ECON372 Study Guide - Final Guide: Interest Rate Risk, Futures Exchange, Futures Contract

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ECON 372 – Final Notes Adrian Law
Chapter 1 - Introduction
Futures contract An agreement to buy or sell an asset at a certain time in the future for a certain price,
allows both parties to eliminate the risk it faces because of the uncertain future price
Futures exchange Allows people who want to buy or sell assets in the future to trade with each other
Futures price Price at which the futures contract is agreed on, for assets to be delivered in the future
Spot price Price for immediate or almost immediate asset delivery
Open-outcry system A system that involves traders physically meeting on the floor of the exchange (the
trading pit), and using hand signals to indicate the trades they would like to carry out
Forward contracts Same as futures contract with the exception that they are traded in the OTC market.
Forward contracts on foreign exchange are very popular and is used by most large banks
Over-the-counter market Alternative to exchanges, trades are done over the phone. Trades are typically much
larger than trades in the exchange as terms of a contract can be negotiated to mutually
attractive terms, however, OTC markets carry a higher credit risk than exchange- traded
market
Options Traded both on exchanges and OTC markets. Two types of options: 1. Call option gives
holder the right to buy an asset by a certain date for a strike price; 2. Put option gives
the holder the right to sell an asset by a certain date at the strike price
European option can only be exercised at maturity date; American option can be
exercised anytime. An option contract is a contract to buy or sell 100 shares.
Option Premium An up-front price an investor must pay when entering an options contract. As strike
price increases, price of call option decreases, and price of put option increases
Hedgers Use futures, forwards, and options to reduce the risk that they face from potential
future movements in a market variable. Hedging reduces the risks, but it is not
necessary the case that the outcome with hedging will be better than the outcome
without hedging.
Speculators Use futures, forwards, and options to bet on the future direction of a market variable
Arbitrageurs Take offsetting positions in two or more instruments to lock in a riskless profit
Chapter 2 – Mechanics of Futures Markets
-Although most futures contracts do not end in actual delivery of the underlying assets, the possibility of final
delivery is what ties the futures price to the spot price.
-When the party with the short position is ready to deliver, it files a notice of intention to deliver with the
exchange
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Contract size The exchange is responsible for setting the correct contract size. Too large and hedgers
looking to hedge relatively small exposures will be unable to use the exchange; too
small and trading may be expensive as there are associated costs with each contract
traded
Limit move If in a day, the price moves from the previous day’s close by an amount equal to the
daily price limit, the contract is said to have a limit move (limit down if price decrease,
limit up if price increase). Normally, trading ceases for the day if there is a limit move.
This is to prevent large price movement from occurring because of speculative excesses.
Position limits The maximum numbers of contracts that a speculator may hold. This is to prevent a
single speculator to have undue influence on the market.
-As the delivery period for a futures contract is approached, the futures price converges to the spot price, and at
delivery date, both prices equal or are very close. This is due to arbitrage activities which eliminates price
difference.
Margins Required by the exchange to minimize the risk of defaults
Margin account Account which investors deposit into
Initial margin Amount that must be deposited at the time the contract is entered into
Daily settlement Also known as marking to market. At the end of each trading day, the margin account is
adjusted to reflect the investor’s gain or loss.
-Investor is entitled to withdraw any balance in the margin account in excess of the initial margin.
Maintenance margin Set lower than initial margin. Should the amount in the margin account falls below this
number, the investor receives a margin call, and is expected to top up the account to
the amount of the initial margin. The extra fund deposited are known as variation
margin.
Day trade Trader announces to the broker an intent to close out the position in the same day.
Spread transaction Trader simultaneously buys a contract for one maturity month and sells the same asset
for another maturity month.
-If the investor does not provide the variation margin, the broker will close out the position.
Clearinghouse Acts as an intermediary in futures transactions. It guarantees the performance of the
parties to each transaction. Members of the clearinghouse needs to pay a membership
fees. Brokers who are not members of the clearinghouse must channel their business
through a member.
Clearing margin Margin account maintained by clearinghouse members
Gross margining Method clearinghouse use to calculate required clearing margin for its members.
Calculated by adding the total amount of contracts its members with their clients.
Net margining Method clearinghouse use to calculate required clearing margin for its members.
Calculated by adding long contracts and subtracting short contracts. Most exchanges
use net margining.
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Systemic risk Risk that a failure by a large financial institution will lead to failures by other large
financial institutions and a collapse of the financial system.
Settlement price The price used for calculating daily gains and losses and margin requirements
Open interest Total number of long and short positions
Normal market Futures price increases as maturity nears
Inverted market Futures price decreases as maturity nears
Futures commission Traders trading on behalf of their clients’ instructions
merchant
Locals Traders trading on their own behalf
Scalpers Type of speculator of whom hold position for a few minutes in look for very short
termed profit
Day traders Type of speculator of whom hold positions for less than a day as they are unwilling to
take adverse risk from news occurring overnight
Position traders Type of speculator of whom hold positions for much longer period of times in look for
major movements from the market to make significant profits.
Market order A request that a trade be carried out immediately at the best price available
Limit order A request that specifies a particular price (or better) before the trade is carried out
Stop / stop-loss order A request that specifies a particular price (or worse) before the trade is carried out. This
is usually used to close out a position if unfavourable price movements take place.
Stop-limit order Combination of both limit and stop order. Two prices are set and is triggered when price
level hits the specified level
Market-if-touched order A request for a trade that executes at the best available price after a trade occurs at a
specified price (or more favourable price)
Discretionary order Also known as market-not-held order. Traded as a market order but at the discretion of
the broker’s decision in an attempt to get a better price.
Front running When traders use their knowledge of customer orders to trade first for themselves.
Forward Futures
Private contract between two parties Traded on an exchange
Not standardized Standardized contract
Usually one specified delivery date Range of delivery dates
Settled at end f contract Settled daily
Delivery or final cash settlement usually takes place Contract is usually closed out prior to maturity
Some credit risk Virtually no credit risk
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