Podcast
Questions and Answers
What main problem does illiquidity create for forward contracts?
What main problem does illiquidity create for forward contracts?
- Difficulty exiting before maturity (correct)
- Ability to modify contract terms easily
- Increased profitability for both parties
- Higher transaction costs on exchanges
What is counterparty risk primarily concerned with?
What is counterparty risk primarily concerned with?
- The risk of market price fluctuations
- The risk of counterparty failing to fulfill obligations (correct)
- The risk of interest rate changes
- The risk of government regulation changes
How are futures contracts different from forward contracts?
How are futures contracts different from forward contracts?
- Futures are less liquid than forwards
- Futures are not standardized
- Futures are backed by a clearing corporation (correct)
- Futures require no pricing agreement
Which of the following is a key feature of futures contracts?
Which of the following is a key feature of futures contracts?
What could incentivize a party to default on a forward contract?
What could incentivize a party to default on a forward contract?
What does a trader in a long position of a futures contract expect?
What does a trader in a long position of a futures contract expect?
Which of the following issues does not typically affect futures contracts?
Which of the following issues does not typically affect futures contracts?
What role does the clearing corporation play in the futures market?
What role does the clearing corporation play in the futures market?
What is a primary characteristic of OTC derivative markets compared to exchange-traded derivatives?
What is a primary characteristic of OTC derivative markets compared to exchange-traded derivatives?
Which type of market participant is NOT typically associated with OTC derivative markets?
Which type of market participant is NOT typically associated with OTC derivative markets?
What does the lack of formal rules in OTC derivative markets imply?
What does the lack of formal rules in OTC derivative markets imply?
How does the derivatives market improve price discovery?
How does the derivatives market improve price discovery?
What is one significant function of derivatives in the financial market?
What is one significant function of derivatives in the financial market?
What is a potential disadvantage of OTC derivative markets?
What is a potential disadvantage of OTC derivative markets?
What is the primary purpose of cash and carry arbitrage?
What is the primary purpose of cash and carry arbitrage?
In OTC markets, how are risks typically managed?
In OTC markets, how are risks typically managed?
What happens when the futures price is less than the fair futures price?
What happens when the futures price is less than the fair futures price?
What is a unique feature of exchange-traded derivatives compared to OTC derivatives?
What is a unique feature of exchange-traded derivatives compared to OTC derivatives?
Which of the following is NOT a component that distorts the no-arbitrage bounds?
Which of the following is NOT a component that distorts the no-arbitrage bounds?
What results from trading activity attempting to exploit an arbitrage opportunity?
What results from trading activity attempting to exploit an arbitrage opportunity?
What would most likely happen if transaction costs were lower in the futures market?
What would most likely happen if transaction costs were lower in the futures market?
How does holding gold and delivering it in the futures market affect the total profit?
How does holding gold and delivering it in the futures market affect the total profit?
What is the result of a wider no-arbitrage bound?
What is the result of a wider no-arbitrage bound?
What must occur for arbitrage to be triggered?
What must occur for arbitrage to be triggered?
What is one of the essential attributes of a good market index?
What is one of the essential attributes of a good market index?
What does liquidity in the stock market refer to?
What does liquidity in the stock market refer to?
What is the bid-ask spread in the order book example provided?
What is the bid-ask spread in the order book example provided?
What transaction cost does a person incur when buying 100 shares and immediately selling them based on the order book?
What transaction cost does a person incur when buying 100 shares and immediately selling them based on the order book?
What happens to the transaction cost when increasing order size from 100 shares to 3000 shares?
What happens to the transaction cost when increasing order size from 100 shares to 3000 shares?
Which of the following best describes an ‘impact cost’ in trading?
Which of the following best describes an ‘impact cost’ in trading?
What does a professional maintenance of a market index imply?
What does a professional maintenance of a market index imply?
Why is it important for a market index to be computed by an independent third party?
Why is it important for a market index to be computed by an independent third party?
What term describes a market condition where futures prices are higher than the spot prices, indicating expectations of rising prices?
