LOS Explanation The spot (cash) price of a commodity or financial asset is the price for immediate delivery. The futures price is the price today for delivery at some future point in time (the maturity date). The basis is the difference between the spot price and the futures price. basis = spot price – futures price As the maturity date nears, the basis converges toward zero. At expiration, the spot price must equal the futures price because the futures price has become the price today for delivery today, which is the same as the spot. Arbitrage will force the prices to be the same at contract expiration. LOS Explanation Like forward contracts, futures contracts have no value at contract initiation. Unlike forward contracts, futures contracts do not accumulate value changes over the term of the contract. Since futures accounts are marked to market daily, the value after the margin deposit has been adjusted for the day’s gains and losses in contract value is always zero. The futures price at any point in time is the price that makes the value of a new contract equal to zero. The value of a futures contract strays from zero only during the trading periods between the times at which the account is marked to market: Value of futures contract = current futures price − previous mark-to-market price If the futures price increases, the value of the long position increases. The value is set back to zero by the mark to market at the end of the mark-to-market period. LOS Explanation There are a number of “real-world” complications that will cause futures and forward prices to be different. If investors prefer the mark-to-market feature of futures, futures prices will be higher than forward prices. If investors would rather hold a forward contract in order to avoid the marking to market of a futures contract, the forward price would be higher than the futures price. From a technical standpoint, the differences between the theoretical (no-arbitrage) prices of futures and forwards center on the correlation between interest rates and the mark-to-market cash flows of futures: Higher reinvestment rates for gains and lower borrowing costs to fund losses lead to a preference for the mark-to-market feature of futures, and higher prices for futures than forwards, when interest rates and asset values are positively correlated. A preference to avoid the mark to market cash flows will lead to a higher price for the forward relative to the future if interest rates and asset values are negatively correlated. LOS Explanation Any positive costs associated with storing or holding the asset in a cash and carry arbitrage will increase the no-arbitrage futures price because it is costly to buy, store, and deliver the asset. Many commodities have storage costs (e.g., corn, live cattle, and gold). There is also risk of loss from spoilage (corn), disease (cattle), and fire (oil or gas). Insuring or bearing these risks adds to the cost of holding these assets. With financial assets there may be a significant benefit to holding the underlying asset. For example, holders of dividend-paying stocks, coupon bonds, and currencies, will earn dividends, coupon payments, and interest, respectively. A monetary benefit from holding the asset will decrease the no-arbitrage futures price since the net cost of holding the asset is reduced. There may also be non-monetary benefits from holding an asset. For a manufacturing firm, for example, this may be the benefit of having a ready supply so that a temporary shortage of their primary input will not disrupt their operations. The return from these non-monetary benefits is called the convenience yield. LOS Explanation Backwardation refers to a situation where the futures price is below the spot price. For this to occur, there must be a significant benefit to holding the asset, either monetary or non-monetary. Backwardation might occur if there are benefits to holding the asset that offset the opportunity cost of holding the asset (the risk-free rate) and additional net holding costs. Contango refers to a situation where the futures price is above the spot price. If there are no benefits to holding the asset (e.g., dividends, coupons, or convenience yield), the futures price will be FP = S0(1 + Rf)T + FV (NC), and contango will occur because the futures price will be greater than the spot price. LOS Explanation If we view a futures contract as a transfer of risk from an asset holder to the buyer of the contract, we would expect the futures price to be lower than the expected price in the future to compensate the futures buyer for accepting asset price risk. This situation is called normal backwardation. If the futures price is greater than the expected spot price, it is called normal contango. The most likely situation in financial markets is one in which futures prices are biased predictors of spot rates (i.e., futures prices do not equal expected spot prices) and, more specifically, futures prices are less than expected spot prices (normal backwardation). LOS Explanation Eurodollar futures are priced as a discount yield, and LIBOR-based deposits are priced as an add-on yield. The result is that the deposit value is not perfectly hedged by the Eurodollar contract, so Eurodollar futures can’t be priced using the standard no-arbitrage framework.
Question 1 - 88882 The price of a 9-month future on a newly issued Treasury bond is calculated as the bond price: A) minus one coupon payment, increased at the 9-month risk-free rate. B) increased at the 9-month risk-free rate, minus one coupon payment increased at the 3-month rate for money 6 months from now. C) increased at the 9-month risk-free rate, minus one coupon payment. -------------------------------------------------------------------------------- Question 2 - 88897 At the expiration of a futures contract, the contract basis is: A) equal to zero. B) always positive. C) at its point of highest volatility. -------------------------------------------------------------------------------- Question 3 - 88777 Under the view that futures transfer risk from asset holders to futures buyers, the: A) futures price will be less than the expected future spot price. B) expected asset price in the future will be less than the futures price. C) convenience yield is positive. -------------------------------------------------------------------------------- Question 4 - 88872 Assume the following for a particular precious metal: Risk free interest rate: 5.50%. Spot Price: 174.00. Forward Price: 172.00. Time to maturity of futures contract: 6 months. Compute the basis for the forward contract. A) $5.50. B) $2.00. C) $1.95. -------------------------------------------------------------------------------- Question 5 - 88861 The value of a futures contract is: A) equal to the variation margin paid on any given day. B) zero when the account is marked to market for an account that has sufficient margin. C) calculated in the same manner as the value of a forward contract. -------------------------------------------------------------------------------- Question 6 - 88833 To initiate an arbitrage trade if the futures contract is underpriced, the trader should: A) borrow at the risk-free rate, buy the asset, and sell the futures. B) borrow at the risk-free rate, short the asset, and sell the futures. C) short the asset, invest at the risk-free rate, and buy the futures. -------------------------------------------------------------------------------- Question 7 - 88830 When interest rate changes are negatively correlated with the price changes of the asset underlying a futures/forward contract: A) futures prices are higher. B) futures prices may be higher or lower depending on the risk-free rate and price volatility. C) forward prices are higher. -------------------------------------------------------------------------------- Question 8 - 88783 Suppose the soybean market is in backwardation with a cash price of $6.50/bushel and a futures price of $6.00/bushel. Also assume that a trader owns 5,000 bushels of soybeans and does not need the soybeans until after futures expiration. Which of the following is the best strategy for the trader? A) Do nothing since the convenience yield is so high. B) Sell the soybeans in the spot market, buy an appropriate futures, and profit $1,250. C) Sell the soybeans in the spot market, buy an appropriate futures, and profit $2,500. -------------------------------------------------------------------------------- Question 9 - 88903 How is market backwardation related to an asset’s convenience yield? If the convenience yield is: A) negative, causing the futures price to be below the spot price and the market is in backwardation. B) larger than the borrowing rate, causing the futures price to be below the spot price and the market is in backwardation. C) positive, causing the futures price to be below the spot price and the market is in backwardation.
