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CHAPTER 11 DERIVATIVES MARKETS

CHAPTER OVERVIEW AND LEARNING OBJECTIVES

Futures markets develop whenever and wherever there is price volatility. Buyers and sellers of the product have the risk of approaching the marketplace and finding the market price too high or too low to justify their efforts. Futures markets enable buyers and sellers to establish prices today for transactions (trading, lending, or borrowing) in the future. Interest rates were quite predictable before the inflation-troubled 1965-1981 period. With ever-increasing inflation and on-off easy and tight monetary policy, interest rate forecasting became a dice-rolling exercise. The situation was right for the development of financial futures, just as variable commodity prices had called forth a commodity futures market years before. Today financial derivative activity is a consideration in every financial decision. Corporate financial managers, financial institutions, and investors have a need to hedge price risk, and financial futures, options on financial futures, or swaps are now a part of their decisionmaking process. It is critical for those who study finance to understand that futures, options, swaps, and other derivatives are integral to understanding the financial environment in which firms operate today.

CAREER PLANNING NOTE: DEVELOP A PROFESSIONAL ATTITUDE


What is a professional? Most people reply, "Someone who makes money." That reply is only half right! When you were admitted to the business school, you were admitted to a "professional" educational program. A professional professes or commits to a task (M.D.), a standard of conduct (M.D., J.D.), and a professional attitude. Having identified goals and objectives, the professional commits to devoting their priorities, energies, and talents toward doing the best job possible, and is always looking for a way to do it better. Your GPA and involvement in your business school reflects your maturity, dedication, and commitment to achieve a goal. Work habits, ethics, and social skills are an important by-product of your "B" school degree. Employers know this and look for it in your resume and during interviews. Don't fake it. Actions speak louder than words. The successful person looks for and develops a professional attitude early, not on the job, but in college!

READING THE WALL STREET JOURNAL: PORK BELLIES FOR BREAKFAST


As you enjoy your morning coffee, you might want to check out the Commodities Report in the Money & Investing Section. It describes recent significant movements in commodities prices and associated futures prices. Refer to the Futures listings in the same section to find out what is happening to

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Pork Belly and other futures prices. Following one or two different types of commodities and their associated futures contracts every day for a week or two will give you a pretty good feel for how commodity prices change relative to spot prices over time.

TOPIC OUTLINE AND KEY TERMS


I. The Nature of Derivative Securities A. Introduction 1. 2. 3. 4. B. Derivatives are financial securities whose value is based upon or derived from the value of other assets (so called underlying assets). Derivative securities can be used to minimize or eliminate an investors or a firms exposure to various types of risk that they may be exposed to. Risk to an investor or a firm can be caused by interest rate changes or foreign exchange rate changes, commodity prices or stock prices. Derivatives are also used for speculation. Speculators, unlike hedgers, consciously take on risk.

Forward Markets 1. 2. 3. 4. 5. 6. Buying/selling of a specified amount, price, and future delivery date of the underlying security or commodity. Direct relationship between buyer and seller Seller delivers at the specified date called the settlement date. Buyer of the forward contract has a long position; seller of the forward contract has a short position in the contract. The terms buyer and seller are a bit deceptive as nothing is bought or sold at the time the contract is negotiated. Banks and foreign exchange dealers are the primary counterparties to most transactions in the forward market. Forward contracts, while designed to achieve the same results as futures contracts, differ in many ways: a. They do not trade on exchanges, but only over-the-counter. b. They are customized contracts in terms of maturity dates, sizes, and grades of deliverable assets. c. Higher default risk exists because either party may default. d. Almost always settled at maturity by delivery of the underlying asset. e. No margin requirement s or other cash flows between origination and termination of contract.

C.

Futures Markets 1. 2. 3. 4. 5. Buying/selling of standardized contracts specifying the amount, price, and future delivery date of a currency, security, or commodity. Buyers/sellers deal with the futures exchange, not with each other. That is, the futures exchange clearing house is the counterparty! A specific trade (buy/sell) may involve two hedgers, a hedger and a speculator, or two speculators. Delivery seldom made buyer/seller offsets previous position before maturity. Spot vs. futures market.

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a. 6. 7.

