Seminar 8 - Answers

1.

Briefly explain the following terms:

Derivatives: A derivative is an instrument whose value depends on the values of
other more basic underlying variables. Derivatives can be dependent on almost any
variable, from the price of juice and coffee to the temperature. A currency option,
for example, is a derivative whose value is dependent on the price of an exchange
rate.
Forward contract: A forward contract is a simple derivative. It is an agreement to
buy or sell an asset at a certain future time for a certain price. It is traded in the
OTC market. Forward contracts on foreign exchange are very popular. Most large
banks have a forward desk within their foreign exchange trading room that is
devoted to the trading of forward contracts.
Futures contract: Agreement to buy or sell an asset for a certain price at a certain
time. Whereas a forward contract is traded OTC, a futures contract is traded on an
exchange.

2.

What are the main characteristics of the derivatives markets? Why traders use
derivatives? Explain.
A derivatives exchange is a market where individuals trade standardised contracts
that have been defined by the exchange. Derivatives exchanges have existed for a
long time. Traditionally derivatives traders have met on the floor of an exchange
(this is known as the open system), but in recent years exchanges have increasingly
moved from the open system to electronic trading. But, not all trading is done on
exchanges. The Over-the counter (OTC) market is an important alternative to
exchanges. It is a telephone- and computer-linked network of dealers, who do not
physically meet. Trades are done over the phone and are usually between two
financial institutions.
Three main types of traders can be identified: hedgers, speculators and
arbitrageurs.
Hedgers are in the position where they face risk associated wit the price of an
asset. They use derivatives to reduce or eliminate this risk.
Speculators wish to bet on future movements in the price of an asset. They use
derivatives to get extra leverage.
Arbitrageurs are in business to take advantage of a discrepancy between prices in
two different markets. Ways derivatives are used: i) To hedge risks, ii) To
speculate, iii) To lock in an arbitrage profit, iv) To change the nature of a liability,
v) To change the nature of an investment without incurring the costs of selling one
portfolio and buying another.

3. What is the difference between a long futures position and a short futures position?
Sketch the profits from long and short futures positions.
When a trader enters into a long futures contract, he/she is agreeing to BUY the
underlying asset for a certain price at a certain time in the future. When a trader
enters into a short futures contract, she/he is agreeing to SELL the underlying asset
for a certain price at a certain time in the future.
4. What are the main differences between forward contracts and futures contracts?
Explain.

Forward contracts differ from futures contracts in a number of ways. Forward

contracts are private arrangements between two parties, whereas futures contracts
are traded on exchanges. There is generally a single delivery date in a forward
contract, whereas futures contracts frequently involve a range of such dates.
Because they are not traded on exchanges, forward contracts need not be
standardised (an extensive set of rules and procedures is not required). A forward
contract is not usually settled until the end of its life, and most contracts do in fact
lead to delivery of the underlying asset or a cash settlement at this time.
5. What are the most important aspects of the design of a new futures contract?
The most important aspects of the design of a new futures contract are the
specification of the underlying asset, the size of the contract, the delivery
arrangements, and the delivery months.
6. Explain how margins protect investors against the possibility of default.
A margin is a sum of money deposited by an investor with his or her broker. It acts
as a guarantee that the investor can cover any losses on the futures contract. The
balance in the margin account is adjusted daily to reflect gains and losses on the
futures contract. If losses are above a certain level, the investor is required to
deposit a further margin. This system makes it unlikely that the investor will
default. A similar system of margins makes it unlikely that the investors broker
will default on the contract it has with the clearinghouse member and unlikely that
the clearinghouse member will default with the clearinghouse.
7. At the end of one day a clearinghouse member is long 100 contracts, and the
settlement price is $50,000 per contract. The original margin is $2,000 per contract.
On the following day the member becomes responsible for clearing an additional
20 long contracts, entered into at a price of $51,000 per contract. The settlement
price at the end of this day is $50,200. How much does the member have to add to
its margin account with the exchange clearinghouse?
The clearinghouse member is required to provide 20 x 2,000=$40,000 as initial
margin for the new contracts. There is a gain of (50,200-50,000) x 100 = $20,000
on the existing contracts. There is also a loss of (51,000 50,200) = $16,000 on the
new contracts. The member must therefore add 40,000 20,000 +16,000 =
$36,000 to the margin account.
8. Explain why a futures contract can be used for either speculation or hedging.
If a trader has an exposure to the price of an asset, she/he can hedge with a futures
contract. if the exposure is such that the trader will gain when the price decreases
and lose when the price increases, a long futures position will hedge the risk. If the
exposure is such that the trader will lose when the price decreases and gain when
the price increases, a short futures position will hedge the risk. Thus either a long
or a short futures position can be entered into for hedging purposes. If the trader
has no other exposure to the price of the underlying asset, entering into a futures
contract is speculation.

