Investments Ch 14

Question 1

DERIVATIVES INTRODUCTION

Answer 1

DERIVATIVES INTRODUCTION

• A derivative is a financial security whose value is derived from the
  value of an underlying security or asset (e.g., coffee, oil).
• Derivatives are contracts or agreements between two parties.
• A futures contract is an agreement between two parties to
  buy or sell a security or a specific commodity (e.g., coffee or
  lumber) of a specified quality at a future time, place, and unit
  price.
• A swap contract is an agreement between two parties to
  exchange cash flows at regular intervals in the future.

Question 2

THE FUTURES MARKET

Answer 2

THE FUTURES MARKET

• Commodity and other futures contract prices constantly change.
• The spot price is the price of a commodity or asset to be
  delivered today. The spot price is also called the cash price.
• A futures price is the price of the commodity or asset at some
  time in the future.
• The difference between the spot and futures price is known as
  the basis.

Question 3

FORWARD VS. FUTURES CONTRACT

Answer 3

FORWARD VS. FUTURES CONTRACT

• A forward contract is an agreement between two parties to buy or
  sell a specific asset at a specified future time, which is agreed to
  today.
• Not standardized, are negotiated private agreements between
  the parties
• A futures contract is similar to a forward contract, but it has several
  important differences.
• Standardized agreement between two parties
• Trade on organized exchange

Question 4

THE FUTURES MARKET

• A futures contract consists of one buyer and one seller, and the
  contract specifies all details, including:

Answer 4

THE FUTURES MARKET

• A futures contract consists of one buyer and one seller, and the
  contract specifies all details, including:
• Time of delivery (usually specified by a delivery month)
• Place of delivery
• Quality and details of the commodity
• Unit price

Question 5

FUTURES EXAMPLE

Beibei is a speculator in the futures market. He believes that coffee
prices will increase in the future. Beibei decides to buy a coffee futures contract, which has the following characteristics:

• Contract Size: 37,500 pounds
• Futures Price - 6 months: $1.2515 per pound
  By entering into the contract, Beibei has agreed to buy 37,500 pounds of coffee at a price of $1.2515 six months from now

Answer 5

FUTURES EXAMPLE

Beibei is a speculator in the futures market. He believes that coffee
prices will increase in the future. Beibei decides to buy a coffee futures contract, which has the following characteristics:

• Contract Size: 37,500 pounds
• Futures Price - 6 months: $1.2515 per pound
  By entering into the contract, Beibei has agreed to buy 37,500 pounds of coffee at a price of $1.2515 six months from now

FUTURES EXAMPLE AT MATURITY
Assume that the spot rate of coffee six months from now at maturity is $1.36.

Since Beibei has locked in a price of $1.2515, he has made a nice
profit.

He will pay $46,931.25 ($1.2515 x 37,500) and the coffee will be worth
$51,000 ($1.36 x 37,500). Beibei’s profit is $4,068.75.

If the spot had decreased to $1.20 per pound, Beibei would have a
loss of $1,931.25 ($1.2515 - $1.20 = $.0515 per pound).

Question 6

CHARACTERISTICS OF FUTURES CONTRACTS

• Futures contracts, by definition, are standardized. These
  agreements have specific/characteristics which include:

Answer 6

CHARACTERISTICS OF FUTURES CONTRACTS

• Futures contracts, by definition, are standardized. These
  agreements have specific/characteristics which include:
• Contract size
• Contract value (also called notional value)
• Price limits
• Margin requirements
• Mark-to-market
• Settlement price
• Margin call

Question 7

FUTURES POSITION

Answer 7

FUTURES POSITION

• Investors can take long or short positions in futures contracts and
  can be hedgers or speculators.
• Purchasing a contract is termed a long position (take delivery).
• Selling a contract is called a short position (make delivery).

Question 8

LEVERAGE COMPARISON

Answer 8

LEVERAGE COMPARISON

• Buy $500,000 of SPY (S&P 500 ETF). This investment has zero
  leverage and requires $500,000 of capital.
• Buy $500,000 of SPY (S&P 500 ETF) on margin. This investment
  provides a 2-to-1 leverage. It controls the same asset as the first
  choice but with only $250,000 of capital.
• Take the long position in an S&P 500 Futures contract. This
  investment provides more than 20 times leverage with only $23,000
  of capital. It has approximately the same exposure to the S&P 500
  index as the SPY ETF.

