Review Questions



CHAPTER 19

Forward, Futures, and Options Agreements

Learning Objectives

The difference between a forward contract and a futures contract

The scope and nature of organized financial futures and options markets

The relationship between spot and futures prices

The difference between put and call options

The reasons for the astounding growth of financial forward, futures, and options agreements in recent years

Chapter Outline

A Single Solution

Forward Transactions

A. Limitations of Forward Agreements

Financial Futures

Determining the Futures Price

Options

A. Put Options

B. Call Options

C. The Option Premium

Answers to Review Questions

1. Define financial futures, forward agreements, and options. What are the advantages and disadvantages of each?

Financial futures: Standardized contracts between two parties to trade financial assets at a future date where the terms of the transaction including the price are determined today. The contracts are standardized with regards to the financial instrument, quantity, and delivery date.

Forward agreements: Agreements completed today regarding the terms for a transaction that will occur on a specified date in the future.

Options: Standardized contracts that give the buyer the right but not the obligation to buy or sell a financial asset in the future up to an expiration date at a price determined today. Put options give the buyer the right to sell financial instruments. Call options give the buyer the right to buy financial instruments. The contracts are standardized with regards to the instrument, quantity, and delivery date.

The advantage of futures, forward agreements, and options is that they can be used for hedging to reduce risk. However, if the above instruments are used for speculation, major financial losses can result. Futures limit both losses and gains, while options limit only losses in exchange for an options premium. Futures are cheaper than options because of the options' premium. Forward agreements are not standardized and are tailored to meet specific individual needs. They are usually arranged by banks and can be costly.

2. How do spot markets differ from forward markets? How do spot markets differ from futures markets?

Spot markets involve transactions that take place immediately, while the futures markets involve transactions that are agreed upon today (including the price) but that take place in the future.

3. A government report forecasts both higher inflation and higher interest rates in the future. Yvette needs to borrow money in six months. What can she, as a future borrower, do now to protect herself from the risk of an increase in the interest rate? What if she is the lender?

As a borrower, Yvette can protect herself from the risk of an increase in the interest rate by utilizing either financial futures or options. In this case, she would sell a futures agreement or buy a put option. As a lender, Yvette can protect herself from the risk of a decrease in the interest rate by utilizing either financial futures or options. In this case, she would buy a futures agreement or buy a call option.

4. Why do both the buyer and the seller of futures contracts have to put up performance bonds? When does the seller profit? When does the buyer profit? How is the clearinghouse protected from losses?

Both the buyers and seller of futures contracts have to put up performance bonds to reduce the risk of either of them reneging on the contract. If the agreed-upon futures price is lower than the spot price when the contract comes due, the buyer wins. If the spot price is lower than the futures contract’s price, the seller wins. The clearinghouse is protected from losses by either party reneging on the agreement through setting margin requirements for both buyers and sellers of futures agreements.

5. Explain why the futures price is very close to the spot price on the day before the delivery date of a futures contract.

Arbitrage insures that on the day before the delivery date of a futures contract, the futures price is very close to the spot price. When there is an opportunity for riskless profit, arbitrageurs move in and purchase in the spot market (driving up the price of a given asset) and sell in the futures market (driving down the price of the asset) and vice versa. As the time comes close to the delivery date of the futures contract, the length of time funds are borrowed for declines. Therefore, the carrying costs are reduced and the futures price approaches the spot price as the deliver date nears. Arbitrage continues until the futures price is bid up (down) to the spot price plus carrying cost and there is convergence.

6. How do arbitrageurs and speculators differ?

Arbitrageurs make riskless profits by buying in one market at a low price and reselling in another market at a higher price. Speculators attempt to gain profits by buying in one market and reselling in another where they hope, but are not sure, that the price will be higher. Speculation entails risk where as arbitrage does not.

7. Explain how arbitrage causes the futures and spot prices to converge.

When there is an opportunity for riskless profit, arbitrageurs move in and purchase in the spot market (driving up the price of a given asset) and sell in the futures market (driving down the price of the asset) and vice versa. As the time comes close to the delivery date of the futures contract, the length of time that the funds are borrowed for (the carrying costs) is reduced. Therefore, the futures price approaches the spot price as the delivery date nears. Arbitrage continues until the futures price is bid up (down) to the spot price plus carrying costs and there is convergence.

8. Explain the difference between call and put options. Does the buyer or the seller of an option pay the option premium? Why does the seller of an option take on the risk?

Put options are options that give the buyer the right but not the obligation to sell a standardized contract of a financial asset at a strike price determined today up to the expiration date of the contract.

Call options are options that give the buyer the right but not the obligation to buy a standardized contract of a financial asset at a strike price determined today up to the expiration date of the contract.

The option premium is paid by the buyer of the option to compensate the seller for accepting the risk of a loss with no possibility of a gain.

The seller of an option takes on the risk in the hopes that the option will not be exercised and the option premium will be the seller’s profit.

9. What are options on futures?

Options on futures are options that give the buyer the right but not the obligation to buy or sell a futures contract up to the expiration date on the option.

10. Explain how an investor could use a stock index future to hedge the risk of a fall in stock prices.

A stock index futures contract gives the buyer or seller the right and obligation to purchase or sell a multiple of the value of a stock index by some specific date in the future at a price determined today. By being able to set the price in advance through stock index futures, an investor can hedge the risk of a fall in stock prices.

