17.1.B.

FORWARD MARKETS AND CONTRACTS AND

17.1.C. FUTURES MARKETS AND CONTRACTS
Futures contracts

Futures contracts allow investors today, to agree upon the terms of some trade that is to be
conducted in the "future". There are 3 terms to every futures contract:
a) the expiry date, or the future date at which the trade will take place,
b) the quantity of the underlying asset that will be traded, and
c) the price at which this future trade will take place.

There are futures contracts available on numerous types of assets. However, most futures
contracts may be grouped into either of 4 categories: commodities, indexes, fixed income
securities, and currencies.

Once the appropriate futures contract has been identified, an investor can either buy it (long) or
sell it (short).

If an investor BUYS a futures contract, then she is obligated to BUY the set quantity of the
underlying asset at the expiry date for the price that was agreed upon at the initiation of the
futures contract.

If an investor SELLS a futures contract, then she is obligated to DELIVER the set quantity of the
underlying asset at the expiry date for the price that was agreed upon at the initiation of the
futures contract.

Forward contracts

A forward contract works exactly the same way as does a futures contract. However, where
futures contracts are standardized by the exchanges, forwards are customized agreements set
between parties that does not involve the exchange markets. For example, where a futures
exchange might set the expiry date and quantity of the underlying asset represented by each
futures contract, a forward contract would allow the counterparties to agree upon these two terms.
But what about the third element, price, who sets that? The market does.

While forward contracts have the advantage of being customized, the fact that it’s a negotiated
instrument between two parties makes it is a very illiquid instrument. Furthermore, just like all
contracts between private parties, there is the risk that one side may not live up to its obligations.
In other words, there will be counterparty credit risk. However, in reality, the counterparties
involved in a forward agreement are some of the largest and most creditworthy financial
institutions in the world. Thus, credit risk is not as big an issue as it may seem.

So how does one choose between executing a futures contract or a forward contract? In general,
for trades that are incredibly large, standardized contracts just won't do. Instead, the parties
involved would customize a forward contract in order to handle such a large trade. Futures on the
other hand, would be more effectively used for smaller trades. For instance, almost always,
individual investors would use futures contracts in order to meet their objectives.

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Question:
Which one of the following statements about a futures contract and a forward contract is true?
A) Forward contracts require an investor to post margins with his or her broker.
B) A futures contract has standardized specifications whereas a forward contract is more customized.
C) Usually, a forward contract has a much shorter maturity than a futures contract.
D) Upon expiry, forward contracts are usually settled in cash as opposed to delivery of the underlying
asset.
Answer:
B

Explanation:
A futures contract is very standardized and it can only be traded on a futures exchange. A forward
contract on the other hand, is more customized and longer term in nature. Furthermore, upon expiry a
forward contract is actually settled with the delivery of the underlying asset.

Question:
Which of the following statements is (are) true with respect to futures trading?

I. Futures contracts are a lot more flexible than forward contracts.

II. Futures contracts are default free.

III. The only cash outflow required at the time of a futures trade is due to commission costs.

IV. Unlike forward contracts, futures contracts trade in over-the-counter markets.

Answer:
II only.
Explanation:
(I) is incorrect due to the fact that futures contracts are standardized contracts, thus making them a lot
less flexible than forward contracts.

(III) is incorrect because during the initiation of a futures trade, both the buyer and the seller must post
margins with their brokers to ensure that there will be enough funds on both sides to meet their future
obligations.

(IV) is incorrect because futures contracts trade on organized futures exchanges.

HEDGER vs. SPECULATOR

Someone who executes a derivatives trade in order to offset a position in the actual underlying
asset itself, is regarded as a hedger. On the other hand, someone who trades in derivatives but

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otherwise does not actually deal in the underlying asset itself, is regarded as a speculator. A
speculator simply wants to make a profit from the price movements of the derivatives contracts,
while a hedger uses the price volatility of the derivatives contract to offset the price volatility of
the matching underlying asset.

As an example, suppose that today is June 1st, and a jeweler needs to purchase some gold in
December. If she waits until December and then purchases the gold, she risks having to pay a
higher price for the gold. Alternatively, she may buy a December gold futures contract today. By
doing so, TODAY she will be locking in the date, the quantity, and the price that she will be
paying for this gold in December. With these 3 elements agreed upon today, the jeweler has
removed all risks associated with purchasing gold in December. In effect, she has "hedged" her
exposure to the price of gold.