Question 9

MARGIN TRADING

• Initial margin deposit:
• Maintenance margin:

Answer 9

MARGIN TRADING

• Initial margin deposit:
• An amount deposited with the broker
• Margin requirements range from 2% to 10% of the value of the
  contract
• Maintenance margin:
• The minimum amount of deposit required at all times
• Margin call occurs if value drops below allowed amount
• Mark-to-the-market - occurs daily, which is cash settlement based
  on the price movement of the underlying asset

Question 10

DAILY SETTLEMENT: EXAMPLE (1 OF 2)

On Monday morning, an investor takes a long position in a British
Pound futures contract that matures in three weeks. At the close of
trading on Monday, the account gains $200.
* At Tuesday close, the account has further gains of $100.
* At Wednesday close, the account loses $250.
* At Thursday close the account again falls, this time $900.
* At Friday close, the account loses $200.
* Initial Margin Requirement - $1,500
* Margin Maintenance - $1,000

Answer 10

DAILY SETTLEMENT: EXAMPLE (1 OF 2)

On Monday morning, an investor takes a long position in a British
Pound futures contract that matures in three weeks. At the close of
trading on Monday, the account gains $200.
* At Tuesday close, the account has further gains of $100.
* At Wednesday close, the account loses $250.
* At Thursday close the account again falls, this time $900.
* At Friday close, the account loses $200.
– Initial Margin Requirement - $1,500
– Margin Maintenance - $1,000

DAILY SETTLEMENT: EXAMPLE (2 OF 2

Question 11

SETTLING FUTURES CONTRACTS

Cash Settlement

Offsetting Trade

Answer 11

SETTLING FUTURES CONTRACTS

Cash Settlement
* Some types of futures contracts, such as the S&P 500 contract, call
for cash settlement. It would be impractical to deliver the underlying
securities in the index.

Offsetting Trade
* An offsetting trade is completed by entering into a position that is
opposite of the currently held position.

Question 12

TAXATION OF FUTURES CONTRACT

Answer 12

TAXATION OF FUTURES CONTRACT

• A futures contract is classified as an IRC Section 1256 contract.
• Sec. 1256 contracts include any regulated futures contract,
  any foreign currency contract, any non-equity option contract,
  any dealer equity option contract, and any dealer securities
  futures contract.
• Any gain or loss on a section 1256 contract is treated as:
  —40% short-term capital gain or loss, and
  —60% long-term capital gain or loss

Question 13

SWAPS

Answer 13

SWAPS

• A swap is an over-the-counter agreement between two or more
  parties to exchange future sets of cash flows.
• The agreement specifies the dates of payments and the
  methodology that is to be used to determine the payments.
• The future payments may be fixed or floating based on changes in
  interest rates, exchange rates, or other variables.
• Common swap types include interest rate swaps, currency swaps,
  and equity swaps

Question 14

INTEREST RATE SWAPS

Answer 14

INTEREST RATE SWAPS

• Financial institutions use interest rate swaps to mange risk.
• Financial institutions must constantly manage interest rate risk due
  to a mismatch in the maturity structure of assets and liabilities.

—Rate paid on deposits (short term) are variable
—Rates received on investments (long term) are fixed

Question 15

NTEREST RATE SWAPS EXAMPLE
* Example: Suppose an investor agrees to pay the fixed rate and receive the floating rate on a $100 million notional amount. The fixed rate is 5% and the floating rate is SOFR + 200 basis points.

• In one year, SOFR is 6%, the payments are as follows:
• The investor pays $5 million (0.05 × $100 million)
• The investor receives $8 million (0.06 + 0.02) × $100 million
• These payments are netted, so the investor receives $2 million
• In two years, SOFR is 2%, the payments are as follows:
• The investor pays $5 million (0.05 × $100 million)
• The investor receives $4 million (0.02 + 0.02) × $100 million
• These payments are netted, so the investor pays $1 million

Answer 15

NTEREST RATE SWAPS EXAMPLE
* Example: Suppose an investor agrees to pay the fixed rate and receive the floating rate on a $100 million notional amount. The fixed rate is 5% and the floating rate is SOFR + 200 basis points.

