MBA Forwards Futures Short Question Model Paper

MBA Forwards Futures Short Question Model Paper

Forwards and futures: forward contract, Features of forward contracts, Futures contract, Types ,Functions, Distinction between futures and forward, Pricing of futures contract, currency futures, Hedging in of futures, Cost of carry model, Application of market index, Index futures in the stick market, Indian derivatives market.

Section B

SHORT ANSWER QUESTIONS

Q.1. What is futures contract?

Ans. Futures Contract: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price, Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. Unlike forward contracts, the counterparty to a futures contract is the clearing corporation on the appropriate exchange. Futures often are settled in cash or cash equivalents, rather than requiring physical delivery of the underlying asset. Parties to a futures contract may buy or write options on futures.

Future contracts, while similar to forward contracts, have certain features that make them different from forward contracts and make them more useful for risk management These include being able to extinguish contract obligations through offsetting, rather than actual delivery of the commodity. In fact few future contracts are ever delivered upon.

Future contracts are traded on organized exchanges in a variety of commodities (including grains, livestock, bonds and currencies). They are traded by open outcry where traders and brokers shout bids and offers from a trading pit at designated times and places. This allows producers, users and processors to establish prices before commodities are traded. Futures prices are forecasts that can and do change according to a variety of reasons, such as crop or weather reports.

Q.2. What are the types of futures contract?

Ans. Futures contract are of mainly two types:

1. Financial Futures: Financial futures are the futures contract to buy or sell a specific financial instrument at a specific future date and at a specified price. There are different types of financial futures which are traded in the various future financial markets of the world. These contracts can be classified into various categories which are as under:

(a) Stock Index Futures: Stock-index futures offer the investor a medium for expressing an opinion on the general course of the market.

(b) Currency Futures: A futures contract is a standardized contract, traded on an exchange, to buy or sell a certain underlying asset or an instrument at a certain date in the future, at a specified price. When the underlying asset is a commodity, e.g., oil or wheat, the contract is termed a ‘commodity futures contract. When underlying an exchange rate, the contract is termed a ‘currency futures contract’.

(C) Interest Rate Futures: An interest rate future contract is an agreement between two parties to buy or sell a fixed income security such as treasury bill or a treasury bond at a given time in the future for a predetermined price.

(d) Stock Futures: Stock futures are agreements to buy or sell a specified stock, i.e. the equity share of a specified company, in the future at a specified price.

2. Commodity Futures: Commodity futures contract involves obligations of both parties to perform in the future – the buyer (long) to purchase the asset underlying the future and the seller (short) to deliver the asset. Thus, both the buyer and the seller of a futures contract must initially post and maintain, on a daily basis, margin to assure contract performance and the integrity of the marketplace. In other words, futures contract is the agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. It is normally traded in the exchange. Forward contracts are bilateral contracts to manage price risk and quantity risk to certain extent and would act as a boost for futures markets.

The agreement will commit the buyer and the seller to a fixed price that will be in effect on a specified future date. When this future date arrives, the buyer is expected to have paid the agreed upon price for the futures and the seller will have delivered ownership of the commodities to the buyer. Commodity futures are based on physical commodities that include items such as gold, silver, other precious metals and grains. Various types of food items, such as corn or pork bellies, are also considered to be commodities. Commodity futures are based on the perceived worth of the goods today and at some future point in time.

 Q.3. What are the functions of futures market?

Ans. The functions of futures market are as follows:

1. Reduction of Risk: Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced because the price is preset, therefore letting participants know how much they will need to buy or sell. This helps to reduce the ultimate cost to the retail buyer because with less risk, there is lesser chance of manufacturers jacking up prices to make up for profit losses in the cash market.
2. Discovery of Prices: Due to its highly competitive nature, the futures market has become an important economic tool to determine prices, based on today’s and tomorrow’s estimated amount of supply and demand. Futures market prices depend on a continuous flow of information from around the world and thus require a high amount of transparency. Factors such as weather, war, debt default, refugee displacement, land reclamation and deforestation can all have a major effect on supply and demand and hence upon the present and future prices of a commodity. This kind of information and the way people absorb it constantly changes the price of a commodity. This process is known as price discovery
3. High Leverage: The primary attraction, of course, is the potential for large profits in a short period of time. The reason that futures trading can be so profitable is the high leverage. To ‘own’ a futures contract, an investor only has to put up a small fraction of the value of contract (usually around 10-20%) as ‘margin’ In other words, the investor can trade a much larger amount of the security than if he bought it outright, so if he has predicted the market movement correctly, his profits will be multiplied (ten-fold on a 10% deposit).
4. Lower Transaction Cost: Another advantage of futures trading is much lower relative

Finn commissions. The commission for trading a futures contract is one-tenth of a per cent (0.10-0.20%). Commissions on individual stocks are typically as much as one per cent for both buying and selling.