Question:
Which of the following statements is (are) true with respect to the uses that may be derived from the
futures market?

I. If a trader buys a futures contract while owning some quantities of the underlying asset, then the
trader is deemed as a hedger.

II. An arbitrageur will take long position in a futures market only to offset a short position in the
undervalued underlying asset.

III. Futures markets enable the transfer of price risk from hedgers over to speculators.

IV. For every contract that is originated by a hedger, the counter-party is always a speculator.

Answer:
III only.
Explanation:
(I) is incorrect because a hedge in this case would involve the sale of a futures contract to offset the long
position in the underlying asset. Consequently, this trader may be deemed as a speculator.

(II) is incorrect because an arbitrageur will take long position in a futures market only to offset a short
position in the overvalued underlying asset. Arbitrage works by selling (shorting) the asset in the
overvalued market and buying it in the undervalued market. Therefore, if the underlying asset is
undervalued, it should be bought in the "cash" market and shorted in the futures market.

(IV) is incorrect because the counterparty to a long hedger could very easily be a shorthedger. For
example, a purchaser of gold and a producer of gold could be counterparties in a gold futures trade, yet
they are both considered as hedgers.

Question:
Which of the following activities may a speculator engage in the futures market?
A) Short a futures contract on wheat because the investor actually is a wheat farmer.

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B) Long a futures contract on the British pound because the investor believes that in the future, the
pound will be much stronger than what the futures markets are pricing in.
C) Long a futures contract on oil not because the investor will need oil today but that he will need it
sometime in the future.
D) Buy a futures contract on the S&P500 and immediately sell the basket of stocks as represented by the
S&P500 in order to exploit any price discrepancies.
Answer:
B

Explanation:
Trading a futures contract on an asset which the investor has no intentions of dealing with in the actual
physical market, is regarded as speculation. In the case of the British pound, the investor is "speculating"
that the pound will be much stronger than what the futures price is indicating today. The wheat and oil
answers relate to a hedger, and finally, the S&P500 answer relates to an arbitrageur.

VOLUME AND OPEN INTEREST

Just as liquidity is an important factor when trading in a stock, the same holds true for futures
contracts. For instance, if a futures contract trades infrequently, it may become very difficult to
form a hedge or execute a speculative strategy. To gauge a particular futures contract's liquidity,
we look at its volume and open interest.

Question:
Which of the following statements is (are) true with respect to futures trading?

I. When one party buys a contract and the counterparty sells the contract, the volume will be
modified to include two more contracts.

II. Open interest is the sum of all the long positions that are open.

III. Open interest will increase every time a new contract is initiated.

IV. If an investor sells 5 of the 20 futures contracts that he owns, the open interest will drop by 5.

Answer:
II and III only.
Explanation:
(I) is incorrect because when one party buys a contract and the counterparty sells the contract, the
volume will be modified to include one more contracts. Therefore, every buy/sell pair constitutes one
contract.

(IV) is incorrect because if an investor sells some of his futures contracts, someone else will buy them, in
other words, the number of contracts that are open (or in circulation) will not be altered.

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CLOSING A FUTURES POSITION

Suppose that the investor who bought the gold futures decides that she no longer needs the hedge.
How can she close her "long" futures position?

a) Do an offsetting trade: Since she originally longed a gold futures contract expiring in
December, now she must execute a sell order for that exact same contract.
Consequently, the original position is "offset" by this new position. However, the
futures price at which this new short trade was conducted may be very different from
the futures price of the original long trade. Hence, the investor will either realize a
gain or a loss on the day she conducts the offsetting trade:

Gain/Loss = [Number of contracts][Dollar Multiplier][Ft – Fo]

Where Ft: is the futures price on the date the offset trade is made.
Fo: is the futures price on the date that the original position was established.

b) Accept delivery: The investor may simply wait for the futures contract to expire in
December, on which date she will accept delivery of the gold and pay the initially
agreed upon futures price for it.

c) Cash settlement: This alternative is primarily geared towards futures contracts based
on financial assets such as stock indexes and bonds, as opposed to commodities like
gold. With this method, instead of actually trading in the underlying asset, the
counterparties simply settle the contract for cash. The gains and losses are
determined in the exact same manner as was used in an offsetting trade.

