fin 431 final

Describe what a futures contract is, and how it is different from an option contract

A future contract is just a standardized agreement between the two party to buy (long position) a commodity from a second party (short position) at a specific price on a specific date in the future. The difference between option and future contract is that a future contract is an obligation to buy/sell the commodity, when the options give us the right to buy/sell.

/ Describe how gains and losses on futures contracts are taxed

Because of the mark to market process, futures traders have no control over when gains or losses are realized. As a general rule, 60% of future gains or losses are treated as long-term, and 40% as short term

Normal backwardation

Claim that futures prices are downward biased estimate of the spot price expected at delivery. This must be true for speculators to profit if they are holder long positions in the futures market. For example, if speculators think that corn will sell for 2.5 in July, then they could profit only if they buy futures contract at a lower price

Expectation hypothesis

Claims that the futures price traders set tody is equal to the spot (cash) price they expect to prevail when the delivery month arrives. If true, then futures prices can be used for "price discovery" (to get an estimate of what a commodity should be selling for in the future)

Describe what the clearing corporation does, and how it improved liquidity

Clearing corporation is an independent corporation whose stockholders are member clearing firms. Each maintains a margin account with the clearinghouse. The clearinghouse is a third party intermediary that guarantees the buyer that the seller will perform, and vice versa. Because of the potential for loss by the clearinghouse, each party to a contract is required to put up a good-faith deposit (margin) when the contract is created)

Describe the daily settlement procedure (mark to market) and be able to perform the associated calculation

Daily settlement procedure (mark to market): the change in the settlement price from previous day is transferred from the seller's account to the buyer's account if the price increases, and from the buyer's account to the seller's account if the price decreased. If the balance in a trader's account falls below the maintenance margin, he/she must deposit enough to bring balance back up to the initial margin.

Describe how trading takes place in the "pit"

Futures trading were traditionally done in an area of the exchange known as the "pit". Traders yell out offers to buy and sell in a system called "open outcry". Each trader wears a badge that allows others to identify him/her to other traders

Explain the terms hedger and speculators

Hedger are individuals or firms that either produce a commodity or need a commodity and find their current price risk exposure unacceptable. They want to transfer the risk of an unfavorable price change to another party Speculators are neither producers nor users. They are persons willing to absorb the price risk that hedgers want to transfer, and are willing to to so in anticipation of earning a profit

Describe the terms: Initial margin, Maintenance margin, Settlement price, Volume, Open interest

Initial margin: amount that each trader must deposit in his or her account to initiate the transaction Maintenance margin: amount that must be maintained every day during the contract's life Settlement price: set by a committee of clearing house official, usually the average price of the last few trades of the day Volume: the number of tract traded on a given day Open interest: total number of futures contracts outstanding at any one time

operational advantages of futures versus spot markets

Lower transaction costs than spot markets Greater liquidity than spot markets Easier to short sell than in spot markets

Explain how most parties to future contract exit the market rather than make/take delivery

Most futures contracts are not held until the delivery date. Instead, both parties enter a reversing (offsetting) trade before delivery. The purpose is to protect from (or speculate on) price changes, not to make/take physical delivery of the commodity

Describe the trading styles of scalpers, day traders, and position traders

Scalpers: attempt to profit from small changes in the contract price in minutes Day traders: attempt to profit from within day price changes Position traders: attempt to profit from long term price changes

Cross hedge risk

The asset being hedged is not identical to the one underlying the future contract

able to use three rules for determining whether you should buy or sell futures contract

a/Identify the worst case scenario and then establish a futures position that will profit if the worst case does occur b/ Take a futures position opposite to the current spot position. c/ Identify the spot transaction that will be conducted when the hedge is terminated The terminal futures transaction will be opposite the terminal spot transaction The futures transaction today will be the opposite of the terminal futures transaction

Contango

claims that futures price are upward biased estimate of the spot price expected at delivery. This must be true for speculators to profit if they are holder short positions in teh futures market. For example, if speculators think that corn will sell for 2.5 in July, they could profit only if they sell futures contract at a higher price

Spot-future parity (cost of carry

combine an asset and a futures contract. Shows the payoff is constant. Thus, the return on the portfolio must equal the risk free rate, otherwise there would be an arbitrage opportunities

Modern portfolio theory

if commodity prices exhibit positive systematic risk, futures prices must be lower than expected spot price

Quantity risk

the short hedger does not know the eventual quantity of the spot asset that will be produce, but must enter the short futures position now to establish the hedge

Primary function of future contract

transfer risk from one party (hedger) to another party (speculator) willing to bear that risk in return for the potential to make profit