1. Financial futures: contracts between two parties to trade financial assets at a future date and where the terms of the transaction are determined today
Forward agreements: completing today the terms for a transaction that will occur on a specified date in the future
Options: Standardized contracts which give the buyer the right but not the obligation to buy or sell an asset in the future at a price determined today
Swaps: agreements which deal with two parties trading interest payment streams to guarantee that the inflows of payments will more closely match outflows
The instruments above can be used for hedging, but if used for speculation they can cause major financial losses. Future limits both losses and gains, while options limit only losses. However, futures are cheaper than options because of options’ premiums.
2. Spot markets involve transactions that take place on the spot, while the futures markets involve transactions that are agreed upon today but take place in the future.
3. As a borrower, Yvette can protect herself from the risk of an increase in the interest rate by utilizing either financial futures or options.
As a lender, Yvette can protect herself from the risk of a decrease in the interest rate by utilizing financial futures and options.
4. Both the buyers and seller of futures contracts have to put up performance bonds to reduce the risk of either of them reneging on the contract.
If the futures contract’s agreed-upon price is lower than the spot price when the contract becomes due, the buyer wins. If the spot price is lower than the futures contract’s agreed-upon price, the seller wins.
The clearinghouse is protected from losses by setting margin requirements for buyers and sellers of futures.
5. Arbitrageurs assure that on the day before the delivery date a futures contract, the futures price is very close to the spot price.
When there is an opportunity for riskless profit, arbitrageurs move in and purchase in the spot market (driving up the price of a given asset) and sell in the futures market (driving down the price of the asset) and vice versa. As the time comes closer to the delivery date of the futures contract, the length of time funds are borrowed for reduces. Therefore, the carrying costs are reduced and the futures price approaches the spot price as the delivery date nears.
Arbitrages continue until the futures price is bid up (down) to the spot price plus carrying cost, and there is convergence.
6. Arbitrageurs make riskless profits by buying in one market and reselling in another market.
Speculators attempt to gain profits by engaging in risky operations.
7. When there is an opportunity for riskless profit, arbitrageurs move in and purchase in the spot market (driving up the price of a given asset) and sell in the futures market (driving down the price of the asset) and vice versa. As the time comes closer to the delivery date of the futures contract, the length of time funds are borrowed for reduces.
Therefore, the carrying costs are reduced and the futures price approaches the spot price as the delivery date nears.
Arbitrages continue until the futures price is bid up (down) to the spot price plus carrying cost, and there is convergence.
8. Put options are options that give the buyer the right but not the obligation to sell a standardized contract of financial asset at a strike price determined today.
Call Options are options that give the buyer the right but not the obligation to buy a standardized contract of a financial asset at a strike price determined today.
The option premium is paid by the buyer of the option to compensate the seller for accepting the risk of a loss with no possibility of a gain.
The seller of an option takes on the risk in the hopes that the option will be exercised for a price, called the option premium.
9. Options on futures are options which give the buyer the right but not the obligation to buy or sell a futures contract up to the expiration date on the option.
10. A swap is often arranged for up to fifteen years and has the advantage over futures and options of allowing the participants to hedge for very long periods of time.
Commercial banks, savings and loans, other intermediaries, government agencies, and securities dealers to reduce interest rate risk mainly use swaps.
11. A stock index futures contract give the buyer or seller the right and obligation to purchase or sell a multiple of the value of a stock index at some specific date in the future at a price determined today. By being able to set the price in advance through stock index futures, an investor can hedge the risk of a fall in stocks prices.
12. An intermediary that uses futures to hedge is not as vulnerable to losses as an intermediary that uses futures to speculate.
When you hedge, you reduce risks to achieve the minimum loss possible. When you speculate, you increase risks to obtain profits. The higher the risk, the higher the probability you will lose.
13. Given the following conditions, the option premium will generally be larger
1) the more volatile the price of the contract asset is,
2) the further away the expiration date of the option is, and
3) the higher the strike price relative to the spot price for put options and the lower the strike price relative to the spot price for call options
14. Angela $1,000. If Angela gives up the opportunity for gain, she reduces her chance of losing.
15. IBM loses because the spot price is higher than the futures’ agreement price.
16. Yes
17. Yes
18. 3.25%
19. If the S & P 500 index is 575, the brokerage house does not make a profit. If the S & P 500 index is 625, the brokerage house does make a profit.
20. If the interest rate goes up, the price of the T-bill future goes down. You will lose money because the spot price is lower than the agreed-upon future price.
21. To alleviate the fear of interest rates going down, I can hedge with futures and options to minimize possible losses.
22. To hedge, Ruben can enter the foreign exchange futures market. He can buy a futures contact tody to be delivered in six months. With the futures contract, Ruben will know exactly what exchange rate he will face in six months.
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