[options]

A trader enters into a short forward contract on 100 million yen. The forward exchange rate is $0.0080 per yen. How much does the trader gain or lose if the exchange rate at the end of the contract is (a) $0.0074 per yen; (b) $0.0091 per yen?

) The trader sells 100 million yen for $0.0080 per yen when the exchange rate is $0.0074 per yen. The gain is 100x0.0006 millions of dollars or $60,000. b) The trader sells 100 million yen for $0.0080 per yen when the exchange rate is $0.0091 per yen. The loss is 100x 0.0011 millions of dollars or $110,000.

market-if-touched order

-a stop order in reverse:it is designed to get an investor into a position rather than out of one. designed to place a limit on the loss that can occur in the event of unfavorable price movements.

4 types of participants in options markets

1. buyers of calls 2. sellers of calls 3. buyers of puts 4. sellers of puts buyers = long positions sellers = short positions

Chicago Mercantile Exchange (CME)

A futures and options exchange in Chicago. The CME group owns the CME, the Chicago Board of Trade and the New York Mercantile Exchange (NYMEX). The CME has both floor trading using open outcry and an electronic trading platform called CME Globex.

stop-limit order

A stop order that becomes a limit order after the specified stop price has been reached or passed. two prices must be specified.

Explain carefully the difference between hedging, speculation, and arbitrage.

A trader is hedging when she has an exposure to the price of an asset and takes a position in a derivative to offset the exposure. In a speculation the trader has no exposure to offset. She is betting on the future movements in the price of the asset. Arbitrage involves taking a position in two or more different markets to lock in a profit.

hedge accounting

An accounting procedure that specifies that gains and losses on hedging instruments be recognized in earnings at the same time that the effects of changes in the value of the items being hedged are recognized.

Distressed Securities

Buy securities issued by companies in or close to bankruptcy

Explain why a futures contract can be used for either speculation or hedging.

If an investor has an exposure to the price of an asset, he or she can hedge with futures contracts. If the investor will gain when the price decreases and lose when the price increases, a long futures position will hedge the risk. If the investor will lose when the price decreases and gain when the price increases, a short futures position will hedge the risk. Thus either a long or a short futures position can be entered into for hedging purposes. If the investor has no exposure to the price of the underlying asset, entering into a futures contract is speculation. If the investor takes a long position, he or she gains when the asset's price increases and loses when it decreases. If the investor takes a short position, he or she loses when the asset's price increases and gains when it decreases.

emerging markets

Invest in debt and equity of companies in developing or emerging countries and in the debt of the countries themselves

bilateral clearing

OTC transactions that are not cleared through CCPs. requires credit support annex (CSA), which requires one or both sides to provide collateral. Collateral significantly reduces credit risk. simple assumption that there are only 8 market participants

Explain carefully the difference between selling a call option and buying a put option.

Selling a call option involves giving someone else the right to buy an asset from you. It gives you a payoff of Buying a put option involves buying an option from someone else. It gives a payoff of max( 0) In both cases the potential payoff is . When you write a call option, the payoff is negative or zero. (This is because the counterparty chooses whether to exercise.) When you buy a put option, the payoff is zero or positive. (This is because you choose whether to exercise.)

maintenance margin

The amount of margin that must be maintained in a futures account; Additional funds must be added to the margin account if the balance falls below this amount. determined by the clearing house

A cattle farmer expects to have 120,000 pounds of live cattle to sell in three months. The live- cattle futures contract traded by the CME Group is for the delivery of 40,000 pounds of cattle. How can the farmer use the contract for hedging? From the farmer's viewpoint, what are the pros and cons of hedging?

The farmer can short 3 contracts that have 3 months to maturity. If the price of cattle falls, the gain on the futures contract will offset the loss on the sale of the cattle. If the price of cattle rises, the gain on the sale of the cattle will be offset by the loss on the futures contract. Using futures contracts to hedge has the advantage that it can at no cost reduce risk to almost zero. Its disadvantage is that the farmer no longer gains from favorable movements in cattle prices.

variation margin

The funds that must be deposited into an account to bring it back up to the initial margin amount

last trading day

The last day on which a futures or option contract may be traded.

initial margin

The money deposited in a futures account before trading begins; Typically around one day's maximum price movement. determined by the clearing house.

What is the difference between the over-the-counter market and the exchange-traded market? What are the bid and offer quotes of a market maker in the over-the-counter market?

The over-the-counter market is a telephone- and computer-linked network of financial institutions, fund managers, and corporate treasurers where two participants can enter into any mutually acceptable contract. An exchange-traded market is a market organized by an exchange where traders either meet physically or communicate electronically and the contracts that can be traded have been defined by the exchange. When a market maker quotes a bid and an offer, the bid is the price at which the market maker is prepared to buy and the offer is the price at which the market maker is prepared to sell.

