Forward Contracts vs Futures Contracts Quiz

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Questions and Answers

In accounting for futures contracts, how are profits recognized?

Profits are recognized daily (correct)

Profits are recognized at the end of the contract

Profits are recognized immediately upon entering the contract

Profits are recognized only upon delivery or final cash settlement

What is a key difference between forward and futures contracts?

Forwards are standardized contracts, while futures are private contracts

Futures contracts involve credit risk, while forwards have virtually no credit risk (correct)

Futures contracts usually have a range of delivery dates, while forwards have one specified delivery date

Forwards are settled at the end of the contract, while futures are settled daily

How are foreign exchange quotes typically presented for GBP, EUR, AUD, and NZD in futures exchange rates?

As USD per unit of foreign currency

As units of the foreign currency per USD

As the number of USD per unit of the foreign currency (correct)

As units of the foreign currency per GBP

When comparing forward and futures contracts, which statement is accurate?

Forward contracts involve credit risk, while futures have virtually no credit risk Signup and view all the answers

How are profits recognized in hedging using futures for speculation purposes?

Profits are recognized immediately upon entering the contract Signup and view all the answers

In the context of futures trading, what is the purpose of bringing the margin account balance up to the initial margin?

To avoid defaulting on the contract Signup and view all the answers

What are daily margin cash flows referred to as in futures trading?

Variation margin Signup and view all the answers

What is the cumulative gain after Day 6 in the given futures trade example?

-$2,760 Signup and view all the answers

What is the significance of a margin call in futures trading?

To request additional funds from the investor Signup and view all the answers

How do futures contracts differ from forward contracts?

Futures contracts have standardized terms and are traded on exchanges Signup and view all the answers

What impact does a decrease in the daily trade price have on the margin balance in futures trading?

Reduces the margin balance Signup and view all the answers

Which of the following is true about open interest?

It equals the number of long positions or short positions in contracts outstanding. Signup and view all the answers

What does closing out a futures position typically involve?

Offsetting the trade by entering another trade. Signup and view all the answers

In futures contracts, when are most contracts closed out?

Before the contract reaches maturity. Signup and view all the answers

What does 'open interest' measure in futures contracts?

The total number of active positions in the market. Signup and view all the answers

Which statement is true about settlement price in futures contracts?

It is the price just before the final bell each day for daily settlements. Signup and view all the answers

In futures trading, what does 'volume of trading' refer to?

The number of trades made in one day. Signup and view all the answers

In a long hedge for the purchase of an asset, what does the term F1 represent?

Futures price at the time the hedge is set up Signup and view all the answers

What formula would you use to calculate the net amount paid in a long hedge for the purchase of an asset?

S2 − (F2 − F1) Signup and view all the answers

When setting up a short hedge for the sale of an asset, what does the term S2 represent?

Asset price at the time of sale Signup and view all the answers

Which formula would you use to calculate the net amount received in a short hedge for the sale of an asset?

S2 + (F1 - F2) Signup and view all the answers

In a futures trading scenario, what does 'basis' typically refer to?

Difference between spot and future prices Signup and view all the answers

When using futures contracts for hedging, what is the primary purpose of closing out a position?

Exiting the hedging strategy Signup and view all the answers

What is a common danger in hedging situations, as mentioned in the text?

Realizing losses on the hedge while the gains on the underlying exposure are unrealized Signup and view all the answers

What did Metallgesellschaft do as part of its hedging strategy involving long-term fixed-price contracts on heating oil and gasoline?

Hedged using stack and roll strategy with futures contracts Signup and view all the answers

What does 'stack and roll' strategy involve in the context of futures contracts hedging?

Rolling futures contracts forward to hedge future exposures Signup and view all the answers

What is a potential issue that can arise if losses are realized on the hedge while gains on the underlying exposure are unrealized?

Liquidity problems due to realized losses Signup and view all the answers

What is a key aspect of rolling futures contracts forward in a hedging strategy?

