Dakota State University
BUS 418 Financial Futures & Options
Spring 2001
Reading Assignments
Chapter 1: Pp. 1-8 Chapter 2: All Chapter 3: All Chapter 4: Pp. 85-87, 98-102
Supplemental Reading
Chapter 5: 138-143 Chapter 6: 179-182 Chapter 7: 214-216 Chapter 8: 227-230 Chapter 9: 273-276
Question & Problem Assignments
Chapter 1: 1, 2, 10, 11, 12 Chapter 2: 6, 7, 9, 11, 12, 13, 14, 15, 16, 17 Chapter 3: 1, 2, 4, 7 Chapter 4: 1, 2, 3, 5, 8
Objectives
* Objective will definitely be on the exam.
Chapter 1: Introduction
* 1. Explain what derivatives are.
2. State the volatility of derivatives relative to the volatility of
the values of the underlying assets.
3. State the primary purpose of derivatives.
4. Define or describe the following:
a) market for real assets and services
b) price system
c) financial asset
d) money markets
e) capital markets
f) primary markets
g) secondary markets
h) spot (cash) markets
5. Describe forward contracts and futures contracts in terms of:
a) definition
b) standardization
c) exchanges
d) marking to market
e) secondary markets
f) expectation of delivery
g) availability of information
h) liquidity
6. State the recent trend in the use of financial derivatives.
7. State the potential for profit or loss in futures trading.
8. State the degree of leverage and riskiness of futures contracts.
9. Explain where the leverage comes from in futures contracts.
10. State whether futures markets create wealth or transfer wealth.
* 11. State the kind of game the futures markets are and explain the
meaning of the term.
* 12. State the primary function of futures markets.
13. State the two general classes of traders in the futures markets and
how they interact.
17. State the economic functions (advantages) of futures markets in
terms of:
a) risk management
b) price discovery
c) leverage
d) transaction costs
e) liquidity for markets
f) short selling
g) market efficiency
h) speculation opportunities
i) market completeness
18. State the correlation between risk and expected return.
19. Explain what is meant by being risk averse.
20. Discuss selling short in the futures market relative to selling
short in the stock market.
21. Discuss efficient markets in terms of reward for risk, impact of new
information, price vs. value, and the opportunity for arbitrage
profits.
22. Define arbitrage.
23. State the Law of One Price.
24. Explain how arbitrageurs promote efficient markets.
25. State whether the spot markets and futures markets are linked or
not.
26. State the city in the U.S. in which futures trading is centered.
27. State the decade in which futures trading on currencies and interest
rates began in the U.S.
28. State the decade in which futures trading on stock indexes began in
the U.S.
Chapter 2: Futures Markets
29. Explain what is meant by the following expressions (applied either
to spot or futures markets):
a) long position
b) short position
c) going short
d) going long
30. Explain what is really meant by "selling a contract" or "buying a
contact."
31. List several U.S. futures exchanges.
32. State several major functions of futures exchanges.
33. State what the following exchange acronyms stand for:
a) CBOT/CBT
b) CME
c) IMM
d) MCE
e) NYM
f) KC/KCBT
g) NYFE
34. Explain what is meant by "open outcry" in the futures pits and why
hand signals are used so much in pits.
35. State the biggest international futures exchange as measured by
number of contracts traded.
36. State what economic conditions in the early 70's led to the creation
of:
a) currency futures
b) interest rate futures
37. State the characteristic of an asset that will make it a possible
candidate for a futures contract.
38. Describe the process of creating a new futures contract, including
who proposes the contract, who approves the contract, and what
specifications are required in the description of the contract.
39. State what two things are needed for a new kind of futures contract
to succeed.
40. State the relative annual volume/open interest of financial futures
versus other futures.
41. Describe the futures exchange clearinghouse including
a) operations
b) responsibilities
c) functions
d) benefit to futures trading
* 42. Describe the nature of the margin required in futures trading,
especially in contrast to the margin required in stock trading.
43. Distinguish between initial margin and maintenance margin and
explain what a margin call is.
44. Describe how the settlement price is determined at the end of the
trading day.
* 45. Describe the process of marking to market (daily settlement).
46. State the relationship between margin and total potential losses in
trading futures.
47. Explain what is meant by daily price limits.
48. Describe delivery and cash settlement including:
a) expiration of futures contracts
b) percentage of contracts that result in actual delivery
c) what is meant by an offsetting trade (reversing trade)
d) typical delivery dates
e) whether shorts or longs control delivery and therefore the
relative control in delivery
f) what is meant by cash settlement
g) whether traders actually desiring the underlying asset usually
use futures markets or spot markets to acquire the asset
49. Describe the following types of futures traders, people, or
entities:
a) commission brokers
b) futures commission merchant (FCM)
c) locals
d) hedgers
e) speculators
f) spreaders
g) arbitrageurs
h) scalpers
i) day traders
j) position trades
k) off-floor traders
l) "Doctors from Dubuque"
50. Explain what is meant by:
a) dual trading
b) front running.
51. State what CFTC stands for.
52. State the government agency responsible for oversight of the futures
exchanges and trading.
53. State the futures industry self-regulating agency supervised by the
CFTC.
