Chapter 14 HW
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Chapter 14 HW
1. What is a derivative?
A derivative is a financial instrument or asset whose value is derived from an underlying security
or asset. Derivatives include forward and futures contracts, options contracts, and swaps
contracts, with values based on agreed-upon terms and traded in organized exchanges or over-
the-counter markets. For example, the price of coffee futures contracts varies based on changes
to the current price of coffee.
2. Define a futures contract.
Futures contracts are standardized forward contracts that trade in a highly liquid secondary
market and require daily settlement. Examples of futures contracts include commodity futures
such as lumber and coffee and financial futures contracts such as the S&P 500 Index. A futures
contract is a standardized agreement between two parties to make (sell) or take delivery (buy) of
a contract of a specific commodity of a specified quality at a future time, place, and unit price.
3. Define an option agreement.
Option contracts give the buyer the right but not the obligation to buy or sell an underlying asset
at a date, or possibly several dates, in the future. One attractive feature of an option contract is
that it gives the owner the right to do nothing and allow the option to lapse. This right is valuable
to the owner, as they can walk away if exercising the option would result in a negative payoff.
Common option contracts include stock options, currency options, and index options.
4. Describe the impact of leverage on derivatives.
Leverage in derivatives allows investors to control a larger asset with a relatively small amount
of capital compared to purchasing the underlying securities directly. While this built-in leverage
magnifies both potential gains and losses, it also enables investors to gain exposure to assets with
limited funds. The use of leverage in derivative trading increases the risk of significant financial
losses but also offers the potential for enhanced returns.
5. Describe a forward contract.
A forward contract is a legal agreement between two parties to buy or sell a specific asset at a
predetermined future date, established today. Unlike standardized and exchange-traded contracts,
forwards are private agreements negotiated directly between the buyer and seller. Initially valued
at zero, the contract's worth fluctuates based on changes in the underlying asset's value. This
dynamic creates a zero-sum game, where one party's gains are mirrored by the other party's
losses.
6. What are the benefits of futures exchanges?
Futures contracts are actively traded on organized exchanges, offering numerous benefits such as
liquidity, transparency, access to account details, and financial safeguards. The exchanges attract
a diverse range of participants, including speculators, hedgers, and asset managers, facilitating
the daily trading of millions of contracts and ensuring substantial liquidity in the futures markets.
Futures trading is characterized by high transparency in pricing and volume, providing real-time
comprehensive trade information to global asset managers, hedgers, and speculators. Rapid
decision-making and near-instantaneous trade execution enable quick responses to economic
changes. Despite the inherent financial risk associated with the high leverage of futures
contracts, some traders deliberately use derivatives to amplify portfolio gains. To minimize
counter-party risk, exchanges offer a clearing service, acting as an intermediary for all trades,
ensuring financial safeguards and managing performance bonds. While trades are transparent in
terms of volume and price, they remain anonymous to mitigate counter-party risk.
7. Explain how price limits for futures contracts work.
Price limits for futures contracts are restrictions set by futures exchanges to curb potential
volatility. These limits, established since 1988, prevent the price of an underlying commodity
from exceeding a specified up limit or falling below a down limit within a single trading day.
Once these limits are reached, trading in the respective futures contract is temporarily halted,
allowing the market to settle and preventing excessive gains or losses. This mechanism acts as a
circuit breaker, mitigating panic-driven volatility and giving traders time to reassess their
positions. Additionally, market-wide circuit breakers may be employed in extreme cases to
temporarily halt or close trading across multiple markets, aiming to prevent further declines and
provide a buffer against liquidity exhaustion.
8. Describe market orders and limit orders.
Market orders and limit orders are two types of orders used in buying or selling futures contracts.
A market order is executed by the broker at the next available price in the market. While market
orders are almost always filled, the investor has no control over the specific price at which the
order is executed. On the other hand, limit orders instruct the broker to execute the buy or sell
order only if the futures contract reaches a specified price. For example, a limit sell order for a
coffee futures contract at $120 means the broker should sell at $120 or a better price. The
execution of limit orders depends on whether the market price reaches the specified limit.
Additionally, limit orders must include a time period during which the broker is instructed to fill
the order, such as a day, week, month, or until canceled by the trader. "Good 'til canceled" orders
remain open until they are filled or until the trader decides to cancel the order.
9. How is a futures contract value determined?
The value of a futures contract, also known as the contract value or notional value, is calculated
by multiplying the size of the contract by the current price of the underlying asset. For instance,
if we consider a futures contract for coffee priced at $1.20 per pound and the contract size is
37,500 pounds, the contract value would be $45,000 ($1.20 x 37,500). Similarly, in the case of
the E-mini S&P 500 futures contract, the contract value is determined by multiplying the price of
the S&P 500 index by a predetermined multiplier, such as $50. For example, if the S&P 500
index is at 4,500, then the contract value would be $225,000 ($50 x 4,500). In essence, the
contract value reflects the monetary worth of the futures contract based on the current market
price of the underlying asset.
