Practice Test 2

Question 1

A business firm that has sold a commodity which is not owned and has hedged with a purchase of futures is said to be:

a. Short the basis
b. Long the basis
c. A short hedger
d. Both b and c

Answer 1

a. Short the basis
An individual is “short the basis” when he is short the cash commodity. Examples would be the grain exporter who has entered into a contract to supply grain at a fixed price for delivery at a later date, and who does not currently own the grain. Another example would be a plywood dealer who has sold plywood to a home builder for delivery at today’s price. Delivery will not be made for six months, and the dealer does not currently own the cash plywood. A third example would be a flour miller who has contracted to supply flour to a bakery over the next 12 months, and who has not yet purchased the wheat.

In all of the above examples, the business firm has committed itself to deliver a commodity at a fixed price sometime in the future. The firm does not own the cash commodity and is concerned with a price rise. It will therefore hedge buying futures (long hedge).

The terms “long the basis” and “short hedger” both apply to the hedger who is long the cash commodity. As he would be concerned with a price decline, he will sell futures. An example of a business that is long the basis (long cash) and who would sell futures (short hedge) is the grain elevator operator who has grain in inventory. He will sell futures to protect against falling prices.

Question 2

Which of the following is NOT considered to be part of carrying charges:

a. Storage costs
b. Interest
c. Transportation
d. Insurance

Answer 2

c. Transportation
Transportation is not considered part of carrying charges.

Question 3

Firms are required to keep a record of all option complaints.

a. True
b. False

Answer 3

a. True
This is true. NFA Rule 2-18 requires that the firm keep a copy of all option complaints they receive and make a notation concerning the action taken to resolve the situation.

Question 4

The term “reversal chart” would apply to a:

a. Bar chart
b. Line chart
c. Point and figure chart
d. Moving average chart

Answer 4

c. Point and figure chart
Point and figure charts are handled differently than bar charts. In a bar chart, the high and low range for the day, plus the closing price, are plotted on the chart. In a point and figure chart, this is not done. In this type of chart, the analyst first determines the scale he will use. The scale might be 1/2 cent, or 1 cent, or any other variation that he chooses. Whatever scale is decided upon then determines what will be plotted on the chart.

Let’s assume that the analyst determines that he will use a 1 cent scale. He will make entries on his chart only if the price of the commodity advances or declines by one cent. It does not matter over how long a period this change takes place. As soon as the change upward or downward is 1 cent, an entry will be made. Let’s assume that the initial price of the commodity is $4.10. The commodity trades the following day up to a high of $.10 3/4. No entry will be made on the chart at all because the price has not varied by the scale amount of 1 cent. The next day, the commodity advances to $4.11 1/4. Since the advance was over 1 cent from the initial starting price, an entry would be made on the chart. The commodity does not fluctuate over the next three days more than 1/4 point, so no entries will be made. On the following day, however, the commodity advances to $4.13. Since the change in price was over 1 cent, another entry would be made on the chart.

On the following day, the commodity drops in price to $4.12 1/2. As this is a change of less than 1 cent, no entry is made. The next day, the price drops again, to $4.11 3/4. As the change was now over one cent, another entry would be made.

Note that prices are plotted when they either advance or decline by the amount that the analyst has determined as his variation. If the price has advanced, and then reverses itself and declines by the amount of the variation (in this case 1 cent), an entry is made on the chart. This is the reason why the point and figure chart is also referred to as a “reversal chart.”

Question 5

A trader buys a corn contract at $1.25. Margin is 12 cents a bushel and the commission is $30. The contract size is 5,000 bushels. If he sells the contract at $1.31, his profit is:

a. 50%
b. 45%
c. 15%
d. 5%

Answer 5

b. 45%
The question states that margin is 12 cents a bushel. Therefore, multiply the margin of 12 cents by the number of bushels (5,000) to indicate a margin deposit of $600. The question further states that the price advances by 6 cents a bushel. Therefore, multiply 6 cents by the number of bushels in the contract, to indicate an advance of $300. The customer’s gross profit is therefore $300. From this profit of $300, we must deduct the commission of $30, to indicate a net profit of $270. In order to determine his margin of profit on his investment, we would divide the net profit of $270 by the total amount of his investment ($600), which indicates a profit of 45%.

Question 6

There is a maximum discount at which a distant futures month can sell under a near futures month.

a. True
b. False

Answer 6

b. False
In an inverted market (also called a discount market), cash is selling above futures, and nearby futures are selling above distant futures. There is no maximum amount of discount between nearby futures and distant futures. In a premium market, where cash is selling for less than futures, and the nearby futures are less than distant futures, there is a maximum premium that distant futures may sell above near futures. This maximum premium is the amount of the carrying charges. However, although there is a maximum premium in a carrying charge market, there is no maximum discount in an inverted market.

Question 7

If an investor is long a put option on a financial futures contract and he decides to exercise, he will assume a:

a. Long futures position
b. Short futures position
c. Long actuals position
d. Short actuals position

Answer 7

b. Short futures position
Anyone who buys or is long a put option on a financial future will assume a short futures position if the option is exercised.

Question 8

Margin due from a clearing house member based upon the settlement price is payable to the clearing house:

a. 24 hours after the call
b. 1 hour after the call
c. Before the market opens the next business day
d. None of the above

Answer 8

c. Before the market opens the next business day
A member firm is required to deposit both original and variation margin with the clearing house before the opening of trading on the following day. In the event that the market for a commodity is particularly volatile, the clearing house has the right to demand immediate margin. This emergency margin would have to be deposited by the member firm within one hour.

Question 9

The sale of corn futures by a hog feeder is a bona fide hedge.

a. True
b. False

Answer 9

b. False
Since the hog feeder is short the basis (does not own corn), he will establish a long hedge.

Question 10

When nearby futures are below the deferred futures, the market is called:

a. A discount market
b. An inverted market
c. A regular market
d. A normal market

Answer 10

d. A normal market
A “normal market,” which is also called a “premium market” and a “carrying charge market,” is one in which the cash price is lower than the futures prices, and the price of near futures is lower than the price of deferred futures.

If the cash price is higher than the price of futures, and the price of near futures is higher than the price of deferred futures, the market is called an “inverted market” or a “discount market.”

Question 11

To liquidate a long position when the futures price reaches a certain level above the existing price, one would enter:

a. A sell stop order
b. A buy stop order
c. A sell limit order
d. A fill or kill order

Answer 11

c. A sell limit order
A trader liquidates a long position by selling. If he wants to liquidate a long position at a price that is above the current market, he will enter a sell limit order. This is an order that may be executed only at or above the price specified in the order. For example, an individual might have bought a contract of plywood at 115. He anticipates that the price will advance to 120, at which price he wants to sell in order to take his profit. He will enter a limit order to sell at 120. If the contract trades up to this price, the broker will sell, but under no circumstances will he accept less than 120.

The sell stop order is placed below the market. This type of order will be entered by a trader who has a long position and who wants to limit his loss on the downside. In the above example, the trader who bought the contract at 115 and anticipated an advance to 120 realizes that the price could drop, in which case he will suffer a loss. Therefore, he might enter a sell stop order at 110, which instructs the broker to sell at the market if the contract sells down to or below 110.

The buy stop order is placed above the market. It is used to limit a loss on a short position. The trader might have sold short at 120, anticipating a drop in price. However, as he realizes the price could also advance, causing a loss, he will enter an order to buy at 125. If the contract rises to 125 or higher, the broker will buy it at the market.

A fill or kill order is an order to be executed immediately when the broker enters the trading pit. He may do all or part of the order. If any part of the order cannot be completed immediately, it will be canceled.

Question 12

The agency responsible for floor brokers and floor traders is the:

a. NFA
b. CFTC
c. Exchange
d. NASD

Answer 12

b. CFTC
The CFTC is the agency responsible for the commodity industry including floor brokers and floor traders. An exchange is a membership organization. The NFA is an industry association. Both the exchange and the NFA are DSROs (Designated Self-Regulatory Organizations). The CFTC is the independent federal agency that has overall responsibility to regulate the futures industry.

Question 13

The primary significance of volume and open interest lies in:

a. Their respective changes in connection with price changes
b. Their changes in connection with each other
c. Whether their size is large or small
d. Their relationship to the size of the crop

Answer 13

a. Their respective changes in connection with price changes
Volume and open interest figures are used by technical analysts to estimate the course of the market. Volume figures measure the total number of contracts that are traded. Open interest is the total number of contracts that have been established and that have not yet been liquidated.

Some technical analysts think that changes in volume and the direction of the market can be reliable indicators of the trend of the market. For example, if the market is increasing in price and the volume is also increasing at the same time, this could indicate a continuing uptrend. If the market declines in price and the volume increases as the price declines, this could indicate a continuing downtrend in the market.

Technical analysts also use the trend of prices and open interest to make judgements about the future course of the market. For example, if the open interest is increasing, this means that new buyers and new sellers are entering the market. If the price increases at the same time the open interest increases, the market is considered to be technically strong. The reasoning behind this analysis is that the new longs are increasing their buying power as the price advances and will be able to assume new positions. The shorts, on the other hand, are suffering losses as the market advances and can be expected to start closing out their positions to cut their losses. Shorts close out their positions by buying the commodity, and this will add more buying pressure to the market, thus causing further price advances.

