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FIN 501 Study Guide - Futures Contract, Financial Instrument, Spot Contract


Department
Finance
Course Code
FIN 501
Professor
Edward Blinder

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FIN501 investment analysis I
CHAPTER 16 OPTIONS AND FUTURES
FUTURE CONTRACTS BASICS
Forward contract: agreement between a buyer and a seller, who both commit to a transaction at a future date at a
price set by negotiation today
o Allows a producer to sell a product to a willing buyer before it is actually produced
Futures contract: contract between a seller and a buyer specifying a commodity or financial instrument to be
delivered and paid at contract maturity
o Futures contracts are managed through an organized futures exchange
o Futures price: price negotiated by buyer and seller at which the underlying commodity or financial
instrument will be delivered and paid for to fulfill the obligations of a futures contract
Futures contract represents a zero-sum game between a buyer and a seller, the net value of a future contract is
always zero
Futures contracts must stipulate at least the following five contract terms
1. The identity of the underlying commodity or financial instrument
2. The futures contract size
3. The futures maturity date, also called the expiration date
4. The delivery or settlement procedure
5. The futures price
WHY FUTURES?
Long position: in futures jargon, refers to the contract buyer; profits from a futures price increase
Short position: in futures jargon, refers to the seller; profits from a futures price decrease
Speculator: trader who accepts price risk by going long or short to bet on the future direction of prices
EX. Suppose the current futures price for delivery in 3 months is $900 per ounce. You purchase 100 three-month gold contracts. Each gold
contract represents 100 troy ounces, so 100 contracts represents 10,000 ounces of gold with a total contract value of 10,000 x $900 =
$9,000,000.
Assuming at contract maturity, the price of gold is $920.
Profit: $20 x 10,000 = $200,000
Assuming at contract maturity, the price of gold is $890
Loss: $10 x 10,000 = $100,000
Hedger: trader who seeks to transfer price risk by taking a futures position opposite to an existing position in the
underlying commodity or financial instrument
Short hedge: sale of futures to offset potential losses from falling prices
Long hedge: purchase of futures to offset potential losses from rising prices
FUTURES TRADING ACCOUNTS
Futures margin: deposit of funds in a futures trading account dedicated to covering potential losses from an
outstanding futures position
Initial margin: amount required when a futures contract is first bought or sold
o Varies with the type and size of a contract, but it is the same for long and short futures positions
Marking-to-market: in futures trading accounts, the process whereby gains and losses on outstanding futures
positions are recognized on a daily basis
Maintenance margin: the minimum margin level required in a futures trading account at all times
Margin call: notification to increase the margin level in a trading account
Reverse trade: a trade that closes out a previously established futures position by taking the opposite position
o Two basic reasons to close out a futures position before contract maturity
i. To capture a current gain or loss, without realizing further price risk
ii. Avoid the delivery requirement that comes from holding a futures contract until
maturity
CASH PRICES VERSUS FUTURES PRICES
Cash price (spot price): price of a commodity or financial instrument for current delivery
Cash market (spot market): market in which commodities or financial instruments are traded for essentially
immediate delivery
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