1 - forwards + futures

what is a forward contract

an OTC transaction for the delivery of a commodity/asset at a specified future date, with the price determined at the trade date

3 advantages of a forward contract

flexibility

wide range of underlyings

easy access - available from most commercial banks

what is cost of carry

the cost of holding the asset for future delivery

what are the three costs considered in cost of carry

interest (either that u pay to borrow money to have it, or that u forgo to buy the thing)

storage

insurance

the price of buying and holding has to be _____________ to the future price

the same, otherwise there is cash and carry arbitrage

so what is the fair value of a future

cash price + cost of carry

equity cost of carry is often…

…negative

so like a benefit of carry

why is equity cost of carry negative

bc of the dividend yields on it that u get

what happens to future prices and cash prices as time goes on

they converge, since cost of carry decreases as u get closer to delivery

what is basis

the cash price - the futures price

(so negative cost of carry)

is basis usually positive or negative

negative

which type of market will have negative basis

contango markets (normal efficient market)

when might basis be positive

backwardation markets (specific circumstances, but they are not necesarily inefficient)

3 factors that could change basis

changes in supply + demand

changes in cost of carry

changes in time to delivery (convergence)

what is strengthening and weakening of basis

strengthening = when it becomes more positive

weakening is opposite

when the basis is strengthening, what is the term for what u should do as a trader

buy the basis

what is buying the basis

buy near + sell far (so like buy a product in the cash market and sell a futures product)

this is because basically the spot price is rising faster than the futures price so u can make money there

AND VICE VERSA OBVS

what is cash and carry arbitrage

when the future is trading above its fair value

how to cash and carry arbitrage

buy the underlying asset + sell the future

what is reverse cash + carry arbitrage

future is trading below fair value

how to reverse cash + carry

sell the underlying + buy the future

what is an arbitrage channel

considers the costs of doing arbitrage and therefore where u should acc do it to make a profit

what is basis risk

the risk that cash + futures don’t move in a uniform way (so basis changes while u r hedged)

how can basis risk be mitigated

by doing it closer + closer to delivery (bc prices converge)

so if a hedger closes out or lifts the hedge before expiry, they will be…

…more exposed to basis risk