Week 12 Flashcards
Why do investors use derivative contracts?
To hedge/protect against risk, allow for speculation, lock in arbitrage profits, or to change the nature of an investment without selling an investment and buying another one.
What is a forward contract?
A forward contract gives the buyer the obligation to buy an asset at a specified date and cost. The seller has the obligation to sell the asset at the specified date and cost, helping to protect against risk. They are customizable and occur in the over the counter market and are privately arranged between two parties.
What risk are parties in forward contracts subject to?
Credit risk.
What is a futures contract?
A futures contract is similar to a forward contract, but has a standardized delivery date and price, it is centralized, making it easier to facilitate as it does not rely on alignment of interests. They are typically marked to market (settling the profits and lossed of at the end of each day), and requires a maintenance margin (collateral, to coer losses, higher in more volatile assets, with a margin call occuring if the margin falls below the required level).
Who realises the profit in a marked to market system?
For a long position if the futures price increases the trader realizes profit in marked to market, for a short position this would result in a loss.
How do we find the expected futures contract price of a stock?
Take its spot price, multiply by (1+risk free rate)^maturity.
What is the clearing house?
The middleman between the buyer and seller of futures contracts. It essentially involves obtaining a short and a long position.
What is the open interest in futures contracts? What is the volume?
The number of outstanding futures contracts, the volume details how many futures contracts are
actually being traded.
How are futures contracts typically closed?
Reversing the trade, if we are currently long we can do this by instructing our broker to enter the short side of the contract to reverse our long position and vice versa.
Only a very small amount of contracts will close out by reaching maturity.
How do speculators use futures contracts?
What about hedgers?
If they think price will rise they take a long position, or a short position if they think the price will fall. Futures contracts are useful for speculators because of the low transaction costs and high leverage.
A hedger will use a futures contract to protect against price movement, using a long hedge to protect against a rise in price, or a short hedge to protect against a fall in price.
What is the basis risk?
The basis risk is the risk attributable to uncertain movements in the price of the future price and spot price. This makes the basis the difference between futures price and the spot price.
What is the convergence property as it applies to futures contracts?
The forward price should be equal to the spot price at maturity. If this is not the case then investors will rush to buy from the cheaper source and sell it in the more expensive market (arbitrage).
However, before maturity the futures price may be quite different, creating risk.
What is a spread position?
Take a long and a short position on the same commodity with a different maturity, this can allow profit if the long position price increases more than the short position, or if the long position decreases price less than the short position.
What are the two ways to obtain an asset at a future date? How does this apply to spot-futures parity theorem?
We can purchase it now at the spot price and store it until the targeted date. Or we can tak a long futures position that calls for purchase at the future price on the date in question.
Under spot-futures parity theorem these prices should be equal, assuming riskless investing in t-bills, this means the futures price = spot price * (1+ risk free rate - discount rate)^maturity, this is known as the cost of carry relationship. If it does not hold then investors may be able to generate arbitrage profits
How do we find the arbitrage profits of using the cost-of-carry relationship?
borrow the money and pay with interest at time T, then buy the item at spot price. If we use a short position to sell it and this is different to our interest payment (which should be the spot price at maturity if parity holds) then profit can be made and parity did not hold. Entering into a futures position does not require an initial flow.