At the top of the market, some longs will attempt to sell to realize their profit, but will find that new buyers are not interested in entering the market at prices that they consider to be too high. The longs will therefore have to offer their contracts at progressively lower prices and the market will drop. Since new buyers are not entering the market, the longs will be selling to the existing shorts and the open interest will be declining. This type of market is technically weak and is called a “liquidating market.”

Question 14

An RCR may enter an order for a customer who is currently undermargined if the customer assures him that a remittance is under way.

a. True
b. False

Answer 14

a. True
The margin rules of the Chicago Board of Trade require that a member may not accept orders for new transactions from a customer unless the minimum initial margin on the new transaction is deposited and the margin on established positions is at least equal to maintenance requirements of the exchange. However, if a customer states that funds required to fully margin his account are being transmitted at once, the member firm may accept this as adequate for a reasonable period of time and may allow the customer to establish a new position.

Question 15

A hedged position does not guarantee full price protection against adverse price movements because:

a. The basis may change
b. The actual position held in inventory may not be an exact multiple of the futures contract
c. The basis grade may differ from the hedger’s cash position
d. All of the above

Answer 15

d. All of the above
All of the factors listed in the answer are correct statements. The purpose of a hedge is to protect the hedger against losses on his cash position. If the hedge is perfect, which means that there is no change in the basis between the hedger’s cash price and his futures price when the hedge is placed and when it is lifted, the hedge would be the purchase of cash wheat at $2.50 and the sale of futures at $2.60, with the hedge lifted when cash wheat is $2.30 and futures are $2.40. The basis was 10 cents under (cash was 10 cents less than futures) when the hedge was placed and when the hedge was lifted.

Few hedges are perfect, and therefore the hedger could still suffer a loss if the basis changes in an adverse direction. The hedge will still afford him protection against most of the loss due to adverse price change, but will not afford him full protection. Let’s examine the reasons why the hedge might not be completely effective.

An adverse change in the basis could result in a loss. Let’s assume that a hedger is long 1,000 tons of sugar. He buys the sugar for 38.70 and hedges when the price of futures is 39.90. His basis is therefore 1.20 cents under. His cash price of 38.70 is 1.2 cents under his futures price of 39.90. Since he is long 1,000 tons of sugar, he will establish a selling hedge by selling 20 sugar contracts (a contract in sugar is 50 tons). If the price of cash and futures rises or falls by exactly the same amount when the hedge is lifted, he will have neither profit nor loss. However, if the price of cash should drop more than the price of futures, he would suffer a loss. Let’s assume that the price drops for both cash and futures. The cash price drops to 38.20 and the futures price drops to 39.50. His basis is now 1.30 under. Since the basis widened, he will suffer a loss. The following shows his initial and closeout positions.

## Cash Futures Basis Buy 1,000 tons at 38.70 Sell 20 contracts at 39.90 1.20 under Sell 1,000 tons at 38.20 Buy 20 contracts at 39.50 1.30 under Loss .50 Profit .40 The hedger has a loss of 50 points (1/2 cent per pound) on his cash position. This was only partially offset by his profit of 40 points on his futures. His net loss was therefore 10 points, which is 1/10th of a cent per pound. As he was long 2,400,000 pounds (1,000 long tons at 2,400 pounds each), his net loss on the hedge was $2,400 (2,400,000 times .001). Had he not hedged his position, however, his loss would have been the full 1/2 cent per pound, or $11,200.

Another reason why a hedge might not be fully effective is if the hedger’s cash position is not a multiple of the futures contract. For example, if the sugar hedger was long 1,030 tons, he would have to hedge either 20 contracts and remain vulnerable for 30 tons on his cash position, or 21 contracts, which would leave him vulnerable for 20 tons on his futures position. If he hedged 20 contracts and the price dropped, he would bear the full extent of the loss on 30 tons. If he hedged 21 contracts and the price advanced, he would bear the full extent of the loss on 20 tons.

A third reason why a hedge might not be fully effective is because the basis grade of the commodity that is traded might differ from the hedger’s cash position. The factors that affect the basis grade might not be the same as the factors that affect the cash grade. For example, an individual might be long No. 1 wheat and he hedges on the Chicago board of Trade, where the basis grade is No. 2 wheat. No. 1 wheat might drop by 1 cent a bushel, while No. 2 wheat drops by only 3/4 cent a bushel, because of different supply and demand factors between the two grades of wheat. His loss of 1 cent on his cash wheat will only be partially offset by his gain of 3/4 cent on his selling hedge of No. 2 wheat.

Question 16

A customer is long five contracts of sugar at 7.55. He offsets the position when sugar is 8.55. Round-turn commissions are $30. The size of the contract is 112,000 lbs. The net profit is:

a. $1,090
b. $1,120
c. $5,450
d. $5,600

Answer 16

c. $5,450
The net profit is $5,450, calculated as follows:

##

Question 17

All of the following are advantages of futures trading EXCEPT:

a. Provides an alternative market for the commodity which increases liquidity of inventory
b. Buyers and sellers are able to deal directly with each other
c. The cost of financing is lowered through hedging
d. The value or price of a commodity is constantly being established

Answer 17

b. Buyers and sellers are able to deal directly with each other
All are advantages of futures trading except that buyers and sellers can deal directly with each other. When a futures contract is entered into by a buyer and a seller, it is done through a brokerage firm that is a member of the exchange. The buyer and the seller are not aware of each other’s identity, and there is no direct dealing between them.

The futures market does provide an alternate channel for the marketing of the cash commodity when a futures contract is settled by delivery, the cost of financing can be reduced because banks will lend money on a more favorable basis when a position is hedged, and the price of a commodity is constantly being established through sales that take place on the exchange.

Question 18

A buy stop order becomes a market order when there is an execution or bid at the stop price.

a. True
b. False

Answer 18

a. True
A buy stop order is an order that is placed above the market, to buy the commodity if the price rises to or above the stop price. The buy stop order in commodities differs from the buy stop order in securities in that the securities stop order is one that becomes a market order when the stock trades at or above the stop price. In the commodities stop order, the order becomes a market order when the commodity trades at or above, or is bid at or above, the stop price.

Let’s examine a buy stop order to see how it is handled. A customer has sold a contract of oats at 99. He thinks that the price will fall, and he will therefore profit by buying the contract at the lower price. However, he realizes that the price could advance as well, and he would like to minimize his loss to around 2 cents a bushel, so he enters an order to buy a contract at 101 stop. The floor broker gets the order and holds it until the price rises. After a few days, the price has risen. The highest bid is now 100 3/4 and the lowest offer is 101 1/4. A broker enters the crowd and buys the contract offered at 101 1/4. The stop is immediately put into effect and a contract will now be bought at the best price available.

Let’s see how the order would be effected on a bid at the stop price. The market is once again 100 3/4 bid, 101 1/4 offered. A broker enters the crowd and bids for the commodity at 101. Since this bid is at the stop price, the order will immediately become a market order. The broker with the stop order will now buy the contract offered at 101 1/4.

Question 19

Since a call option is the right to go long the futures market and a put option is the right to go short the futures market, a put option offsets a call option.

a. True
b. False

Answer 19

b. False
This is false. An investor closes out (offsets) an option position by undoing the opening position. An investor long a call option closes out the position by selling the call (not with a put).

Question 20

When a customer signs his margin agreement, he is allowing the member firm to automatically transfer funds from his regulated commodities account to his securities account if there is excess equity in the commodities account and a deficit in the securities account.

a. True
b. False

Answer 20

b. False
The margin agreement does not allow the member firm to transfer funds from a commodity futures account into a securities account. In order to transfer funds, the customer would either have to give his written permission each time a transfer is to be made, or would have to sign the transfer consent form (supplemental agreement) to have transfers made automatically.

Question 21

A businessman has agreed to deliver the cash commodity in three months at the price in effect today. In order to hedge effectively, he would:

a. Sell futures
b. Buy futures
c. Buy the cash commodity
d. All of the above are possible ways to hedge his risk

Answer 21

b. Buy futures
The businessman has agreed to deliver the cash commodity in the future. He does not own the cash commodity and wishes to protect himself against a price rise. He would therefore buy futures.

Question 22

Which of the following is not an important influence affecting futures prices for an agricultural commodity?

a. Changes in Government agricultural policy
b. Stated opinions of officials of the various exchanges
c. News regarding international developments and monetary devaluation
d. Weather, seasonal price patterns and general business conditions

Answer 22

b. Stated opinions of officials of the various exchanges
Choices (a), (c) and (d) are all important influences that will cause price changes in commodities. Government agricultural policy is a very important factor. To just cite two of many possibilities, if the Government announced the end of acreage allotments in a commodity that was subject to them, this could be expected to greatly increase the supply of the commodity. If the Government announced that it was increasing its purchases of commodities to make donations to needy nations, this would have a direct bearing on demand for the commodity.

News regarding international developments and money devaluations would have a direct impact on prices of commodities. For example, announcement of a much larger crop in certain foreign countries would lead to a greater supply and a concurrent drop in price, whereas news of a drought would lead to a smaller crop and a greater demand, indicating a price increase. A devaluation of money by a country lessens the ability of that country to import foreign goods, and therefore this would lessen demand in that country.

