to lock in an interest rate.

FRA settlement=Notional amount×Notional rate×Day count fraction×Interest rate difference
Where:

Notional rate is the agreed-upon rate
Day count fraction is the time between the start date and settlement date

Question 32

Explain the concept of interest rate parity and provide the formula for covered interest rate parity (CIRP).

Answer 32

Question 33

Explain how roll yield influences the returns in futures trading.

Answer 33

Roll yield represents the returns generated from rolling over futures positions, influenced by changes in the term structure of futures prices and can impact overall portfolio returns.

Question 34

Define the concept of roll return in futures trading and provide its formula.

Answer 34

Roll return refers to the profit or loss incurred when shifting from one futures contract to another as contracts approach expiration.

Roll Return=New Futures Price−Old Futures Price
Where:
New Futures Price = Price of the new futures contract
Old Futures Price = Price of the expiring futures contract

Question 35

Explain how arbitrage opportunities arise in futures markets due to basis risk.

Answer 35

Basis risk can lead to temporary deviations between the futures price and the spot price, creating opportunities for arbitrage if the basis deviates from its historical relationship.

Question 36

Provide the formula for calculating the net advantage of carry.

Answer 36

Net Advantage of Carry=(Yield+Storage Income)−Interest Expense
Where:

Yield = Income from holding the asset
Storage Income = Income from storing the asset
Interest Expense = Cost of financing the asset

Question 37

Explain the concept of “full carrying charge” in futures markets.

Answer 37

Full carrying charge is the total cost incurred when holding a physical asset until the futures contract’s expiration, including storage, financing, and other expenses.

Question 38

Define the concept of no-arbitrage pricing in futures markets.

Answer 38

No-arbitrage pricing ensures that there are no risk-free opportunities for profit with no initial investment. Prices adjust to eliminate arbitrage opportunities.

Question 39

Explain how the cost-of-carrying model affects the pricing of futures contracts.

Answer 39

The cost-of-carrying model accounts for costs such as interest rates, dividends, and storage, influencing the pricing of futures contracts based on the carrying costs of the underlying asset.

Question 40

Explain the relationship between the spot price, interest rates, dividends, and forward/futures prices using mathematical models.

Answer 40

Forward/futures prices depend on spot prices, interest rates, dividends, storage costs, and time to expiration, as indicated by various pricing models, such as the cost-of-carry model and the cost-of-carrying model.