Docstoc

Chapter 18

Document Sample
Chapter 18 Powered By Docstoc
					                              Chapter 20
                              FUTURES

Multiple Choice Questions

       Understanding Futures Markets

       1.        Spot markets are:

       a.        for a limited number of commodities.
       b.        for immediate delivery
       c.        for future delivery.
       d.        markets designed to attract speculators.

       (b, easy)

       2.        A forward contract differs from a futures contract in that:

       a.        a forward contract is for a shorter period of time.
       b.        a forward contract does not specify the selling price.
       c.        a forward contract does specify the selling price.
       d.        a forward contract is non-binding.

       (c, moderate)

       3.        Futures contracts are regulated by the:

       a.        Securities Exchange Commission.
       b.        National Association of Security Dealers.
       c.        National Association of Commodity Dealers.
       d.        Commodity Futures Trading Commission.

       (d, easy)

       4.        A futures contract is

       a.        a nonnegotiable, nonmarketable instrument.
       b.        a security, like stocks and bonds.
       c.        a standardized transferable agreement providing for the deferred delivery
                 of a specified traded quantity of a commodity.
       d.        not a legal contract, and therefore its terms can be changed .

       (c, easy)




Chapter Twenty                                257
Futures
       5.        Futures contracts were first traded on

       a.        stock indexes.
       b.        foreign currencies.
       c.        commodities.
       d.        government bonds.

       (c, easy)

       6.        Which of the following variables is not established on a futures contract?

       a.        contract size
       b.        price
       c.        delivery date
       d.        specified grade

       (b, easy)

       The Structure of Futures Markets

       7.        Futures trade on the:

       a.        NYSE
       b.        over-the-counter market.
       c.        futures exchanges.
       e.        options exchanges.

       (c, easy)

       8.        Futures exchange members:

       a.        trade strictly for their own accounts.
       b.        trade strictly for others.
       c.        can trade for their own accounts or for others.
       d.        are all controlled by commodity firms.

       (c, moderate)

       9.        On the other side of every futures transaction is:

       a.        the dealer.
       b.        the futures exchange.
       c.        the commodity producer.
       d.        the clearinghouse.

       (d, moderate)




Chapter Twenty                                258
Futures
       10.       An appealing feature of options on futures contracts is that:

       a.        they have longer terms until expiration.
       b.        the purchaser has limited liability.
       c.        losses virtually never occur.
       d.        margin calls occur less frequently.

       (b, moderate, p. 2)

       The Mechanics of Trading

       11.       In the case of a futures contract, buyers can settle their positions

       a.        only by taking delivery.
       b.        only by arranging an offsetting contract.
       c.        either by delivery or offset.
       d.        by a combination of delivery and offset.

       (c, easy)

       12.       The typical method of settling a futures contract is by:

       a.        arbitrage.
       b.        delivery
       c.        offset.
       d.        hedging.

       (c, moderate)

       13.       When trading futures, margin

       a.        is seldom used.
       b.        indicates that credit is being extended.
       c.        is a down payment.
       d.        in effect, is a performance bond.

       (d, moderate)




Chapter Twenty                                 259
Futures
       14.       Which of the following is a characteristic of futures contracts? They

       a.        are marked to the market daily.
       b.        can be sold short only on an uptick.
       c.        are handled by specialists on futures exchanges.
       d.        have no daily price limits.

       (a, easy)

       15.       The initial margin required for futures trading

       a.        is only put up by the seller.
       b.        is only put up by the buyer.
       c.        can be put up by either party, whoever initiates the transaction.
       d.        must be put up by both the buyer and the seller.

       (d, moderate)

       16.       Of the following statements about futures trading, which one is
                 INCORRECT?

       a.        There are no specialists on futures exchanges.
       b.        All futures contracts are eligible for margin trading.
       c.        Trading is halted for the day if the prices reach the daily limit.
       d.        The uptick rule applies to the shorting of futures contracts.

