Finance: Hedging and Arbitrage

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Questions and Answers

What does open interest indicate regarding a market?

The total number of buying orders made in a given trading day.

The number of contracts that will be delivered on the maturity date.

The total number of contracts traded during a single day.

The market's willingness to hold positions and long-term commitment. (correct)

Which of the following best describes market depth?

The total volume of orders placed in a particular trading day.

The time required to execute a trade at a specific price.

The speed at which prices return to former levels after a large transaction.

The size of the order book above and below the latest trade price. (correct)

A large market order, placed with thin market depth, can lead to which phenomenon?

Reduced transaction costs.

Price slippage. (correct)

Increased market immediacy.

Increased market resilience.

How does immediacy, as a measure of liquidity, differ from resilience?

Immediacy refers to the time needed to trade at a set price, and resilience is measured over a period of time. Signup and view all the answers

What does a higher open interest and volume generally indicate about a market?

Increased market liquidity. Signup and view all the answers

What is the primary goal of a hedger using derivatives?

To protect an existing or anticipated position against adverse price movements. Signup and view all the answers

Which of the following best describes a 'perfect hedge'?

A position that eliminates all risk exposure. Signup and view all the answers

A fund manager uses futures to offset potential losses in their share portfolio. This strategy is an example of:

Hedging Signup and view all the answers

What is the primary objective of an arbitrageur?

To exploit price discrepancies between two markets to earn a risk-free profit. Signup and view all the answers

Why do arbitrage opportunities tend to be short-lived?

Because arbitrage activity itself brings prices back into alignment. Signup and view all the answers

Which scenario best describes 'intertemporal arbitrage'?

Profiting from price differences between contracts with different delivery dates Signup and view all the answers

What distinguishes geographic arbitrage from other types of arbitrage?

It involves exploiting price differences of the same contract on different exchanges. Signup and view all the answers

An arbitrageur simultaneously buys crude oil and sells refined products, taking advantage of a pricing anomaly. This is an example of:

Value-Chain Arbitrage Signup and view all the answers

What is the maximum potential loss for a buyer of a futures contract?

The pre-agreed futures price. Signup and view all the answers

When does a seller of a futures contract make a profit?

When the underlying asset's price decreases below the pre-agreed level. Signup and view all the answers

What is the maximum theoretical reward for a seller of a futures contract?

The pre-agreed futures price. Signup and view all the answers

What happens to the profit of a futures contract buyer if the price of the underlying asset at expiry is higher than the pre-agreed futures price?

The profit increases. Signup and view all the answers

What is the risk to the seller of a futures contract when the price of the underlying asset rises above the pre-agreed price at expiry?

The risk is, theoretically, unlimited. Signup and view all the answers

If the pre-agreed price of a futures contract is £115, and the underlying asset has a zero price at expiry, what is the loss for the buyer?

A loss of £115. Signup and view all the answers

In the context of futures contracts, what does 'underlying asset' refer to?

The asset that will be sold or bought at a future date. Signup and view all the answers

What does it mean when a futures contract is described as a 'mirror image' of the other side of the transaction?

The profit of one side corresponds to the loss of the other side. Signup and view all the answers

What is a key reason why CFDs and spread betting are prohibited in some major economies?

The leveraged nature poses a risk of significant financial loss for retail investors. Signup and view all the answers

Which of these best describes an 'up bet' in spread betting?

A bet placed with the expectation of a price increase. Signup and view all the answers

In the provided spread betting scenario, what is the value of the investor's gain when the FTSE 100 rises?

£1,000 Signup and view all the answers

What is the tax implication of the gain made from the spread betting example?

The gain is not subject to any tax. Signup and view all the answers

What does 'cashing in' a profitable spread bet position involve?

Placing a down bet to close out the up bet. Signup and view all the answers

What is the main difference between an 'up bet' and a 'down bet'?

An 'up bet' profits from price increases and 'down bet' profits from price decreases. Signup and view all the answers

What type of contract is the 'three-month short sterling future' frequently used in spread betting?

A short-term interest rate (STIR) contract. Signup and view all the answers

If a spread betting firm quotes 7250/7275 for three months into the future, at which price would an investor place an 'up bet'?

7275 Signup and view all the answers

What is a key difference between exchange-traded and OTC derivatives in terms of standardization?

Exchange-traded derivatives are standardized, while OTC derivatives allow for more customization. Signup and view all the answers

Why might an entity choose to use an OTC derivative instead of an exchange-traded derivative for hedging?

To perfectly match the underlying exposure. Signup and view all the answers

Which entity acts as the counterparty in exchange-traded contracts?

The clearing house (CCP). Signup and view all the answers

What is a key difference in counterparty risk between exchange-traded and over-the-counter (OTC) contracts?