9. Suppose that you enter into a 6-month forward contract on a non-dividend-paying

stock when the stock price is $30 and the risk-free interest (with continuous
compounding) is 12% per annum. What is the forward price?
The forward price is 30e 0.120.5 $31.86
10. A stock index currently stands at 350. The risk-free interest rate is 8% per annum
(with continuous compounding) and the dividend yield on the index is 4% per annum.
What should the futures price for a four-month contract be?
The futures price is 350e ( 0.080.04 )0.3333 $354.7
11. Explain carefully the meaning of the term cost of carry and convenience yield.
What is the relationship between futures price, spot price and cost of carry?
Convenience yield measures the extend to which there are benefits obtained from
ownership of the physical asset that are not obtained by owners of long futures
contracts. The cost of carry is the interest cost plus storage cost less the income
( c y )T
earned. The futures price F0 , and the spot price, S 0 , are related by F0 S 0 e
where c is the cost of carry, y is the convenience yield, and T is the time to maturity of
the futures contract.
12. A 1-year long forward contract on a non-dividend-paying stock is entered into
when the stock price is $40 and the risk-free rate of interest is 10% per annum with
continuous compounding. a. What are the forward price and the initial value of the
forward contract? b. six months later, the price of stock is $45 and the risk-free
interest rate is still 10%. What are the forward price and the value of the forward
contract?
0.1
(a) The forward price, F0 , is given by: F0 40e $44.21 . The initial value of the
forward contract is zero.

(b) The delivery price K in the contract is $44.21. The value of the contract, f, after
six months is: f 45 44.21e 0.10.5 =$2.95. The forward price is given by:
45e 0.10.5 47.31

13. The risk-free rate of interest is 7% per annum with continuous compounding, and
the dividend yield on a stock index is 3.2% per annum. The current value of the index
is 150. What is the six-month futures price?
The six month futures price is: 150e ( 0.07 0.032 )0.5 $152.88
14. Suppose that the risk-free interest rate is 10% per annum with continuous
compounding and that the dividend yield on a stock index is 4% per annum. The
index is standing at $400, and the futures price for a contract deliverable in four
months is 405. What arbitrage opportunities does this create? Explain.
The theoretical futures price is: $ 400e ( 0.10.04)0.3333 408.08 . The actual futures
price is only $405. This shows that the index futures price is too low relative to the

index. The correct arbitrage strategy is: (a) go long futures contracts, (b) short the
shares underlying the index. Short sell the index and get $400. Invest the money at
10% for 4 months at get $413.5. Pay 4% dividend at the end of the 4 months ($5.4)
and buy the futures contract (to close the short selling) at $405. You end up with a
risk-free profit of about $3.1.
15. The two-month interest rates in Switzerland and the United States are 3% and 8%
per annum, respectively, with continuous compounding. The spot price of the Swiss
franc is $0.65. The futures price for a contract deliverable in two months is $0.66.
What arbitrage opportunities does this create? Explain.
The theoretical futures price is: 0.65e 0.1667( 0.080.03) 0.6554 . The actual futures
price is too high. This suggests that an arbitrageur should borrow US dollars, buy
Swiss francs, and short Swiss franc futures.
16. The current price of silver is $9 per ounce. The storage costs are $0.24 per ounce
per year payable quarterly in advance. Assuming that interest rates are 10% per
annum for all maturities, calculate the futures price of silver for delivery in nine
months.
The

present

value
0.250.1

of

the
0.50.1

0.06 0.06e
0.06e
F

(
9
.
000

0.176)e 0.10.75
where 0

storage

costs for nine months are:

$0.176 . The futures price is given by F0 ,
$9.89 per ounce.