5. Profit in Both Bull and Bear Markets: In futures trading, it is as easy to sell (also referred to as going short) as it is to buy (also referred to as going long). By choosing correctly, investor can make money whether prices go up or down. Therefore, trading in the futures markets offers the opportunity to profit from any potential economic scenario.
6. High Liquidity: Most futures markets are very liquid, i.e. there are huge amounts of contracts traded everyday. This ensures that market orders can be placed very quickly as there are always buyers and sellers for most contracts.

Q.4. Give the features of a futures contract.

Ans. The features of futures contract are:

1. Association with Clearing House: Futures are associated with a clearing house to ensure smooth functioning of the market. Future exchanges have clearing house arrangements to guarantee the fulfillment of contract obligations,
2. Margin Requirements and Daily Settlement: Futures are margin requirements and daily settlement to act as further safeguard. Future positions can be closed easily.
3. Involvement of Regulatory Authority: Futures provide for supervision and monitoring of contract by a regulatory authority.
4. Cash Settlement: Almost ninety per cent future contracts are settled via cash settlement instead of actual delivery of underlying

asset.

5. Trading on Organized Exchange: Futures are traded on up and a short futures position

an organized exchange like IMM, LIFFE, NSE, BSE, CBOT, etc.

6. Standardized Contract: Futures involve standardized profits when the future price contract terms viz., the underlying asset, the time of maturity and the manner of maturity, etc.

Q.5. Distinguish between futures and forwards.

Ans.                                        Difference between futures and Forwards

Sino	Basis of difference	Futures	Forwards
1.	Size of contracts	Standardized in each futures market.	Decided between buyer and seller.
2.	Trading	Traded in a competitive arena (recognized exchange).	Traded by telephones of telex (OTC).
3.	Mark to market	Matched to market everyday.	Not done.
4.	Price of contract	Changes everyday.	Remains fixed till maturity.
5.	Hedging	Hedging is by nearest month and quantity contracts. So, it is not perfect.	These are tailor-made for specific date and quantity: So, it is perfect.
6.	Counter party	Not present.	Present.
7.	Margin	Margins are to be paid by both buyers and sellers.	No margin required.
8.	Frequency of delivery	Very few futures contracts are settled by actual delivery.	90% of all forward cpmtract are settled but actual delivery.
9.	Liquidity	Highly liquid.	No liquidity.
10.	Mode of delivery	Standardized. Most of the contracts are cash settled.	Specifically decided. Most of the contracts result in delivery.
11.	Transaction	Include brokerage fees for buy and sell orders.	Costs are based on bid-ask spread.
12.	Nature of market	Exchange traded.	Over the counter.

Q.6. Write a brief note on financial future contracts.

Ans. Financial Future Contracts: A financial futures contract is a standardized agreement to deliver or receive a specified amount of a specified financial instrument at a specified price and date. The buyer of a financial futures contract buys the financial instrument, while the seller of a financial futures contract delivers the instrument for the specified price. Financial futures contracts are traded on organized exchanges, which establish and enforce rules for such trading. Futures exchanges provide an organized marketplace where futures contracts can be traded. They clear, settle and guarantee all transactions that occur on their exchanges.

Financial futures are extremely diverse and each kind of financial future have their own trading characteristics and behavior. Financial futures are usually cash settled futures without any physical delivery upon maturity. This means that upon expiration, the long and short settles their wins and losses in cash without the need to actually trade the underlying. However, with the exception of index lather kinds of financial futures has offered physically settled versions. Index futures can never be physically settled due to the fact that an index is simply a number and not made up of any physical assets.

Financial futures generally display an inverted market term structure due to the fact that financial futures such as index futures have only the foregone interest rate on cash as opportunity cost without any of the complicated storage and ownership cost of commodity futures. This makes it hard to produce a roll yield when rolling forward a financial futures position. However, single stock futures do sometimes display normal market characteristics.

Q.7. What are the features of financial future contract?

Ans. The features of financial future contract are:

1. Financial futures are extremely diverse and each kind of financial futures have their own trading characteristics and behavior.
2. Every contract that is traded has a short and long position.
3. A futures contract is a type of derivative instrument.
4. Two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price.
5. Financial futures generally display an inverted market term structure due to the fact that financial futures such as index futures have only the foregone interest rate on cash as opportunity cost without any of the complicated storage and ownership cost of commodity futures.
6. Financial futures are usually cash settled futures without any physical delivery upon maturity.

Q.8. What are the features of currency futures?