Weather conditions have a direct bearing on the size of the crop. Seasonal price patterns will give a trader an indication of comparative factors between the current year and past years. General business conditions will indicate the ability of consumers to purchase a particular commodity. If conditions are good, there will presumably be more purchases than if conditions are poor.

The stated opinions of the officials of the exchanges are not of particular importance in regard to supply and demand factors that determine prices for commodities.

Question 23

Cash and futures prices will converge:

a. At the country elevator
b. At the market location during the month of delivery
c. At the terminal elevator
d. At the clearing house

Answer 23

b. At the market location during the month of delivery
The price of cash and the price of futures must converge during the delivery month. If the prices did not converge, traders would buy the less expensive and sell the more expensive, thereby causing the prices to come together. For example, let’s assume that the price of the cash commodity is $3.00 and the price of futures is $3.10 during the delivery month. Traders would sell futures at $3.10 and immediately buy cash at $3.00. They would then deliver the cash commodity against the futures they just sold (as this is the delivery month, there would be no carrying charges) and would thereby insure themselves of a profit of 10 cents. The act of selling futures would drive the price down, while the purchase of cash would drive the price up. Eventually, the prices would converge.

Question 24

A trader takes a position in a corn contract and deposits the necessary margin of $1,500. Maintenance is $1,100. The exchange subsequently raises the initial margin requirement to $2,000 and the maintenance requirement to $1,500. In this case the trader:

a. Must immediately deposit an additional $500
b. Need not deposit any additional margin on his existing position
c. Would have to deposit an additional $2,000
d. Would be required to liquidate his position

Answer 24

b. Need not deposit any additional margin on his existing position
If the exchange raises the initial margin requirement, the FCM would not be required to obtain additional margin unless the equity in the account dropped below the new maintenance margin level.

Question 25

An individual buys a contract of wheat at $4.10 a bushel and wants to guarantee himself against a loss of more than 5 cents. You would advise him: a. To place a stop order to sell at $4.05 b. To place a stop limit order to sell at $4.05 c. To place a market if touched order to sell at $4.05 d. That there is no way he can guarantee himself against losing no more than 5 cents a bushel

Answer 25

**d. That there is no way he can guarantee himself against losing no more than 5 cents a bushel** There is no order that can guarantee a customer against losing more than a specified amount. In this question, the customer is long a contract at $4.10 and wants to protect himself against a price drop. He would like to limit his potential loss to approximately 5 cents. Therefore, he will place an order to sell below the market at $4.05. Choice (c) may be disregarded because it says that he will place a market if touched order to sell at $4.05. MIT orders to sell are similar to limit orders to sell and are placed above the market. Choices (a) and (b) both describe possible orders that he could place below the market. The stop order is one that will become a market order once the contract trades down to that price. Let's assume that it trades at $4.05 and the best bid is now $4.04 1/2. The broker would sell on this bid and the loss would be 5 1/2 cents. If the broker had a stop limit order, he would be required to obtain the limit price or better once the contract sold at or below the stop price. In the above example, the order became a market order once a trade occurred at $4.05. Since the best bid is now $4.04 1/2, the broker will not execute the order at all. If the price never rises to the limit of $4.05, the customer may end up selling for substantially less at a later date.

Question 26

Spread positions, compared to net long and net short positions: a. Generally require lower margin and have lower risk b. Generally require higher margin and have higher risk c. Generally require lower margin and have higher risk d. Generally require higher margin and have lower risk

Answer 26

**a. Generally require lower margin and have lower risk** Spreads require a lower margin than net long or net short positions because there is usually lower risk associated with a spread than with a net position.

Question 27

A moving average chart: a. Will indicate the trend of the market without any time lag b. Is the same as a point and figure chart c. Is the same as a bar chart d. Will indicate the trend of the market, but may lag behind the current market

Answer 27

**d. Will indicate the trend of the market, but may lag behind the current market** A moving average chart is a simple chart to construct that indicates the trend of the market. Let's construct a moving average chart first, and then see what the pitfalls are in its use. The moving average chart takes the closing prices of a commodity for a number of successive days and averages the prices. On the following day, the oldest price is dropped and replaced by the price of the current day. The chart might be constructed on any number of days or even weeks that the chartist chooses to use. For example, he might make a three day chart, a 10-day chart, a 20-day chart, etc. In each case, the prices would be averaged for the number of days, with the oldest price dropped on each day. Let's examine a simple three day chart. Let's assume that the chartist is starting the chart right now and the commodity closed on the last 3 days at $2.00, $2.10 and $2.20. The three prices would be added together ($6.30) and divided by the number of days in the average (3) to indicate a price of $2.10. This would be charted and would be point A on the chart. The next day, the commodity jumps substantially in price to $2.40. The first day's price would be dropped and the close of $2.40 substituted. Adding the three prices ($2.10, $2.20 and $2.40) and dividing by 3 indicates an average of slightly more than 2.23. This is charted at point B. On the following day, the commodity closes at $2.60, another substantial increase. We would drop the oldest price of $2.10 and substitute $2.60. The average of $2.20, $2.40 and $2.60 is $2.40. This is charted at point C. So far, we have charted the average prices and the chart indicates that the prices are advancing, as they are indeed advancing. However, on the following day, the price drops to $2.50. Dropping the last price in our previous average and substituting $2.50, we have an average of $2.50 ($2.40, $2.60 and $2.50 divided by 3). This is charted at point D. Note that the chart indicates an advancing market even though the market has turned downward. On the following day, the price again drops to $2.40. Our average is still $2.50 (we drop the price of $2.40 of three days ago and substitute the closing price today: 2.60, 2.50 and 2.40 divided by 3 equals 2.50). This is charted at point E. $2.60\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ $2.50\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_D\_\_\_\_\_\_E\_\_\_\_\_\_\_\_\_\_\_\_ $2.40\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_C\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ $2.30\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ $2.20\_\_\_\_\_\_\_\_\_\_\_\_B\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ $2.10\_\_\_\_\_\_A\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ Using the information concerning the closing prices, it is apparent that the price dropped substantially on the fourth day, from $2.60 to $2.50, but the average continued to indicate a rising market. On the following day, the price again dropped substantially, from $2.50 to $2.40, but the chart did not reflect this drop. If a trader based his buying and selling decisions on the chart, he might buy at point D or E, which indicates a rising market, even though the market is actually falling at these points. He could very well buy in a declining market and sell in a rising market because of the delay inherent in this type of chart in its indication of the trend of the market.

Question 28

A customer's securities account has a debit of $2,000 and his regulated commodity account has a surplus of $2,500. The member firm may: a. Automatically transfer funds from the regulated commodity account to the securities account b. Automatically transfer funds from the regulated commodity account to the securities account if the customer has given the firm prior written instructions c. Not transfer funds under any circumstances d. None of the above

Answer 28

**b. Automatically transfer funds from the regulated commodity account to the securities account if the customer has given the firm prior written instructions** The CFTC has established regulations which prohibit a member firm from using customers' funds that relate to commodity futures. The member firm is required to segregate these funds and may not use the funds for its own purposes nor may the firm combine these funds with funds relating to securities or anything else. If the customer wants to transfer funds relating to commodity futures to any other account, the customer would have to give the member firm specific instructions each time the transfer is to be made. If the customer wanted the broker to be able to transfer funds relating to commodity futures automatically, without requiring specific consent for each transfer, he would sign the transfer consent form.

Question 29

_January 2:_ Cash: 424 1/2 Futures: 443 3/4 _February 9:_ Cash: 428 Futures: 449 Using the information given above, assume that a farmer initiates a short hedge on January 2. What would be the contribution of the hedge to the carrying charges if the hedge were closed out on February 9: a. +1 3/4 b. - 1 3/4 c. +8 3/4 d. - 8 3/4

Answer 29

**b. - 1 3/4** The farmer initiates his positions on January 2 when cash is selling for 424 1/2 and futures are selling for 443 3/4. He lifts the hedge on February 9, when cash is 428 and futures 449. The net result of the hedge, taking into consideration the profit on cash of 3 1/2 and the loss on futures of 5 1/4, is a net loss of 1 3/4.

Question 30

The fundamental study of a commodity entails knowledge of: a. Basic economic forces of supply and demand b. Seasonal price patterns c. Demand factors d. Past futures prices

Answer 30

**a. Basic economic forces of supply and demand** All of the items listed in the answer are significant factors and will be considered by a trader. However, the fundamental study of commodities entails knowledge of the basic supply and demand factors regarding that particular commodity and therefore answer (a) is the best answer.

Question 31

A customer is long 10 December 500 gold puts. He wishes to liquidate the position. He would: a. Buy 10 December gold calls b. Buy 10 December futures contracts c. Sell 10 December 500 gold calls d. Sell 10 December 500 gold puts

Answer 31

**d. Sell 10 December 500 gold puts** In order to close-out (liquidate) an option position, the customer must undo his opening transaction. In this case he would sell the puts he originally purchased.