What term describes a market condition where futures prices are higher than the spot prices, indicating expectations of rising prices?
What can be inferred when the futures prices are lower than the spot prices?
What can be inferred when the futures prices are lower than the spot prices?
What is the key principle regarding futures prices as they approach maturity?
What is the key principle regarding futures prices as they approach maturity?
In the context of futures pricing, what does the term 'price discovery' refer to?
In the context of futures pricing, what does the term 'price discovery' refer to?
Which type of market participant primarily seeks to minimize risk associated with price fluctuations in the underlying asset?
Which type of market participant primarily seeks to minimize risk associated with price fluctuations in the underlying asset?
During the expiry of a futures contract, what happens to the futures price?
During the expiry of a futures contract, what happens to the futures price?
What do participants in a 'Backwardation market' expect regarding future spot prices?
What do participants in a 'Backwardation market' expect regarding future spot prices?
Which of the following roles in the derivatives market is primarily focused on taking advantage of price differences?
Which of the following roles in the derivatives market is primarily focused on taking advantage of price differences?
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Study Notes
OTC Derivatives Market
- Contracts are matched through a negotiated bidding process via telephone or electronic media links between intermediaries.
- The market has seen significant growth due to advancements in information technology.
- Participants include banks, financial institutions, hedge funds, corporations, and high net-worth individuals.
- It operates as a less regulated market, with transactions occurring privately between qualified counterparties.
Features of OTC Derivatives
- Contracts are customized to meet specific requirements of dealing parties.
- Counterparty credit risk management is decentralized within individual institutions.
- No formal central limits exist on positions, leverage, or margining.
- Lack of centralized risk management rules can affect market stability and integrity.
- Transactions occur privately with minimal market disclosure.
Exchange-Traded Derivatives vs OTC Derivatives
- Exchange-traded contracts are standardized and traded on organized exchanges.
- Prices are determined through anonymous auction interfaces.
- Clearing corporations guarantee the performance and settlement of exchange-traded transactions.
Significance of Derivatives
- Enhances price discovery based on real valuations and future expectations.
- Facilitates risk transfer from low-risk appetite holders to those willing to assume risk (e.g., hedgers to traders).
- Encourages speculative trades to move from unregulated to organized markets, improving overall market stability.
Attributes of a Good Market Index
- Should accurately reflect market behavior.
- Must be calculated by an independent third party, preventing market participant influence.
- Requires professional maintenance for integrity.
Liquidity in Stock Markets
- Defined as the ability to execute large orders without affecting prices.
- Bid-ask spread represents the transaction cost; a market buy order can incur losses due to this spread.
- Larger order sizes (e.g., 3000 shares) lead to increased transaction costs due to greater market impact.
Counterparty Risk
- The risk of financial loss if a counterparty fails to fulfill contractual obligations (also known as default risk or credit risk).
- Incentives for default may arise if market prices deviate favorably compared to contract terms.
- Illiquidity and transparency issues compounded by direct settlement complications.
Futures Contracts
- Designed to overcome limitations of forward contracts, offering a standardized agreement to buy/sell assets at a future date through organized exchanges.
- Clearing corporations associated with exchanges ensure trade settlement.
- Traders take long positions by buying futures and short positions by selling.
Cost of Transaction and No-Arbitrage Bounds
- Costs like margins and transaction fees create barriers, maintaining futures prices within no-arbitrage bounds.
- Futures prices reflect expected future spot prices, influencing market behavior and arbitrage opportunities based on deviations from these bounds.
Market Conditions: Contango and Backwardation
- Contango occurs when futures prices are higher than spot prices, indicating expectations of price increases.
- Backwardation occurs when futures prices are lower than spot prices, suggesting expectations of price decreases.
Price Discovery and Futures Expiry
- Futures prices indicate market expectations for asset valuation at contract maturity.
- Prices converge at contract expiry, ensuring no price differences between futures and spot markets.
Roles of Market Participants
- Participants are categorized as hedgers, who manage risk; speculators, who seek profit from price movements; and arbitrageurs, taking advantage of price discrepancies across markets.
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