Study Session 16 - Derivatives - Forwards and Futures

Question 1

In simple terms,describe what a forward contract is….

Answer 1

An agreement between two parties in which one party, the buyer, agrees to buy from the other party, the seller, an underlying asset or other derivative, at a future date at a price established at the start of the contract.

Question 2

What is the general formula for how to calculate the forward contract price?

Answer 2

Question 3

In a cash and carry arbitrage, what should be done if the FRA is overpriced?

Answer 3

1. Short (sell) the forward
2. Long (buy) spot asset
3. Borrow money

Question 4

In a cash and carry arbitrage, what should be done if the FRA is underpriced?

Answer 4

1. long (buy) the forward
2. short (sell) the spot asset
3. invest (lend) money

Question 5

How is the value of a forward contract calculated at its initiation ???

Answer 5

Question 6

How is the Long value of a forward contract calculated during the life of the contract???

Answer 6

Question 7

How is the Short value of a forward contract calculated during the life of the contract ???

Answer 7

Question 8

How do you calculate the value of a long position in a forward contract on a dividend-paying stock?

Answer 8

Question 9

How do you calculate the price of an equity index forward contract whose dividends are paid continuously?

Answer 9

Question 10

How do you calculate the value of the forward contract on an equity index that is continuously compounded?

Answer 10

Question 11

A FRA with the notation 2 X 3 means what?

Answer 11

A 1 month loan 2 months from now

Question 12

What is the equation to calculate the price of a currency forward contract?

Answer 12

Question 13

What is the equation to value a currency forward contract at any time prior to maturity???????

Answer 13

Question 14

What are some reasons we may want to know the value of a forward contract?

Answer 14

1. It makes good business sense to know the monetary value of an obligation to do something at a later date
2. Accounting rules require that a company mark its derivatives to their current market values and report the effects on this I/S and B/S.
3. The market value can be used as a gauge of the credit exposure
4. The market value can be used to determine how much money one party can pay to the other to terminate the contract.

Question 15

Is the forward price a forecast of where the spot price is expected to go in the future?

Answer 15

No

If a forward price is higher than the spot price, it just indicates that the effect of the risk-free rate is greater than the effect of the dividends.

Question 16

What does it mean that futures contracts are said to be fungible?

Answer 16

That futures contract with any counterparty can be offset by an equivalent futures contract with another counterparty.

Question 17

What are the important differences between Futures contracts and Forward contracts?

Answer 17

1. Futures are marked to market at the end of every trading day. Forwards are not marked to market
2. Forwards are private contracts and do not trade on exchanges. Futures trade on exchanges
3. Forwards are customized to the parties involved needs. Futures are highly standardized
4. Forwards are with a counterparty, futures the counterparty is the exchange
5. Forwards are not regulated, Futures are.

Question 18

What is a cash-and-carry arbitrage?

Answer 18

Consists of buying the asset, storing/holding the asset and selling the asset at the futures price when the contract expires

Question 19

What are the steps involved in creating a cash-and-carry abitrage?

Answer 19

At Initiation:

1. Borrow money for the term of the contract at market interest rates
2. Buy the underlying asset at the spot price
3. Short a futures contract at the current futures price

At expiration:

1. Deliver the asset and receive the futures contract price
2. Repay the loan plus interest.

Question 20

What are the steps in a reverse cash-and-carry arbitrage?

Answer 20

At initiation:

1. Sell the asset short
2. Lend the short sale proceeds at the market interest rates
3. Go long the futures contract at the market price

At expiration:

1. Collect the loan proceeds
2. Take delivery of the asset for the futures price and cover the short sale commitment.

Question 21

What is normal backwardation?

Answer 21

When the futures price is lower than the expected spot price

Question 22

What is normal contango?

Answer 22

If the futures price is greater than the expected spot price.

Question 23

What is the formula to adjust the futures price of a bond with the identical face value that needs to be delivered?

Answer 23

Question 24

What is the equation used to calculate the futures price of an equity index whose dividends are paid continuously?

Answer 24

Question 25

What is the equation to calculate the no arbitrage futures price of a currency contract?

Answer 25

Question 26

What is the equation to solve for the futures price when there are storage costs involved in holding an asset?

Answer 26

Question 27

What is the equation to solve for the futures price when there are cash flows (ie dividends or coupons) involved in holding an asset?

Answer 27

***because when cash is generated from holding the assets it results in a lowe futures price

Question 28

What is the equation to calculate the futures price when there are storage costs and nonmonetary benefits (ie convenience yield)?

Answer 28

***This is referred to as the cost-of-carry model****