One orange juice future contract is on 15,000 pounds of frozen concentrate. Suppose that in September 2011 a company sells a March 2013 orange juice futures contract for 120 cents per pound. In December 2011 the futures price is 140 cents. In December 2012 the futures price is 110 cents. In February 2013 it is closed out at 125 cents. The company has a December year end. What is the company's profit or loss on the contract? How is it realized? What is the accounting and tax treatment of the transaction if the company is classified as a) a hedger and b) a speculator?

The price goes up during the time the company holds the contract from 120 to 125 cents per pound. Overall the company therefore takes a loss of 15,000×0.05 = $750. If the company is classified as a hedger this loss is realized in 2013, If it is classified as a speculator it realizes a loss of 15,000×0.20 = $3000 in 2011, a gain of 15,000×0.30 = $4,500 in 2012, and a loss of 15,000×0.15 = $2,250 in 2013.

"Options and futures are zero-sum games." What do you think is meant by this statement?

The statement means that the gain (loss) to the party with the short position is equal to the loss (gain) to the party with the long position. In aggregate, the net gain to all parties is zero.

A trader enters into a short cotton futures contract when the futures price is 50 cents per pound. The contract is for the delivery of 50,000 pounds. How much does the trader gain or lose if the cotton price at the end of the contract is (a) 48.20 cents per pound; (b) 51.30 cents per pound?

The trader sells for 50 cents per pound something that is worth 48.20 cents per pound. Gain ($0.5000 -$0.4820)x50,000=$900 . (b) The trader sells for 50 cents per pound something that is worth 51.30 cents per pound. Loss ($0.5130-$0.5000)x50,000=$650 .

What is the difference between a long forward position and a short forward position?

When a trader enters into a long forward contract, she is agreeing to buy the underlying asset for a certain price at a certain time in the future. When a trader enters into a short forward contract, she is agreeing to sell the underlying asset for a certain price at a certain time in the future.

inverted market

a future market where price decrease with maturity.

normal market

a futures market where prices increase with maturity.

limit move

a move in either direction equal to the daily price limit. normally trading ceases for the day once the contract is limit up or limit down. have become an artificial barrier to trading when the price of the underlying asset is advancing or declining rapidly.

market order

a request that a trade be carried out immediately at the best price available in the market

clearing house

acts as an intermediary in futures transactions and guarantees the performance of the parties to each transaction. main task is to keep track of all of the transactions that take place during a day so that it can calculate the net position of each of its members.

margin accounts

adjusted at the end of each trading day attune to the process known as daily settlement or marking to market. the whole purpose of the margining system is to ensure that funds are available to pay traders when they make a profit- avoid credit risk.

futures contract

an agreement to buy or sell and asset at a certain time in the future for a certain price. (CME, ICE). The agreement provides a way for each side to eliminate the risk it faces because of the uncertain future prices. potential loss as well as potential gain is very large. settled daily. a zero-sum contract, in effect the contract is closed out and rewritten at a new price each day.

cornering the market

an investor group takes a huge long futures position and also tries to exercise some control of the underlying commodity. as the maturity of the contracts is approached, the investor does not close out its position, so the number of outstanding contracts may exceed the amount of the commodity available for deliver. Short positions find that their is not enough of the commodity to deliver their positions. this results in a large rise in futures and spot prices

discretionary order

an order to buy (or sell) a stock that allows the broker to get the best possible price

stop order

an order to sell a particular stock at the next available opportunity after its market price reaches a specified amount. usually taken to close out a position if unfavorable price movements take place, thus limiting the losses that can be incurred.

Convergence of Futures Price to Spot Price

as the delivery period for a futures contract approaches, the futures price converges to the spot price of the underlying asset.

over the counter markets

banks, large financial institutions, fund managers, and corporations are the main participants. were largely unregulated, but standarized OTC derivatives between two financial institutions must be traded on swap-execution facilities (SEFs)

global macro

carry out trades that reflect anticipated global macroeconomic trends

delivery

delivery is determined by the party with the short position. then a notice of intention to deliver is sent to the long position holder to accept delivery, specifying where the deliver will take place and the number of contracts.

hedge transaction

designed to protect against a price change or currency fluctuations that would negatively affect profits on a property. to reduce the risk of price or interest rate changes with respect to borrowings.

futures price

determined by the laws of supply and demand. also can be contrasted with the spot rates

minimum levels of margin accounts

determined by the variability of the underlying asset. higher the variability the higher the levels.