• In one year, SOFR is 6%, the payments are as follows:
  —The investor pays $5 million (0.05 × $100 million)
  —The investor receives $8 million (0.06 + 0.02) × $100 million
  —These payments are netted, so the investor receives $2 million
• In two years, SOFR is 2%, the payments are as follows:
  —The investor pays $5 million (0.05 × $100 million)
  —The investor receives $4 million (0.02 + 0.02) × $100 million
  —These payments are netted, so the investor pays $1 million

Question 16

CURRENCY SWAPS

Answer 16

CURRENCY SWAPS

• Currency swaps involve the exchange of principal and interest
  payments in one currency for principal and interest payments in
  another currency.
• The swap identifies the currencies as well as the principal amounts
  in each currency.
• The amounts are equivalent based on the exchange rate.
• In addition, the counterparties exchange the principal in each
  currency at the effective date of the agreement and exchange the
  principal back at the expiration of the agreement

Question 17

The futures price of an asset is increased by:

Answer 17

higher cost of carrying.
Rationale

Carrying cost generally results in a relatively higher futures price compared to the spot price for a commodity.

Question 18

Which of the following types of contracts are traded on exchanges in the United States?

Answer 18

Futures contracts.

Rationale

Executive contacts are generally employments contracts between corporations and executives. Forward contracts are negotiated agreements between two parties. Spot contracts are agreements to buy or sell at current prices. None of these contracts are traded on exchanges. Futures contracts are standardized agreements that are traded on exchanges.

Question 19

Futures trading in the U.S. is regulated by:

Answer 19

The Commodity Futures Trading Commission (CFTC).

Rationale

The mission of the Commodity Futures Trading Commission (CFTC) is to foster open, transparent, competitive, and financially sound markets, to avoid systemic risk, and to protect the market users and their funds, consumers, and the public from fraud, manipulation, and abusive practices related to derivatives and other products that are subject to the Commodity Exchange Act. In carrying out this mission and to promote market integrity, the Commission polices the derivatives markets for various abuses and works to ensure the protection of customer funds. Further, the agency seeks to lower the risk of the futures and swaps markets to the economy and the public.

Question 20

Which of the following is an advantage of interest rate swaps?

Answer 20

The ability to manage interest rate risk.
Rationale

An interest rate swap is an exchange of cash flows based on interest payments and is used to manage interest rate risk.

Question 21

Elsie entered into a “forward contract” to sell 100 shares of MMN stock at a price of $9 per share in exactly nine months. Now, the nine-month period has expired. MMN stock is trading at $12 per share.

What are the economic consequences for Elsie?

She has lost $300.
She has lost $900.
She has gained $300.
She has gained $1,200.

Answer 21

She has lost $300.

Rationale

Elsie has lost $300 [($9 - $12) x 100 shares].

Question 22

Which of the following is marked-to-market daily?
A fixed-rate loan.
A futures contract.
An option contract.
A forward contract.

Answer 22

A futures contract.

Rationale

Futures contracts are marked-to-market on a daily basis to help eliminate default risk.

Question 23

Which of the following is NOT correct regarding derivative securities?

Derivatives can be used for speculation and hedging.

The use of leverage is both an advantage and a disadvantage of derivatives.

The value of a derivative is tied to the value of an underlying security or asset.

Most types of derivatives are suitable investments for unsophisticated investors.

Answer 23

Most types of derivatives are suitable investments for unsophisticated investors.

Rationale

The use of leverage exponentiates both gains and losses, which can be an advantage or a disadvantage. This exponentiation of gains and losses, along with their relative complexity, makes most types of derivatives unsuitable for small unsophisticated investors.

Question 24

The financial institution that guarantees both sides of a futures contract is most likely known as a:

Answer 24

Clearing house.

Rationale

The clearing house is the institution that guarantees both sides of a futures contract.

