Learning objectives: Explain the convergence of futures and spot prices. Describe the role of a clearinghouse in futures and over-the-counter market transactions. Describe the role of collateralization in the over-the-counter market and compare it to the margining system. Identify the differences between a normal and inverted futures market. Evaluate the impact of different trading order types.
Questions:
709.1. Barbara is a value investor who bought 1,000 shares of Apple (ticker: AAPL) in 2014 when the share price was $95.00 and she considered them under-valued. In hindsight, her view was correct as the shares currently (as of mid-2017) trade at $140.00. She now thinks the shares are slightly over-valued. However, she does not want to sell them unless there is a market crash. This is because she believes the shares are likely to trade in a range and may even gain modestly in the future. However, she also believes there is something like a 10.0% probability of a technology sector crash (a possibility enabled by the low interest rate regime). If the technology sector does crash, she fears the AAPL shares could plummet. If the AAPL shares drop, Barbara does wants to sell, however she does not want to sell in a panic at fire-sale prices.
Specifically, if the shares were to quickly lose more than 13.0% of their current value, Barbara will be eager to sell them. However, she also wants to ensure that she realizes a minimum holding period return (HPR) of 30.0%; and to this HPR dividends have already contributed 6.0%. Therefore, she only wants to sell if the price appreciation (from her $95.00 cost basis) is at least +24.0%. She justifies this conditional view on a belief that if the shares plunge too far such that she cannot realize her HPR threshold, the market will have overreacted. In this case of an over-reaction, she believes it will be better to avoid selling in a panic and instead she will be better off to await an eventual recovery. Which of the following orders is most consistent with her strategy?
a. A market order
b. A limit order at $121.80 plus a market order at $135.57
c. A stop-limit order with stop at $121.80 and limit at $117.80
d. Two stop-loss orders: a soft-stop at $121.80 and a hard-stop at $105.00
709.2. Each of the following statements about futures and/or forwards is true EXCEPT which is false?
a. Margin requirements are the same on short futures positions as they are on long futures positions.
b. In the case of a futures contract, initial margin typically does earn interest, but variation margin does not
c. When an exchange clearinghouse or central counterparty (an OTC CCP) accepts a transaction, it both cases it assumes the credit risk of both buyer and seller
d. The delivery period is the same across commodities and exchanges, in order to prevent arbitrage, but the buyer (i.e., the long position) gets to make the decision on exactly when to receive delivery within the delivery period
709.3. Which statement is TRUE about the shape of the commodities forward curve?
a. In a normal market (aka, contango), the basis is positive
b. In an inverted market (aka, backwardation) the basis is negative
c. An inverted market (aka, backwardation) might be explained by negative interest rates but does not necessarily imply negative rates
d. In a contango (aka, normal) market with a static forward curve, the price of a futures contract will INCREASE as time to maturity approaches zero
Answers here:
Questions:
709.1. Barbara is a value investor who bought 1,000 shares of Apple (ticker: AAPL) in 2014 when the share price was $95.00 and she considered them under-valued. In hindsight, her view was correct as the shares currently (as of mid-2017) trade at $140.00. She now thinks the shares are slightly over-valued. However, she does not want to sell them unless there is a market crash. This is because she believes the shares are likely to trade in a range and may even gain modestly in the future. However, she also believes there is something like a 10.0% probability of a technology sector crash (a possibility enabled by the low interest rate regime). If the technology sector does crash, she fears the AAPL shares could plummet. If the AAPL shares drop, Barbara does wants to sell, however she does not want to sell in a panic at fire-sale prices.
Specifically, if the shares were to quickly lose more than 13.0% of their current value, Barbara will be eager to sell them. However, she also wants to ensure that she realizes a minimum holding period return (HPR) of 30.0%; and to this HPR dividends have already contributed 6.0%. Therefore, she only wants to sell if the price appreciation (from her $95.00 cost basis) is at least +24.0%. She justifies this conditional view on a belief that if the shares plunge too far such that she cannot realize her HPR threshold, the market will have overreacted. In this case of an over-reaction, she believes it will be better to avoid selling in a panic and instead she will be better off to await an eventual recovery. Which of the following orders is most consistent with her strategy?
a. A market order
b. A limit order at $121.80 plus a market order at $135.57
c. A stop-limit order with stop at $121.80 and limit at $117.80
d. Two stop-loss orders: a soft-stop at $121.80 and a hard-stop at $105.00
709.2. Each of the following statements about futures and/or forwards is true EXCEPT which is false?
a. Margin requirements are the same on short futures positions as they are on long futures positions.
b. In the case of a futures contract, initial margin typically does earn interest, but variation margin does not
c. When an exchange clearinghouse or central counterparty (an OTC CCP) accepts a transaction, it both cases it assumes the credit risk of both buyer and seller
d. The delivery period is the same across commodities and exchanges, in order to prevent arbitrage, but the buyer (i.e., the long position) gets to make the decision on exactly when to receive delivery within the delivery period
709.3. Which statement is TRUE about the shape of the commodities forward curve?
a. In a normal market (aka, contango), the basis is positive
b. In an inverted market (aka, backwardation) the basis is negative
c. An inverted market (aka, backwardation) might be explained by negative interest rates but does not necessarily imply negative rates
d. In a contango (aka, normal) market with a static forward curve, the price of a futures contract will INCREASE as time to maturity approaches zero
Answers here:
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