11. Assume that an intermediary uses futures only to hedge risk and never to speculate. Is it as vulnerable to losses as an intermediary that uses futures to speculate? Explain.

An intermediary that uses futures to hedge is not vulnerable to loses because all he/she does is give up the opportunity to gain while at the same time reducing the possibility of a loss. When you speculate, you assume the risk of a loss in order to hopefully gain (obtain profits).

12. (Appendix 19-B) What factors determine the size of the option premium?

Given the following conditions, the option premium will generally be larger

1) the more volatile the price of the contract asset is,

2) the further away the expiration date of the option is, and

3) the higher the strike price relative to the spot price for put options and the lower the strike price relative to the spot price for call options.

Given the following conditions, the option premium will generally be smaller

1) the less volatile the price of the contract asset is,

2) the closer the expiration date of the option is, and

3) the lower the strike price relative to the spot price for put options and the higher the strike price relative to the spot price for call options.

Answers to Analytical Questions

13. Angela buys a Treasury bond futures agreement for $94,000. On the delivery date, the spot price is $95,000. Does she win or lose? How much? If Angela bought the futures contract to hedge, can she lose? Explain. (Hint: What if she is willing to give up the opportunity for gain to reduce the risk of loss?)

Angela is purchasing an interest rate hedge. She will be worse off if interest rates go down. In this case, Angela wins $1,000 to compensate her for the fact that interest rates did go down. If the interest rates had gone up, Angela would have been better off without the futures agreement. However, she was willing to give up the opportunity to gain in exchange for reducing or hedging the risk of interest rates going down. If Angela gives up the opportunity for gain, she reduces her chance of losing.

14. IBM sells a Treasury bond futures agreement for $94,000. On the delivery date, the spot price is $95,000. IBM sold the futures agreement to speculate. Does IBM win or lose? Explain.

IBM is speculating. IBM loses because the spot price is higher than the futures' agreement price at which they have agreed to sell.

15. A firm buys a December $100,000 Treasury bond call option with a strike price of 110. If the spot price in December is $108,000, is the option exercised?

No, the call option is not exercised because the Treasury bonds can be bought at a lower price in the spot market ($108,000) than at the strike price of 110 ($110,000).

16. An investment firm buys a December $100,000 Treasury bond put option with a strike price of 110. If the spot price in December is $108,000, is the option exercised?

Yes, the put option is exercised because the Treasury bonds can be bought at a lower price in the spot market ($108,000) and then resold at the higher strike price of 110 ($110,000).

17. If the settle price for a T-bill futures contract is 96.75, what is the percent discount?

The percent discount is 100 less the settle price. In this case, the percent discount is 3.25 percent (100 – 96.75 = 3.25).

18. A brokerage house purchases an S&P 500 futures agreement for $300,000. On the delivery date, the S&P 500 Index is 575. Does the brokerage house make a profit? What if the S&P 500 is 625?

The contract size for a futures agreement on the S&P 500 is $500 times the value of the index. If the S&P 500 index is 575, the brokerage house does not make a profit since the value of the futures agreement on the delivery date is $287,500 ($500 ( 575 = $287,500) and the brokerage house paid $300,000. If the S&P 500 index is 625, the brokerage house does make a profit of $12,500 since the value of the futures agreement on the delivery date is $312,500 ($500 ( 625 = $312,500).

19. If I buy a T-bill future for $950,000 and interest rates go up between now and the delivery date, what will happen to the price of the T-bill future? Will I make money or lose money? Explain.

Because there is an inverse relationship between the interest rate and the price of a financial instrument, if the interest rate goes up, the price of the T-bill future goes down. You will lose money because the spot price is lower than the agreed-upon future price.

20. Assume that you will inherit a $1 million trust fund from your family when you turn 21 next year. Interest rates are high right now, and you fear they may be lower in a year. Explain in detail how you can use futures or options to alleviate your fears.

To alleviate the fear of interest rates going down, I can hedge with futures and options to minimize possible losses.

If I used the futures market, I would purchase a futures agreement. If interest rates do go down, then I would make money on the futures agreement that would offset my losses that result from interest rates being lower in one year. If I were to use the options market to hedge, I would purchase a call option. If interest rates do go down, the value of the call option would increase and offset my losses.

21. (Appendix 19-A) Ruben is importing Colombian coffee to the United States. He will be paid $100,000 in six months, but he is concerned about how much of his domestic currency (Columbian pesos) he will receive for the $100,000. Explain in detail how he can reduce the risk that in six months the peso will depreciate in value against the dollar and he will receive fewer pesos than he anticipates.

To hedge, Ruben can enter the forward, futures, or options market. The forward agreement, arranged by a large bank, could provide an exact offsetting match, so that all exchange rate risk would be eliminated. He could also hedge by buying a futures contact today with a delivery date in six months. Ruben will make a profit on the futures contract if the peso does depreciate to offset the losses he would make in the spot market. If he used the options market, he would purchase a put option. If the peso depreciated enough to make it worth his while, he would exercise the option and make a profit. The profit on the put option would offset his losses in the spot market from the depreciation.

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