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Ch1 - Introduction to Derivatives > 2. Futures and Forwards > Flashcards

2. Futures and Forwards Flashcards

1
Q

What are five components of a futures contract?

A
  1. An agreement to buy (or sell)
  2. A specified quantity of
  3. A specified asset on
  4. A specified future date at a
  5. A price agreed today
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2
Q

How are futures typically traded?

A

On an Exchange

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3
Q

Future contracts have certain terms standardised in which document?

A

The contract specification

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4
Q

Why do contract specifications exist?

A

Because it would not be financially viable for an Exchange to satisfy every single traders precise requirements

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5
Q

Contract specifications also promote what?

A

Transparency across Exchange users

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6
Q

What three elements of the contract are specified by the Exchange?

A
  1. The asset
  2. The quantity
  3. The future date
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7
Q

What is NOT dictated by the Exchange, and how is it impacted instead?

A

The price
- it is impacted by market forces

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8
Q

What three commodities are categorised as ‘softs’?

A
  1. Cocoa
  2. Coffee
  3. Sugar
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9
Q

Metal commodities are categorised into which two types?

A

Base metals and precious metals

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10
Q

Name five types of financial futures?

A
  1. Interest Rates
  2. Bonds
  3. Credit
  4. Currency Exchange (FX)
  5. Stock market indices
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11
Q

What is meant by the term ‘basis’?

A

Basis is the difference between the price of the underlying asset, and the price of the future.

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12
Q

Can basis risk be perfectly hedged?

A

No
The movement in basis represents a risk that cannot be perfectly hedged by a futures position.

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13
Q

What is meant by the term ‘fungible’? What two elements must be the same for the contract to be considered ‘fungible’?

A

A contract that is identical to, and substitutable with another contract.
1. The underlying asset must be the same
2. The delivery date must be the same

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14
Q

How can a trader remove any delivery obligations?

A

By taking an equal and opposite position to the one held. By doing so, they’ve ‘closed out’ their position.

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15
Q

What is the long position in a futures contract?

A

The long is the buyer who will buy the asset from the short.

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16
Q

What is the short position in a futures contract?

A

The short is the seller who will sell the asset to the long.

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17
Q

The long position is what type of strategy? Explain.

A

A bullish strategy. They believe that the price will go up, so they will enter the future to buy at the agreed price, believing that they will sell it on for a profit.

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18
Q

The short position is what type of strategy? Explain.

A

A bearish strategy. They believe that the price will go down, so on the agreed date they will be able to buy the asset for a reduced price ams sell at the agreed price making a profit.

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19
Q

Name four key organised exchanges

A
  1. ICE Futures (Europe)
  2. Euronext Derivatives (Europe)
  3. CME Group (US)
  4. Singapore Exchange (SGX)
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20
Q

How do forwards mainly differ from futures?

A

They are commonly bilaterally (directly between two parties) OTC (over-the-counter)

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21
Q

In a futures/forwards contract, is the agreed price paid on the day the terms are agreed?

A

No

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22
Q

Are any forward (OTC) contracts traded on Exchange as an exception?

A

Yes. The London Metals Exchange (LME) trades certain OTC contracts for non-ferrous metals and steel

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23
Q

Who are most forward OTC contracts with? Name two institutions.

A

Banks and Imvestment Banks

24
Q

Outright forwards are a product most commonly traded on which market?

A

The foreign exchange (FX) market

25
Q

In which market is physical delivery most common?

A

The commodities markets. For example an airline will require oil, and want physical delivery.

26
Q

What are the three main advantages of forwards compared to futures?

A
  1. Flexibility (to customise precise terms)
  2. A wide range of underlying assets, and
  3. Available from most commercial banks
27
Q

What are the three main disadvantages of forwards compared to futures?

A
  1. Less liquidity
  2. Lack of transparency & increased costs
  3. Increased counter-party risk
28
Q

Explain what is a physically deliverable contract?