european vs american options

euro: can be exercised on the maturity date american: can be exercised at any time during its maturity

position traders

exchange members who take a position in the futures market based on their expectations about the future direction of the prices of the underlying assets

Eurodollar

futures contract based on the future value of a short-term interest rate

limit up

futures market in which the price at which a transaction would be made is at or above the upper limit. purpose is to prevent large price movements from occurring because of speculative excesses.

call options

give the holder the right to buy an asset at a specified time in the future for a certain price. The price of a this option decreases as strike price increases.

put options

give the holder the right to sell an asset at a specified time in the future for a certain price. The price of this option increases as the strike price increase.

day traders

hold their position for less than one trading day. unwilling to take longer term risk.

limit down

if in a day the price moves down from the previous day's close by an amount equal to the daily price limit. purpose is to prevent large price movements from occurring because of speculative excesses.

spot price

is for immediate, or almost immediate delivery

Central counterparty (CCP)

its role is to stand between the two sides in an over-the-counter derivatives transaction in much the same way that an exchange does in the exchange-traded derivatives market. assumes the credit risk of the parties its it transacting for. transactions are valued daily, this leads to variation margin payments

60/40 rule

non-corporate taxpayer give rise to capital gains and losses with 60% treated as long term and 40% treated as short term

open interest

number of contracts outstanding. The total number of contracts of a particular option that have been written.

exercise or strike price

price set for calling an asset or putting an asset

settlement price

price used for calculating daily gains and losses and margin requirements. it is calculated as the price at which the contract traded immediately before the end of a day's trading session

forward

private contract between two parties not standardized usually one specified delivery date settled at the end of contract delivery or final cash settlement some credit risk

long /short equities

purchase securities considered to be undervalued and short those considered to be overvalued in such a way that the exposure to the overall direction of the market is small

opening a futures position

referred to by the delivery month (month when the delivery can be made). party with short position chooses when then delivery is made.

clearing house members

required by the clearing house to provide an initial margin reflecting the total number of contracts. in determining the margin required by the members the number of contracts is calculated on a net basis. assumes the credit risk of the parties its it transacting for.

forward contract

similar to a futures contract in that is an agreement to buy or sell and asset at a certain time in the future for a certain price. but whereas futures are traded on exchanges, these contracts trade in the over-the-counter market. designed to neutralize risk by fixing the price that the hedger will pay or receive for the contract. settled at end of life.

limit order

specifies a trade a particular price

convertible arbitrage

take a long position in a thought to be undervalued convertible bond combined with an actively managed short position in the underlying equity

arbitrageurs

take offsetting positions in two or more instruments to lock in a profit. these opportunities do not last for long. take advantage of a discrepancy between prices in two different markets.

scalpers

take positions for very short periods of time, sometimes only minutes, in an attempt to profit from active trading

cash settlement

the cash value of the underlying asset (rather than the asset itself) is delivered to satisfy the contract. is equal to the spot price of the underlying asset at either hte open or closing of the trading day.

first notice day

the first day on which a notice of intention to make delivery can be submitted to the exchange

last notice day

the last day on which a notice of intention to make delivery can be submitted to the exchange

haircut

the market value of the securities is reduced by a certain amount to determine their value for margin purposes - use of securities to satisfy margin or collateral requirements

position limits

the maximum number of contracts that a speculator may hold. the purpose of these limits is to prevent speculators from exercising undue influence on the market.

closing a futures position

this is done by entering into an opposite trade to the original one that opened the position. vast majority of futures contracts do not lead to delivery. most traders choose to finalize their positions prior to delivery period on a specific contract.

merger arbitrage

trade after a possible merger or acquisition is announced so that a profit is made if the announced deal takes place

options contract

traded in both OTC and exchanges. must pay and up-front price know. designed to provide insurance, offering a way to protect against adverse price movements in the future while still allowing them to benefit from favorable price movements. loss is limited to the amount paid for the contract.

future

traded on an exchange standardized contract range of delivery dates settled daily contract is usually closed out before maturity virtually no credit risk

future commission merchants

traders following the instructions of their clients and charge a commission for doing so

locals

traders whoa re trading on their own account

hedgers

use forwards, futures, and options to reduce risk that they face from potential future movements in a market variable. this act reduces the risk, but it is not necessarily the case that the outcome with this will be better than the outcome without this. forwards: designed to neutralize risk by fixing the price that the they will pay or receive for the contract options: designed to provide insurance, offering a way to protect against adverse price movements in the future while still allowing them to benefit from favorable price movements.

speculators

use options to bet on the future direction of a market variable. the futures market allows them to obtain leverage, with a small initial outlay, a large speculative position can be taken. money is deposited in a margin account. futures:potential loss as well as potential gain is very large options: loss is limited to the amount paid for the contract.