Exchange-traded contracts have relatively small counterparty risk due to the CCP. Signup and view all the answers

What is a primary limitation of using exchange-traded derivatives for hedging?

They may not precisely match the underlying exposure, due to standardization. Signup and view all the answers

In the context of financial derivatives, what does 'notional principal amount' refer to?

The reference amount on which cash flows are calculated, such as in swaps. Signup and view all the answers

How does regulation typically differ between exchange-traded and OTC products?

Exchange-traded products have reasonable regulation, while OTC products historically had light regulation. Signup and view all the answers

How does the availability of speculation for exchange-traded products compare to OTC derivatives?

Speculation is more limited in exchange trade products. Signup and view all the answers

What is a characteristic of the trading activity and price information on exchanges?

It is published on a real-time basis, with participant identification kept confidential. Signup and view all the answers

What is a fundamental characteristic of a swap contract?

It involves an exchange of cash flows or liabilities, based on a notional amount. Signup and view all the answers

What is a particular feature regarding the publication of trading activity on OTC markets?

There is little or no real-time publication of trading activity. Signup and view all the answers

According to the provided text, what is an important risk associated with OTC derivatives?

Counterparty risk and limited liquidity Signup and view all the answers

What has the implementation of legislation such as the Dodd-Frank Act in the US impacted, with respect to OTC products?

It has led to changes in regulation of OTC products. Signup and view all the answers

Which of the following is true about trades for OTC products?

They can be opened and closed with different members. Signup and view all the answers

What is a key feature of EMIR (European Market Infrastructure Regulation) reporting?

It requires real-time reporting of OTC transactions. Signup and view all the answers

What is a consequence of the lack of real-time publication of trading activity in OTC markets?

Increased confidentiality, but a lack of information on the competitiveness of quoted prices. Signup and view all the answers

Study Notes

Hedging

Participants use derivatives to protect themselves against adverse price movements.
Hedging involves taking an opposite position in the futures market to protect a current or anticipated position in the underlying market.
A perfect hedge eliminates risk.
Fund managers use hedging to temporarily reduce exposure to market events, like stock market falls.
The effectiveness of a hedge depends on the correlation between the portfolio and the hedging instrument (basis).

Arbitrage

Arbitrageurs exploit price differences in different markets for the same asset.
Arbitrage involves buying low and selling high in different markets.
Arbitrage is a risk-free profit as prices will eventually converge.
"Mispricing" implies that prices will revert to their proper value.
Common forms of arbitrage include intertemporal (different maturities), geographic (different exchanges), and value-chain (different stages of production).

Futures Contracts (Buyer)

The buyer's maximum risk is the pre-agreed price for a contract if the underlying assets value becomes zero at expiry.
The profit potential is theoretically unlimited, increasing with the price of the underlying asset at expiry.

Futures Contracts (Seller)

The seller's maximum risk is theoretically unlimited as prices rise above the agreed price.
The reward is limited to the pre-agreed price as the underlying value falls below the pre-agreed amount.

Spread Betting

Spread betting allows investors to bet on the direction of market movements.
Investors using spread betting make a profit from the difference between buy and sell prices, for example, if the FTSE 100 Index rises.
This profit is not generally subject to capital gains tax.
Spread betting can be used to bet on market decreases.

Options Contracts

Options contracts give the buyer the right (but not the obligation) to buy or sell an underlying asset at a specified price (strike price) on or before a specific date.
Options can be on cash assets or derivatives.
Types include American, European, Asian, and exotic.

Open Interest and Liquidity

Open interest is the total number of outstanding long and short positions in a market.
High open interest and volume suggest greater market liquidity and commitment.
Other aspects of liquidity include immediacy, market depth, and resilience.
Market depth measures order book size above or below the latest trade, showing how large orders can be filled without affecting the price.
Resilience measures the speed that prices return to normal after significant transactions.

Exchange-Traded vs. OTC Derivatives

Exchange-traded derivatives use a clearing house (CCP) as the counterparty, reducing counterparty risk.
OTC derivatives rely on the creditworthiness of the counterparties.
Exchange-traded contracts tend to have more regulated trading activity and publicly published trading details.
OTC derivatives allow for more customised contracts to precisely hedge portfolios.
However, OTC contracts may have limited liquidity and counterparty risk.

Swaps

Swaps are OTC derivatives contracts where parties exchange cash flows (or liabilities) from different financial instruments.
These are typically related to a principal amount.
Swaps have varying terms and conditions.

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Description

This quiz explores the concepts of hedging and arbitrage in financial markets. Participants will learn how derivatives protect against price movements and discover how arbitrageurs take advantage of price discrepancies. Test your understanding of these crucial financial strategies.