Question 32

A sell stop limit order becomes a market order when the contract trades at or below the limit price. a. True b. False

Answer 32

**b. False** A *stop limit* order is an order that becomes a limit order to sell once the contract sells at or below the stop price. On a straight stop order, the order would become a market order to sell once the commodity trades at or below the stop price. Let's look at both the stop order and the stop limit order to see how they are handled by a floor broker. A broker receives a stop order to sell at 98 and a stop limit order to sell at 98. In both cases, nothing will be done until the contract trades (or is offered) at 98 or less. The broker enters the pit and the market is currently 97 3/4 bid, 98 1/4 offered. Nothing will be done by the floor broker. Another broker now enters the pit and sells a contract at 97 3/4. Since the contract has now traded below the stop price, both orders will be elected. The best bid in the pit after the above transaction is now 97 1/2. The broker will immediately sell one contract (the one that was a straight stop order) because this order became a market order, to be executed at the best price available, once the stop price was reached. Nothing will be done with the stop limit order until a bid arrives in the pit at 98 or higher as the customer has specified that, once the stop price was reached, his order was to become a limit order to be executed only at 98 or higher.

Question 33

A customer buys a futures contract. The price drops below the original margin level but is above the maintenance level. The customer may buy additional contracts based upon the excess equity above the maintenance level. a. True b. False

Answer 33

**b. False** A customer may not withdraw equity from his account, nor may he use equity to take additional positions (pyramiding), unless the equity is above the original margin level. If the account is below the original margin level but is above the maintenance level, the customer is not required to deposit additional margin on his existing positions, but he will not be able to withdraw any equity. If the equity drops below the maintenance margin level, the customer will be required to deposit additional margin to bring the equity back to the original level. Let's look at an example. The original margin level is $1,000 and the maintenance level is $750. The customer buys five contracts and deposits $5,000. The contracts advance in price and the equity increases to $7,000. In this case, the customer could either withdraw $2,000 in cash or he could initiate two new positions. Let's assume that the contracts decline in price and the equity is reduced to $4,000 ($800 per contract). No call would be sent for additional margin as the equity is still above the $750 maintenance level, but no money may be withdrawn nor may new positions be assumed based upon the current equity in the account. The contracts continue to decline in price and the equity is now $3,500 ($700 per contract). Since the equity is below the maintenance level, a call for additional margin of $1,500 will be sent in order to bring the account back to the original margin level of $5,000 ($1,000 per contact).

Question 34

An inverted head and shoulders pattern usually indicates to technical analysts: a. A continuing price decline in a declining market b. The reversal of a declining market c. The reversal of an advancing market d. A stagnating market

Answer 34

**b. The reversal of a declining market** An inverted head and shoulders pattern is considered to be a bullish chart formation that usually leads to advancing prices.

Question 35

A grain exporter has sold grain for delivery in three months. The long range weather report indicates turbulent conditions in the shipping lanes. To protect against potential higher shipping costs, the exporter may go long freight futures. a. True b. False

Answer 35

**a. True** Freight futures can be purchased to protect against the potential rise in shipping costs.

Question 36

A trader takes a long position of two contracts of silver. He sells the contracts after the price advances by 35 1/2 cents. The size of the contract is 5,000 ounces. The total commission on the two contracts is $100. The trader's profit is: a. $3,450 b. $3,550 c. $17,450 d. $34,500

Answer 36

**a. $3,450** If the price advances 35 1/2 cents, the total profit would be $3,550 (10,000 ounces times .355). As the commission on the two contracts is $100, the net profit after deducting commission is $3,450.

Question 37

When ex-pit transactions are made, the cash purchase is made at a specified basis and the futures transaction is made outside the trading pit. a. True b. False

Answer 37

**a. True** An ex-pit transaction (also called an "against actuals" or an "exchange for physicals" transaction) is one in which a hedger enters into a cash market transaction with another hedger. The rules of the exchange allow the futures transaction to be made outside of the trading pit, at a prearranged basis, and open outcry is not required. In an ex-pit transaction, a person who is long the basis (long the cash commodity) will have a selling hedge (sale of futures). He will sell his cash commodity to someone who is short the basis (short cash) who would have established a buying hedge (purchase of futures). The hedgers will determine the basis on which the transaction is to occur and will exchange their futures position on the basis they have negotiated. The person who is long the basis (long cash) will exchange his cash commodity for the long futures of the other person. The person who is short the basis will exchange his long futures position for the cash commodity.

Question 38

If a customer has granted power of attorney to another individual to handle his account: a. The member firm must obtain written permission for the customer prior to the exercise of discretion b. The customer must get written confirmations on each trade c. The customer must receive a monthly statement of account d. All of the above

Answer 38

**d. All of the above** Before a member firm will allow anyone to exercise discretion in a customer's account, the member firm will require that the customer sign the proper documents authorizing the other person to exercise discretion. The customer will receive duplicate confirmations on each trade that is made in the account and will also receive duplicate monthly statements.

Question 39

A customer's sell stop limit order at 140 1/2 may be executed at all of the following prices EXCEPT: a. 140 b. 140 1/2 c. 140 3/4 d. 150 1/2

Answer 39

**a. 140** A sell stop limit order is an order that becomes a limit order once the commodity trades at or through the stop price. A straight stop order is one that becomes a market order once the commodity trades at or through the stop price. In the stop limit order, the trader will not accept an execution at a price that is lower than the limit price, while in a straight stop order, he will accept whatever the price happens to be once the stop is elected. For example, a broker receives a sell stop order to sell at 140 1/2 and a sell stop limit order to sell at 140 1/2. In the straight stop order, he is being instructed by the trader to sell at the best available price once the commodity trades at 140 1/2 or less. In the sell stop limit order, he is being instructed by the trader to accept no less than 140 1/2 if the commodity trades at this price or less. The broker goes to the floor with both orders. The market is currently 140 1/4 bid and 140 3/4 offered. This means that neither order will be elected at present. A trader enters the pit and sells a contract at 140 1/4. This elects both the stop order and the stop limit order. The best bid now available is 140. The broker will sell the stock on his straight stop order at this price. However, he will not take any action on the stop limit order until a bid arrives at 140 1/2 or higher because the customer has given him a limit and will not accept an execution below this price.

Question 40

On many commodity exchanges, hedgers have a lower original margin than speculators. a. True b. False

Answer 40

**a. True** The rules of some exchanges allow member firms to charge their hedge customers a lower original margin than the amount that they charge speculators. The hedge customer has a cash position to offset his futures position. Therefore, his risk is lower if the price of the futures should move against him. Any loss on the futures position will be offset by a gain on the cash position. In addition, the hedge customer is more likely to have the facilities to make or take delivery on the actuals than would a speculator. A third reason for lower hedge margin is because it is generally easier to determine the financial condition of the hedge customer than it is to determine the financial condition of the speculator.

Question 41

Changes in the basis might occur because of: a. Change in the current demand factors for a commodity b. Change in demand for a commodity at a particular destination at a particular time c. Change in the demand for future delivery d. All of the above

Answer 41

**d. All of the above** The term "basis" describes the relationship between the cash price today and the price of the particular futures month in which the hedge is established. One factor that can cause a change in the relationship between the cash and futures price is a change in demand for the commodity which will, in turn, cause a change in its price. This might be a temporary situation, such as a current shortage of the commodity causing an increase in purchases as users try to assure supply by buying it today. This will cause a rise in the price of cash and near futures, but not necessarily distant futures. Conversely, there might be adequate supplies currently, but it is anticipated that there will be a shortage in the future. Therefore, distant futures will receive more buying support than near futures and its price will increase more. Another factor is that there might be a shortage of the commodity at a particular location due to local factors, which will cause its price to rise. This will not be reflected in prices elsewhere. Therefore, all of the choices listed are correct statements.

Question 42

A member firm requires a customer to sign the Customer's Agreement in order to: a. Assure itself that the customer has sufficient funds to speculate in futures b. Allow the broker to liquidate the customer's position if the customer fails to meet the broker's margin call c. Free the broker from any liability for failing to execute the orders of the customer properly d. Allow the broker to use the funds of the customer in any way he sees fit

Answer 42

**b. Allow the broker to liquidate the customer's position if the customer fails to meet the broker's margin call** The customer agreement has a provision that allows the member firm to liquidate a futures position if the customer fails to meet a margin call.

Question 43

When prices of futures fluctuate over a relatively narrow range, chartists believe that a congestion area has been formed. a. True b. False

Answer 43

**a. True** A congestion area is a chart formation in which the price of the commodity has traded in a relatively narrow range for a period of time. A small upward movement in the price is met by increased selling and the price does not advance any further, while a small downward movement in price is met by increased buying and the price does not decline any further.

Question 44

A major economic role filled by a futures market is: a. Determination of prices b. Price restraint c. Providing a market for surplus commodities d. Solving commodity shortages

Answer 44

**a. Determination of prices** One of the most important functions met by commodity exchanges is the determination of the price for commodities. This price is determined by the interaction of the forces of supply and demand which are manifested on the floor of the exchange.

