FIN 4720 midterm-converted.docx

FIN 4720 midterm-converted.docx - FIN 4720 FTR Spring 2019...

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FIN 4720 FTR - Spring 2019 SAMPLE MIDTERM QUESTIONS Essay Questions (20 points each – Explain in detail) 1. How do futures contracts facilitate trading among strangers? Futures contracts facilitate trading among strangers by eliminating counter party risks. Like a forward contract, a futures contract is an agreement between two parties to buy or sell a stipulated grade and quantity of a commodity at a specific future time for an agreed-on price. Margin ensures that buyers and sellers have the economic incentive and financial where withal to complete their futures contract agreements. 2. How would you explain an “Inverted Market”? Inverted market is a condition in the futures market where the contract for nearer months are quoting at a premium to the contracts for future months. This is also known as backwardation. This is unusual as investors demand a premium for longer term investments. This may usually occur when the underlying securities have low supply in the short term. 3. What are the differences between futures and forward markets? Futures and forwards are financial contracts which are very similar in nature but there exist a few important differences: Futures contracts are highly standardized whereas the terms of each forward contract can be privately negotiated. Futures are traded on an exchange whereas forwards are traded over-the-counter. 4. Do futures prices contain information about spot prices in the future? It's a fairly safe bet that as the delivery month of a futures contract approaches, the future's price will generally inch toward or even come to equal the spot price as time progresses. This is a very strong trend that happens regardless of the contract's underlying asset. This convergence can be easily explained by arbitrage and the
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law of supply and demand. 5. Explain the theory of Normal Backwardation. Explain the expected effects on price relationships and risk premiums. How would you use the theory of Normal Backwardation to explain a futures market at Full Carry? Cost of carry says that each link to reference commodity spot price is a function of net cost to underlying commodity. Time, Space & Product dependent. Full carry = spot price you see is equal to theoretical price. When market in contango, the nearby prices are lower than distance prices. Positive carrying costs. Backwardation – also called inverted market – nearby futures price is higher than the price of distant futures – negative carrying costs- do not store as you’ll get a lower price later, immediately push to market. Cash and carry = Sell futures, buy commodity when expected is greater than spot, deliver on contract for profit. 6. You have been requested by the secretary of agriculture of a Central American country to determine whether cattle produced in that country could be hedged using the Chicago Mercantile Exchange (CME) live cattle contract.
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