Futures Contracts

Question 1

What are the market participants and what do they do?

Answer 1

Hedgers - Hedgers use futures markets for protection against negative price movements.

Speculators – aim to make money from higher or lower prices by taking a view of future price direction.

Arbitrage traders – profit from mispriced instruments by entering and executing a trade.

Question 2

Define: Futures market

Answer 2

a place where market participants
(buyers and sellers) meet to determine the future price of something (underlying asset) today.

Question 3

Define: Futures contract

Answer 3

Instruments which give the holder the opportunity to buy/sell a particular commodity or financial instrument at a predetermined price in the future

Question 4

How are future contracts used?

Answer 4

Used to fix the value of a commodity or financial instrument for the future.

Question 5

List: Two basic futures positions

Answer 5

Long futures position
Short futures position

Question 6

Explain: Long futures position

Answer 6

Buying a futures contract
This will lead to a long position in the market as well

Side note: Hedge against an INCREASE in the price of the underlying

Question 7

What does it mean when a long futures position is in-the-money?

Answer 7

when the underlying spot price price (S) > contract strike price (X) (receives margin)

Question 8

What does it mean when a long futures position is out-of-the-money?

Answer 8

when the underlying spot price price (S) < contract strike price (X) (pays margin)

Question 9

What does it mean when a long futures position is at-the-money?

Answer 9

when the underlying spot price price (S) = contract strike price (X) (neutral)

Question 10

Explain: Short futures position

Answer 10

Selling short a futures contract
This will lead to a short position in the market as well

Side note: Hedge against a DECREASE in the price of the underlying

Question 11

What does it mean when a short futures position is in-the-money?

Answer 11

when the underlying spot price price (S) < contract strike price (X) (receives margin)

Question 12

What does it mean when a short futures position is out-of-the-money?

Answer 12

when the underlying spot price price (S) > contract strike price (X) (pays margin)

Question 13

What does it mean when a short futures position is at-the-money?

Answer 13

when the underlying spot price price (S) = contract strike price (X) (neutral)

Question 14

List: The two ways to execute a futures contract

Answer 14

Offsetting
Making or taking delivery of the underlying instrument (mostly for agricultural commodities)

Question 15

Explain: Offsetting

Answer 15

entering into an opposite position of what you have
(same expiry month, same underlying instrument)

Question 16

How to close a long futures position?

Answer 16

sell a long futures contract

Question 17

How to close a short futures position?

Answer 17

buy back a short futures contract

Question 18

Define: In-the-money

Answer 18

(a) a call option where the asset price is greater than the strike price
(b) a put option where the asset price is less than the strike price.

Question 19

Define: Out-of-the-money

Answer 19

(a) a call option where the asset price is less than the
strike price
(b) a put option where the asset price is greater than the strike price.

Question 20

Define: At-the-money

Answer 20

Where the underlying spot price is equal to the contract strike price (neutral)

Question 21

Define: Spot price

Answer 21

The price for immediate delivery.

Question 22

Define: Strike price (exercise price)

Answer 22

The price at which the asset may be bought or sold in an option contract.

Question 23

Define: Contango

Answer 23

is the market condition wherein the price of a
forward or futures contract is trading above the expected spot price at contract maturity – Normal market conditions

Question 24

Define: Backwardation

Answer 24

is the market condition wherein the price of a
forward or futures contract is trading below the expected spot price at contract maturity – NOT normal market conditions

Question 25

Define: Initial margin

Answer 25

The amount that must be deposited at the time the contract is entered into

Question 26

Define: Variation margin

Answer 26

An extra margin required to bring the balance in a margin account up to the initial margin when there is a margin call.

Question 27

What happens when the delivery period for a futures contract approaches?

Answer 27

the futures price converges to the spot price of the underlying asset

Question 28

What happens when the delivery period for a futures contract is reached?

Answer 28

the futures price equals or is very close to the spot price

Question 29

Why is the futures price equals or is very close to the spot price when the delivery period is reached?

Answer 29

the carry cost is reduced over time, causing the market to “arbitrage” the difference between the futures price and the spot price

Question 30

Explain: Cash settlement

Answer 30

The movement on the underlying is payable in cash

Question 31

Explain: Physical settlement

Answer 31

The physical underlying asset is exchanged

Question 32

Define: Futures prices (X)

Answer 32

is the price at which you agree to buy or sell

Question 33

How is the futures prices determined?

Answer 33

It is determined by supply and demand of the underlying in the same way as a spot price

Question 34

Define: Hedging

Answer 34

is the process where we reduce or offset the probability of loss from fluctuations in the prices of commodities, currencies, or securities.

Question 35

Define: Hedge ratio

Answer 35

The ratio of the size of a position in a hedging instrument to the size of the position being hedged.

Question 36

What are the uses of hedging?

Answer 36

it can be used in protecting one's capital against effects of inflation through investing in high-yield financial instruments, real estate, or precious metals.

Question 37

Define: Hedge effectiveness

Answer 37

the proportion of the variance that is eliminated by hedging

Question 38

What are we seeking to get with the hedge effectiveness?

Answer 38

seeking a 100% hedge or as close as possible

Question 39

What is h*?

Answer 39

optimal hedge ratio

Question 40

What is h* called when it comes to shares?

Answer 40

Beta

Question 41

What does beta (h*) measure?

Answer 41

measures sensitivity of a share in relation to the market

Question 42

What is the correlation between a portfolio and the market?

Answer 42

+1 (tracker fund)

Question 43

What is the beta value (h*) for an all share index (ALSI)?

Answer 43

1

Question 44

Define: Basis risk

Answer 44

the uncertainty as to the difference between the spot price and the futures price

Question 45

When are we exposed to basis risk?

Answer 45

When using different futures contracts to hedge other assets

Question 46

Profit or loss:When is profit or loss made?

Answer 46

When the position is closed

Question 47

Profit or loss: When will the money in the variation account translate into a profit or loss?

Answer 47

The money in the variation margin account will translate into a profit/loss when the position is closed out

Question 48

Rolling positions: When can profit or loss be made?

Answer 48

The profit/loss can only be made on current open positions (long or short)

Question 49

Rolling positions: When does the profit or loss position resets?

Answer 49

Once the position is “rolled” to a following contract month, the P/L position resets and will be calculated on the new contract month

Question 50

Buying or selling the spread: List the two types of spreads

Answer 50

Calendar spreads Inter-commodity spreads

Question 51

Buying or selling the spread: Explain calendar spreads

Answer 51

The difference between two contract months

Question 52

Buying or selling the spread: Explain inter-commodity spreads

Answer 52

The difference between two different commodities/assets

Question 53

Buying or selling the spread: How do you choose the positions of two assets (A & B) when buying the spread?

Answer 53

a long position is taken in asset A while a short position is taken in asset B