CH 22, 23) Futures Markets & Futures, Swaps, and Risk Management

Futures markets are regulated by the _____________. CFTC OCC SEC CFPB

CFTC (Commodities Futures Trading Commission)

Because long hedgers will agree to pay high furthers prices to shed risk, and speculators must be paid a premium to enter the short position, the ___________ theory holds that Fo must exceed E(PT).

Contango

T/F: Trading of futures contracts is almost exclusively performed between floor traders in the trading pit on futures exchanges.

False Traditional trading required the use of floor traders, but today almost all trading is done using electronic networks.

T/F: Cash settlement avoids the costs that would be incurred if the long trader had to purchase the stocks in the index and deliver them to the short position, and if the short position then had to sell the stocks for cash instead.

False Reason: Cash settlement avoids the costs that would be incurred if the short trader had to purchase the stocks in the index and deliver them to the long position, and if the long position then had to sell the stocks for cash instead.

____________ ____________ replace informal ____________ ____________ with highly standardized, exchange-traded securities.

Futures markets; forward contracts

____________ ____________ ____________ have a tremendous appeal to fixed-income managers because these contracts allow managers to quickly, cheaply, and anonymously restructure the balance sheet.

Interest rate swaps

T/F: A reverse strategy involving a short sale of the commodity may be done as long as the short sale contract appropriately accounts for the storage costs.

True

T/F: Because of convergence, the futures price at maturity equals the spot price so total futures profits may be expressed as PT - FO.

True

T/F: In the strategy of a calendar spread, profits accrue if the differences in futures prices between the two contracts change in the hoped-for direction, if the future prices on the contract held long increases by more than the futures price on the contract held short.

True

An oil producer who wishes to sell barrels of oil in three months would most likely take the ____________ position in the futures market. a) short b) long

a)

James Webb takes the long position in a wheat futures contract when the spot price of wheat is $4.00 per bushel and the futures price of wheat is $4.10 per bushel. If the spot price at maturity date of the contract is $4.20, what is the profit to Webb's position? a) $0.10 per bushel b) $0.30 per bushel c) $0.20 per bushel

a)

When replicating an index with a futures and bills portfolio, the amount held in futures is the desired stock investment divided by the _______________ and the amount in T-bills equals the _______________ of the futures price. a) product of the multiplier and the index; present value b) multiplier; present value c) product of the multiplier and the index; future value d) multiplier; future value

a)

Consider a futures contract on corn in which the futures price is $2 per bushel and the spot price is $1.93 per bushel. The basis of the contract is ______________. a) $0.07 b) $2.00 c) $1.93

a) Basis is the difference between the spot price and the futures price

Determine the one-year arbitrage profit under the following conditions: US rates are 3%; German rates are 7%; spot exchange rate is $1.10/€; forward rate is $1.08/€. Borrow either $100 or €100 to begin the transaction. a) $2.05 b) $5.05 c) €2.09 d) €9.09

a) Reason: 1) Borrow $100 and repay $103 2) Convert $100 to €90.909 3) Invest €90.909 at 7% to get a FV of €97.27 4) Use forward contract to convert back to $105.05 PROFIT of $105.05 - $103 = $2.05 not c) this is the loss if the transaction begins with a €100 loan

According to the expectations hypothesis, the futures contract price is ________________. a) equal to the expected value of the future spot price b) equal to the current spot price

a) Market expectations suggests the price paid today for a futures contract must be equal to the expected spot price Futures prices and spot prices are almost never identical, except as the contract nears maturity

Which of the following is best described as a cross-hedge? a) A grapefruit farmer uses orange juice futures to hedge commodity price risk. b) A risk-free fixed income security investor uses Treasury futures contracts. c) A pension fund manager with a passively-managed index portfolio with a beta of 1.0 uses an S&P 500 Index futures contract.

answer: a) Reason: The asset owned by the farmer is different than the underlying futures contract asset. not b) the two assets have identical profiles not c) Diversified portfolios with betas of 1 would be almost identical to the index, especially one that is not actively managed.