A

A contract based on a tangible asset, e.g. crude oil. If the contract is carried out to expiry the underlying is exchanged for the agreed cash sum & delivered.

29
Q

What is a CFD (Contract for Difference)?

A

Where it is impossible or impractical to deliver the underlying, e.g. an interest rate or stock market index, therefore On expiry they will be cash settled.

30
Q

What is the name given to an informal CFD?

A

Spread betting

31
Q

Why are two reasons that traders attracted to spread betting?

A
  1. Very wide range of underlying assets
  2. In many jurisdictions it is classed as gambling, and the gain is not subject to capital gains tax (CGT).
32
Q

What is the most popular spread bet?

A

A STIR (a short term interest rate contract).

33
Q

In spread betting, what are a long and short position referred to as?

A
  1. Long position = up bet
  2. Short position = down bet
34
Q

What are three ways that futures & forwards can be used?

A
  1. Speculation
  2. Hedging
  3. Arbitrage
35
Q

What do speculators do?

A

They take on risk to seek to make profits from price movements.

36
Q

What is it important to note regarding speculators?

A

They neither have nor want the asset - they simply wish to profit from the price movement.

37
Q

If a speculator believes that prices will go up, what position will they take?

A

A long position

38
Q

If a speculator believes that prices will go down, what position will they take?

A

A short position.

39
Q

Why are futures often more attractive than simply buying the underlying directly?

A

Because they have leverage/gearing. For a small initial investment/expenditure they obtain a big exposure.

40
Q

When trading in futures, what must a trader also account for?

A

Margin requirements - they must have sufficient liquidity to meet these.

41
Q

What do hedgers do?

A

They seek to reduce risk, and protect themselves from price movements.

42
Q

Explain what a hedged will do to reduce risk?

A

They will take an opposition position in the futures market to the one currently held.

43
Q

Explain this hedging example; if a fund manager is long the underlying, what is their concern and how do they hedge against this?

A

As they are long, they are concerned about prices falling. To hedge they will sell a future to create a ‘short hedge’.

44
Q

Explain this hedging example; if a fund manager is short the underlying, what is their concern and how do they hedge against this?

A

As they are short, they are concerned about prices rising. To hedge they will buy a future, thus a ‘long hedge’.

45
Q

A perfect hedge is described as what?

A

A risk free position.

46
Q

Is it easy to achieve a perfect hedge through exchange-traded derivatives?

A

No, due to the standardisation of the contract specifications you cannot perfectly match the terms you require.

47
Q

What will an arbitrageur seek to do?

A

Exploit price anomalies between two market. They will buy the asset at the lower price in one market, and sell at the higher price in another market. This gives a risk free profit realised when the two markets come into line, and the position is closed out.

48
Q

Draw a long future pay off profile, assuming an agreed price of £100. Include the maximum loss and gain

A

See image

49
Q

Draw a short future pay off profile, assuming an agreed price of £100. Include the maximum loss and gain

A

See image

50
Q

What is market risk?

A

The risk of the price of the underlying moving for/against you on expiry.

51
Q

In a futures/forward contract, the long and short position are said to be what of each other?

A

Mirror images/opposites of each other

52
Q

Due to the fact the long and the short positions in a futures contract are the mirror image of each other, the contracts are sometimes called what?

A

A zero sum game.

53
Q

What is counter-party risk?

A

The risk that the other side (the counter party) of the contract does not or cannot honour their obligations.

54
Q

Is counter party risk higher or lower in the case of futures compared to forwards?

A

Extremely low due to the clearing house becoming the counter-party to both the buyer and seller in a futures contract.

55
Q

What is liquidity risk?

A

Risk of loss due to being unable to exit (or enter) a contract in a reasonable timeframe, and at a fair price.

56
Q

Is liquidity risk higher or lower with futures compared to forwards?

A

Lower due to contract specification/standardisation increasing liquidity.

57
Q

What is operational risk?

A

Risk of failed processes, people and systems.

Ch1 - Introduction to Derivatives (7 decks)

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