8. D.

Trading for immediate or very-near-term delivery is called the spot market. b. Trading for future delivery - futures market. A position in the futures market: a. Long - an agreement to buy in the future. b. Short - an agreement to sell (deliver) in the future. Margin requirements varies by contract type. a. Initial margin - small deposit required to trade a futures contract. b. Daily settlements (marking to market) reflect gains/losses daily and cash payments. c. Maintenance margin - minimum deposit requirements on futures contracts. Futures contracts expire on specific dates.

Futures Market Instruments 1. Futures exchanges tend to specialize (capture the trading market) in a type of futures contract. 2. See Exhibit 11-4 for the specific financial futures contracts traded. Futures Exchanges 1. 2. 3. 4. Competition between exchanges is keen. Contract innovation is common. Exchanges advertise and promote heavily. Exchange specifies terms of a contract. a. Dates b. Denomination c. Specific items that can be delivered d. Method of delivery e. Minimum daily price variance f. Rules for trading

E.

F.

Futures Market Participants. 1. Hedgers attempt to reduce or eliminate their risk exposure by using short or long positions in the futures and forward markets. a. Are hedging to protect the value of their business and financial transactions. b. Their major objective is to reduce risk by securing a future price. Speculators In contrast to hedgers, speculators seek to take risk in financial markets to make money. a. They are not involved with commodities or securities, but buy/sell in these markets to achieve profits. Traders - speculate on very-short-term changes in future contract prices. a. Traders limit (hedge) the extent of their exposure (risk). b. Traders keep bid/ask differentials very close.

2.

3.

II.

Uses of Financial Futures Markets to Hedge and/or Speculate A. Reducing Systematic Risk in Stock Portfolios

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1. 2. 3. 4. B.

Stock index futures contracts trading began in 1982. Stock index futures derive their value from the value of an underlying group of selected stocks. Stock index futures permit investors to alter the market or systematic risk of their portfolio. Investors who try to protect stock gains may hedge against a decline in the market value of their stock portfolio by selling (shorting) stock index futures.

Stock Index Program Trading 1. 2. 3. Stock Index program trading is done to arbitrage the price discrepancies between a stock index future and the stocks that make up the stock index. Program trading allows to earn a risk-free return higher than a T-Bill yield for the corresponding period. Stock index program trading involves buying or selling large number of stocks in high volume which can influence stock prices dramatically over the short-term.

C.

Guaranteeing Cost of Funds 1. 2. Futures and forward contracts can be used to hedge future borrowing costs by utilizing the inverse relationship between interest rates and security prices. If interest rates are expected to rise (leading to an increased cost of funds), a borrower who executes a short hedge (sells interest rate futures) will gain in the futures market and therefore offset all or part of the increased borrowing cost.

D. E.

Funding Fixed-Rate Loans. (See Exhibit 11-5) Hedging a Balance Sheet 1. Price sensitivity rule of hedging a. To hedge properly, a futures contract value must change by the same amount as the change in the underlying asset. b. The price sensitivity rule states that to hedge properly the relative price change or sensitivity (elasticity) of the underlying asset, PA, given a change in market interest rate, rM must be equal to the ratio of the change in the price of the futures contract, PF, divided by the change in market interest rates, rM, times the number of futures contracts, or: PA / rM = N x PF/ rM (Equation 11.1)

N is the number of contracts needed to be sold hedge the risk exposure. To solve for N, transpose the above equation:

N=

PA / rM PF / rM

As you see, the relative volatility of the value of the underlying asset and the futures contract caused by a change in market interest rates determines the number of contracts needed to hedge properly. If the

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futures value and your portfolio value move in opposite directions with a change in interest rates, the resulting N will be negative. It means that you need to buy N futures contracts to hedge your risk exposure. 2. The financial institution may hedge its earnings or the market value of its net worth, not both.

III.

Risks in the Futures Markets A. Profile of Risks 1. 2. While futures contracts can help investors and businesses hedge against certain kinds of risk, they need to be aware of their exposure to risks that are inherent in trading futures. Basis risk - risk of an imperfect hedge because the value of item being hedged may not always keep the same price relationship to the futures contracts. a. Cross hedging is hedging an asset with a derivative contract whose characteristics do not exactly match those of hedged assets. Related-contract risk risk of failure due to an unanticipated change in the business activity being hedged, such as a loan default or prepayment. Manipulation risk risk of price losses due to a person or group trading (buying or selling) to affect price. Margin risk the liquidity risk that added maintenance margin calls will be made by the exchange. If a hedger does not add funds to meet the margin requirement, the futures exchange will close his position in order to avoid default. The hedge will be lost.

