FIN 353 EXAM 4 CHs14-19

forward contract

• an agreement made today between a buyer and seller who are obligated to complete a transaction with one another at a set date in the future

• the buyer and seller know each other, and they negotiate the terms of the contract

• terms are customized

• one party faces default risk, because the other party might have an incentive to default on the contract

forward price

the price at which the trade will occur is also determined when the agreement is made

futures contract

• an agreement made today between a buyer and seller who are obligated to complete a transaction at a set date in the future

• the buyer and seller do not know each other

• terms are standardized

• no one faces default risk, even if the other party has an incentive to default on the contract

futures price

the price at which the trade will occur is determines in the “pit” or increasingly in the electronic market

Chicago board of trade (CBOT)

established in 1848, the first organized futures exchange in the US

• the intercontinental exchange purchased the New York board of Trade

• the chicago mercantile exchange and the chicago board of trade merged and are now the CME group inc.

during 2007, what were the several important events for organized futures exchanges?

1. the identity of the underlying commodity or financial instrument

2. the futures contract size

3. the futures maturity date, also called the expiration date

4. the delivery or settlement procedure

5. the futures price

what five terms must futures contracts stipulate at least?

zero sum game

• futures contracts represent this

• gains realized by the buyer are offset by losses realized by the seller (and vice versa)

• the futures exchanges keep track of the gains and losses every day

hedging and speculation

• futures contracts are used for these

• complementary activities

• hedgers shift price to speculators

• speculators absorb price risk

speculating with futures, long

• buying a futures contract (today) is often referred to as going long or establishing a long position

• every day before expiration, a new futures price is established

• if this new price is higher than the previous day’s price, the holder of a long futures contract position profits from this futures price increase

• if this new price is lower than the previous day’s price, the holder of a long futures contract position loses from this futures price decrease

speculating with futures, short

• selling a futures contract (today) is often called going short or establishing a short position

• every day before expiration, a new futures price is established

• if this new price is higher than the previous day’s price, the holder of a short futures contract position loses from this futures price increase

• if this new price is lower than the previous day’s price, the holder of a short futures contract position profits from this futures price decrease

hedger

• trades futures contracts to transfer price risk

• transfer price risk by adding a futures contract position that is opposite of a existing position in the commodity or financial instrument

• when hedge is in place: the futures contract throws off cash when cash is needed and the futures contract absorbs cash when cash is available

hedging with futures, short hedge

• a company has a large inventory that will be sold at a future date

• so, the company will suffer losses if the value of the inventory falls

• the act of selling futures contracts to protect from falling prices

hedging with futures, long hedge

• company needs to buy a commodity at a future date

• company will suffer losses if the price of the commodity increases before then

• the act of buying futures contracts to protect from rising prices

future trading accounts

• allows only exchange members to trade on the exchange

• exchange members may be firms or individuals trading for their own accounts, or they may be brokerage firms handling trades for customers

• important aspects:

  • margin is required- initial margin as well as maintenance margin

  • the contract values are marked to market on a daily basis, and a margin call will be issued if necessary

  • a futures position can be closed out at any time; this is done by entering into a reverse trade

initial margin

• required when a futures position is first established

• levels depend on the price volatility of the underlying asset and can differ by type of trader

marking to market

when the price of the futures contract changes, the futures exchange adds or subtracts money from trading accounts

maintenance margin

when the balance of trading accounts gets too low it violates this

margin call

stern request by the broker that more money be deposited into the trading account

cash price (spot price)

price for immediate delivery of a commodity or financial instrument

cash market (spot market)

the market where commodities or financial instruments are traded for immediate delivery

cash futures arbitrage

earning risk-free profits from an unusual difference between cash and futures prices

basis

the difference between the cash price and the futures price for a commodity

carrying charge market

for commodities with storage costs, the cash price is usually less than the futures price; basis<0

inverted market

cash price is greater than the futures price; basis>0

spot futures parity

• relationship between spot prices and futures prices that must hold to prevent arbitrage opportunities

• = S(1+r)^T

stock index futures

• are usually cash settled

  • when the futures contract expires, there is no delivery of shares of stock

  • instead, the positions are marked to market for the last time, and the contract no longer exists

index arbitrage

• refers to trading stock index futures and underlying stocks to exploit deviations from spot futures parity

• often implemented as program trading strategy

cross hedging

refers to hedging a particular spot position with futures contracts on a related, but not identical, commodity or financial instrument

cheapest-to-deliver option

refers to the seller’s option to deliver the cheapest instrument when a futures contract allows several instruments for delivery

ended

ch 15 slide 1