IC 301
IC 301
Seminar 1
Advantages of using derivatives
Hedging
Purchasing a a derivative whose price moves in the opposite direction of the price of underlying
Underlying price determination
Help to project the prices of the underlying assets, e.g. Spot prices of futures as an approximation of a commodity price
Market efficiency
Easier to correct for mispricing as the operational costs are low + liquidity
Access to more markets
e.g. interest rate swaps to obtain more valuable interest rates
Risks?
Volatlity
Speculation
Counterparty risk
Forwards Futures
A forward contract is a customized contract between two parties to buy or sell an asset at a predetermined price on a future date. A futures contract is a legal agreement to buy or sell a certain commodity or an asset at a predetermined price at a specific time in the future.
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Forwards Futures
Where OTC, private Exchange
Contract Size
&
Type Not standardized Standardized
Delivery Months Flexible, usually 1 specific delivery date as agreed Standardized
Risk Subjected to counterparty risk Virtually no counterparty risk
Maturity Settled at the end of contract Settled before maturity, gain/loss realized day by day
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A one-year forward contract is an agreement where…
A: One side has the right to buy an asset for a certain price in one year’s time.
B: One side has the obligation to buy an asset for a certain price in one year’s time.
C: One side has the obligation to buy an asset for a certain price at some time during the next year.
D: One side has the obligation to buy an asset for the market price in one year’s time.
Answer: B
A one-year forward contract is an obligation to buy or sell in one year’s time for a predetermined price. By contrast, an option is the right to buy or sell.
Which of the following is approximately true when size is measured in terms of the underlying principal amounts or value of the underlying assets?
A: The exchange-traded market is twice as big as the over-the-counter market.
B: The over-the-counter market is twice as big as the exchange-traded market.
C: The exchange-traded market is ten times as big as the over-the-counter market.
D: The over-the-counter market is ten times as big as the exchange-traded market.
Answer: D
The OTC market is about $600 trillion whereas the exchange-traded market is about $60 trillion
Which of the following is approximately true when size is measured in terms of the underlying principal amounts or value of the underlying assets?
A: The exchange-traded market is twice as big as the over-the-counter market.
B: The over-the-counter market is twice as big as the exchange-traded market.
C: The exchange-traded market is ten times as big as the over-the-counter market.
D: The over-the-counter market is ten times as big as the exchange-traded market.
Answer: D
The OTC market is about $600 trillion whereas the exchange-traded market is about $60 trillion
Which of the following best describes the term ‘spot price’?
A: The price for immediate delivery
B: The price for delivery at a future time
C: The price of an asset that has been damaged
D: The price of renting an asset
Answer: A
The spot price is the price for immediate delivery. The futures or forward price is the price for delivery in the future
Which of the following is true about a long forward contract?
A: The contract becomes more valuable as the price of the asset declines
B: The contract becomes more valuable as the price of the asset rises
C: The contract is worth zero if the price of the asset declines after the contract has been entered into
D: The contract is worth zero if the price of the asset rises after the contract has been entered into
Answer: B
A long forward contract is an agreement to buy the asset at a predetermined price. The contract is only worth zero when the predetermined price in the forward contract equals the current forward price (e.g. beginning of the contract).
An investor sells a futures contract an asset when the futures price is $1,500. Each contract is on 100 units of the asset. The contract is closed out when the futures price is $1,540. Which of the following is true?
A: The investor has made a gain of $4,000
B: The investor has made a loss of $4,000
C: The investor has made a gain of $2,000
D: The investor has made a loss of $2,000
Answer: B
An investor who buys (has a long position) has a gain when a futures price increases. An investor who sells (has a short position) has a loss when a futures price increases.
A company knows it will have to pay a certain amount of a foreign currency to one of its suppliers in the future. Which of the following is true?
A: A forward contract can be used to lock in the exchange rate
B: A forward contract will always give a better outcome than an option
C: An option will always give a better outcome than a forward contract
D: An option can be used to lock in the exchange rate
Answer: A
An option provides insurance that the exchange rate will not be worse than a certain level but requires an upfront premium. Options sometimes give a better outcome and sometimes give a worse outcome than forwards.
Which of the following is true?
A: Both forward and futures contracts are traded on exchanges.
B: Forward contracts are traded on exchanges, but futures contracts are not.
C: Futures contracts are traded on exchanges, but forward contracts are not.
D: Neither futures contracts nor forward contracts are traded on exchanges.
Answer: C
Futures contracts trade only on exchanges. Forward contracts trade only in the over-the-counter market.
Which of the following is NOT true?
A: Futures contracts nearly always last longer than forward contracts
B: Futures contracts are standardized; forward contracts are not.
C: Delivery or final cash settlement usually takes place with forward contracts; the same is not true of futures contracts.
D: Forward contracts usually have one specified delivery date; futures contract often have a range of delivery dates.
Answer: A
Spot USD/JPY is 106.32. The 3-month FX forward swap points are quoted 66/65. What is the outright forward rate? Is it a premium or a discount?
USD rate > JPY rate, discount
106.32 – 0.66 = 105.66
106.32 – 0.65 = 105.67,
So the answer is: 105.66/67
USD/CAD is 1.1239
3-month US deposit is 0.4%
3-month CAD deposit is 0.75%
Calculate the 3-month forward FX (90 days)
Answer with the -1 in the formula: 1.1239[(1+0.0075*90/360)/(1+0.004*90/360)-1] = +10 points premium
Note on forward FX pricing
The market quotes points as premiums or discounts
The outright forward FX rate is calculated from adding or subtracting from the spot FX rate
SO read the question to see if it asks for points or outright rate (the calculation is the same except for the -1)
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