Question:
Which of the following statements is (are) true with respect to closing out a futures contract?

I. To reverse a long position, an investor must short a contract that has the same settlement date
and price as the original trade.

II. A futures contract may be closed out anytime before the settlement date if the short position
delivers the underlying asset.

III. A futures contract may be closed out at the settlement date by a cash transfer equal to the gain on
the contract from the losing party over to the profitable party.

IV. If an original long position is reversed at a higher settlement price, than a profit will have been
realized.

Answer:
III and IV only.
Explanation:
(I) is incorrect because to reverse a long position, an investor must short a contract that has the same
settlement date, contract size, and underlying asset. The settlement price will rarely be the same as the
original trade.

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(II) is incorrect because delivery may only take place during the settlement date. Delivery is prohibited
before that time.

Question:
An investor shorts 50 oil futures contracts with a futures price of $28.15 per barrel. Each contract
encompasses 250 barrels of oil. If the clearinghouse requires an initial margin of $900 per contract and
maintenance margin of $650 per contract, how much will be the investor's dollar profit or loss should the
price of oil settle at $29.75 at the futures expiration date?
A) Loss of $7,500.
B) Loss of $20,000.
C) Gain of $20,000.
D) Gain of $7,500.
Answer:
B

Explanation:

MARGINS

Futures contracts are simply agreements. Therefore they cost nothing to enter into. However,
once the expiry date does come, large amounts of money may be needed in order to carry out the
trade as agreed upon. But this creates the potential for default risk if the losing counterparty does
not have sufficient assets to carry out his part of the deal.

To offset such default risk, a clearinghouse takes the role of the counterparty for every futures
trade. Therefore, when an investor enters into a futures contract, he is entering into an agreement
with the clearinghouse. Thus, the terms of the futures contract will be always be guaranteed.

The clearinghouse is able to make this guarantee because it requires every party that it enters into
a futures contract with to post a margin. This "initial margin" acts as a cushion just in case the
investor's futures position begins to lose money. By having this safety margin, the clearinghouse
always ensures that the counterparty has enough assets to settle any losses.

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Therefore, instead of calculating total losses on a futures contract on its expiry date, which may
end up being overwhelming, the clearinghouse requires that any gains or losses be computed on a
daily basis. This is called marking to market. The purpose of this procedure is to determine
whether the initial margin is enough to cover any accumulated losses up to that point.

Should Investor A have a losing day in his futures position, the amount of the loss is deducted
from his margin and is transferred to the account of the investor who had an opposite position in
the exact same futures contract. If these daily losses continue for Investor A, the initial margin
that he posted will reach close to depletion.

Consequently, once the margin drops below a pre-set amount, called the "maintenance margin"
level, Investor A will be called upon to post an additional amount, called the "variation margin",
in order to bring the total margin amount back to its initial level. This way, the clearinghouse is
always assured that losing parties have enough assets to cover any subsequent losses. It is this
mechanism that enables the clearinghouse to guarantee all futures trades.

Question:
Which of the following statements is (are) true with respect to the mechanics involved in futures trading?

I. When an investor buys a future contract, the counter-party will be the investor who sold that
exact same contract independently.

II. The initial margin is almost always less than 5% of the underlying asset's market value.

III. A variation margin is the additional amount that must be deposited in order to keep the account
above its maintenance margin level.

IV. A margin call on a short position is triggered when the unit price of the underlying asset
appreciates by an amount equal to the difference between the initial and maintenance margin
levels, divided by the contract size.

Answer:
II and IV only.
Explanation:
(I) is incorrect because when an investor buys or sells a future contract, the counter-party will always be
the clearinghouse.

(III) is incorrect because a variation margin is the additional amount that must be deposited in order to
restore the account to its initial margin level.

Question:
An investor shorts 50 oil futures contracts with a futures price of $28.15 per barrel. Each contract
encompasses 250 barrels of oil. If the clearinghouse requires an initial margin of $900 per contract and
maintenance margin of $650 per contract, how much can the price of oil fluctuate before a margin call is
made?

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A) Price of oil would have to increase by $0.13.
B) Price of oil would have to increase by $1.00.
C) Price of oil would have to decrease by $1.00.
D) Price of oil would have to increase by $0.13.
Answer:
B

Explanation:

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