Question 45

An IB may be guaranteed by more than one FCM. a. True b. False

Answer 45

**b. False** Introducing brokers can only be guaranteed by one Futures Commission Merchant at a time.

Question 46

A customer is long five contracts of orange juice (OJ) at 1.3915. He liquidates the position at 1.4560. Round-turn commissions are $30. The size of the contract is 15,000 lbs. What is the net profit or net loss? a. $937.50 profit b. $937.50 loss c. $4,687.50 profit d. $4,687.50 loss

Answer 46

``` **c. $4,687.50 profit** ## ```

Question 47

A pension fund manager can use a short hedge in stock index futures to protect the value of his portfolio. a. True b. False

Answer 47

**a. True** A pension fund manager with (long) a portfolio of stocks could hedge the position by selling stock index futures.

Question 48

An order to buy December corn at 1.45 MIT should be entered: a. Below the market price b. Above the market price c. May not be entered for corn d. At the market

Answer 48

**a. Below the market price** A market-if-touched order is similar to a limit order. Both are entered below the market in the case of a buy order and above the market in the case of a sell order. In the case of the buy MIT and the buy limit order, the trader is instructing his broker to buy the contract only if it goes down to a price that he considers to be attractive. He is unwilling to buy at the current price because he thinks it is too high. In the case of the sell MIT and the sell limit order, the trader is long the commodity and he instructs the broker to sell only if the price rises to the limit specified in the order. His reasoning is that it will go to this price and he does not wish to give up his long position below this price and therefore take a lower profit. The MIT order differs from the limit order in that the limit order must be executed at the limit price or better. In the case of the buy limit, the purchase must be made at the limit or less; in the case of the sell order, at the limit price or higher. In the case of the MIT order, the order becomes a market order once the contract trades at the limit price and could be executed at, above or below the limit price once a trade occurs at this price.

Question 49

After a customer deposits his original margin with his broker and the market moves in his favor: a. He may initiate additional positions with the excess equity in his account whether or not the position has been liquidated b. He may borrow against the excess equity and is charged interest c. He may withdraw equity from the account only if the position has been liquidated d. None of the above

Answer 49

**a. He may initiate additional positions with the excess equity in his account whether or not the position has been liquidated** If the equity in a customer's account increases because of a favorable price change, the customer is free to use the excess equity in any way he wishes. He may use the excess equity to "pyramid" his position, which means that he can assume additional futures positions without having to deposit additional margin, or he may direct the broker to send him the excess equity in the form of cash. For example, a customer might assume a position in a commodity and deposit initial margin of $1,000. The price changes in his favor and the increase in value of the contract is $3,000. The customer could use this $3,000 to assume three additional positions, or he could withdraw it. The money that the customer is withdrawing is unrealized profits on his position. The clearing house sends the excess money to the member firm. The clearing house gets the money from the customer on the other side of the transaction who has an unrealized loss that is equal to the profit of our trader. The brokerage firm is not in any sense lending money to the customer as would be the case in a securities margin account, and there is no such concept as a debit balance and no interest is charged.

Question 50

If the price of March wheat is higher than the price of May wheat of the same crop year, this would indicate that: a. The supply of wheat is high and the demand for wheat is low b. Supplies of wheat are low and demand for wheat is low c. Supplies of wheat are low and demand for wheat is high d. Any of the above could be correct because supply and demand for wheat has no bearing on the relative price between the different months

Answer 50

**c. Supplies of wheat are low and demand for wheat is high** If the price of near futures is higher than the price of deferred futures, this would indicate an inverted market. An inverted market results when there is a shortage of the cash commodity accompanied by strong demand.

Question 51

The IB must keep the daily and monthly statements sent to customers in his files. a. True b. False

Answer 51

**b. False** This is false. An IB is not required to keep on file copies of monthly statements sent to customers. The FCM carrying the customer's account must maintain statements. The IB is only required to keep a record or journal of customer transactions if he places some of or all of the orders for the customers.

Question 52

Your client is a London customer who imports cocoa from Ghana and pays for the imports in British pounds. He would hedge against a decline in the value of the pound by buying British pound futures. a. True b. False

Answer 52

**b. False** In this situation the importer, who pays for the cocoa in British pounds, fears a price decline in British pounds. Therefore, he will place a short hedge, which is the sale of British pound futures.

Question 53

The term "liquidating market" is used to refer to a market that is characterized by a large amount of offsetting of positions with a decline in the price of the contract. a. True b. False

Answer 53

**True** A liquidating market is one in which existing long and short traders are exiting the market at a faster pace than new buyers and sellers are entering the market, and the price of the futures contract is declining.

Question 54

When futures prices are higher than the cash price, the market would be: a. Inverted b. Reverse c. Discount d. Premium

Answer 54

**d. Premium** If near futures are selling above cash, and deferred futures are selling above near futures, the market is called a normal or premium market.

Question 55

A candy manufacturer purchasing cocoa futures as protection against a rise in cocoa butter prices would be an example of a legitimate hedge. a. True b. False

Answer 55

**a. True** The candy manufacturer is importing cocoa, therefore, will establish a long hedge to protect against price increases.

Question 56

A customer has indicated that he might be interested in taking a position if the price of a commodity reaches a certain level. Two weeks later, the commodity reaches the level indicated. The Registered Commodity Representative tries to contact the customer but is unable to do so. Even though the RCR does not have discretionary authorization, he may enter the order if he thinks he will be able to contact the customer within a short time after the order is executed. a. True b. False

Answer 56

**b. False** Since the associated person or registered commodity representative does not have discretionary authorization, the order cannot be executed.

Question 57

The CFTC may go directly into court independently of the U.S. Attorney General's office to seek restraining orders enjoining any contract market or person from violating the Commodity Exchange Act or restraining trade in a commodity for future delivery. a. True b. False

Answer 57

**a. True** The CFTC is empowered to go to court independently of the U.S. Attorney General's office.

Question 58

An elevator operator has, in inventory, 10,000,000 bushels of wheat. He wishes to hedge, but he is reluctant to use futures. He also wants very little risk. Which of the following would hedge his position? a. Buying puts b. Selling puts c. Buying calls d. Selling calls

Answer 58

**a. Buying puts** To hedge a long cash position with options the elevator operator could buy puts or sell calls. Since the risk is less in buying puts than in writing calls, long puts are more appropriate for an investor interested in limited risk.

Question 59

A "normal market" is all of the following EXCEPT: a. A "carrying charge market" b. A market in which the distant months sell progressively higher than nearer months c. A market in which the distant months sell progressively lower than nearer months d. A "premium market"

Answer 59

**c. A market in which the distant months sell progressively lower than nearer months** A "normal market" is also called a "carrying charge market" and a "premium market". It is a market where the price of the cash commodity is lower than the price of futures, and the price of near futures is lower than the price of distant futures. If the price of cash is higher than the price of futures, and the price of near futures is above the price of distant futures, the market would be called an "inverted market" or a "discount market".

Question 60

A trader has $1,500 invested in soybeans and soybean margin is 30 cents per bushel. Soybeans close today at $4.74 per bushel. The soybean contract size is 5,000 bushels. What percentage of his position does margin money represent? a. .02% b. 6.30% c. 30.00% d. 1.70%

Answer 60

**b. 6.30%** Margin is 30 cents. The price of soybeans is $4.74. As a percent, margin represents: $.30 / $4.74 or 6.3%.

Question 61

An investor purchases a March sugar futures contract at 13 cents paying an initial margin requirement of $1,500. He also sells a March 13 call option at a premium of $750. If the futures price at expiration is below 13 cents, the option will provide a return on the original margin deposit of: a. 5.1% b. 20.0% c. 50.0% d. No return

Answer 61

**c. 50.0%** At the expiration of the short option, the investor will retain the premium of $750. This will provide a return of 50% on the original margin ($750 divided by $1,500).

Question 62

An American importer places an order with a Swiss watch manufacturer. The order, to be delivered in August, is valued at 2,000,000 Swiss francs. The cash price for the franc is $.5975 and September futures are trading at $.5725. The most effective hedge for the importer would be to: a. Buy Swiss francs in the cash market and sell Swiss franc futures b. Sell Swiss francs in the cash market and buy Swiss franc futures c. Buy Swiss franc futures d. Sell Swiss franc futures

Answer 62

**c. Buy Swiss franc futures** The importer is short the Swiss francs (short the basis). He is concerned with a rise in the price of the Swiss franc. If the price rises, he will have to pay more dollars to acquire the same number of francs. Therefore, he will buy Swiss franc futures.

Question 63

If a country was to devalue its currency, this would mean that it would be able to purchase more U.S. dollars than before the devaluation, and therefore, U.S. exports to that country could be expected to increase. a. True b. False

Answer 63

**b. False** If a country devalues its currency, this means that more of that currency is required to buy the same amount of U.S. dollars than before the devaluation. This would make U.S. exports more expensive than before the devaluation, and therefore U.S. exports could be expected to decrease.

Question 64

An important responsibility of an exchange is the prevention of any form of price manipulation. a. True b. False

Answer 64

**a. True** The prevention of price manipulation is a very important function of the directors of the exchange, who implement rules to deal with manipulation and prescribe severe penalties for any participant in a member firm who engages in any form of price manipulation. The CFTC insists that an exchange have adequate rules and machinery to deal with price manipulation of commodity futures.

Question 65

A customer enters an order to buy a contract at $4.00. The contract trades at this price but the broker is unable to buy the contract because another broker buys it before him. The customer is entitled to an execution under these circumstances because the market reached the limit price. a. True b. False

Answer 65

**b. False** This is a limit order in which the broker was unable to execute the order because another broker, holding an order at the same price, executes his order first. The broker who was unable to execute the order cannot be held responsible for failing to execute the order.

Question 66

An IB may accept funds in the name of the FCM if authorized by the FCM. a. True b. False

Answer 66

**a. True** An IB may accept funds in the name of the FCM if authorization to do so was given by the FCM.

Question 67

## Referring to the information above for a wheat elevator operator, how much would a hedge placed in July and lifted in September contribute toward carrying charges: a. - 5 cents b. - 15 cents c. + 5 cents d. +15 cents

Answer 67

**BLANKANSWER** The hedger establishes his cash and futures positions in July and lifts them in September. The opening and closing positions would appear as follows: ##

Question 68

Assume that the commission on a sugar transaction on the New York Coffee and Sugar Exchange is $62 per contract. The contract size is 112,000 lbs. If a trader has a long position of two contracts at 7.65 and he covers his position when the price has advanced to 8.65, what is the trader's net profit? a. $2,240 b. $996 c. $2,116 d. $1,996

Answer 68

**c. $2,116** Since each contract is 112,000 pounds and since the price advanced by one cent, simply multiply 112,000 by .01 (1 cent is .01; 1/10th of a cent is .001; 1/100th of a cent is .0001). This would indicate that the contract has advanced by a dollar amount of $1,120. The trader has two contracts, and thus we would multiply the profit received on one contract by two, indicating a gross profit of $2,240.00. The commission is stated to be $62 on a contract. Therefore, the commission on two contracts would be $124. If we subtract $124 in commissions from the total profit of $2,240, we are left with a net profit of $2,116. Let's try another problem to make certain this is clear to you. The first point to determine is the size of a cocoa contract. Cocoa trades in 30,000 pound units. Multiply 30,000 by .01, which indicates a gross profit of $300. Since three contracts are involved, multiply $300 by three, which indicates a total profit of $900.00. Commission on each contract is $60, so the commission on three contracts is $180.00. Subtract $180 from $900, to arrive at a net profit of $720.

Question 69