Current interest rates are higher in Scotland than in Mexico. The spot exchange rate is Peso20/Pound. Which of the following is more likely to be the no-arbitrage futures price? a) Peso18/Pound b) Peso22/Pound

answer: a) Reason: Countries w/ higher interest rates will have their currencies sell for discounts in the derivatives markets, such as the forward and futures markets not b) This is a depreciation of the peso, which will occur in the spot market, but just the opposite in the futures market.

BBJ International is paying its bondholders LIBOR plus 125 basis points. BBJ is concerned that rates will rise so it enters which of the following swaps? a) Pay fixed for floating b) Pay floating for fixed

answer: a) Reason: BBJ will receive floating payments from the swap dealer and make fixed payments to the dealer. not b) BBJ is paying its bondholders a floating rate payment, so it does not want to receive floating rate payments from the swap dealer.

The price of a financial futures contract will be less than the spot price if _____________. a) the risk-free rate exceeds the dividend yield b) the dividend yield exceeds the risk--free rate

answer: b) Not a) When the risk-free rate is higher than the dividend yield, the futures price will be greater than spot b) The cost of carry relationship shows this explicitly

Which of the following swaps behaves most like an insurance contract? a) Interest rate swap b) Credit default swap c) Foreign exchange swap

answer: b) Reason: In a CDS, the swap buyer pays a regular premium to the swap seller in return for a promise of payment if the bond defaults. not a) An interest rate swap is one in which two parties simply swap fixed income payments. not c) A foreign exchange swap is one in which two currencies are swapped.

An investor believes the shares of HHY Inc are undervalued and wants a market neutral bet because she feels the broader market is overvalued. The determining factor in computing the accurate number of futures contracts to execute the hedge effectively is _______________. a) the exchange on which the contract is traded b) the beta of HHY c) if HHY is contained in the index on which the futures contract is written

answer: b) Reason: Hedging strategies are based on the firm's measure of systematic risk, which is the firm's beta. not a) Most futures contract markets are highly liquid, so this should not be an issue not c) Whether HHY is in the index or not will not affect the number of futures contracts. HHY's beta will reflect its level of risk.

Select all that apply... When the unprotected portfolio position is ___________ related to the value of an asset, the hedge strategy calls for a ____________ position in that asset. a) positively; short b) negatively; long c) negatively; short d) positively; long

answers: a) and b)

Select all that apply... According to portfolio theory, the equilibrium futures price will be ____________ than the currently expected time T spot price if the asset has a ____________ beta. a) lower; positive b) higher; negative c) higher; positive d) lower; negative

answers: a) and b) a) The hedge imposes an expected loss on the short position who is willing to accept that expected loss as a means to shed systematic risk b) The hedge provides an expected gain on the short position who requires it to accept systematic risk

Select all that apply... Which statements are true of the swap market? a) The notional principal in the swap market is not a good description of the amount of its credit risk. b) At the time a swap transaction is initiated, it has zero net present value. c) The loss to the losing side of a swap is the notional value of the contract. d) A party to a swap transaction typically only makes payments with a loss on the contract.

answers: a) and b) yes a) Credit risk in the swap market is not nearly as large as the magnitude of notional principal. yes b) That is why both sides are willing to enter the swap. not c) The loss is only the difference between the values of the original obligation and the new obligation. not d) Typically both parties make payments regardless of the change in their value.

Select all that apply... At the maturity of a futures contract, the profit to the ___________ position is ____________. a) long; spot price at maturity − original futures price b) short; spot price at maturity − original futures price c) long; original futures price − spot price at maturity d) short; original futures price − spot price at maturity

answers: a) and d)

Select all that apply... Which statements are correct about the use of futures to replicate positions in broad market indexes? a) Transactions costs are lower than buying and selling the index's securities. b) A disadvantage is that index futures are settled by delivery of the securities that make up the index. c) A bills-plus-futures portfolio can be used to generate a 100% stock strategy. d) More interest is earned on the T-bill position when holding a short futures position than is typically earned on the proceeds of short sales.

answers: all except b) not b) They are settled by a cash amount equal to the value of the index on the contract maturity date times a multiplier that scales the size of the contract.