3. 4. 5.

IV.

Options Markets A. The Nature of Options 1. 2. 3. 4. 5. 6. 7. B. An option gives the holder a right (not an obligation) to buy/sell a certain amount (e.g., a round lot of 100 shares) of the underlying security or commodity on or before a specified date at a specified price (called strike or exercise price). An American option gives the buyer the right to exercise the option at any time before the expiration date. A European option can be exercised only on its expiration date, not before. An option that would be profitable if exercised immediately is said to be in the money. The seller of the option is called the writer, and the buyer of the option, holder. The buyer will pay the writer of the option a premium. With options the buyer can lose only the premium and the commission paid. If the holder decides to exercise his option, the writer is obligated to honor it.

Calls and Puts 1. 2. Call option - an option to buy an asset at the strike price. Put option - an option to sell an asset at the strike price.

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C.

Potential for gains and losses differ for: (Exhibit 11.7) 1. 2. buyers and sellers of options. futures contracts versus options.

D.

Covered and Naked Options 1. 2. Covered option - writer either owns the security involved in the contract or has limited his or her risk with other contracts. Naked option - writer does not have or has not made provision to limit the extent of risk.

E.

The Value of Options 1. The size of the option premium varies: a. directly with the price variance of the underlying commodity or security. b. directly with the time to its expiration. c. directly with the level of interest rates, and for options based on stocks, with the dividends of the underlying stocks.

F.

Options vs. Futures Contracts 1. 2. 3. 4. The option to transact at the strike price exists over a period of time, not at a given date. The buyer of an option pays the seller (writer) a premium which the writer keeps regardless of whether or not the option is ever exercised. The option does not have to be exercised by the buyer; it can be sold if it has a market value, before the expiration date. Gains and losses are unlimited with futures contracts; with options the buyer can lose only the premium and the commission paid.

V.

Regulation of the Futures Market A. The Commodity Futures Trading Commission (CFTC) 1. 2. 3. B. Federal commission formed in 1974 to centralize government regulation of the futures markets. Purpose to prevent abuse of the public through misrepresentation or market manipulation. Regulates all options that are settled with the delivery of a futures contract.

The Securities Exchange Commission (SEC) 1. 2. Regulates option contracts that have equity securities as underlying assets. Regulates stock index options markets.

C.

Exchange Regulation 1. 2. Exchanges impose self-regulation with rules of conduct for members. Exchange rules determine trading procedures, contract terms, and maximum daily price movements for commodities.

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3.

Position limits are also determined by the exchange to prevent market manipulation by any one investor.

VI.

Swap Markets A. Role of Swaps 1. 2. 3. B. Swaps are used to offset interest rate risk Fixed interest rate payments are exchanged for variable interest rate payments. Institutions with excessive GAP positions swap variable cash flows for fixed and vice versa to reduce their effective GAP.

Swaps vs. Forwards/Futures 1. 2. 3. 4. Swaps are like series of forward contracts in that they guarantee the exchange of two items at several points of time in the future, but a swap only transfers the net amount. Unlike in forwards, price changes are tied to changes in an indexed interest rate. Similar to forwards and futures, swaps can be used to hedge both interest rate and foreign exchange risks. Unlike forwards and futures, credit risk differences between the counterparties provide the impetus for swaps.

C.

Swap Transaction Characteristics 1. 2. 3. Swap dealers serve as counterparties to both sides of swap transactions. Dealers negotiate a deal with one party, then seek out other parties with opposite interests and write a separate contract with them. The two contracts hedge each other and the dealer earns a fee for serving both parties.

D.

Swaps have limited regulation. 1. 2. 3. Bank regulators require risk-based capital support for swap-risk exposure. Other swap market participants, such as investment banks and life insurance companies, have no regulatory capital costs. The market is self-regulated because of the lack of any organized regulator. The International Swap Dealers Association leads in this effort.