Given the scenario of diminishing inflation and a strengthening dollar, an investor would not: a. Go long gold put options b. Go short gold put options c. Go short gold futures d. Grant gold call options

Answer 69

**b. Go short gold put options** The price of gold would generally decrease given the scenario of diminishing inflation and a strengthening dollar.

Question 70

An individual who wishes to trade in futures contracts should be advised that he should use only money that is "risk capital" in his speculating activities. All of the following would be considered to be risk capital EXCEPT: a. Cash surrender value of his life insurance policies and savings in a bank that is set aside for emergencies b. Money that the individual can afford to lose if the market turns against him c. Money that the investor has available above and beyond his needs to provide for his living expenses d. All of the above

Answer 70

**a. Cash surrender value of his life insurance policies and savings in a bank that is set aside for emergencies** Risk capital includes capital above and beyond the daily requirements of the individual. It is capital that, if lost, will not have a serious effect on the individual's ability to meet his obligations. Cash value of life insurance and savings set aside for emergencies are clearly not risk capital.

Question 71

##

Answer 71

**##** BLANKANSWEREXPLANATION

Question 72

A speculator discovers in June that September corn futures contracts are 250 1/4 and December corn futures are 253 1/2. He believes the spread will widen. He should: a. Buy September and sell December b. Buy September and buy December c. Sell September and buy December d. Sell September and sell December

Answer 72

**c. Sell September and buy December** In expectation of a widening in the spread difference, he should sell the nearby and buy a distant futures contract.

Question 73

The Chicago Board of Trade clearing house requires a clearing member firm to deposit margin on: a. All long positions and short positions that the member firm clears b. The member firm's net long position c. The member firm's net short position d. The member firm's net long or net short position

Answer 73

**d. The member firm's net long or net short position** The Chicago Board of Trade requires brokers to deposit margin on the firm's net long or short position.

Question 74

One of the major differences between a cash market transaction and a futures transaction is that offset is more easily accomplished in the futures market. a. True b. False

Answer 74

**a. True** Futures contracts may be easily offset through a closing transaction on the exchange. A cash market transaction is a personal contract between the buyer and seller and both parties are obligated to fulfill their part of the contract.

Question 75

A corporate treasurer expects to have money to invest in T-bonds in several months. The current interest rates are high and expected to decline. He should: a. Buy a call b. Buy a call and buy futures c. Buy a put d. Buy a put and sell futures

Answer 75

**a. Buy a call** In this situation, if interest rates decline, bond prices generally increase. The investor would, therefore, buy a call.

Question 76

Deep out-of-the-money options: a. Offer the buyer a remote chance for profit b. Offer the grantor small premiums c. Offer very limited liquidity d. All of the above

Answer 76

**d. All of the above** The chance is very minimal that a deep out-of-the-money (put or call) option will be exercised. Therefore, it offers very limited liquidity, small premiums for the grantor (writer) and a remote chance of profit for the buyer.

Question 77

If a commodity pool being solicited has traded commodity interests for less than three years, the CPO must disclose a prominent statement to this effect and also present the actual performance of each other pool it is operating for the last: a. Three years b. Five years c. Three years or the life of the pool, whichever is less d. Five years or the life of the pool, whichever is less

Answer 77

**d. Five years or the life of the pool, whichever is less** The CPO's offered pool has less than three years' performance history. The CPO must disclose the performance history of each pool operated for five years or the life of the pool, whichever is less.

Question 78

A corporation issues bonds with a price equal to 86-24. The corporation intends to issue another $10,000,000 bonds in April. The bonds will have a 20-year maturity. The corporation wishes to hedge on its anticipated offering. Treasury bond futures prices are as follows: December 88-16 March 88-22 June 88-26 September 89-02 The corporation would be concerned with: a. Rising interest rates and would establish a buying hedge b. Rising interest rates and would establish a selling hedge c. Falling interest rates and would establish a buying hedge d. Falling interest rates and would establish a selling hedge

Answer 78

**b. Rising interest rates and would establish a selling hedge** The corporation is concerned that interest rates will rise. If interest rates rise, the price of fixed income securities that are already outstanding will fall. Therefore, the corporation will sell futures.

Question 79

The storage, insurance, and interest costs involved in the ownership of stored cash commodities over a period of time are known as carrying charges. a. True b. False

Answer 79

**a. True** Carrying charges include storage costs, insurance, and interest but does not include transportation charges.

Question 80

A customer enters an order to buy two July copper contracts at 104.35. The floor broker reports that he bought the two contracts at 104.55. When the floor trader is contacted, he acknowledges that he made an error in executing the order above the limit price. In this case: a. The customer is required to accept the trade at 104.55 if the error was made in good faith b. The floor broker would be responsible to the customer for any loss that is incurred as a result of the error c. The Arbitration Committee of the exchange must resolve who is responsible for the loss d. The Floor Committee of the exchange must resolve who is responsible for the loss

Answer 80

**b. The floor broker would be responsible to the customer for any loss that is incurred as a result of the error** In this situation the floor broker is responsible for any loss incurred.

Question 81

In a debit options transaction, the profit is limited to the debit. a. True b. False

Answer 81

**b. False** This is false. In a debit spread position, the amount of potential loss is limited to the net debit.

Question 82

If the initial margin requirement is $1,000 and the maintenance margin requirement is $750, a trader with an equity above $1,000 could use the excess equity as margin on new positions that he is establishing, but if the equity were above the maintenance level but below the initial level, there would be no excess equity that could be used to margin new positions. a. True b. False

Answer 82

**a. True** When an order is executed, initial margin must be deposited. If the equity rises above the original level, equity could be withdrawn. If the equity drops below the maintenance margin level, additional margin will be required in order to bring the account back to the original margin level. If the equity drops to a point below the original level but above the maintenance level, no margin will be required. In this question, margin could be withdrawn if the equity is above $1,000. If the equity is below $1,000 but above $750, no action need be taken. If the equity drops below $750, additional margin would be required to bring the account back to $1,000.

Question 83

A plumber successfully bids for a contract that requires the installation of 500,000 pounds of copper tubing in six months. The contract size is 25,000 lbs. In order to hedge against a rise in copper prices, he would: a. Sell 25 copper contracts b. Sell 20 copper contracts c. Buy 25 copper contracts d. Buy 20 copper contracts

Answer 83

**d. Buy 20 copper contracts** The plumber would buy 20 copper contracts, determined as follows: No. of Contracts = Required Pounds of Copper / Contract Size 20 = 500,000 / 25,000

Question 84

If an individual buys a contract of corn on the Chicago Board of Trade and at the same time sells a contract of wheat on the Chicago Board of Trade, this would be: a. An intermarket spread b. An intercommodity spread c. An interdelivery spread d. An intramarket spread

Answer 84

**b. An intercommodity spread** The purchase of corn and the sale of wheat on the same exchange is an intercommodity spread.

Question 85

Which of the following is not an advantage of futures trading? a. The price of the finished product is reduced to the public because producers can hedge by buying or selling futures. b. Futures exchanges act as a focal point for the dissemination of statistics and other information. c. Large quantities of risk capital are attracted to one location. d. A buyer of a futures contract is assured of getting delivery of a specific lot of the commodity.

Answer 85

**d. A buyer of a futures contract is assured of getting delivery of a specific lot of the commodity.** Choices (a), (b) and (c) all describe advantages of futures trading. Let's look at each of these advantages first. If a businessman is able to hedge his risk through the use of futures, he can afford to operate at a lower profit margin. The businessman who has a cash position must be concerned about loss due to price change. If he does not hedge, he must include the factor of risk in his price for his commodity. This extra markup will be included to offset the risk of loss due to unfavorable price change. However, if the businessman can hedge his position, he can eliminate this extra markup for risk because he can eliminate most (but not all) of the risk due to price change. Therefore, choice (a) is an advantage of futures trading. Choice (b) also describes an advantage of futures trading. The exchanges act as a focal point for the dissemination of important information regarding the commodities traded on the exchange. In addition, the exchange acts as a focal point for the attraction of risk capital. All speculators who are interested in taking the risk associated with futures trading in return for potential profit will send their orders to a single location, the trading pit of the exchange. Therefore, choice (c) is also correct. Choice (d) is not a correct statement. When one buys a futures contract and stands for delivery, he is not assured of getting a specific lot or even a specific grade of commodity. The buyer must accept whatever grade the seller delivers, provided that it is one that is acceptable under exchange rules.

Question 86

The premium is paid by the seller and received by the buyer. a. True b. False

Answer 86

**b. False** The premium is paid by the buyer and received by the seller.

Question 87

A trader buys two live cattle contracts and sells his position when the price advances $3.20 per hundredweight. The contract size is 40,000 lbs. His profit would be: a. $1,920 b. $2,304 c. $2,560 d. $2,688

Answer 87

**c. $2,560** The live cattle contract is 40,000 pounds. Two contracts would represent a total of 80,000 pounds. If the price advances $3.20 per hundredweight, this would equals 3.2 cents per pound. Multiplying 80,000 pounds by .032 indicates a gross profit of $2,560.00.

Question 88

In a bona fide hedge account, the customer: a. Must be a purchaser or seller of the cash commodity that he is hedging b. Must be a member of the exchange on which he is trading c. Must deposit margin that is at least 125% of the margin that is required from speculative accounts d. All of the above

Answer 88

**a. Must be a purchaser or seller of the cash commodity that he is hedging** A hedger is defined as a producer or user of the cash commodity who buys or sells futures in an amount that is equal and opposite to his cash position.

Question 89

An FCM is required to report to the CFTC all purchases and sales that occur in the account of a bona fide hedger on a daily basis once he has reached the position reporting level. a. True b. False

Answer 89

**a. True** Bona fide hedgers are exempt from speculative position limits, not position reporting levels.

Question 90

A trader enters an order to buy 50,000 bushels of wheat at $3.50 stop limit. After the order reaches the floor, the word "FAST" appears on the tape, and trades are then reported at $3.49, $3.50 and $3.51. The RCR may safely report to the customer that his order was filled at the limit. a. True b. False

Answer 90

**b. False** If the word "FAST" appears on the tape, this means that the market in a commodity is very active. In this situation, trades that occur at small variations will be omitted from the tape, and prints will appear only at large intervals. For example, the word "FAST" appears and then quotations appear at $3.49 and $3.50. This does not mean that transactions did not occur between $3.49 and $3.50. However, because trading is so active, all of the trades between $3.49 and $3.50 were left off the tape. If all of the trades between $3.49 and $3.50 were included, this would cause the tape to run substantially behind the actual trades on the floor. By printing only the larger variations, it is possible to keep the tape more current. In this question, trades appeared at $3.49, $3.50 and $3.51. If a customer had a stop limit order to buy 50,000 bushels at $3.50, it would not be possible to know if the order was filled. Once the contract traded at $3.50, the stop was elected and it became a limit order to be done at $3.50. There may not have been any other offers at this price, and therefore it is possible that the order was not executed because it could not be filled at the limit of $3.50.

Question 91

In a normal sugar market, when the deferred delivery is at a premium to the nearby and in anticipation of a narrowing in the spread difference, your customer should: a. Sell the nearby and sell the deferred b. Buy the deferred and sell the nearby c. Buy the deferred and buy the nearby d. Buy the nearby and sell the deferred

