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Questions and Answers
What distinguishes a futures contract from a regular forward contract?
What distinguishes a futures contract from a regular forward contract?
Which of the following is NOT a characteristic of futures contracts?
Which of the following is NOT a characteristic of futures contracts?
Which exchange is recognized as the largest futures market in North America?
Which exchange is recognized as the largest futures market in North America?
What is a primary use of futures contracts by hedgers?
What is a primary use of futures contracts by hedgers?
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In a futures contract involving copper, how much would the loss be if prices decrease by 5 cents per pound for 10 contracts?
In a futures contract involving copper, how much would the loss be if prices decrease by 5 cents per pound for 10 contracts?
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What is the main benefit of speculating in futures contracts?
What is the main benefit of speculating in futures contracts?
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Which of the following statements is true regarding an interest rate swap?
Which of the following statements is true regarding an interest rate swap?
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What is a common example of a commodity futures contract?
What is a common example of a commodity futures contract?
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What is the primary purpose of an interest rate swap between two companies?
What is the primary purpose of an interest rate swap between two companies?
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Which type of swap involves exchanging one currency and its interest rate for another?
Which type of swap involves exchanging one currency and its interest rate for another?
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Why should a company borrow money where it has a comparative advantage?
Why should a company borrow money where it has a comparative advantage?
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What is a credit default swap primarily designed to do?
What is a credit default swap primarily designed to do?
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Which statement best describes hedge funds?
Which statement best describes hedge funds?
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What distinguishes credit default swaps from interest rate swaps?
What distinguishes credit default swaps from interest rate swaps?
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What is NOT a characteristic of hedge funds?
What is NOT a characteristic of hedge funds?
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Which of the following best illustrates the flexibility of hedge funds?
Which of the following best illustrates the flexibility of hedge funds?
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Study Notes
Futures Contracts
- Futures contracts are standardized forward contracts.
- They are traded on organized exchanges like the CME (North America), MFE (Canada), WCE (Canada), PBOT, MidAmerica Commodities Exchange, Tokyo International Financial Futures Exchange, and London International Financial Futures Exchange.
- Standardizations include quantity, quality (not always required in financial futures), delivery dates/procedures, and delivery prices of underlying assets.
- Types include commodity (gold, oil, wheat), stock, and index futures.
Hedging with Futures
- Hedging allows counterparties with offsetting risks to eliminate risk (e.g., farmer and cereal manufacturer).
- Hedgers can transfer risk to speculators.
- Speculators absorb price risk from hedgers.
Speculation in Futures
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Speculators don't need to meet; terms are standardized.
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Speculation involves going long (expecting price increase) or short (expecting price decrease).
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Example: Speculating on copper futures: Buying 10 contracts of 25,000 pounds of copper, at USD$0.70/pound delivers profit or loss of USD$12,500 per 5 cent price movement.
Interest Rate Swaps
- Interest rate swaps exchange fixed-rate payments for floating-rate payments on similar loans (e.g., Company A with fixed 7% and Company B with adjustable rate).
- They are common in multinational corporations.
- Two main types: Fixed-for-floating interest rate swaps, and currency swaps (one currency/rate for another).
- Companies borrow where they have a comparative advantage, then swap to match needs.
- No standardized market for swaps.
Credit Default Swaps
- Credit default swaps are insurance-like instruments, not swaps.
- Buyers bet against a financial product (e.g., bond), hoping it will default, similar to an insurance premium.
- Example: The Big Short movie illustrates the 2007-2008 housing bubble crisis, showing the role of credit default swaps in the crisis.
- No regulation for derivatives.
Hedge Funds
- Hedge funds are private investment funds for wealthy investors, managed by professional managers.
- They are called "hedge funds" because their investment performance isn't always closely tied to the overall stock market.
- They can invest in virtually anything: stocks, bonds, government securities, currencies, derivatives, commodities, tangible assets, closely held companies, and can use leverage by borrowing funds or shorting stock.
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Description
This quiz covers the fundamentals of futures contracts, including their definitions, types, and the role of hedging and speculation in the futures market. Explore how standardized contracts operate and the strategies used by hedgers and speculators to manage risk. Test your understanding of this essential financial tool.