       (d, moderate)

       17.       Which of the following features is NOT similar between stock and futures
                 trading?

       a.        Buying and selling mechanics
       b.        Existence of highly organized exchanges
       c.        The charging of interest on margin trades
       d.        The ability of only members to trade on the floor

       (c, difficult)

       18.         The cumulative number of futures contracts that are not offset at any
                   point in time is called:

       a.        margin.
       b.        open interest.
       c.        hedged position.
       d.        marked to the market position.

       (b, moderate)




Chapter Twenty                                 260
Futures
       Using Futures Contracts

       19.       To protect the value of a bond portfolio against a rise in interest rates
                 using futures, the portfolio owner could execute a ____________ hedge.

       a.        long
       b.        duration
       c.        short
       d.        maturity

       (c, moderate)

       20.       An investor with a bond portfolio wishes to protect the value of his
                 position by using futures contracts. This investor should use a

       a.        long hedge.
       b.        short hedge.
       c.        time spread.
       d.        money spread.

       (b, moderate)

       21.       The difference between the cash price and the futures price on the same
                 asset or commodity is known as the

       a.        basis.
       b.        spread.
       c.        yield spread.
       d.        premium.

       (a, easy)

       22.       Speculators in the futures markets

       a.        make the market more volatile.
       b.        contribute liquidity to the market.
       c.        engage mainly in short sales.
       d.        serve no real economic function.

       (b, moderate)




Chapter Twenty                                261
Futures
       23.       One difference between a hedger and a speculator is that the hedger

       a.        may have either a profit or a loss.
       b.        may not close out his position by taking an opposite position.
       c.        does not have to put up margin.
       d.        faces a risk without the futures contract.

       (d, moderate)

       24.       Which of the following is NOT a potential advantage of speculating in
                 futures?

       a.        Leverage
       b.        Ease of transacting
       c.        Low transactions costs
       d.        High, narrow probability distribution of expected returns

       (d, moderate)

       Financial Futures

       25.       Interest rate futures are not currently available on which of the following
                 securities?

       a.        Corporate bonds
       b.        Treasury notes
       c.        one-month LIBOR rate
       d.        Treasury bonds

       (a, moderate)

       26.       Select the CORRECT statement regarding basis risk associated with
                 futures.

       a.        Basis risk can be completely eliminated.
       b.        Although the basis fluctuates over time, it can be precisely predicted.
       c.        The basis must be zero on the maturity date of the
                 contract.
       d.        A hedge will reduce risk as long as basis fluctuations are positive.

       (c, difficult)




Chapter Twenty                                262
Futures
       27.       Stock-index futures can be used to hedge against which of the following
                 types of risks?

       a.        Diversifiable risk
       b.        Systematic risk
       c.        Unsystematic risk
       d.        Company specific risk

       (b, easy)

       28.       An investor who sells a treasury bond futures contract is expecting to
                 profit from

       a.        an increase in the price of the treasury bond.
       b.        an increase in the underlying level of interest rates.
       c.        interest rates remaining unchanged.
       d.        a decrease in the underlying level of interest rates.

       (b, difficult)

       29.       If an investor strongly believes that the stock market is going to have a
                 sharp decline shortly, he or she could maximize profit by

       a.        short selling stock-index futures contracts.
       b.        hedging current short positions.
       c.        using stock-index futures to straddle the market.
       d.        buying stock-index futures contracts.

       (a, moderate)

       30.       An attempt to exploit the differences between the prices of a stock index
                 future and the prices of a stock index is known as:

       a.        index programming.
       b.        arbitrage speculation.
       c.        index arbitrage.
       d.        program speculation.

       (c, moderate)




Chapter Twenty                                 263
Futures
       True/False Questions

       Understanding Futures Markets

       1.        Unlike stock positions, futures position can remain open indefinitely.

       (F, easy)

       2.        Japan, which banned financial futures in 1985, now is very active in
                 developing futures exchanges.

