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# Chapter 16 Options and Futures.docx

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School
Department
Finance
Course
FIN 501
Professor
Edward Blinder
Semester
Summer

Description
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 FIN501 investment analysis I EX. Suppose you notice that spot gold is trading for \$400 per ounce while the two-month futures price is \$450 per ounce. Buying spot gold today at \$
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