Select all that apply... The role of the CFTC is to... a) oversees maintenance of daily trading records b) set capital requirements for member firms of the futures exchanges c) make futures trading recommendations d) authorizes trading in new contracts

answers: all except c)

Select all that apply... Which aspects of futures contracts are standardized by the exchange? a) Delivery date b) Delivery location c) Contract Price d) Grade of the deliverable asset

answers: all except c) C) traders negotiate the price

Select all that apply... Which statements are true of the spot-futures parity theorem? a) It is also called the cost-of-carry relationship. b) It predicts a futures price of S0(1 + rf - d). c) Violation of the parity relationship gives rise to arbitrage opportunities. d) It predicts a futures price of S0(1 - rf + d).

answers: all except d)

Select all that apply... Which statements are true of currency futures? a) No money changes hand until the delivery date. b) They trade on formal exchanges. c) Their contracts are not standardized. d) Counterparty risk is lessened by the clearinghouse being a party to both sides of transactions.

answers: b) and d) not a) Margin must be posted, and positions are marked daily not c) they are standardized by size

Select all that apply... Which statements are true of forward markets for foreign exchange? a) Positions are marked to market to determine margin obligations. b) They are an informal network of banks and brokers. c) Risk is lessened because a trader's counterparty is an exchange. d) Their contracts are not standardized.

answers: b) and d) not a) this occurs in futures markets not c) this is true of futures markets

Select all that apply... Which statements are true of futures markets? a) Closing a position requires renegotiation. b) Buyers and sellers trade in a centralized futures exchange. c) The contracts are standardized. d) Futures contracts call for a daily settling up of any gains or losses. e) No money changes hands until the delivery date.

answers: b), c) and d) d) This is true of forwards. In futures markets, traders post margin to guarantee contract performance

***Select all that apply... Suppose the current exchange rate is $2 per pound, rUS is 0.04, rUK is 0.05, and the futures price for a one-year contract is $1.981. Which statements are true? a) If you receive £1 in one year, you should be able to convert it to $2 on the spot market then. b) Because the interest rate is higher for pounds than dollars, investors would prefer to have £1 than $2 now. c) If you have £1 that you convert to dollars in the spot market and invest in risk-free US securities, you will have $2.08 in one year. d) If you invest £1 in risk-free UK securities and you contract now to purchase £1.05 at the futures price, you will have $2.08 in one year.

answers: c) and d)

When hedgers are willing to take a loss on their short positions in the futures market, it is known as _____________. a) contango b) normal backwardation

b) Contango theory holds that the futures price exceeds the expected futures spot price In a normally backward market, hedgers are willing to accept small losses in the sale of their underlying asset to remove price risk with the futures contract

Rock Financial has written a currency derivative contract in which the terms are standardized and which is traded on an organized exchange. The contract is most likely a ______________. a) forward contract b) futures contract

b) Forward contracts are unique contracts specifically designed for the needs of each client

The current spot price of gold is $1,000 per troy ounce while the futures price for a two-month gold contract is priced at $1,080. Economists at a large financial institution expect the spot price of gold to be $1,070 in two months. This market is most likely in ______________. a) normal backwardation b) contango

b) Normal backwardation is when the expected spot price is greater than the futures price Contango is defined as a futures price that exceeds the expected future spot price

Determine if there is an arbitrage opportunity in the foreign exchange market between Germany and England if interest rates are 8% in Germany and 6% in England. Current spot rate is GBP2.00/EUR and the quoted forward rate is GBP1.963/EUR. a) An arbitrage opportunity does exist. b) An arbitrage opportunity does not exist.

b) Reason: Since (1.06)/(1.08) times 2.00 = GBP1.9629/EUR, there is no arbitrage opportunity not a) the quoted futures rate is equal to the no arbitrage condition rate, so there is no opportunity

A bond portfolio is currently valued at $500,000. The portfolio would lose $3,000 in the event of a 10 basis point increase. The price value of a basis point is ___________. a) $30,000 b) $300 c) $3,000 d) $500 e) $50,000 f) $5,000

b) Reason: The PVBP is the ratio of the change in portfolio value over the basis point change (3000/10).