       (T, moderate)

       3.        The National Futures Association is the federal agency which regulates the
                 futures markets.

       (F, moderate)

       4.        Futures are essentially standardized forward contracts.

       (T, easy)

       The Mechanics of Trading

       5.        Futures contracts are handled by specialists on futures exchanges.

       (F, moderate)

       6.        Most futures contracts are settled by delivery.

       (F, easy)

       7.        Futures contracts are written for specific amounts of a commodity and for
                 specific delivery dates.

       (T, easy)

       8.        Investors can speculate on interest rate declines by purchasing interest
                 rate futures.

       (T, moderate)

       Using Futures Contracts

       9.        With futures, hedging requires one to simply take an opposite position.

       (T, moderate)



Chapter Twenty                                264
Futures
       Financial Futures

       10.       The DJIA is the most popular stock-index futures contract.

       (F, moderate)

       11.       An anticipatory hedge is when an investor anticipates a falling market and
                 liquidates his position.

       (F, difficult)

       12.       A pension fund holds $10 million in Treasury bonds. In order to protect
                 against a rise in interest rate, the pension fund should use a short hedge in
                 T-bond futures.

       (T, difficult)

       13.       Index arbitrage attempts to exploit the differences between the prices on
                 two different stock indices.

       (T, difficult)

       14.       Program trading generally involves positions in both stocks and stock-
                 index futures.

       (T, difficult)

       15.       Stock-index futures may be settled either by cash or by delivery of
                 securities.

       (F, easy)

       16.       A recent innovation in financial futures is the single stock future.

       (T, easy)




Chapter Twenty                                265
Futures
       Short-Answer Questions

       Understanding Futures Markets

       1.        Explain the difference between a forward contract and a futures contract.

       (moderate)

       Answer:          A forward contract is an individual agreement for the delivery of
                        an item for a specified price at a specified future date. Forward
                        contracts are not standardized. Futures contracts are standardized,
                        transferable agreements for the delivery of specified grades,
                        amounts, and delivery dates. Futures are traded in organized
                        markets.

       The Structure of Futures Markets

       2.        What is the role of the clearinghouse in futures trading?

       (moderate)

       Answer:          The clearinghouse is between the buyer and seller in every trade.
                        Every trade is actually made with the clearinghouse instead of with
                        another party. The clearinghouse ensures the integrity of every
                        trade. If either the buyer or seller defaults, the clearinghouse
                        makes good on the transaction, allowing an orderly market to
                        proceed. The clearinghouse makes it possible for traders to reverse
                        their positions by buying or selling an opposite transaction.

       The Mechanics of Trading

       3.        Explain a long position and a short position in futures trading.

       (easy)

       Answer:          A buyer who agrees to purchase an item at contract maturity has a
                        long position. The seller who agrees to deliver the item at contract
                        maturity has the short position.

       4.         Compare the obligation entered into in a futures contract to the obligation
                 in an options contract.

       (moderate)




Chapter Twenty                                266
Futures
       Answer:          The buyer in an options contract has the choice of whether or not
                        to exercise the contract. The seller of the option is obligated to
                        deliver if the buyer chooses to exercise the option. Both the buyer
                        and seller are obligated to take or make delivery in a futures
                        contract. The obligation can be offset, however, by buying or
                        selling an opposite contract.

       5.        Briefly discuss the concept of margin in futures trading.

       (moderate)

       Answer:          The item being traded is not transferred at the time of the futures
                        contract, so the margin is not a down payment. Instead, it is a
                        performance bond. It is common for the margin to be in the range
                        of two to 10 percent of the value of the contract.

       6.        What are the methods of settling a futures contract?

       (moderate)

       Answer:          A purchaser of a futures contract can take delivery of the
                        commodity or, in the case of financial futures, settle in cash. The
                        alternative usually taken, however, is to offset the contract by
                        selling an identical contract (or buying one if the trader was short).
                        Thus, the trader has one obligation to deliver and one to receive, so
                        they offset one another. Delivery actually occurs in less than two
                        percent of the contracts.

