P1.T3.21.12. Futures markets

David Harper CFA FRM

David Harper CFA FRM
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Learning objectives: Define and describe the key features and specifications of a futures contract, including the underlying asset, the contract price and size, trading volume, open interest, delivery, and limits. Explain the convergence of futures and spot prices ... Describe the application of marking to market and hedge accounting for futures. Compare and contrast forward and futures contracts.

Questions:

21.12.1. In regard to the specifications of futures contracts and the patterns of futures prices, which of the following statements is TRUE?

a. The delivery period is the last trading day (24 hours) of the month
b. The pattern of futures prices for a given commodity can be partly normal (aka, contango) and partly inverted (aka, backwardation)
c. Whenever there is a choice about what is delivered, the party with the long position always has the right to insist on the grade, location, and delivery time
d. Price limits and position limits are imposed for the purpose of preventing arbitrageurs from exploiting any price difference between the spot and futures price as the delivery period approaches


21.12.2. For a consumption commodity of a certain grade, the December futures price is $31.50. Adam, Betty, Charles and Denise are interns who work at a commodity futures trading firm. They have the following preferences:
  • Adam does not have a position but would like to take a short position as quickly as possible (and he is not concerned with the exact price)
  • Betty does not have a position but would like to buy (aka, take a long position) but conditional on a favorable price (she is okay if the order does not execute)
  • Charles already has an in-the-money short position with a delivery price of $40.00; if his position's value were to rapidly decrease, he would like to trigger an exit (i.e., close-out the position) at whatever is the then-prevailing market price
  • Denise already has an in-the-money short position with a delivery price of $38.00; if her position's value were to rapidly decrease, she would like to trigger an exit (i.e., close-out the position) but conditional on a price that she designates (or more favorable)
Based on these preferences, their mutual friend Eddie makes the following recommendations:
  • Adam should place a market order
  • Betty should place a limit order
  • Charles should place a stop-loss order to buy at some price above $40.00
  • Denise should place a stop-loss order to buy at some price below $40.00
Three of Eddie's recommendations are good and appropriate, but one of his recommendations is a mistake. Which of the following statements is TRUE; i.e., which recommendation is the mistake?

a. He's mistaken about Adam, who should not place a market order
b. He's mistaken about Betty, who should not place a limit order
c. He's mistaken about Charles, who should not place a stop-loss order to buy at a some price above $40.00
d. He's mistaken about Denise, who should not place a stop-loss order to buy at a some price below $40.00


21.12.3. Today an exchange introduced a new futures contract. The open interest started at zero. Because it is a new contract, there were only the following four trades:
  • Trader Adam (TA) buys (aka, takes a long position in) 1,000 contracts from Trader Betty (TB) who is the seller (aka, takes a short position) and both are new positions
  • Trader Charles (TC) buys 300 contracts, in a new position, from Trader Adam (TA) who closes out 300 of his contracts
  • Trader Denise (TD) sells 225 contracts, in a new position, to Trader Betty (TB), the the buyer who closes out 225 of her contracts
  • Trader Betty (TB) delivers on 175 of her short contracts to Trader Adam (TA) who takes delivery on 175 of his long contracts
What is the open interest, after the above four trades, at the end of the day?

a. Zero
b. 300 contracts
c. 825 contracts
d. 1,000 contracts

Answers:
 
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