The risk attributable to uncertain movements in the spread between a futures price and a spot price is referred to as ___________ ___________.

basis risk

A US-based exporting firm has estimated the following regression equation: Annual Earnings = α + β (Exchange Rate). The regression results show alpha to be 10 and beta to be 8. If the exchange rate is USD1.25/Euro, determine the expected annual earnings. a) $8.00 b) $80.00 c) $20.00 d) $16.40

c)

As the settlement date of a futures contract approaches, its open interest typically _____________. a) remains the same b) rises c) falls

c)

At the initiation of futures contracts, margin must be posted by ____________. a) traders taking the long position but not those taking the short position b) traders taking the short position but not those taking the long position c) traders taking the long position and those taking the short position

c)

A farmer uses futures contracts to hedge commodity price risk of his corn harvest. The farmer computes a hedge ratio of 219, which implies _______________. a) the farmer has 219 days to harvest his corn to match the maturity date of the futures contract b) the most the farmer can lose in the futures market is $219 c) the farmer needs 219 corn futures contracts to hedge risk

c) not a) Hedge ratio does not determine the days to maturity in a futures contract not b) Hedge ratios do not determine minimum or maximum losses in the futures market Reason for c) The hedge ratio is the # of futures contracts required to remove commodity price risk for this farmer

An investor takes a long position in a futures contract of one maturity and a short position in a contract on the same commodity but with a different maturity in a(n) ____________ ____________.

calendar spread

A futures contract that calls for "delivery" of a cash amount equal to the value that the index attains on the maturity date of the contract is an example of a ____________ ____________.

cash settlement

The provision of some futures contracts that requires not delivery of the underlying assets but the dollar value of the asset is referred to as ___________ ___________.

cash settlement

Established by exchanges to facilitate transfer of securities resulting from trades, the middleman between two futures traders is the ______________.

clearinghouse

That the futures price and the spot price at the maturity of a futures contract must be the same is referred to as the _____________ property.

convergence

The ____________-____________-____________ relationship is also called the _____________ relationship because it asserts that the futures price is determined by the relative costs of buying a stock with deferred deliver in the futures market vs. buying in the spot market with immediate delivery and "carrying" it in inventory.

cost-of-carry; parity

The risk to an investor that the other side of a contract will not perform its contractual obligations is referred to as _______________ risk.

counterparty

When the interest rate parity equation does not hold and it is possible to earn profits without exchange-rate risk, there is said to be a(n) ______________ interest arbitrage opportunity. naked covered equilibrium uncovered

covered

The ___________ ____________ ___________ allows two counterparties to take positions on the credit risk of those firms.

credit default swap

The ____________ ___________ in the swap market is not as large as the magnitude of notiational principal as markets suggest because the loss is only the difference between values of the fixed-rate and floating-rate obligations, not the total value of the payments that the floating-rate payer was originally obligated to make.

credit risk

Hedging a position in one asset using futures on another commodity is a(n) ____________-hedge.

cross

The obligation, rather than the right, to buy or sell an underlying asset is specified by ___________. a) forward contracts but not futures contracts b) futures contracts but not forward contacts c) neither forward nor futures contracts d) both forward and futures contracts

d)

The profit for the owner of a long position who buys a contract and closes, or reverses, it at a later time is the change in the ____________ over the period. a) intrinsic value b) time value c) spot price d) futures price

d)

The term used in futures quotations for the representative trading price during the last few minutes of trading of the day is the _____________ price. a) discovery b) ending c) open d) settlement

d)

Which formula gives the fair futures price of a commodity? Define F0 as the futures price, P0 as the spot price, and c as the carrying costs as a percentage of the current price. a) F0 = P0 (1 + rf - c)^(-1) b) F0 = P0 (1 + rf + c)^(-1) c) F0 = P0 (1 + rf - c) d) F0 = P0 (1 + rf + c)

d)

A broad equity index has a current value of 700 while a futures price on the index is quoted at 722. If the index increases in value by 10% by the maturity date of the futures contract, determine the profit to the long futures position. a) $70.00 b) $92.20 c) $24.20 d) $48.00

d) Reason: The index will be valued at 770 on the maturity date of the contract (1.10 * 700). The profit will be 770 - 722

The currency futures markets employ ____________ quotes. direct indirect

direct

The euro-dollar exchange rate is an example of a(n) _________ quote.