Replacing contracts just before maturity with new ones reflecting new exposure Signup and view all the answers

What type of hedge is appropriate when you know you will sell an asset in the future and want to lock in the price because you expect the price to fall?

Short futures hedge Signup and view all the answers

In the context of hedging, what is the primary aim of futures market transactions?

Mitigating risk by reducing it Signup and view all the answers

If a copper fabricator requires 100,000 pounds of copper on May 15 and decides to lock in the price at 320 cents per pound with futures contracts, how many futures contracts should they go long on based on the given information?

4 future contracts Signup and view all the answers

What is the main reason for using a long futures hedge?

Locking in the price for a purchase expected in the future Signup and view all the answers

Why are perfect hedges considered rare in futures trading?

Due to the unpredictability of market prices Signup and view all the answers

When should a short futures hedge be used?

When anticipating a decrease in asset prices Signup and view all the answers

Study Notes

Futures Contracts and Profit Recognition

Profits in futures contracts are recognized daily through the marking to market process, which adjusts the margin account based on daily price fluctuations.
Forward contracts are customized agreements traded over-the-counter, whereas futures contracts are standardized and traded on exchanges.

Foreign Exchange Quotes

GBP, EUR, AUD, and NZD foreign exchange quotes in futures are typically presented in relation to a base currency, reflecting the market's valuation of these currencies against it.

Characteristics of Forward and Futures Contracts

A key statement highlights that futures contracts have daily settlement and margin requirements, unlike forward contracts which settle at contract maturity.
In speculative hedging using futures, profits are recognized as gains from favorable price movements in the underlying asset.

Margin Accounts in Futures Trading

Margin accounts are adjusted to maintain a balance at the initial margin level to ensure sufficient collateral for potential losses.
Daily margin cash flows are commonly referred to as "variation margin."

Open Interest and Position Closing

Open interest measures the total number of outstanding futures contracts, indicating the market's liquidity and trader interest.
Closing out a futures position typically involves executing an offsetting trade to eliminate exposure.

Settlement Prices and Trading Activity

The settlement price in futures contracts is the final price used to calculate profits and losses at the end of the trading session.
The volume of trading refers to the total number of contracts traded during a specific period, indicating market activity.

Hedging Strategies

In a long hedge for asset purchase, F1 represents the futures price at the time the position is taken.
The net amount paid in a long hedge is calculated by factoring in the futures price and the quantity of the asset.

Short Hedge Dynamics

In a short hedge for asset sale, S2 denotes the futures price when initiating the hedge.
The net amount received from a short hedge is computed by subtracting the futures price from the expected sale price.

Basis and Position Management

'Basis' in futures trading refers to the difference between the spot price of an asset and the futures price.
The primary purpose of closing a hedged position is to lock in profits or limit losses based on market fluctuations.

Risks in Hedging

A common danger in hedging is the potential for realized losses on the hedge while the underlying exposure remains unrealized.
Metallgesellschaft's strategy included long-term fixed-price contracts combined with futures to hedge against price volatility.

Rolling Futures Contracts

The 'stack and roll' strategy involves rolling over expiring futures contracts to maintain exposure without interruption in hedging.
Key considerations in rolling forwards include potential financial exposure and ensuring continued market alignment.

Copper Futures Example

If a fabricator needs 100,000 pounds of copper and locks in a price at 320 cents per pound, the number of futures contracts required depends on contract specifications (e.g., contract size).

Hedging Purpose and Execution

The primary aim of futures market transactions in hedging is risk management and price stabilization for future financial commitments.
Long futures hedges are employed to protect against price increases, while short futures hedges are used to guard against price decreases.

Hedging Effectiveness

Perfect hedges are rare due to market uncertainties and pricing discrepancies.
A short futures hedge should be utilized when there is a known future sell date and a desire to secure a selling price against anticipated declines.

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Description

Test your knowledge on the differences between forward contracts and futures contracts based on Table 2.3 from John C. Hull's 'Options, Futures, and Other Derivatives' book. Explore key distinctions such as private vs exchange-traded, standard vs non-standard contracts, settlement methods, credit risks, and more.