Ans. The features of currency futures are as follows:

1. Standardization: In the case of forward currency contract, the amount of currency to be delivered and expiry date are negotiated between the buyer and the seller and can be tailor-made to suit the requirements of either party. In a futures contract, both these are standardized by an exchange on which the contract is traded.
2. Clearinghouse: On the trading floor, a futures contract is agreed between two parties A and When it is recorded by the ex It is recorded by the exchange, the contract between A and B is immediately replaced by tusk there between B and the clearinghouse. This contracts, one between A and the clearinghouse and another between processes is called notation. Thus the clearinghouse interposes itself in every deal, being buyer to seller and seller to every buyer. Further, the clearinghouse guarantees pel buse guarantees performance. This eliminates the need for A and B to investigate each other’s credit worthiness and ensures the financial integrity of the market.
3. Organized Exchanges: Unlike forward contracts which are traded in the OTC market, futures! are traded on organized exchanges, either with a designated physical location where trading takes place, i.e. the trading pit, or via computer screens. This provides a ready, liquid market in which futures can be bought and sold at any time during trading hours as in a stock market.
4. Marking to Market: This essentially means that, at the end of a trading session, all outstanding contracts are re-priced at the settlement price of that session. Margin accounts of those who made losses are debited and of those who gained are credited. At this stage, there is an important difference that marking to market creates between forwards and futures. In a forward contract, gains or losses arise only on maturity. There are no intermediate cash flows. In a futures contract, even though the overall gain/loss is the same, the time profile of its accrual is different. The total gain or loss over the entire period is broken up into a daily series of gains and losses that clearly has different present value.
5. Actual Delivery: In most, if not all forward contracts, the exchange of currencies actually takes place. Forward contracts are usually entered into to acquire or dispose off a currency at a future date but at a price known today. In contract, in most futures markets, actual delivery takes place in less than one per cent of the contracts traded.
6. Pay-off Profile: If one holds a long position in forwards or futures and the underlying currency value goes up (or down), a gain (or loss) will be realized. Thus, the pay-off is symmetrical. It has unlimited profit as well as unlimited loss potential. If one wants unlimited profit potential and at the same time limited downside, then options provide that alternative.
7. Margins: Only members of an exchange can trade in futures contracts on the exchange. The other participants, i.e. non-members use the member’s services as brokers to trade on their behalf (of course, an exchange member firm can also trade on its own account). A subset of exchange members is the clearing member, i.e., members of the clearinghouse when the clearinghouse is a subsidiary of the exchange. A non-clearinghouse member must clear all transactions through a clearing member for a fee.

Q.9. How pricing of currency futures is done?

Ans. Pricing of Currency Futures: In a currency futures contract, one enters into a contract to buy a foreign currency at a price fixed today. To explain the issue of pricing of currency futures, let us take an example of an Indian investor (Mr. A) who wishes to invest a certain amount for one year Mr. A could invest in a one year risk-free security issued by the Government of India. Alternatively, Mr. A could buy US dollars with home currency and use the US dollars to buy a one year risk-free US security. Further, the investor could short sell the requisite number of one-year US dollar futures contracts. With such an arrangement, the investor would know exactly how much INR Mr. A would receive a year later. In other words, there is no risk associated with the investments, as both the investments are risk-free and the investor knows exactly what amount in home currency the investments will yield after one year.

The strategy of investing INR 1 in a risk-free Indian security that has a return of Rah will provide a cash inflow of INR 1 (1 + Rh) after one year. Similarly, the strategy of investing INR 1 in a risk-free US security has a return of Rf. The current spot rate is So and the futures price is Fr. Thus, the investment of INR 1 in the risk-free US security will provide an INR cash inflow of (INR 1/S2)(1 + Rp) after one year. Since the two strategies cost the same (i.e. INR 1), their payoffs must be equal.

Therefore, the futures price of the US dollar can be determined in terms of the interest rate parity equation as:

 where, Ft = Futures contract price at time point t.

Rr = Interest rate in the country of the foreign currency.

Rn = Interest rate in the home country.

So = Current spot rate of foreign exchange.

The futures contract price is a function of the spot exchange rate and the cost of carrying the underlying currency. The cost of holding one currency rather than another is an opportunity cost measured by differences in the interest rates prevailing in the two currencies.

 For example, if the current spot rate is USD/INR 72 and the Indian and US one year risk-free rates are 8 per cent and 6 per cent respectively, then the one-year futures price of the US dollar will be:

Q.10. What is hedging with currency futures?

Ans. Hedging with Currency Futures: Foreign exchange risk can pose a significant risk for any business or individual that transacts in more than one currency. When a firm’s revenue is denominated in a foreign currency, exchange risk exists. Other times, an individual may own assets denominated in a foreign currency, but does not wish to be exposed to fluctuation in the exchange rate. An appropriate hedging strategy can help firms and individuals to manage these types of risks.

A hedging strategy aims to minimise exposure to currency fluctuations and provide stability to future earnings and expected cash flows. The objective of a proper hedge is to eliminate the uncertainty of futures transactions denominated in a foreign currency, not to maximize profits from currency speculation. A successful hedge will therefore not produce excess returns, but will protect the hedger against losses resulting from unfavorable exchange rate fluctuations.