direct

The _________ _________ states that the futures price equals the expected value of the future spot price: Fo = E(PT).

expectations hypothesis

An agreement calling for future delivery of, and payment for, an asset at a previously agreed-upon price is a __________ contract.

forward

A ___________ ___________ is a deferred-delivery sale of some asset with the sales price agreed on now.

forward contract

The ____________ ____________ is not purchased; it is simply a contract.

futures contract

The futures contract calls for delivery of a commodity at a specified delivery or maturity date, for an agreed-upon ____________ ___________, to be paid at contract maturity.

futures price

The price at which a futures trader commits to make or take delivery of the underlying asset is the ___________ ____________.

futures price

The number of hedging vehicles such as futures contracts required to offset the risk of a particular unprotected position is the ___________ ___________.

hedge ratio

John's Soup Company (JSC) uses corn in many of its recipes and purchases corn regularly throughout the year. If JSC uses a futures contract to purchase corn, it is most likely ___________. hedging speculating

hedging Hedgers enter futures contracts to remove price risk, which is the goal of JSC Speculators do not have a position in the underlying asset, like JSC does

By ___________ the _____________, the portfolio manager can make stock picks without concern for the market exposure of those stocks.

hedging; market

The investment strategy that exploits divergences between the actual index futures price and its theoretically correct parity value is _____________ ______________.

index arbitrage

Whenever the actual futures price differs from its parity value, there is an opportunity for profit referred to as _____________ ______________.

index arbitrage

Exchange rates for the Japanese yen or Swiss franc are examples of a(n) ___________ quote.

indirect

The spot-futures exchange rate relationship that prevails in well-functioning markets is given by the __________ ___________ __________ theorem.

interest rate parity

A jeweler who wishes to purchase gold in the futures market would take the __________ position. short long

long

The established value below which a trader's margin cannot fall without triggering a margin call is ______________ margin.

maintenance

If the value of an account falls below the maintenance margin, the trader receives a ____________ ___________, requiring that the _____________ account be replenished or the position be reduced to a size commensurate with the remaining funds.

margin call; margin

A strategy designed to exploit relative mispricing within a market, but which is hedged to avoid taking a stance on the direction of the broad market is said to be ___________-___________.

market-neutral

The ____________ ___________ theory fine-tunes the market approach by refining the notion of risk used in the determination of risk premiums, meaning if commodity prices pose positive systematic risk, futures prices must be lower than expected spot prices.

modern portfolio

The theory ___________ ___________ of suggests that the futures price will be bid down to a level below the expected spot price and will rise over the life of the contract until the maturity date, at which points FT = PT.

normal backwardation

The principal amount used to calculate swap payments is the ______________ principal.

notional

The total number of short or long futures contracts outstanding for a particular delivery month is referred to as the _________ _________.

open interest

The change in the value of a fixed-income asset resulting from a 1 basis point change in the asset's yield to maturity defines the ____________ ___________ of a ______________ _______________.

price value of a basis point

A futures investor can undo a position through a(n) _____________ trade.

reversing

A representative trading price during the last few minutes of trading is known as the ___________ price.

settlement

Futures contracts on the shares of one company rather than an index are ____________-____________ futures.

single-stock

In addition to indexes on broad stock indexes, the electronic OneChicago market lists __________-__________ ___________ on some actively traded individual stocks and narrowly based stock indexes.

single-stock futures

Andrew Full is a high net worth investor who strongly believes the price of ethanol is going to fall sharply over the next three months. If Full uses a futures contract, he is most likely _______________. speculating hedging

speculating Speculators use futures contracts to make a price movement bet w/o having any interest in buying or selling the underlying asset Hedgers seek to avoid risk, while Full is seeking risk by betting the price of ethanol will fall

The immediate (two-day) purchase or sale of foreign exchange occurs on the __________ market.

spot

The theoretically correct relationship between spot and futures prices is given by the __________-_________ ___________ theorem.

spot-futures parity

The exchange of a series of cash flows proportional to a given interest rate for a corresponding series of cash flows proportional to a floating interest rate is a common interest rate _____________.

swap

Until about 20 years ago, most futures trades in the U.S. occurred among floor traders in the "___________ _____________" for each contract.

trading pit