       7.        What is meant by the term "marked to the market"?

       (moderate)

       Answer:          All profits and losses are credited and debited to investors’
                        accounts daily. This is called marking to the market. If an account
                        has gains, the excess can be withdrawn. If the equity fall below
                        the maintenance margin level, a margin call will be issued. The
                        process is known as daily resettlement.

       Using Futures Contracts

       8.        What is the difference between hedgers and speculators in the futures
                 markets?

       (moderate)

       Answer:          Hedgers face the risk of buying or selling commodities or financial
                        instruments before entering the futures markets. Hedgers enter the
                        futures markets in an attempt to reduce an already existing risk.


Chapter Twenty                                267
Futures
                        Speculators face no risk before entering the futures market. They
                        enter a high-risk contract in expectation of high returns.

       Financial Futures

       9.        What is the focus of speculators who spread stock-index futures?

       (moderate)

       Answer:          Stock-index spreaders think that the prices of different index
                        futures are out of equilibrium and soon will adjust. They are
                        interested in relative, not absolute, price changes. Intramarket
                        spreads use two contracts on the same index with different
                        settlement months. Intermarket spreads use two contracts on
                        different indexes with the same expiration dates.

       Critical Thinking/Essay Questions

       1.        What economic functions are fulfilled by futures?

       (difficult)

       Answer:          Forward contracts have long allowed two parties to make an
                        agreement for future delivery of some commodity at an agreed
                        upon price, addressing the risk of intervening price fluctuations.
                        Futures contracts transfer the risk of price fluctuations from
                        hedgers to speculators. Speculators absorb excess supply or
                        demand, contribute to the liquidity of the markets, and reduce price
                        variability over time. Hedgers are glad to transfer the risk and
                        accept lower expected returns, whereas, the speculator seeks the
                        high end of the risk-expected return tradeoff.

       2.        Are futures – commodity, interest-rate, stock-index, or currency –
                 appropriate for most individual investors?

       (moderate)

       Answer:          Futures are appropriate for sophisticated institutional investors or
                        businesses wanting to hedge a position. Futures are very
                        dangerous for individual speculators because of the extremely high
                        leverage, rapid price changes, and high commissions. Individual
                        speculators are no match for the professionals on the floor of the
                        exchanges. The professionals' knowledge, expertise, and ability to
                        buy or sell instantaneously put them at an advantage over the
                        individual.




Chapter Twenty                               268
Futures
       3.        Do options on futures serve any economic purpose or are they just
                 sophisticated games?

       (easy)

       Answer:          Options on futures transfer risk just as futures contracts do. Thus,
                        they do serve an economic purpose.

       Problems
       1.        Assume that an investor buys one June NYSE Composite Index Futures
                 Contract on May 1 at a price of 72. The position is closed out after four
                 days. The prices on the three days after purchase were 72.5, 72.1 and
                 72.2. The initial margin is $3500.

       (a)       Calculate the current equity on each of the next three days.
       (b)       Calculate the excess equity for those three days.
       (c)       Calculate the final gain or loss on this position.

       (moderate)

       Solution:      The initial margin is $3500.
       Each point in price is equivalent to 20 ticks worth $25 each, or $500.

       (a)    Equity on day of purchase                             = $3500
       Increase in equity after day one (price goes to 72.5) = (72.5 - 72 = .5 or 10 ticks
              worth $250)
       Equity after one day =         250 + 3500 = $3750
                      Decrease in equity after day 2 (price goes to 72.1) = (72.1 - 72.5
              = -.4 or 8 ticks worth - $200)
       Equity after day two =         -200 + 3750 = $3550
       Increase in equity after day three (price goes to 72.2)      = (72.2 - 72.1 = .1 or
              2 ticks worth $50)
       Equity after day three =       +50 + 3550 = $3600

       (b)       The excess equity is $250, $50, $100.
       (c)       The final gain is $3600 - $3500 = $100.