10. Explain a performance bond.
A performance bond, also referred to as initial margin, is the amount of money that both the
buyer and seller of a futures contract are required to deposit with a broker to initiate a trade. This
initial margin serves as a form of collateral, held by the broker, to ensure that traders have the
financial capacity to meet their obligations related to the futures contracts they have bought or
sold. These funds are held in an account and may earn interest while being held. As the value of
the underlying commodity or security fluctuates, the trader's equity in the account also changes.
If the equity falls below the initially deposited performance bond, the trader may need to deposit
additional funds to maintain the required margin level. Conversely, if the equity rises, it may
provide the trader with more flexibility in managing their positions. Brokers may allow traders to
meet margin requirements using securities rather than cash, such as Treasury securities or equity
securities, though the value of these assets may not be counted dollar-for-dollar for margin
purposes.
11. What is the process of mark-to-market?
The process of mark-to-market in futures trading is a daily practice designed to allocate gains
and losses to the accounts of buyers and sellers. At the end of each trading day, a settlement price
is determined for each futures contract. This price results in gains for one party to the contract
and losses for the other. Gains are added to the trader's account, increasing the equity, while
losses are subtracted, decreasing the equity. The initial equity in the trader's account is
established through the performance bond deposited to enter into the initial futures contract
position. If losses during the day reduce the equity below the maintenance margin level, the
trader may receive a margin call. A margin call is a request for additional funds to restore the
equity in the trader's account, ensuring that they have sufficient funds to meet their financial
obligations for the contracts they have bought or sold. Mark-to-market thus helps maintain
financial stability in futures trading by regularly adjusting account balances based on daily price
movements.
12. Differentiate between long and short positions with a futures contract.
A long position in futures involves buying a contract for future delivery (taking delivery), while a
short position entails selling a contract for future delivery (making delivery). Similar to stocks, a
long position gains value with an increase in the underlying security or commodity, while a short
position gains value with a decrease in the underlying security or commodity.
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13. Describe a short hedge and a long hedge.
The short hedge is taking a position against a material needed in factors of production that affect
the value of the product that will affect in the long run the price of the stock. the elimination of
the risk by having a long position (
14. Describe 1256 contracts and their tax treatment.
Section 1256 contracts are a specific category of financial instruments defined by the Internal
Revenue Code (IRC) in the United States. These contracts include certain types of financial
derivatives, and their tax treatment is distinct from other types of investments. The tax rules for
Section 1256 contracts are designed to provide consistency and simplicity in reporting gains and
losses.
15. What is a swap agreement?
SWAP is an over-the-counter agreement between two or more parties to exchange future sets of
cash flows. Swap agreements define the terms of the agreement, including the dates of payments
and the methodology used to determine the payments. The future payments may be fixed or may
change (float or fluctuate) based on changes in interest rates, exchange rates, or other variables.
As with future and forward contracts, both parties are obligated to perform in the future cash
flows. For one of the parties, the cash flows are fixed amounts. For the other party, the cash
flows are based on market interest rates. The term floating simply means that the interest
payments change from one period to another based on changes in underlying interest rate or
some other variable. Currently, swaps are agreements to exchange flows in different currencies.
One of the reasons that a company would engage in an interest rate swap is to better manage
interest rate risk. Interest rate risk is the risk that changes in interest rates (up or down) will have
an adverse effect on the value of assets.
16. Describe a plain vanilla swap.
A plain vanilla swap is a simple and straightforward financial derivative contract between two
parties to exchange cash flows over time. This type of swap involves the exchange of one stream
of cash flows for another, typically based on interest rates. The most common form of a plain
vanilla swap is an interest rate swap
.
17. Describe a currency swap.
A currency swap is a monetary plan between two gatherings, frequently worldwide companies or
monetary foundations, to trade a specific measure of one cash for an identical worth of another
money. This trade is normally finished to meet explicit monetary targets, for example, overseeing
cash risk, diminishing acquiring costs, or accessing good loan fees in various business sectors.
18. Describe equity swaps.
Equity trades are monetary subsidiaries that include the trading of incomes between two
gatherings in light of the profits of various values or value files. These trades are utilized for
different purposes, including supporting, hypothesis, and accomplishing explicit venture goals.
Value trades permit financial backers to acquire openness to the exhibition of a specific stock or
a bushel of stocks without possessing the basic resources.
Related Questions
34) What is an interest-rate futures contract? How does it differ from an interest-rate forward contract?
35) Explain using an example the statement that "at the expiration date of a futures contract, the price of the contract is the same as the price of the underlying asset to be delivered."
36) Where are financial futures traded? Describe that market.
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Question 2
Which type of financial derivative is used to protect against adverse price movements in an asset?
A) Call option
B) Put option
C) Futures contract
D) Swap contract
arrow_forward
Advantages of currency futures contracts relative to forward contracts include _
a.
Higher liquidity
b.
Standardized contract specifications
c.
Freedom to sell the contract before maturity
d.