COMPLETION QUESTIONS
1. 2. 3. The participants in futures markets include risk-averse ________ and risk-assuming ________. A U.S. importer who must pay 200 million yen to a Japanese exporter in 90 days might buy/sell yen in a ________ contract from a foreign exchange dealer. Forward and futures markets develop when future ________ of a commodities, claims, etc. are highly variable/stable.

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4. 5. 6.

When a futures contract is purchased, a long/short position is established. In the forward market, the hedger contracts directly with a ________; in the futures market the hedger's relationship is with the ________. A farmer growing corn is concerned about a(n) ___________ in the future ________ price of corn, will be long /short in the next few months, and is likely to take a long /short position in the futures market. An option writer receives a ___________ from a buyer of the contract. A ________ option enables the buyer to purchase stock at a _________ price over a certain period of time. An S&L with a negative GAP would enter a swap contract with the intention to swap ________ rate loan interest for ________ rate loan interest, with the purpose of reducing its ________ _______ risk. An increase in the interest rate causes the price of a T-Bill futures contract to ____________.

7. 8. 9.

10.

TRUE-FALSE QUESTIONS
T T T T T T T T T T F F F F F F F F F F 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Foreign exchange risk can be hedged in either the forward or the futures market. Futures price reflect the markets estimate of future spot prices at specific dates. Margin risk relates to the risk that futures contract prices may not vary similarly to the item hedged. Options premiums vary directly with the maturity of the option. Most forward contracts are delivered; most futures contracts are not. Futures markets develop for assets with considerable price fluctuation. A futures contract always involves a hedger (risk averter) and a speculator (risk taker). Forward markets involve more standardized contracts compared to futures markets. A swap dealer brings two interested parties together to make a swap agreement. Bid/ask price spreads narrow with more traders and more trades.

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MULTIPLE-CHOICE QUESTIONS
1. A hedger in the futures market hedges to prevent a loss in a business transactions, but also gives up: a. a sizable fee to the exchange b. the loss on the futures contract c. the opportunity to gain from a favorable turn in prices of the item hedged. d. The potential gain on the futures contract All of the following are risks associated with futures contracts except: a. margin risk. b. basis risk. c. price risk. d. manipulation risk. What action would the holder of a maturing call option take with an option which cost $3 and had a strike price of $50 if the market value of the stock was $52? a. let the option expire unexercised b. exercise the option c. request that the $300 be returned d. none of the above An S&L with long-term assets and short-term liabilities would most likely take which action to hedge its interest rate risk? a. buy futures contracts b. sell futures contracts c. buy put options on futures contracts d. both b and c above The value of an option varies directly with: a. the price variance of the underlying commodity. b. the time to expiration. c. the level of interest rates. d. both a and b above. e. all of the above. A farmer growing wheat is ______ in wheat and may hedge price risk by ______ wheat futures. a. short; long b. buying; selling c. selling; buying d. long; selling First National Bank recently purchased a T-bill futures contract to hedge a risk position at the bank. If the price of the futures contract is increasing, a. First National is "gaining." b. First National is "losing." c. First National is neither "gaining" nor "losing." d. First National is taking a loss in the futures.

2.

3.

4.

5.

6.

7.

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8.

Daily changes in futures prices means one party (long position or short position) has gained and another lost money on the contract. How are the exchanges able to keep the "daily" loser in the contract and prevent default? a. the threat of bankruptcy b. daily margin calls if needed c. loans d. guarantees by third parties A five-member federal regulatory commission, which serves as the primary regulator of the futures market, is the: a. Chicago Mercantile Exchange. b. Federal Commodity Futures Commission. c. Commodity Futures Trading Commission. d. Chicago Board of Trade. A bank which hedges its future funding costs in the T-bill futures market is a. hedging perfectly. b. accepting some basis risk with its hedge. c. speculating. d. is not hedging or speculating at all The purchase of one million dollars of Treasury Bonds, delivered in 60 days, from a government securities dealer is: a. a call. b. a swap. c. a forward contract. d. a put. An agreement between a business and a large money center bank to sell 10 million British Pounds in sixty days is called a a. a call option. b. a forward contract. c. a put option. d. a long futures position. An investor planning to buy IBM stock in 30 days can protect himself against price risk by a. selling an IBM put option that expires in 30 days b. buying an IBM call option that expires in 30 days c. selling an IBM call option that expires in 30 days d. buying an IBM put option that expires in 30 days A portfolio manager is concerned that the expected drop in interest rates is going to lower the yield on the $1,000,000 of T-Bill she plans to buy in 3 months. She can hedge this interest rate risk by: a. Taking a short position in 3-month T-bill futures contract. b. Taking a long position in 3-month T-bill futures contract. c. Buying a put on a 3-month T-bill futures contract. d. Either a or c above. e. She cannot hedge this risk.