54. Explain what is meant by a corner in a market.
55. Explain why corners and squeezes have been made illegal.
56. Describe the attempt of the Hunt brothers to corner the silver
market in 1979-80.
Chapter 3: Futures Prices
57. Define the following terms:
a) spot price (cash price or current price)
b) futures price
c) spot rate
d) futures rate
e) basis
f) spread
g) expected future spot price
h) open interest
i) volume
j) nearby contract
k) distant contract
l) settlement price
58. State the limit on the open interest relative to the actual
quantities of the underlying asset existing and why this is not a
problem.
59. Describe the typical pattern in the open interest over the life of a
contract.
60. Given the quotation from the Wall Street Journal for any futures
contract, explain what each item in the quotation means.
61. Calculate the value in dollars of one tick in the price of a futures
contract.
* 62. State the value of a futures contract:
a) when written
b) during the trading day
c) after marking to market at the end of the day
63. State the relationship between spot prices and futures prices at the
expiration of the futures contract.
64. State the value of the basis at expiration of a contract.
65. Explain what is meant by convergence relative to spot and futures
prices.
66. State the transportation costs of financial futures and assets.
67. State the relative volatility of cash prices, futures prices, and
the basis.
68. Explain what is meant by the cost of carry model of futures
prices.
69. Explain what is meant by cost of carry.
70. State some storage costs.
71. State what component is frequently the major portion of the cost of
carry.
72. Explain why financing costs are included in the cost of carry even
if the cash needed to buy the underlying asset was not borrowed.
73. Explain why the cost of the underlying asset is not considered part
of the cost of carry.
74. Using the cost-of-carry model state what today's spot price should
be in terms of the future spot price under conditions of
certainty.
75. Using the cost-of-carry model state what today's spot price should
be in terms of the future spot price under conditions of
uncertainty and risk aversion.
* 76. Give the equation for the formation of futures prices based on the
cost of carry model.
77. Give a diagram relating spot price, futures price, expected future
spot price, and cost of carry, labeled thoroughly and assuming
f0 > S0 and f0 = E(ST).
78. Explain what is meant by convenience yield and how it relates to
futures prices and the cost of carry.
79. Explain what is meant by the expectations model of futures prices.
80. Give examples of nonstorable, limited storable, and indefinitely
storable assets.
81. Explain how the cost-of-carry model relates to the expectations
model, especially with regard to the storability of the underlying
asset.
82. Describe two things that can happen to the risk in the cash market
when it is redistributed into the futures market.
83. Explain why theory would indicate that there should be risk premiums
in futures prices.
* 84. State what is meant by futures prices being unbiased expectations
(predictors) of future spot prices.
85. State what is meant by futures prices being biased expectations
(predictors) of future spot prices.
86. State the conclusion of academic research on whether futures prices
are biased or unbiased.
87. State the practical attitude most people have toward futures prices
with regard to their being biased or unbiased.
88. State the correlation between the price of contracts and their
months of expiration, everything else being equal, and explain the
correlation.
89. State the speed with which futures prices assimilate new
information.
Chapter 4: Using Futures Markets
90. State three major uses of futures markets.
91. Describe the use of futures markets for price discovery.
* 92. State the economic market function of speculators in the futures
markets.
93. State why hedgers use the futures markets.
94. Describe the following:
a) short hedge
b) long hedge
c) anticipatory hedge
95. Give an equation, with a key to the symbols used, for the profit
to be made in a short hedge.
96. Explain what a short hedger (long the asset, short the futures
contract) is trying to do by setting up the hedge.
97. Use a diagram as in #77 to describe how a short hedge locks in a
profit of the cost of carry, other things being equal, for the
following situations:
a) the actual future spot price equals the expected future spot
price
b) the actual future spot price is greater than the expected
future spot price
c) the actual future spot price is less than the expected future
spot price
* 98. Given a diagram of current and future spot and futures prices,
determine:
a) the basis in the beginning
b) the basis at expiration
c) the cost of carry
d) the profit or loss in the spot (cash) market at expiration
e) the profit of loss in the futures market at expiration
f) what overall profit or loss a hedger was trying to lock in by
setting up the hedge
g) what overall profit or loss a hedger achieved at the end of the
hedge
* 99. State who should get the profit or loss beyond the cost of carry in a
hedge and explain why.
100. Give an equation, with a key to the symbols used, for the profit
to be made in a long hedge.
101. Explain what a long hedger (short the asset, long the futures
contract) is trying to do by setting up the hedge.
102. Describe the following types of risk in hedging:
a) basis risk
b) quantity risk
c) maturity risk
d) cross hedge risk
103. State the usual rule of thumb for each of the four decisions that a
hedger must make:
a) which contract to use
b) which expiration month to hold
c) whether to go long or short
d) how many contracts to use
104. State the significance of margin requirements in establishing a
hedge.
105. State and explain the significance of marking to market of futures
contracts in establishing a hedge, in terms of cash flow.
106. Distinguish between micro hedging and macro hedging.
107. Explain what is meant by hedge ratio.
108. State the goal of calculating the hedge ratio.
109. Describe the naïve equivalent-size hedge ratio method.
110. State how a hedger should establish a hedge in a given scenario,
without calculating a specific hedge ratio.
111. State whether perfect hedges ever exist.
[Unit One Study Guide in Word format]
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Last update: February 2, 2001