Answer 91

**d. Buy the nearby and sell the deferred** If a spreader anticipates that a spread will widen, he will buy the higher-priced (deferred) contract and sell the lower-priced (nearby) contract. If he expects the spread to narrow, he will buy the lower-priced (nearby) contract and sell the higher-priced (deferred) contract.

Question 92

A hedge position may not give full protection against adverse price movement because: a. The basis may change during the time the hedge is operative b. Cash prices and futures prices usually move in unison c. The various futures months do not usually sell at the same price d. The cash price will generally move in a different direction than the futures price

Answer 92

**a. The basis may change during the time the hedge is operative** A hedge might not give full protection during the period it is in effect because it is possible for the basis to change unfavorably. Let's look at an example of an unfavorable change in the basis to see how this would occur. An individual is long the basis (long the cash commodity) at 34.50 and he sells futures at 36.50. His basis therefore is 2 cents under. His cash price of 34.50 is 2 cents under his futures price of 36.50. In the event that the price of cash and futures move up or down by exactly the same amount, he will have neither profit nor loss. However, if the prices change at different rates, he could have a small profit or a small loss. Let's assume that the price of cash goes down by 3 cents to 31.50 and the price of futures goes down by 2 1/2 cents to 34.00. The hedger closes out his cash and futures positions at these prices. His net results would be as follows: The hedger loses 3 cents on cash. He makes 2 1/2 cents on his futures position. Therefore, his net result is a loss of 1/2 cent. However, if the hedger had not hedged, his loss would have been the full 3 cents on his cash position. Choice (b) is incorrect because, although it is generally a true statement, it does not answer the question. Choice (c) is incorrect because the fact that the different futures months do not sell at the same price is irrelevant. Choice (d) is incorrect because the price of cash and futures generally move in the same direction.

Question 93

A customer is long a gold futures contract and long a gold put option. This is known as a: a. Synthetic long put b. Synthetic long call c. Synthetic long future d. Synthetic short call

Answer 93

**b. Synthetic long call** A synthetic long call is comprised of a long futures contact plus a long put option.

Question 94

If a trader buys or sells a futures contract, he is contingently liable for: a. No more than 50% of the value of the cash commodity b. The full value of the contract c. The original margin that he deposits d. 75% of the value of the futures contract

Answer 94

**b. The full value of the contract** If an individual has an open position, he is contingently liable for the full value of the commodity if there is a delivery. He is also liable for any losses that arise due to price changes. This liability remains in effect until the person offsets his futures position.

Question 95

GNMAs have the lowest degree of rate correlation with which of the following? a. AAA Corporate bonds b. Long-term U.S. Treasury bonds c. Three-month Treasury bills d. Conventional mortgages

Answer 95

**c. Three-month Treasury bills** GNMAs have the lowest degree of rate correlation with three-month Treasury bills. GNMA contract size: $ 100,000 T-bills contract size: $1,000,000 This is a 10:1 ratio.

Question 96

If one is "long the basis," it means that he is in possession of the actual commodity and has established a selling (short) hedge. a. True b. False

Answer 96

**a. True** An individual who is long the basis owns the commodity and, therefore, has established a selling hedge.

Question 97

Soybean margin is 25 cents per bushel. Soybeans close today at $4.50 per bushel. The soybean contract size is 5,000 bushels. What percentage of a position in soybeans does the margin money represent? a. 3.3% b. 5.6% c. 7.0% d. 7.6%

Answer 97

**b. 5.6%** Margin is 25 cents per bushel and soybeans are at $4.50 per bushel. This represents 5.6% ($ .25 / $4.50).

Question 98

The safest spread is: a. Buy T-bonds and sell T-bills b. Buy T-bonds and sell GNMAs c. Buy GNMAs and sell CDs d. Buy GNMAs and sell T-bills

Answer 98

**b. Buy T-bonds and sell GNMAs** The proper spread would be the purchase of T-bond futures and the sale of GNMA futures because both are long-term maturities. The other choices have a combination of long-term and short-term maturities.

Question 99

A stop order to sell may only be entered to offset a long position. a. True b. False

Answer 99

**b. False** A stop order to sell is usually entered to liquidate a long position, but it could also be used to establish a new short position. For example, a speculator might place a stop order to sell at a price below the current market if he anticipates a further price decline once a contract trades through the specified price.

Question 100

A FCM maintains an account with another FCM that is a member of the exchange's clearing house. The non-clearing FCM enters orders for a number of customers at the same time without designating the names or any other identity of the individual customers. This type of account would be: a. Prohibited by the rules of the exchange b. An omnibus account c. A discretionary account d. A hedging account

Answer 100

**b. An omnibus account** There are two types of clearing accounts. In a fully-disclosed account, a non-clearing firm will open the account with a clearing firm. The clearing firm will then be responsible for all functions such as execution of orders, maintenance of records and collection of margin. The non-clearing firm will only solicit orders. In an omnibus account, the clearing firm will only execute and clear transactions. The non-clearing firm will maintain its own customer records, collect margin and perform all other back-office functions.

Question 101

An individual anticipates that he will have funds available in three months to invest in mortgages. If he thinks that the rate on mortgages at the present time is attractive and he anticipates that rates will decline in the next three months, he would probably: a. Sell GNMA mortgages in the futures market b. Buy GNMA mortgages in the futures market c. Keep his money in the bank d. None of the above

Answer 101

**b. Buy GNMA mortgages in the futures market** The investor wishes to protect himself against a decline in interest rates. If interest rates decline, the price of already-outstanding fixed-income securities will rise. Therefore, he will buy GNMA futures.

Question 102

Support and resistance areas are trading zones in which prices have moved in a sideways direction and tend to: a. Set the objective of a subsequent move when prices break out b. Respectively contain price declines and check price rises c. Project the direction of the next price trend d. Project the magnitude of the next price trend

Answer 102

**b. Respectively contain price declines and check price rises** The terms "support area" and "resistance area" define a technical condition of the market and is used by those analysts who use charts to determine the condition of the market. The type of market that would lead to support and resistance areas is one in which the market will repeatedly advance to a certain point, but not beyond this point, and then decline to a lower point, but not below this point. Once the market reaches the high point, it will encounter resistance in the form of additional selling; once it reaches the low point, it will encounter support in the form of additional buying. The support area will therefore be the area at which price declines are contained and the resistance area will be the point at which price rises are checked.

Question 103

Trading in futures ceases when the market advances the daily price limit or declines the daily price limit. a. True b. False

Answer 103

**b. False** If a contract trades up to or down to its daily trading limit, trades may not occur above the top limit or below the bottom limit, but may continue at or within the limits. For example, let's assume that the daily trading limit is 1 cent a point. The commodity closed yesterday at 45 cents. The next day, the commodity trades up to 46 cents. Trading may continue at or below 46 cents as this would be within the limit. No trade could take place above 45 cents. If the commodity traded down to 44 cents, trading could continue at or above 44 cents, but no trade could take place below 44 cents.

Question 104

A synthetic short futures is long a put option and short a call option. a. True b. False

Answer 104

**a. True** This is true. A synthetic short future consists of a long put and short call. A synthetic long future consists of a long call and short put.

Question 105

A buy MIT order becomes a market order if the order price is either traded or offered. a. True b. False

Answer 105

**a. True** A buy market if touched order becomes a market order when the commodity trades or is offered at or below the order price. A sell market if touched order becomes a market order when the commodity trades or is bid at or above the order price.

Question 106

Development of a premium market is caused by all of the following EXCEPT: a. Selling pressure at harvest time in order for farmers to raise cash to repay bank loans, thereby causing price weakness b. Buyers who are not eager to accumulate cash supplies quickly c. The cost of storing, insuring and carrying commodities for later use or delivery d. By people wishing to sell futures at harvest time

Answer 106

**d. By people wishing to sell futures at harvest time** Choices (a), (b), and (c) would lead to a premium or carrying charge market. Let's examine each of these factors. A premium market will come about when there are adequate supplies of the cash commodity. During the harvest, a great deal of the cash commodity will come to market at the same time. Farmers will be under pressure to sell their crop in order to raise cash to repay loans and to prepare for the next planting season. At the same time, buyers are not anxious to accumulate more of the crop than they need to fill their present needs. Therefore, the fact that there is pressure on supply, without a corresponding pressure on demand, will cause the price of cash to drop at harvest time. There are costs associated with storing a commodity for future use. These costs, which include finance charges on loans, storage costs and insurance, will be added to the price of the commodity and will be paid by users who defer their purchases until later in the crop year. This will cause distant futures to sell above near futures. Choice (d) is not complete. If it said that hedgers sell the near months at harvest time, causing its price to drop, but distant months do not receive this same selling pressure, then choice (d) would also be correct.

Question 107

A corporation intends to issue commercial paper in nine months. In order to hedge against rising interest rates, the corporation would sell Treasury bill futures. a. True b. False

Answer 107

**a. True** The corporation is concerned that interest rates will rise and that it will be forced to issue its commercial paper at a higher rate. If interest rates rise, the price of fixed-income securities already outstanding will fall. Therefore, the corporation will sell futures. If interest rates rise, the price of the futures will fall and the corporation will close out its futures position at a profit.

Question 108

An individual takes a short position in soybeans when the price of soybeans is $3.50. He deposits 20 cents margin per bushel. His total investment is $5,000. The margin represents what percentage of the value of the soybeans? a. 5.7% b. 7.7% c. 8.5% d. 33.3%

Answer 108

**a. 5.7%** To determine the percentage of margin to the value of soybeans, you would divide .20 margin by $3.50 price of the soybeans. The answer is 5.7%.

Question 109

A futures market is inverted when: a. The near delivery months sell at a premium to the more distant delivery months b. The near delivery months sell at a discount to the more distant delivery months c. The futures price is higher than the cash price d. The market is overbought

Answer 109

**a. The near delivery months sell at a premium to the more distant delivery months** An inverted market (also called a discount market) is one in which the price of cash is higher than the price of futures, and the price of near futures is higher than the price of distant futures. An inverted market comes about when there is a shortage of the cash commodity. Users of the cash commodity will bid up the price on whatever is available because they need it now to keep their businesses in operation. They will also buy near futures with the intention of taking delivery in order to obtain the actuals. This combination of buying cash and near futures will cause the price to rise. Distant futures will not be subject to the same pressures and therefore will not receive the same buying support. Therefore, the price of cash and the price of near futures will rise above the price of more distant futures.

Question 110

Volatility is a measure of intrinsic value in an option premium. a. True b. False

Answer 110

**b. False** This is false. Volatility is a measure of time value.

Question 111

A Futures Commission Merchant who makes an option trade for a customer shall confirm the trade to the customer no later than: a. The same day as the transaction b. The next business day after the transaction c. Three business days after the transaction d. Five business days after the transaction

Answer 111

**b. The next business day after the transaction** Confirmations on an options transaction must be sent to customers no later than the business day following the transaction.

Question 112

An order that consists of two parts, with instructions that one part of the order is to be canceled if the other part is executed, is called: a. An OCO order b. An MIT order c. A stop order d. A CFO order

Answer 112