9.

10.

11.

12.

13.

14.

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15.

All of the following is true except: a. A swap is like a series of forward contracts in that it guarantees the exchange of two items of value at some future points in time. b. Only the net interest difference is swapped in an interest rate swap. c. Swap parties usually have the same level of credit risk. d. Unlike in a forward contract, the exact terms of exchange of the swap will vary with changes in interest rates.

SUPPLEMENTARY MATERIAL: SHOULD I BUY OR SELL FUTURES CONTRACTS?


To understand whether to take a long or short position in the futures market to hedge a specific price risk, you can try either one of the following two approaches. Long/Short Analysis: The wheat farmer is long in the spot market (will have wheat), so his hedge involves taking an opposite position in the futures market. He sells (shorts) wheat futures. General Mills who must buy wheat in the future is short in the spot market (does not have the grain) and must take a long position (buy) in the futures market. A life insurance company that will receive a loan payoff in 90 days is short in the spot or cash market and will take a long (buy) position in the futures market. Remember, too, that hedging with futures or options eliminates the benefits of favorable price movements of the business, commodity, or security. These contracts are known as two-way hedges. Options, on the other hand, preserve a potential for upside gains while protecting from downside losses. They are oneway hedges. Since an option acts like insurance, a buyer must pay a premium to a writer. Hurt If . . . Analysis: A method that may be easier to think through involves an analysis of the price risk faced by the business or investor. One simply asks "Would they be hurt if future spot prices went up or down?" Once one knows the spot price movement that would hurt (or that which we wish to avoid or hedge), one then takes a position in derivatives that would provide a gain, offsetting the "hurt" or loss in the business. The wheat farmer would be hurt if future spot prices were to decrease. He then sells wheat futures or buys puts on wheat futures, which will result a gain if wheat prices decline in the months ahead. The life insurance company that is receiving funds in the future will be hurt if interest rates decline in the future (opportunity cost). To offset the risk of a drop in interest rates, the firm will buy appropriate financial futures or calls on futures. If rates decline (security prices increase), an actual gain will be accumulated in the futures market (sell the futures contract at a price higher than the purchase price). The "hurt" of specific price movements will be offset by the gains in the futures market.

THE WALL STREET JOURNAL FINDING FUTURES, OPTIONS, AND FUTURES OPTIONS QUOTATIONS
The daily quotations of the futures, options, and futures options are located near the quotations of the underlying instruments in Section C. Commodity futures and futures options are located on the Commodities page, as are the Index Trading options, futures and futures options quotations. The Interest Rate options, futures, and futures options follow the bond quotations, and foreign exchange futures, option and futures options are located in the Currency Market Section. Listed Options Quotations are located on a separate full page, classified by each exchange. Look through Section C and review the five lists of quotations. Review the WSJ-Educational Version for details.

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SUPPLEMENTARY ASSIGNMENT: ANALYSIS OF FUTURES PRICES


A. Locate the futures prices pages noted in the above paragraph, in a recent copy of The Wall Street Journal (second section). One will find a presentation of "Cash Prices" or spot prices of commodities, usually an article analyzing the futures market activity of the previous day, and the "Futures Prices" quotations for the previous day. Each futures quotation lists the type of contract, where (exchange) it is traded, the standard denomination, and an explanation of the price. The quotation for varied contract maturities include: the opening price of the day; the high, low, and daily settlement prices; the change for the day; the lifetime high and low; and the number of contracts outstanding (open interest). For financial futures, settlement (closing) yields and the daily change in yields are quoted, not the lifetime high and low. Note that futures prices (yields) reflect the market's expectations of future spot prices (yields). SUPPLEMENTARY ASSIGNMENT: FUTURES MARKETS QUESTIONS 1. What is the market's expectation of Treasury bill interest rates approximately one year from now? What does the futures market expect crude oil prices, the Canadian dollar, and the S&P 500 to be one year from now? Compare with spot rates and prices.

