Arbitrage Futures contract part (A)

Question 1

what is the basic idea behind arbitrage?

Answer 1

is that if two assets provide the same cash flows, they must have the same price.

If not, investors are provided with the opportunity to make a risk-free profit by buying the undervalued asset and simultaneously selling the overvalued asset.

Question 2

what is a forward contract

Answer 2

a contract made today for delivery of an asset at a pre-specified time in the future at a price agreed upon today

setting a price today for a trade that will occur in the future. Both parties are obliged to fulfill their obligations under a forward contract

Question 3

describe role of buyers and sellers in a forward contract

Answer 3

The buyer (the person in the “long” position) of a forward contract agrees to take delivery of an underlying asset at a future time, T, at a price agreed upon today. No money changes hands until time T;

The seller (the person in the “short” position) agrees to deliver the underlying asset to the person in the long position at a future time, T, at a price agreed upon today. Again, no money changes hands until time T; and,

Question 4

Where are forward contracts traded?

Answer 4

traded over the counter rather than on a centralized exchange

Question 5

describe the over-the-counter market

Answer 5

is an informal market involving trades between a buyer and a seller of a security

Question 6

features of over-counter-market

Answer 6

–One of the parties is often an investment bank;
–The terms of the contract (size, timing, etc.) are customized for the clients (ie agreed upon by buyer and seller in each contract); and,
- Performance of the contract is not guaranteed by any third party, so each party bears the credit risk of the other (ie the risk that the other party will default

Question 7

distinguish between a future and forwards contract

Answer 7

1. Futures contracts are traded on organised exchanges with standardised terms, whereas forward contracts are traded over-the-counter (with the latter being customised one-off transactions between a buyer and a seller); and,
2. Intermediate gains or losses are posted each day during the life of the futures contract, a feature known as marking to market. This feature is designed to reduce the risk faced by each party

Question 8

why are future contracts standardized?

Answer 8

to create liquidity

Question 9

future contracts are standardized with respect to what three characteristics?

Answer 9

1. The type of asset underlying the contract, with futures contracts not available over every type of asset. By way of example, the Sydney Futures Exchange offers several futures contracts over wool (eg fine, greasy and broad wool futures), but doesn’t currently offer contracts over wheat;
2. The amount of a particular asset traded under 1 contract. For example, one greasy wool futures contract covers the equivalent of 2,500 kilograms clean weight of 21 micron merino combing fleece; and,
3. The expiry date, or the time when the contract ceases to exist (or when the asset is actually traded, if applicable). For example, greasy wool futures expire in February / April / June / August / October and December up to 18 months in advance

Question 10

apart from standardization of future contracts, what is another difference between future and forward contracts?

Answer 10

, futures transactions occur between two traders with an exchange clearing house providing a guarantee of performance for both parties.

Question 11

Futures Contracts and Marking to Market:

broadly what does marking to market mean?

Answer 11

When a party enters into a futures contract, they are required to establish a margin account, which will be used as part of the marking to market process

Question 12

Futures and marking to market

what does marking to market mean?

Answer 12

1. Marking to market involves the posting of intermediate gains or losses at the close of each trading day during the life of the futures contract;
2. These intermediate gains or losses, or margins, represent the difference between each day’s closing futures price and the prior day’s closing price, and are posted between the margin accounts of parties to the contract; and,
3. At the end of the contract, parties will settle at the last closing price.

Question 13

Calculate how much is transferred to your account each day

Answer 13

Question 14

Features of margin accounts

Describe initial balance requirements

Answer 14

These accounts have initial balance requirements (“initial margin”), typically set at an amount that is larger than usual one-day moves in the futures price. Consequently, relatively more margin is required for more volatile contracts than for more stable contracts. This is done to ensure that both parties will have sufficient funds available to mark to market.

Question 15

features of margin accounts

describe margin calls

Answer 15

–The margin account must be topped up by posting extra funds (“margin calls”) to the account when its balance falls below a predetermined level (often referred to as the “maintenance margin”);

Question 16

features of margin accounts

what is margin call?

Answer 16

margin call is the amount equal to the difference between the initial margin and the current account balance (ie the amount necessary to restore the account balance to the initial margin)

Question 17

features of margin accounts

what option do parties have?

Answer 17

Parties have the option of withdrawing funds in excess of the initial margin (ie they can choose to keep these funds in the account);

Question 18

features of margin accounts

what do parties settle at?

Answer 18

The parties settle at the closing futures price, with the balance of the margin account returned to parties upon expiration of the futures contract

Question 19

features of margin accounts

example of these features

Answer 19

Australian context, are traded on the Sydney Futures Exchange (SFE). Imagine that the following margin conditions apply to each party to a greasy wool futures contract*
–Each party to the contract must post an initial margin of $1,200 per contract, with each contract covering 2,500 kg clean weight of 21 micron merino combing fleece; and,
–Each contract has a maintenance margin of $1,000. In other words, if the balance of either party’s margin account falls below $1,000, they will be required to post a margin call to top the account back up to $1,200.

Question 20

If the initial and maintenance margins on the aforementioned contract are $1,200 and $1,000 respectively, and it is your practice not to withdraw funds in excess of the minimum required balance, the flow of funds into / out of the account would be as follows:

Answer 20

Question 21

Future contracts

Margin Accounts

residual credit risk exists only to the extent that:

Answer 21

1. Futures prices move so dramatically that the amount required to mark to market is larger than the balance of an individual’s margin account; and,
2. The individual defaults on payment of the balance of part 1.