Q.11. What do you understand by speculation with currency futures?

Ans. Speculation with Currency Futures: Hedgers use the currency futures market to hedge the risk that they face on account of their dealings in foreign currencies. Speculators, on the other hand, are not exposed to any such risk. The constant fluctuations in the exchange rates of foreign currencies provide an opportunity for making profit. The speculators enter the currency futures market to exploit the exchange rate fluctuations in the market for making short-term gains. In contrast to the hedgers who try to reduce or eliminate risk through hedging, speculators assume risk to make profits. The activities of speculators add volumes of the trading in the currency futures market.

Speculators may adopt different techniques for speculating. Position trading, spreading and arbitrage are the commonly used techniques of speculation.

unlike hearers who use futures markets to offset risks from positions in the spot market, speculate wade in future to profit from price movements. They hold view about future price movements which are at variance with the market sentiments as reflected in futures prices and want to profit from the discrepancy. They are willing to accept the risk that prices may move against them resulting in a loss.

Speculation using futures can be classified into open position trading and spread trading. In the former, the speculator is betting on movements in the price of a particular futures contract while in the latter he or she is betting on movements in the price differential between two futures contract.

Q.12. Write a short note on arbitrage with currency futures.

Ans. Arbitrage with Currency Futures: Buying in one market (like spot market) and simultaneously selling in another market (like futures market) to make risk free profits when there is substantial mismatch between two prices is called arbitrage. Arbitrage is described as risk free because participants are not speculating on market movements. Instead, they bet on the mispricing of a share/ asset that has happened between the related markets.

The futures price has a definite relationship with the spot price. In normal market conditions, futures price would be greater than the spot price because of the effect of cost of carry and it moves in tandem with the price of the underlying asset. So, broadly it can be said that if the spot price of the share moves up by 5, the futures position would also have made a profit of 5. The correlation is not very accurate but, almost so.

Q 13. What are the types of financial futures contract? Discuss about currency futures market.

Ans. Types of Financial Futures Contract: Financial futures contract can be divided into four parts which are as follows:

1. Currency Futures Market,
2. Interest Rate Futures,
3. Stock Index Futures,
4. Stock Futures.

 Currency Futures Market

Currency futures market means the market in which currency futures are traded. Currency futures means a standardized foreign exchange derivative contract traded on a recognized Stock Exchange to buy or sell one currency against another on a specified future date, at a price specified on the date of contract, but does not include a forward contract.

In other words, it is an agreement between two parties to exchange one currency for another, with the actual exchange taking place at a specified date in future but with the exchange rate being fixed at the time the agreement is entered into. However, there are a number of significant differences between forwards and futures. These relate to contractual features, the way the markets are organized, profiles of gains and losses, kinds of participants in the markets and the way in which they use the two instruments,

Q.14. What is hedge ratio?

Ans. Hedge Ratio: Hedge Ratio is the ratio of the size of the position taken in futures contract to the size of the exposure. In the market, it is not very often that the cash and future prices move in the same ratio. The price behavior of the futures contract tends to differ from that of the underlying instrument Hedge ratios become useful since they indicate the extent of variation in the futures price relative to the variation in the spot price. If the security to be hedged shows relatively large variations, then it is appropriate to take more futures contracts than in the case of a more stable instrument.

While hedging a portfolio of securities, the entire portfolio might not have the same composition as that of the index to which it is related. The index could vary more or less than the portfolio. Thus, in such circumstances, it is essential to compute the hedge ratio to know the extent of hedge that an investor should enter into.

 Components of Hedge Ratio

As with options, a futures hedge ratio indicates the number of contracts needed to mimic the behavior of the portfolio. The hedge ratio has two components.

1. First is a scale factor, which deals with the dollar value of the portfolio relative to the dollar value of the futures contract. The larger the portfolio, the more futures contracts will be necessary.
2. The second component of the hedge ratio comes from the level of systematic risk of the stock portfolio. Futures contracts have a beta of 1.0, whereas the stock portfolio can have a beta much higher or lower than this. If the stock portfolio has a beta greater than 1.0, it changes in value faster than the futures contract and more contracts are necessary to offset these changes. A beta less than 1.0 means that the hedge requires fewer contracts.

 Q.15. What are the advantages of future trading?

Ans. Future trading has the following advantages:

1. Such trading occurs in very large amounts and attract world wide participation,
2. Many future markets offer an equal opportunity for traders.
3. Liquid markets enable traders to quickly transact their business at a fair price.
4. Commission charges are less as compared with other types of investments.
5. There is a large variety of trading opportunities in the global futures market.
6. Financial leverage is an important benefit offered by the futures market.

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