B.

2.

What futures contract has the largest number of contracts outstanding on the day of your analysis?

C.

SUPPLEMENTARY ASSIGNMENT: HEDGING IN THE FUTURES MARKET For each of the following situations, what futures contract would be bought/sold to hedge the price risk of the business situation? 1. An orange grove wants to hedge its price risk for its crop that will mature in four months.

2.

A U.S. importer must pay 1 million Canadian dollars in six months.

3.

A life insurance company investment manager must sell $1 million in Treasury bonds in three months to make a policy settlement.

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4.

A pension fund manager of a $1 billion diversified stock portfolio wishes to protect the portfolio gains made in the early part of her annual pension management contract with a large corporation.

5.

A corporation must borrow $1 million for 90 days six months from now.

6.

A large S&L has committed $5 million in construction financing six months from today at a specified rate.

7.

A fuel oil supplier with limited storage space must buy fuel oil to meet customer needs over the coming winter months.

8.

A commercial bank customer wants a $5 million fixed-rate loan for six months, normally financed by 3-month CDs.

SOLUTIONS TO COMPLETION QUESTIONS


1. 2. 3. 4. 5. 6. 7. 8. 9. hedgers; speculators buy; forward prices; variable long dealer; exchange decrease; spot; long; short premium call; strike fixed, variable, interest rate

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10.

decrease

SOLUTIONS TO TRUE/FALSE QUESTIONS


1. 2. 3. T T F A forward contract can be negotiated with a dealer or a futures contract can be purchased or sold. Futures prices are consensus estimates of future spot prices. Margin risk relates to the chances that added funds must be contributed to keep the contract solvent. Basis risk relates to the correlation of the price of the hedged item and the futures contract prices. The longer the time, the increased chance of significant price changes. The forward market involves a party who must buy/sell foreign exchange and looks to the forward contract to execute the transaction. The hedger has a desire to fix a price for the future. A futures contract might involve two hedgers, two speculators, or one of each. Each is unique as to the amount of value and future date as required by future business transactions. Each party would independently negotiate a swap agreement with the dealer. As in most markets, as the number of traders and trades increase, the spreads narrow.

4. 5. 6. 7. 8. 9. 10.

T T T F F F T

SOLUTIONS TO MULTIPLE CHOICE QUESTIONS


1. c If a farmer is concerned about declining wheat prices in the future and hedges in the futures market, finds that spot wheat prices are increasing, then his spot gain will be offset by the losses on the futures contracts. One uses the futures market to eliminate the risk of variable future spot prices. If not exercised, the holder would lose $3 per share; if exercised, the $3 premium paid would be offset by a $2 gain per share in the purchase/sale of the stock less commissions. The S&L would be hurt if interest rates increased. They would sell futures contracts (Tbill or CD) or purchase put options (options to sell) on futures contracts. If rates do rise, the S&L will lose in its business but gain by covering its futures sale at lower prices (rates rise; financial futures prices decline). One will pay a higher premium if the chances of gain are higher or if the cost of alternatives associated with trading the underlying item are higher.

2. 3. 4.

c b d

5.

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6. 7.

d c

The farmer will have (be long in) wheat in the future so he shorts (sells) wheat futures maturing just beyond the wheat harvest date. Hedging means they have established a price for the future which hopefully allows them to generate reasonable profits in their business activities. If "hedged" properly, the bank will offset its balance sheet risk exposure by purchasing a T-bill futures contract. Margin calls, like an ante, keep the players in the game! The CFTC and the exchanges attempt to provide an orderly, fair marketplace. T-bill and CD yields (prices) are not likely to vary uniformly during the hedged period due to the cross-hedge selected. The purchase of T-bill for future deliver is a forward contract. It is a forward contract sale. Buying an IBM call option that expires in 30 days will give the investor protection against the IBM stock price going up beyond the strike price. Taking a long position in 3-month T-bill futures contract would protect the portfolio manager against price risk the risk of the T-bill prices increasing as rates decrease! Swap parties do not have the same level of credit risk. In fact, credit risk differences between the counterparties provide the impetus for some swaps.

8. 9. 10. 11. 12. 13. 14. 15.

b c b c b b. b. c.

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