Q1.B (Fp = BV*(1+RFR)^t - FVC) Q2.A (Basis = SP - FP) Q3.A (Futures’ holder take on the Asset Risk and need to be conmpensated) Q4.B. 174-172 = 2 Q5.B (Always zero after MTM activity) Q6.C (short asset - lend short proceeds - buy futures) Q7.C (r = -ve We prefer Forwards over Futures as we hate the MTM Cash flow when correlation is neg as money comes home at the time we need it the least for reinvestment purpose) Q8.C (sell soya, buy future and profil = 0.5*5000) Q9.B (if CY>RFR more benefits to holding the asset, hence driving the future prices low)
Ditch, You are nuts with these lunch crunches… I read them daily, but wish i had read thru more of the cfai books so i could review… Only up to equities so still a couple books left until everything you are teaching me becomes a review. Good stuff
CFAdreams Wrote: ------------------------------------------------------- > Ditch, > > You are nuts with these lunch crunches… I read > them daily, but wish i had read thru more of the > cfai books so i could review… Only up to equities > so still a couple books left until everything you > are teaching me becomes a review. > > Good stuff I’m not this far either. Above is a summary of the subject, then questions follow. Do your best.
Ditch - you are indeed crazy & nuts 
Nobody on the forum could possibly be that far in the game with more than 3+ months left and each person handling a full time job (which is at a higher priority in such an economy).
swaptiongamma Wrote: ------------------------------------------------------- > Q1.B (Fp = BV*(1+RFR)^t - FVC) > Q2.A (Basis = SP - FP) > Q3.A (Futures’ holder take on the Asset Risk and > need to be conmpensated) > Q4.B. 174-172 = 2 > Q5.B (Always zero after MTM activity) > Q6.C (short asset - lend short proceeds - buy > futures) > Q7.C (r = -ve We prefer Forwards over Futures as > we hate the MTM Cash flow when correlation is neg > as money comes home at the time we need it the > least for reinvestment purpose) > Q8.C (sell soya, buy future and profil = > 0.5*5000) > Q9.B (if CY>RFR more benefits to holding the > asset, hence driving the future prices low) Good Work! Exam ID: 87 Time Started: 2009-02-25 10:38:14 Time Ended: 2009-02-25 12:00:34 Total Time: 00:04:02 Questions: 9 Points Possible: 9 Points Correct: 9 Score: 100%
5/9… not too good even after reading the summary… For #1, you have the formula Fp = BV*(1+RFR)^t - FVC. Is this a FI formula or like the FRA forumla from the first book? Dont remember seeing this anywhere. I am assuming it means Future price = bond value * (1+risk free)^time - FVC. What does FVC stand for?
Thanks Ditch! FP = SP*(1+RFR)^t - FVC OR FP = (SP - PVC)*(1+RFR)^t FVC = Future Value of Coupons PVC = Present Value of Coupons
very helpful…thanks
What’s funny is that this is exactly where I am now. I wanted to take a break from reading and saw this. I have been reviewing FC parity relationships along with future and forwards. Just like everything else, I need to work a lot of problems on this.
swaptiongamma Wrote: ------------------------------------------------------- > Q7.C (r = -ve We prefer Forwards over Futures as > we hate the MTM Cash flow when correlation is neg Can someone provide an example to clear up any confusion on Q7?
Question 7 - 88830 When interest rate changes are negatively correlated with the price changes of the asset underlying a futures/forward contract: A) futures prices are higher. B) futures prices may be higher or lower depending on the risk-free rate and price volatility. C) forward prices are higher. Meaning of Negative correlation: when interest rate rises - underlying price falls. when interest rate falls - underlying price increases. if you had the price rise situation (when interest rate falls) person holding the future has to pay the “mark-to-market” charges (difference between the new price and the old price) - which he would not prefer. So based on this, the future price would be lower than a Forward price - since forward would be preferred to a Future.
Thanks CPK, for some reason this is still tripping me up though. So if rates and assets are positively correlated, and both go up, why are futures preferred? Wouldn’t the person holding the future still have to pay the mark-to-market charges? I’m pretty sure I’m just having a brain cramp here, and the answer is quite obvious, but I’m not getting it yet!