       2.        Assume a portfolio manager holds $2 million (par value) of 9 percent
                 Treasury bonds due 1994-1999. The current market price is 77, for a yield
                 of 12 percent. Fearing a rise in interest rates over the next three months,
                 the manager seeks to protect this position by hedging in futures.
       (a)       If T-bond futures are available at 67, what is the gain or loss from a simple
                 hedge of 20 contracts if the price three months later is 60?
       (b)       What is the gain or loss on the cash position if the bonds are priced at 68
                 three months hence?
       (c)       What is the net effect of this hedge?

       (difficult)

Chapter Twenty                                269
Futures
       Solution:     (a)     Since the manager is long in the cash market, the correct
              hedge is a short futures position.
       This problem ignores weighted hedges. The $2 million face value represents
              $2,000,000/$1000 = 2000 bonds, which at a current price of 77 is worth
              $1,540,000.

       The manager sells 20 contracts at a current price of 67, for a total transaction
             value of 20($67,000) = $1,340,000. Repurchasing the futures three
             months later at a price of 60 results in a total cost of 20($60,000) =
             $1,200,000.

                                Beginning sale $67,000 x 20 =      $1,340,000
                                Ending purchase       $60,000 x 20 =       1,200,000
                                Gain from short futures            =        $140,000

       (b)       As noted in (a), there are 2000 bonds. If the bonds are priced at 68 three
                 months later, the cash market position is:

       Beginning:    $770 x 2000 =      $1,540,000
       Ending:              $680 x 2000 =      $1,360,000
       Loss from long bonds        =      $180,000

       (c)       The net effect of this hedge is a loss of $40,000.

                                Gain from short futures                =         $140,000
              from part (a)
       Loss from long bonds            =            180,000 from part (b)
                                Net loss                                          $40,000


       3.        An investor has just sold seven contracts of June corn on the CBOT. The
                 price per bushel is $1.64, and each contract is for 5000 bushels. The
                 performance bond (initial margin deposit) is $2000 per contract with the
                 maintenance margin at $1250.

       (a)       How much does the investor have to deposit on the investment?
       (b)       If the prices of the futures on the three days following the short sales
                 were: 1.60, 1.66, and 1.68 calculate the current equity on each of the next
                 three days.
       (c)       If the investor closes out his position on the fourth day, what is his final
                 gain or loss over the four days in dollars and as a percentage of
                 investment?

       (moderate)




Chapter Twenty                                270
Futures
       Solution:      (a)      Position on Day 1 (purchase day)
                               Market value of futures sold short                 $1.64 x
               5000 x 7        =       $57,400
       Initial margin or total deposit at time of purchase $2000 x 7      =
                       $14,000

       (b)    Position on Day 2
       Market value of futures                             $1.60 x 5000 x 7        =
                     $56,000
       Price when short sold (from part a)
                     $57,400
                                  Gain (loss) (Note: A decrease in price creates a gain
              on a short position.)   $1,400

       Current equity (initial margin + gain)       $14,000 + 1,400       =
                      $15,400

       Position on Day 3
       Market value of futures                             $1.66 x 5000 x 7       =
                     $58,100
       Price when short sold (from part a)
                     $57,400
                                  Gain (loss)
                                ($700)

       Current equity (initial margin + gain)       $14,000 - 700 =       $13,300

       Position on Day 4
       Market value of futures                             $1.68 x 5000 x 7       =
                     $58,800
       Price when short sold (from part a)
                     $57,400
                                 Gain (loss)
                             ($1,400)

       Current equity (initial margin + gain)       $14,000 – 1,400       =
                      $12,600

       (c)     Final gain or loss
       Price at time of short sale                         $1.60 x 5000 x 7       =
                       $57,400
       Price at time of purchase to cover                  $1.68 x 5000 x 7       =
               58,800
                                   Gain (loss)
                               ($1,400)

       Rate of Return over the 4 days               =      Loss/Initial Deposit
       =      (1,400)/14,000
       =      -10 percent

Chapter Twenty                             271
Futures

				
DOCUMENT INFO