Question 25

An individual buyer and seller of lumber may enter into a customizable sales transaction that will occur nine months from today. This type of contract is typically called a:

Buy/Sell agreement.
Forward contract.
Lumber contract.
Sales contract.

Answer 25

Forward contract.

Rationale

A forward contract is a customizable contract to buy/sell a specified commodity in the future at a predetermined price.

Question 26

Beau entered into a “forward contract” to buy 100 shares of ABC stock at a price of $8 per share in exactly nine months. Now, the nine-month period has expired. ABC stock is trading at $11 per share. What are the economic consequences for Beau?

He has lost $800.
He has gained $1,100.
He has lost $300.
He has gained $300

Answer 26

He has gained $300.

Rationale

Beau has gained $300 [($11 - $8) x 100 shares].

Question 27

Which of the following is most accurate?

Speculators always take the “other” side of trades made by hedgers.

Limit orders can only be used to exit a market position.

Price move limits remain the same regardless of market conditions.

Mark-to-market settlement of futures positions is based on end of trading day or trading session prices.

Answer 27

Mark-to-market settlement of futures positions is based on end of trading day or trading session prices.

Rationale

Option a is incorrect because futures contracts are “anonymous” transactions cleared, therefore it is impossible for participants to know what kind of transaction (i.e. hedge, speculation, offset) is the counterparty to their trade.

Option b is incorrect because all order types can be utilized to enter or exit a market position.

Option c is incorrect because limits are set by the Exchange and help to regulate dramatic price swings. When a futures contract settles at its limit price, the limit may be expanded to facilitate transactions on the next trading day. This may help futures prices return to a more normal trading range.

Question 28

A futures contract price is adjusted daily during the term of the contract, up or down, depending on current market conditions.
This adjustment is called:

SEC requirements for futures contracts.

Mark-to-market.

The “cheapest to deliver” option on a futures contract.

Initial margin requirements changing on a daily basis.

Answer 28

Mark-to-market.

Rationale

This is mark-to-market.

Question 29

In order for Kylie to buy a coffee futures contract, she is required to deposit a certain amount of money. What are these funds called?

Mark-to-market.

Cheapest to deliver.

Initial margin.

Open interest.

Answer 29

Initial margin.

Rationale

The initial margin is the amount of money that is required of the buyer and seller to help ensure that traders meet their financial obligations under the futures contract.

Question 30

A corn farmer who wants to hedge the price of corn should enter into what type of contract?

Buy a corn futures contract.
Sell a corn futures contract.
Long position in an option index.
Short position in an option index.

Answer 30

Sell a corn futures contract.

Rationale

A corn farmer would enter into a short (sell) futures contract because they wants to sell their corn.

Question 31

The risk of unexpected change in the difference between currency futures prices and currency spot prices is called:

Basis risk.
Foreign currency risk.
Exchange rate risk.
Interest rate risk.

Answer 31

Basis risk.
Rationale

Basis reflects the relationship between the spot price and the futures price. It is found by subtracting the futures price from the cash price. Basis risk is the risk of unexpected changes in the futures and spot prices.

Question 32

Which of the following factors are important when selecting a futures contract to trade?

Volatility.
Contract size (dollar value of the contract).
Liquidity.
All of the above.

Answer 32

All of the above.

Rationale

All of the factors are important in selecting a futures contract to trade

Question 33

Which of the following regarding futures contracts is least accurate?

A futures contract is essentially a standardized and marketable forward contract.

Futures markets use a clearing house to mitigate default risk.

Futures contracts can be used to lock in the future selling price of a commodity regardless of future changes in spot market prices.

The basis in futures is similar to a basis point in bonds.

Answer 33

The basis in futures is similar to a basis point in bonds.

Rationale

A futures contract is essentially a standardized marketable forward contract traded on an exchange.

The clearing house helps to eliminate default risk for the parties to the futures contract.

Buying or selling a futures contract fixes the price at which a good is bought or sold, regardless of changes in the spot price.

Basis reflects the relationship between the spot price and the futures price. It is found by subtracting the futures price from the cash price.

Question 34

Liquidity can be defined as the ability to transact quickly and efficiently without a substantial impact to the price of the underlying asset.