All of the above
arrow_forward
“Hedging is the basic function of futures market”. Discuss the statement in the light of uses of futures contract.
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Which of the following is a reason why the default risk of a futures contract is assumed to be less than that of a forward contract?
a. Forward contracts can be tailored, while future contracts are non-standardized.
b. Forward contracts are classified as exotic derivatives.
c. Futures contracts are exchange-traded contracts, daily settlements are implemented by the clearing house.
d. More flexibility as the buyer can decide whether or not to exercise the contract at maturity.
e. For futures contracts, all cash flows are required to be paid at one time on contract maturity.
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QUESTION 6
The most active bond derivatives contracts are:
O [A] Treasury futures contracts
O [B] LIBOR futures contracts
[C] Eurodollar futures contracts
[D] Index futures contracts
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(a) Outline in detail what is meant by a forward and futures contract. Evaluate the relationship between futures price and spot price, and give reasons to justify the necessity for exchange margin accounts.
(b) Explain the concept of cost of carry model and its role in the pricing of financial futures contracts.
arrow_forward
Why might an individual purchase futures contracts, rather than the underlying assets?Please provide a long and detailed answer! <3
arrow_forward
In the context of financial derivatives, what is a futures contract?
A) An agreement to exchange assets at a predetermined price and date.
B) A contract that grants the holder the right, but not the obligation, to buy or sell an asset.
C) A contract to buy or sell a specific quantity of an asset at a future date at a price specified today.
D) A contract that provides regular interest payments and returns the principal at maturity.
arrow_forward
Changes in what price lead to gains and/or losses in futures contracts?
arrow_forward
M3
The terms "contango" and "backwardation" are used to describe term structures of forward/futures prices (i.e., patterns of forward/futures prices of various maturities). Please explain the meanings of these two terms and the situations in which they occur (i.e., the reasons for them). Also, consider futures prices of gold. Do you expect them to be in contango or backwardation? Why?
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Describe how the price of a futures contract is established in theory, with reference to arbitrage.
arrow_forward
The fact that the clearinghouse is the counterparty to every futures contract issued is important because it eliminates _________ risk.
A. Market
B. Basis
C. Interest rate
D. Credit
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4: A futures contract is used for hedging. Carefully explain why the daily settlement of the contract can give rise to cash flow problems.plz explain it
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detail two procedures which the seller of a futures contract can use to lock in a gain at some time t, 0<t<T.
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Related Questions
- 34) What is an interest-rate futures contract? How does it differ from an interest-rate forward contract? 35) Explain using an example the statement that "at the expiration date of a futures contract, the price of the contract is the same as the price of the underlying asset to be delivered." 36) Where are financial futures traded? Describe that market.arrow_forwardQuestion 2 Which type of financial derivative is used to protect against adverse price movements in an asset? A) Call option B) Put option C) Futures contract D) Swap contractarrow_forwardAdvantages of currency futures contracts relative to forward contracts include _ a. Higher liquidity b. Standardized contract specifications c. Freedom to sell the contract before maturity d. All of the abovearrow_forward
- “Hedging is the basic function of futures market”. Discuss the statement in the light of uses of futures contract.arrow_forwardWhich of the following is a reason why the default risk of a futures contract is assumed to be less than that of a forward contract? a. Forward contracts can be tailored, while future contracts are non-standardized. b. Forward contracts are classified as exotic derivatives. c. Futures contracts are exchange-traded contracts, daily settlements are implemented by the clearing house. d. More flexibility as the buyer can decide whether or not to exercise the contract at maturity. e. For futures contracts, all cash flows are required to be paid at one time on contract maturity.arrow_forwardQUESTION 6 The most active bond derivatives contracts are: O [A] Treasury futures contracts O [B] LIBOR futures contracts [C] Eurodollar futures contracts [D] Index futures contractsarrow_forward
- (a) Outline in detail what is meant by a forward and futures contract. Evaluate the relationship between futures price and spot price, and give reasons to justify the necessity for exchange margin accounts. (b) Explain the concept of cost of carry model and its role in the pricing of financial futures contracts.arrow_forwardWhy might an individual purchase futures contracts, rather than the underlying assets?Please provide a long and detailed answer! <3arrow_forwardIn the context of financial derivatives, what is a futures contract? A) An agreement to exchange assets at a predetermined price and date. B) A contract that grants the holder the right, but not the obligation, to buy or sell an asset. C) A contract to buy or sell a specific quantity of an asset at a future date at a price specified today. D) A contract that provides regular interest payments and returns the principal at maturity.arrow_forward
- Changes in what price lead to gains and/or losses in futures contracts?arrow_forwardM3 The terms "contango" and "backwardation" are used to describe term structures of forward/futures prices (i.e., patterns of forward/futures prices of various maturities). Please explain the meanings of these two terms and the situations in which they occur (i.e., the reasons for them). Also, consider futures prices of gold. Do you expect them to be in contango or backwardation? Why?arrow_forwardDescribe how the price of a futures contract is established in theory, with reference to arbitrage.arrow_forward
arrow_back_ios
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