``` **a. An OCO order** An OCO (one cancels the other) order is one in which, if one part of the order is accomplished, the other part is immediately canceled. An example of an OCO order would be to buy 5 September wheat at $4.90 or buy 5 December wheat at $4.93. If either order is done, the other will be immediately canceled. ```

Question 113

What type of transaction would a hedger use to protect the value of his inventory against a possible price decline: a. Buying hedge b. Long hedge c. Interdelivery spread d. Selling hedge

Answer 113

**d. Selling hedge** If an individual owns a commodity, he would be concerned about a price decline. In order to hedge, he would sell futures. Since the individual is long the cash commodity (long the basis), he will establish a selling hedge (also called a short hedge). If the price of the cash commodity goes down, a loss will be suffered. However, the price of futures can be expected to move in the same direction as the price of cash, and therefore the futures will also go down. When the hedger lifts the hedge by selling the cash commodity (at a loss), he will buy the futures at a comparably lower price and have a profit. The profit on the futures will essentially equalize the loss on the cash commodity.

Question 114

A commodity futures commission merchant does not include profits on futures contracts when calculating a customer's equity. a. True b. False

Answer 114

**b. False** When determining a customer's equity, the member firm will take into account the current status of the account. If there is a profit in the account, this will be credited to the customer who may withdraw the cash or use it to make additional commitments. If there is a loss, the customer will be called for additional margin when the loss causes the equity to drop below the maintenance level.

Question 115

To handle a discretionary account, an AP must have at least two years' experience and be continuously registered during this period. a. True b. False

Answer 115

**a. True** This is true. Two years' consecutive experience is required for an AP to operate a discretionary account. Rule 2-8 of the NFA reads in part, "an associate may not exercise discretion unless the associate (AP) has been continuously registered for a minimum of two years and has worked in such registered capacity for that period."

Question 116

An investor sells a March 7.00 cent sugar call and buys a March 8.00 cent sugar call. This is a: a. Straddle b. Vertical spread c. Horizontal spread d. Ratio spread

Answer 116

``` **b. Vertical spread** This is a vertical spread. It is the simultaneous purchase and sale of options of the same class with the same expiration date but with different exercise prices. ```

Question 117

A trader believes the market will rally, reach a resistance point, and then sell off sharply. Which of the following orders should he place? a. Market if touched b. Stop order c. Limit order d. Fill or kill order

Answer 117

**a. Market if touched** A sell MIT order is placed above the current price in the market. It is used by someone who wants to establish a short position when the market advances to a certain level.

Question 118

The area on a chart where one can expect a possible increase in the selling of futures would be called a: a. Support area b. Resistance area c. Congestion area d. None of the above

Answer 118

**b. Resistance area** A resistance area is the top of a congestion area, where increased selling retards the price advance of a futures contract.

Question 119

When spot prices are over futures prices, it may reflect: a. An oversupply of the spot commodity b. A tight supply picture c. Inadequate storage space d. All of the above

Answer 119

* *BLANKANSWER** b. A tight supply picture

Question 120

The price difference between the actual cash commodity and the futures price is called the spread. a. True b. False

Answer 120

**b. False** The price difference between cash and futures is called the basis.