Which of the following transactions is the LEAST liquid?

Buying or selling an exchange-traded fund (ETF).
Buying or selling an E-mini S&P 500 futures contract.
Buying or selling a car.
Buying or selling a house.

Answer 34

Buying or selling a house.

Rationale

Buying and selling homes are very illiquid transactions. There are numerous factors for this, including substantial transaction costs (agent fees), difficulty in ascertaining an accurate market price and complications in verifying the capability of the buyer to complete the transaction.

All other transactions are more liquid.

Question 35

If the S&P 500 index futures price is undervalued relative to the spot S&P 500 index price, an arbitrage exists if the investor were to:

Buy the S&P 500 futures.

Sell short all the stocks in the S&P 500 and buy call options on the S&P 500 index.

Sell short all the stocks in the S&P 500 and buy the S&P 500 index futures.

Sell the S&P 500 index futures and buy all the stocks in the S&P 500.

Answer 35

Sell short all the stocks in the S&P 500 and buy the S&P 500 index futures.

Rationale

On a relative basis, the S&P 500 index is overpriced and the S&P futures is underpriced.

Therefore, an investor should sell the index and buy the futures.

Question 36

Which of the following best describes a futures contract?

The right to buy or sell a specified quantity of a particular asset during a given period at the spot price.

A standardized obligation to buy or sell a specified quantity of a particular asset during a given period for a given price.

An option to buy or sell a specified quantity of a particular asset during a given period for a given price.

A standardized obligation to buy or sell a particular asset in a specified quality at a future time, place, and unit price.

Answer 36

A standardized obligation to buy or sell a particular asset in a specified quality at a future time, place, and unit price.
Rationale

A futures contract is a standardized obligation to buy or sell a particular asset in a specified quality at a future time, place, and unit price.

Question 37

Which of the following regarding margin requirements for futures contracts is least accurate?

Margin requirements for futures contracts are generally significantly lower than requirements for equities.

The maintenance margin is always smaller than the initial margin.

The maintenance margin is only required for sellers of futures contracts.

The initial margin is the money placed with the clearing house when the trade is initially executed.

Answer 37

The maintenance margin is only required for sellers of futures contracts.

Rationale

The maintenance margin is required for both buyers and sellers of future contracts.

Question 38

The futures exchange specifies which of the following contract terms for futures contracts on commodities?

Option Quality Quantity Delivery Date Price
a √ √ √ √
b √ x √ x
c √ √ √ x
d x √ √ √

Option a.
Option b.
Option c.
Option d.

Answer 38

Option c.

Rationale

The futures exchange specifies all terms of the contract except price.

Question 39

Swaps and forward contracts are negotiated directly by the counterparties to the agreement and are:

Spot contracts.
Without default risk.
Over-the-counter contracts.
Standardized agreements offered by an exchange.

Answer 39

Over-the-counter contracts.
Rationale

Swaps and forward contracts are traded in the over-the-counter market between private companies. They are not void of default risk.

Question 40

Which of the following regarding basis is least accurate?

The basis is the difference between the spot price and the futures price.

The hedger bears the basis risk.

A short hedger suffers losses when the basis decreases.

The basis increases when the futures price increases by more than the spot price.

Answer 40

A short hedger suffers losses when the basis decreases.

Rationale

Losses to a short hedger occur when basis increases, not decreases.

Question 41

Which of the following regarding futures contracts is least accurate?

Futures contracts are available for Treasury bonds.
Futures contracts are available for stock indexes.
Futures contracts are available for silver.
Futures contracts are available for common stocks.

Answer 41

futures contracts are available for common stocks.
Rationale

Futures contracts are not available for common stocks.

Question 42

Bank 1 promises to pay Bank 2 a fixed rate of interest on a $20 million dollar principal amount. In exchange for this, Bank 2 promises to Bank 1 a floating rate of interest on the same $20 million dollar principal.

What is this called?

A call options contract.
A put option contract.
An interest rate swap.
A futures market transaction.

Answer 42

An interest rate swap.
Rationale

This is an example of a plain vanilla interest rate swap.