Week 4: Forward and Future Flashcards
What is hedging/ Hedge investment?
An investment that is made with the intention of reducing the risk of adverse price movements on an asset.
Give an advantage and disadvantage of hedging:
Advantage: reduces risk.
Disadvantage: May reduce potential profit.
Is hedging essential?
Although hedging can be useful in many ways, it can be argued as irrelevant. Shareholders care about results, doesn’t matter how you get there.
What is a forward contract?
A commitment to purchase at a future date a given amount of commodity or an asset at a price agreed on.
What are the features of a forward contract?
1) customised - Private transaction between buyers and sellers. Can customise price, quantity, etc.
2) Non-standard and traded over the counter.
3) Financial transaction at maturity date (A lot of counterparty risk).
4) Low liquidity- hard to sell these contracts as it involves loads of risks.
What is a futures contract?
A futures contract is an exchange-traded, standardized, forward-like contract that is marked to market daily. This contract can be used to establish a long (or short) position in the underlying asset.
What does the term mark to market mean?
the buyer and the seller of a forward contract decided to settle the contract every day since day 1.
One party pays the other the price difference, and then a new contract is formed.
What is a margin account? (Futures)
It eliminates counter party risk.
A margin is cash or marketable securities deposited by an investor with his or her broker
The balance in the margin account is adjusted to reflect daily settlement
Margins minimize the possibility of a loss through a default on a contract
Features of a futures contract:
1) Standardised contracts, quantity, maturity, etc.
2) Traded on exchanges.
3) Guaranteed by the clearinghouse- no counter-party risk.
4) Gains/losses settled daily (marked to market).
5) Margins required as collateral to cover costs.
Why is future contracts superior to a forwards contract?
1) Futures are more liquid- due to standardisation
2) Margins and marking to market reduce default risk.
3) Clearing-house guaruntee reduces counter-party risk.
Futures contract: what happens if you declare bankruptcy?
The clearing house has the right to take other assets to make-up the loss. But it is very unlikely to happen because the price changed everyday, so it it unlikely to be that big. Initial margin is normally enough to cover one days price. There is sometimes extreme cases like the global crisis.
Does the clearing house have a fee?
The clearing house only charges a little transaction fee- they’re aim is not profit, but to provide a stable environment where everybody can trade.
Key information for forward price of gold:
1) Easy to store, no cost of storage.
20 No dividends or benefits.
At what point do you pay for a futures contract?
At delivery
Who initiates the delivery of a commodity in a futures contract?
The party with the short position
