BFW2751 S1, 2021 Week 2 Tutorial Suggested Solutions Topic: Mechanics of Future Contracts Question 1. a) Outline the differences between a forward contract and a futures contract b) Explain how the clearinghouse operates to protect the futures market. c) Explain how margins protect investors against the possibility of default a) Differences between futures and forwards can be summarized by the following table: Buyer-seller interaction Contract specification Delivery date Settlement Closing out of contract Credit risk/counterparty risk FORWARD Private contract between 2 parties Non-standard contract Usually 1 specified delivery date Settled at end of contract By delivery or final cash settlement Some credit risk FUTURES Exchange traded Standard contract Range of delivery dates Settled daily Prior to maturity Virtually no credit risk b) The clearinghouse intervenes in each contract, guaranteeing to the buyer that the seller's losses will be covered and guaranteeing to the seller that the buyer's losses will be covered. This allows a trader to enter into a transaction without having to check the creditworthiness of the other party. In turn, to protect themselves against risk of default by futures parties, the clearinghouse requires that each trader maintain a margin account to cover losses. Daily marking to market is performed to prevent loss from accumulating. The clearinghouse also maintains a cash reserve to cover losses in the event of a failure to cover a loss by a trader or firm. c) A margin is money deposited by an investor with their broker. It acts as a guarantee that the investor can cover any losses on the futures contract. The balance in the margin account is adjusted daily to reflect gains and losses on the futures contract. If losses are above a certain level, the investor is required to deposit a further margin. This system makes it unlikely that the investor will default. A similar system of margins makes it unlikely that the investor’s broker will default on the contract it has with the clearinghouse member and unlikely that the clearinghouse member will default with the clearinghouse. Question 2. Suppose now you enter into a short position in September futures contract to sell Silver for $17.20 per ounce. The contract size is 5,000 ounces. The initial margin is $4,000, and the maintenance margin is $3,000. What change in the futures price will lead to a margin call? What happens if you do not meet the margin call? Answer: There will be a margin call when $1,000 has been lost from the margin account. This will occur when the price of silver increases by 1,000/5,000 = $0.20. The price of silver must therefore rise to $17.40 per ounce for there to be a margin call. If the margin call is not met, your broker closes out your position. Question 3. Suppose that you buy a stock index futures contract at the opening price of 452.25 on July 1. The multiplier on the contract is 500 times, so the contract value at inception is $500(452.25) = $226,125. You hold the position open until selling it on July 10 at a settlement price of $451.45.The initial margin requirement is $9000 and the maintenance margin is $6000. Assume that you deposit the initial margin and do not withdraw the excess on any given day. Complete the table below and explain any additional funds deposited Settlement Price Total Contract Value Daily Gain/ (Loss) Cumulative. Gain/Loss Margin Balance Margin Call (index Point) ($) ($) ($) ($) ($) 01-Jul 453.95 226,975 850 850 9,850 No 02-Jul 454.5 227,250 275 1,125 10,125 No 03-Jul 452 226,000 -1,250 -125 8,875 No 07-Jul 441.62 220,810 -5,190 -5,315 3,685 5,315 Day 9,000 08-Jul 455.25 227,625 6,815 1,500 15,815 No 09-Jul 452.65 226,325 -1,300 200 14,515 No 10-Jul 451.45 225,725 -600 -400 13,915 No Explanation of additional Funds deposited 1/7: Initial margin deposit of $9,000 8/7: Balance on 7/7 was $3,685 which is below $6,000 maintenance margin. Required to deposit $5,315 to replenish the margin balance to initial margin of $9,000 Therefore, on 1st July the contract value was $226,125 and the close out was $225,725 225,725 – 226,125 = -$400 Final margin balance =$13,915 – Initial Margin $9000 = $4,915 less Margin call $5,315 = -$400 Question 4. Show that, if the futures price of a commodity is higher than the spot price during the delivery period, then there is an arbitrage opportunity. Does an arbitrage opportunity exist if the futures price is less than the spot price? Explain your answer. Answer: If the futures price is greater than the spot price during the delivery period, an arbitrageur buys the asset, shorts a futures contract, and makes delivery for an immediate profit. If the futures price is less than the spot price during the delivery period, there is no similar perfect arbitrage strategy. An arbitrageur can take a long futures position but cannot force immediate delivery of the asset. The decision on when delivery will be made is made by the party with the short position. Nevertheless companies interested in acquiring the asset may find it attractive to enter into a long futures contract and wait for delivery to be made. Question 5. A trader enters into a short cotton futures contract when the futures price is 50 cents per pound. The contract is for the delivery of 50,000 pounds. How much does the trader gain or lose if the cotton price at the end of the contract is (a) 48.20 cents per pound; (b) 51.30 cent s per pound? Answer: (a) The trader sells for 50 cents per pound and buys back the same for 48.20 cents per pound. Gain ($0.5000 - $0.4820) x 50 000 = $900 (b) The trader sells for 50 cents per pound and buys back the same for 51.30 cents per pound. Loss ($0.5000 - $0.5130) x 50 000 = ($650) Question 6. Explain carefully the difference between hedging, speculation, and arbitrage. Answer: A trader is hedging when he/she has an exposure to the price of an asset and takes a position in a derivative to offset the exposure. In a speculation, the trader has no exposure to offset. He / She is betting on the future movements in the price of the underlying asset. Arbitrage involves taking a position in two or more different markets to lock in a guaranteed profit. Question 7 Explain why a futures contract can be used for either speculation or hedging. Answer: If an investor has an exposure to the price of an asset, he or she can hedge with futures contracts. 1) If the investor will buy the asset, he will gain when the price decreases and lose when the price increases; a long futures position will hedge the risk. 2) If the investor will sell the asset, he will lose when the price decreases and gain when the price increase; a short position will hedge the risk If the investor has no exposure to the price of the underlying asset, entering into a futures contract is speculation. 1) If the investor takes a long position, he or she gains when the asset’s price increases and loses when it decreases. 2) If the investor takes a short position, he or she loses when the asset’s price increases and gains when it decreases. Question 8 Explain how margins protect investors against the possibility of default. Answer: A margin is a sum of money deposited by an investor with his or her broker. It acts as a collateral/guarantee that the investor can cover any losses on the futures contract. The balance in the margin account is adjusted daily to reflect gains and losses on the futures contract. If losses are above a certain level, the investor is required to deposit a further margin. This system makes it unlikely that the investor will default. [END OF TUTORIAL WEEK 2]