Futures Contracts and Hedging Strategies

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Questions and Answers

What distinguishes a futures contract from a regular forward contract?

  • Futures contracts are only available for agricultural products.
  • Futures contracts can only be used for speculating.
  • Futures contracts have unlimited negotiation terms.
  • Futures contracts are standardized and traded on organized exchanges. (correct)

Which of the following is NOT a characteristic of futures contracts?

  • Standardization of quantity of underlying asset
  • Exchange guarantees delivery
  • Quality specifications are not required for financial futures
  • Negotiable delivery dates (correct)

Which exchange is recognized as the largest futures market in North America?

  • Philadelphia Board of Trade
  • Montreal Futures Exchange
  • Tokyo International Financial Futures Exchange
  • Chicago Mercantile Exchange (correct)

What is a primary use of futures contracts by hedgers?

<p>To eliminate risk by offsetting positions (D)</p> Signup and view all the answers

In a futures contract involving copper, how much would the loss be if prices decrease by 5 cents per pound for 10 contracts?

<p>$12,500 (D)</p> Signup and view all the answers

What is the main benefit of speculating in futures contracts?

<p>Opportunity to absorb price risk from hedgers (A)</p> Signup and view all the answers

Which of the following statements is true regarding an interest rate swap?

<p>Company A pays a fixed interest rate, while Company B pays a floating rate. (A)</p> Signup and view all the answers

What is a common example of a commodity futures contract?

<p>Crude oil (D)</p> Signup and view all the answers

What is the primary purpose of an interest rate swap between two companies?

<p>To exchange interest rate payments on loans. (B)</p> Signup and view all the answers

Which type of swap involves exchanging one currency and its interest rate for another?

<p>Currency swap (B)</p> Signup and view all the answers

Why should a company borrow money where it has a comparative advantage?

<p>To get better borrowing terms before swapping. (B)</p> Signup and view all the answers

What is a credit default swap primarily designed to do?

<p>Act as an insurance against bond defaults. (C)</p> Signup and view all the answers

Which statement best describes hedge funds?

<p>They are private investment funds for wealthy investors. (C)</p> Signup and view all the answers

What distinguishes credit default swaps from interest rate swaps?

<p>Credit default swaps function as insurance, while interest rate swaps exchange payments. (D)</p> Signup and view all the answers

What is NOT a characteristic of hedge funds?

<p>They are typically highly regulated. (D)</p> Signup and view all the answers

Which of the following best illustrates the flexibility of hedge funds?

<p>They can invest in diverse assets, including derivatives and currencies. (B)</p> Signup and view all the answers

Flashcards

Futures Contract

A standardized forward contract for trading assets, without negotiation of terms.

Forward Contract

A contract for a future transaction, typically customized to accommodate individual needs.

Futures Exchange

An organized marketplace for trading futures contracts (e.g., CME, MFE).

Hedging (Futures)

Using futures contracts to reduce risk by offsetting potential price changes of an asset, often in business to mitigate price volatility.

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Speculator (Futures)

Someone who buys or sells futures contracts to profit from price movements.

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Interest Rate Swap

An agreement to exchange interest payments on loans with different interest rate structures (fixed vs. floating).

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Fixed Interest Rate

An interest rate that remains constant throughout the agreement.

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Floating Interest Rate

An interest rate that changes over time, often based on an agreed benchmark.

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Currency Swap

An agreement to exchange interest payments on loans in different currencies. One party pays interest in one currency, while the other pays in another.

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Comparative Advantage

A company's ability to borrow money at a lower interest rate than another company.

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Credit Default Swap (CDS)

An insurance policy that protects the buyer against a financial product's (like a bond) default. The buyer pays a premium and receives payment if the product defaults.

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Hedge Fund

A private investment fund managed by professional managers, primarily for wealthy investors. They invest in various assets, often using leverage.

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Leveraging

A strategy used by hedge funds to amplify returns by borrowing money to invest, or borrowing stocks and selling them short.

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Shorting

Borrowing shares of a stock and selling them immediately, hoping to buy them back at a lower price later to make a profit.

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What is the purpose of a currency swap?

To exchange interest payments on loans in different currencies, potentially reducing the risk of exchange rate fluctuation.

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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

  • Speculators don't need to meet; terms are standardized.

  • Speculation involves going long (expecting price increase) or short (expecting price decrease).

  • 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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