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Mechanics of Futures Markets Practice Questions Essay Example

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Futures Contract, Money

Pages: 6 (1402 words)
Published: August 8, 2018

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The party with a short position in a futures contract sometimes has options as to the precise asset that will be delivered, where delivery will take place when delivery will take place, and so on. Do these options increase or decrease the futures price? Explain your reasoning. These options make the contract less attractive to the party with the long position and more attractive to the party with the short position. They, therefore, tend to reduce the futures price.
What are the most important aspects of the design of a new futures contract? The most important aspects of the design of a new futures contract are the specification of the underlying asset, the size of the contract, the delivery arrangements, and the delivery months.
Explain how margins protect investors against the possibility
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of default. A margin is a sum of money deposited by an investor with his or her broker. It acts as a guarantee that the investor can cover any losses on the futures contract. The balance in the margin account is adjusted daily to reflect gains and losses on the futures contract. If losses are above a certain level, the investor is required to deposit a further margin. This system makes it unlikely that the investor will default. A similar system of margins makes it unlikely that the investor’s broker will default on the contract it has with the clearinghouse member and unlikely that the clearinghouse member will default with the clearinghouse.
A trader buys two July futures contracts on frozen orange juice. Each contract is for the delivery of 15,000 pounds. The current futures price is 160 cents per pound, the

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initial margin is $6,000 per contract, and the maintenance margin is $4,500 per contract. What price change would lead to a margin call? Under what circumstances could $2,000 be withdrawn from the margin account? There is a margin call if more than $1,500 is lost on one contract. This happens if the futures price of frozen orange juice falls by more than 10 cents to below 150 cents per lb. $2,000 can be withdrawn from the margin account if there is a gain on one contract of $1,000. This will happen if the futures price rises by 6. 67 cents to 166. 67 cents per lb.

Show that, if the futures price of a commodity is greater than the spot price during the delivery period, then there is an arbitrage opportunity. Does an arbitrage opportunity exist if the futures price is less than the spot price? Explain your answer. If the futures price is greater than the spot price during the delivery period, an arbitrageur buys the asset, shorts a futures contract, and makes a delivery for an immediate profit. If the futures price is less than the spot price during the delivery period, there is no similar perfect arbitrage strategy. An arbitrageur can take a long futures position but cannot force immediate delivery of the asset. The decision on when delivery will be made is made by the party with the short position. Nevertheless, companies interested in acquiring the asset will find it attractive to enter into a long futures contract and wait for delivery to be made.

Explain the difference between a market-if-touched order and a stop order. A market-if-touched order

is executed at the best available price after a trade occurs at a specified price or at a price more favorable than the specified price. A stop order is executed at the best available price after there is a bid or offer at the specified price or at a price less favorable than the specified price.

Explain what a stop-limit order is to sell at 20. 0 with a limit of 20. 10 means. A stop-limit order to sell at 20.30 with a limit of 20.10 means that as soon as there is a bid at 20. 30 the contract should be sold providing this can be done at 20. 10 or a higher price.

At the end of one day a clearinghouse member is long 100 contracts, and the settlement price is $50,000 per contract. The original margin is $2,000 per contract. On the following day the member becomes responsible for clearing an additional 20 long contracts, entered into at a price of $51,000 per contract. The settlement price at the end of this day is $50,200. How much does the member have to add to its margin account with the exchange clearinghouse? The clearinghouse member is required to provide 20*$2, 000 = $40, 000 as initial margin for the new contracts. There is a gain of (50,200 *50,000) 100 = $20,000 on the existing contracts. There is also a loss of (51, 000 *50, 200) *20 = $16, 000 on the new contracts. The member must therefore add 40, 000 *20, 000 + 16, 000 = $36, 000 to the margin account.

On July 1, 2010, a

Japanese company enters into a forward contract to buy $1 million with yen on January 1, 2011. On September 1, 2010, it enters into a forward contract to sell $1 million on January 1, 2011. Describe the profit or loss the company will make in dollars as a function of the forward exchange rates on July 1, 2010 and September 1, 2010. Suppose F1 and F2 are the forward exchange rates for the contracts entered into July 1, 2010 and September 1, 2010, and S is the spot rate on January 1, 2011. (All exchange rates are measured as yen per dollar). The payoff from the first contract is (S ? F1 ) million yen and the payoff from the second contract is (F2 ? S ) million yen. The total payoff is therefore ( S ? F1 ) + ( F2 ? S ) = ( F2 ? F1 ) million yen.

The forward price on the Swiss franc for delivery in 45 days is quoted as 1. 1000. The futures price for a contract that will be delivered in 45 days is 0. 9000. Explain these two quotes. Which is more favorable for an investor wanting to sell Swiss francs? The 1. 1000 forward quote is the number of Swiss francs per dollar. The 0.9000 futures quote is the number of dollars per Swiss franc. When quoted in the same way as the futures price the forward price is 1 / 1. 1000 = 0. 091. The Swiss franc is, therefore, more valuable in the forward market than in the futures market. The forward market is, therefore, more attractive for an

investor wanting to sell Swiss francs.

Suppose you call your broker and issue instructions to sell one July hogs contract. Describe what happens. Hog futures are traded on the Chicago Mercantile Exchange. The broker will request some initial margin. The order will be relayed by telephone to your broker’s trading desk on the floor of the exchange (or to the trading desk of another broker). It will be sent by messenger to a commission broker who will execute the trade according to your instructions. Confirmation of the trade eventually reaches you. If there are adverse movements in the futures price your broker may contact you to request additional margin.

“Speculation in futures markets is pure gambling. It is not in the public interest to allow speculators to trade on a futures exchange. ” Discuss this viewpoint. Speculators are important market participants because they add liquidity to the market. However, contracts must be useful for hedging as well as speculation. This is because regulators generally only approve contracts when they are likely to be of interest to hedgers as well as speculators.

Identify the three commodities whose futures contracts have the highest open interest. Based on the contract months listed, the answer is crude oil, corn, and sugar (world).

What do you think would happen if an exchange started trading a contract in which the quality of the underlying asset was incompletely specified? The contract would not be a success. Parties with short positions would hold their contracts until delivery and then deliver the cheapest form of the asset. This might well be viewed by the party with

the long position as garbage! Once news of the quality problem became widely known no one would be prepared to buy the contract. This shows that futures contracts are feasible only when there are rigorous standards within an industry for defining the quality of the asset. Many futures contracts have in practice failed because of the problem of defining quality.

“When a futures contract is traded on the floor of the exchange, it may be the case that the open interest increases by one, stays the same, or decreases by one. ” Explain this statement. If both sides of the transaction are entering into a new contract, the open interest increases by one. If both sides of the transaction are closing out existing positions, the open interest decreases by one. If one party is entering into a new contract while the other party is closing out an existing position, the open interest stays the same.

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