Pricing futures and forwards

Question 1

Explain treasury rates

Answer 1

treasury rates are the rates an investor earns on treasury bills and bonds issued by a government to borrow money in its own currency. treasury securities are usually regarded as default-risk free because investors are certain that interest and principal payments will be made.
treasury rates are sometimes used to define the payoff from a derivative but it is more common to use LIBOR rates as the estimate of the risk-free rate.

Question 2

explain LIBOR Rates

Answer 2

they are the london interbank offered rate. they are rates at which a bank is prepared to make a large wholesale deposit with other banks.

Question 3

how long is the maturity on LIBOR rates?

Answer 3

from one day to one year

Question 4

what is the minimum credit rating to accept a LIBOR quote?

Answer 4

AA

Question 5

what rate do derivative traders consider the best indication of the risk-free rate of interest?

Answer 5

LIBOR

Question 6

what are investment assets?

Answer 6

assets held purely for investment purposes. some examples are bonds, shares and gold.
note: that these don’t have to be held exclusively for investment

Question 7

what are consumption assets?

Answer 7

assets held primarily for consumption. examples include, copper, lead, oil and grains

Question 8

why is the distinction between investment and consumption assets important

Answer 8

because arbitrage arguments can be used to determine the forwards prices of investment assets but not always consumption assets.

Question 9

what are 3 conditions for arbitrage?

Answer 9

1. an imperfect market
2. simultaneous transactions
3. risk free returns

Question 10

when calculating the forward price of an investment asset, the difference between the spot and forwards price represents…..

Answer 10

the opportunity cost of funds

Question 11

If F0>S0eᴿᵀ the forward is _______, meaning

Answer 11

overpriced, meaning arbitrageurs could earn a risk-free profit by buying the asset and shorting the forward.

Question 12

If F0<S0eᴿᵀ the forward is ________, meaning

Answer 12

arbitrageurs can sell the asset short and buy the forward to lock in a risk-free profit.

Question 13

with regards to share price index arbitrage, what happens if F0 > S0e(r-q)T. How may arbitrageurs exploit this

Answer 13

an arbitrageur could buy the stocks in proportion to their index weights and sell futures

Question 14

with regards to share price index arbitrage, what happens if F0 < S0e(r-q)T. How may arbitrageurs exploit this

Answer 14

an arbitrageur could buy futures and short the underlying index.

Question 15

at initiation, the value of a forward contract is _______ as time progresses the value may become_____________

Answer 15

$0
positive or negative.

Question 16

what is interest rate parity theorem?

Answer 16

IRP suggests that the forward price relative to the spot price will reflect the difference in interest rates. if not, arbitrage activity will ensure that IRP holds. when rf > r, the forward price of the foreign currency will be less than the spot rate. when rf < r the forward price of the foreign currency will be less than the spot rate.

Question 17

how may arbitrage activity be muted in consumption assets futures

Answer 17

where F0 < S0e(r+u)T. in other words when the futures price is less than the present value of the spot price.

Question 18

what is the convenience yield

Answer 18

the convenience yield occurs when a commodity is in short supply, this may produce an abnormally high spot price. the benefit from holding a physical asset is that the asset can be used in production. this benefit is the premium earned by those who hold inventory of the commodity in short supply.

Question 19

what effect may a convenience yield have on pricing?

Answer 19

if the yield is greater than the cost of carry, futures prices for more distant delivery months will be lower than the spot price and the futures price for the nearer delivery months.

Question 20

explain contango

Answer 20

for storable assets and financial assets for which (risk free rate +u (storage costs)) exceeds income (q) on the underlying asset, the cost of carry is positive, this would cause the futures price to be grater than the spot price.

Question 21

explain backwardation

Answer 21

when the futures price is less than the spot price, attributable to a convenience yield. this is known as backwardation.

Question 22

What is meant by LIBOR and LIBID. Which is higher?

Answer 22

LIBOR is the London interbank offer rate. It is the rate a bank quotes for deposits it is prepared to place with other banks. LIBID is the London interbank bid rate. It is the rate a bank quotes for deposits from other banks. LIBOR is greater than LIBID.