HullFund8eCh02ProblemSolutions

# HullFund8eCh02ProblemSolutions - CHAPTER 2 Mechanics of...

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CHAPTER 2 Mechanics of Futures Markets Practice Questions Problem 2.8. The party with a short position in a futures contract sometimes has options as to the precise asset that will be delivered, where delivery will take place, when delivery will take place, and so on. Do these options increase or decrease the futures price? Explain your reasoning. These options make the contract less attractive to the party with the long position and more attractive to the party with the short position. They therefore tend to reduce the futures price. Problem 2.9. What are the most important aspects of the design of a new futures contract? The most important aspects of the design of a new futures contract are the specification of the underlying asset, the size of the contract, the delivery arrangements, and the delivery months. Problem 2.10. Explain how margin protect investors against the possibility of default. Margin is money deposited by an investor with his or her broker. It acts as a guarantee that the investor can cover any losses on the futures contract. The balance in the margin account is adjusted daily to reflect gains and losses on the futures contract. If losses are above a certain level, the investor is required to deposit further margin. This system makes it unlikely that the investor will default. A similar system of margin accounts makes it unlikely that the investor’s broker will default on the contract it has with the clearing house member and unlikely that the clearing house member will default with the clearing house. Problem 2.11. A trader buys two July futures contracts on frozen orange juice. Each contract is for the delivery of 15,000 pounds. The current futures price is 160 cents per pound, the initial margin is \$6,000 per contract, and the maintenance margin is \$4,500 per contract. What price change would lead to a margin call? Under what circumstances could \$2,000 be withdrawn from the margin account? There is a margin call if more than \$1,500 is lost on one contract. This happens if the futures price of frozen orange juice falls by more than 10 cents to below 150 cents per lb. \$2,000 can be withdrawn from the margin account if there is a gain on one contract of \$1,000. This will happen if the futures price rises by 6.67 cents to 166.67 cents per lb. Problem 2.12. Show that, if the futures price of a commodity is greater than the spot price during the delivery period, then there is an arbitrage opportunity. Does an arbitrage opportunity exist if the futures price is less than the spot price? Explain your answer. If the futures price is greater than the spot price during the delivery period, an arbitrageur

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buys the asset, shorts a futures contract, and makes delivery for an immediate profit. If the futures price is less than the spot price during the delivery period, there is no similar perfect arbitrage strategy. An arbitrageur can take a long futures position but cannot force immediate delivery of the asset. The decision on when delivery will be made is made by the party with the short position. Nevertheless, companies interested in acquiring the asset will find it
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