Week 5 - Futures and Forwards

Question 1

what are derivatives ?

Answer 1

securities whose prices are determined by other securities

Question 2

what do we use derivatives for?

Answer 2

to hedge risk
or speculate gains
when there is a lot of uncertainty in the market, like COVID, derivative contracts increased everywhere because you can lock in a price and escape the uncertainty

Question 3

key derivatives

Answer 3

forwards
futures
options
swaps

Question 4

what are futures and forwards?

Answer 4

contracts that specify purchase or sale of an underlying security at some future date
they carry an obligation (unlike options)
both price and date are locked in

Question 5

forward contract (4 characteristics)

Answer 5

private contract
one specified date
settled on maturity
some credit risk

Question 6

futures contract (4 characteristics)

Answer 6

can be exchanged on the market
range of delivery dates
daily settlements
no credit risk

Question 7

long forward position (buy)

Answer 7

trader commits to buying something on the maturity date
long position benefits from price increases
limited upside potential

Question 8

short forward position (sell)

Answer 8

trader commits to sell the commodity upon maturity
short position benefits from price decrease
unlimited downside potential (there is no limit to how high the price can increase)

Question 9

why is there a difference in price of future and forward contracts

Answer 9

because of the timing of the cash flows and fluctuation in interest rates

Question 10

what are daily settlements?

Answer 10

in a futures contract your position is valued at the end of each day and any gains/losses are immediately settled in cash

Question 11

why do daily settlements matter?

Answer 11

because the timing of cash flows affect the present value of your gains/losses. Cash you receive earlier is worth more if you can reinvest it at a good rate.

Question 12

futures are worth more than forwards when….

Answer 12

asset prices are positively correlated with interest rates.
since futures settle daily, any profits received can be reinvested at higher interest rates.

Question 13

forwards are worth more than futures when….

Answer 13

assets are negatively correlated with interest rates.
your daily profits from a future are reinvested at lower rates, reducing the benefit of early settlement.

Question 14

what are 4 key differences between futures and forwards

Answer 14

customisation vs standardistion
credit risk
settlement method
liquidity and exit flexibility