In this case, the exchange bears the loss (via the clearing house) so that participants in futures markets bear essentially zero counterparty credit risk.

Question 22

What is a Futures Contract?

Contract Settlement

Answer 22

marking to market will occur each day over the life of the futures contract. Then at the end of the contract, parties will settle at the last closing price (often referred to as the final settlement price).

The manner in which this settlement actually occurs depends on the type of contract. Specifically:

–Most physical futures (agricultural, metal and energy futures) are settled by delivery of the physical commodity; but,
–Many financial futures (such as stock index futures) are cash settled.

Question 23

Example: Physical Contract Settlement

Let’s illustrate the first type of settlement using our wool example and, in doing so, show how, in effect, we have locked in the price current at the time we first entered the contract (i.e. 800 c / kg).

Throughout this example, we assume that the contract expires at the conclusion of trading on 11th February. Based on the settlement (closing) price at this time, the long position will provide 802c / kg in exchange for 2,500 kg of wool from the short position (NB: Penalties / discounts apply to the short position for variations around stipulated quality rules). However, in effect, the net impact of entering the contract is that the long position paid 800 c / kg, as evidenced below:

Answer 23

• Net change in margin account after accounting for margin calls (ie closing balance less opening balance less margin calls made) = $1,475 - $1,200 - $225 = + $50 or $50 / 2,500kg = +2 cents / kilogram (ie inflow);
• Buy wool at 802 cents / kilogram (ie outflow); and, therefore
• Net outflow is 802 – 2 = 800 cents / kilogram

Question 24

Futures Contract

Cash Settlement

what does this involve?

Answer 24

cash settlement simply involves a final exchange of cash at the expiration of the contract. More specifically, the expiration day is treated just like any other day in terms of its involving standard marking to market.

Question 25

Example: Cash Settlement

Imagine that you are a fund manager holding a $100 million portfolio that mimics the ASX 200 Index, and wish to lock in the value of the portfolio today in preparation for its sale in December. Further:
–You are aware of the existence of a type of futures contract known as the SPI contact, whose underlying asset is the ASX 200 Index;
–To “lock in” the value of your portfolio, you decide to take a short position in the necessary number of December SPI futures contracts, which each have a current price of 5000 points; and,
As SPI futures contract prices are quoted in points, with one point equal to $25, each contract covers ______

Answer 25

–As SPI futures contract prices are quoted in points, with one point equal to $25, each contract covers 5,000 x $25 = $125,000. Therefore, to lock in the value of your portfolio, you decide to go short in $100 million / $125,000 = 800 contracts.

Question 26

Imagine that you are a fund manager holding a $100 million portfolio that mimics the ASX 200 Index, and wish to lock in the value of the portfolio today in preparation for its sale in December. Further:

–You are aware of the existence of a type of futures contract known as the SPI contact, whose underlying asset is the ASX 200 Index;
–To “lock in” the value of your portfolio, you decide to take a short position in the necessary number of December SPI futures contracts, which each have a current price of 5000 points; and,
As SPI futures contract prices are quoted in points, with one point equal to $25, each contract covers 5,000 x $25 = $125,000. Therefore, to lock in the value of your portfolio, you decide to go short in $100 million / $125,000 = 800 contracts

Fast forward to December, and let’s imagine that the both the settlement (closing) price of the SPI futures contract and the spot price of the ASX 200 are 5,100. Accounting for the last day’s movement in prices (ie after marking to market identical to any other day during the contract), the contract ceases to exist. However, by entering into the contracts, you have still locked in the value of the contract as:

Answer 26

–Over the life of the SPI futures contract, you are “worse off” by 5,000 – 5,100 or 100 points (100 points x $25= $2,500) in margins per contract (as the contract will cease to exist after the last marking to market), or $2,500 per contract x 800 contracts = $2 million overall;

–Your portfolio has increased in value by 5,100 / 5,000 – 1 = 2%, meaning you can sell your portfolio in the spot market for 1.02 x $100 million = $102 million; and,

–Overall, despite going short in a contract that only involves cash settlement, your position is still $102 million - $2 million = $100 million.

Question 27

What features do forward contracts have that futures don’t?

Answer 27

–Can be tailored to meet the requirements of counterparties.

However, as these contracts are traded over the counter, they are illiquid

Question 28

What features do futures contracts have that forwards don’t?

Answer 28

1. Highly standardized and, therefore, cannot be tailored to suit individual requirements
2. However, as these contracts are exchange traded, they are highly liquid.
3. Also, the existence of marking to market on the contracts reduces default risk.

Question 29

Profits from Forward and Futures Contracts

Answer 29

futures contracts are marked-to-market and, therefore, profits are settled daily whereas profits for forward contracts are settled at the end of the contract

Question 30

Profits from Forward and Futures Contracts

–that futures contracts are marked-to-market and, therefore, profits are settled daily whereas profits for forward contracts are settled at the end of the contract; but,

Answer 30

Despite these timing differences, the overall profit on a futures contract will be the same as that on an otherwise identical forward (ie a forward contract relating to the same asset with the same contract price, contract size, expiry date and spot price at expiry)

Question 31

profits from a long position in a forward contract

Examination of the payoff diagrams shows that

Answer 31

The profit of a party long in a forward or futures contract is an increasing function of the spot price of the asset underlying the contract at the contract’s maturity

Question 32

profits from a short position in a forwards contract

Examination of the payoff diagrams shows that

Answer 32

The profit of a party short in a forward or futures contract is a decreasing function of the spot price of the asset underlying the contract at the contract’s maturity.