Ch025 Derivatives & Hedging Risk

Ch025 Derivatives & Hedging Risk - Chapter 25:...

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Chapter 25: Derivatives and Hedging Risk 25.1 a. A forward contract is an arrangement calling for the future delivery of an asset at an agreed-upon price. b. A futures contract obliges traders to purchase or sell an asset at an agreed-upon price on a specified future date. The long position is held by the trader who commits to purchase. The short position is held by the trader who commits to sell. Futures differ from forward contracts in their standardization, exchange trading, margin requirements, and daily settling (marking to market). 25.2 1. Futures contracts are standardized and traded on exchanges, while forward contracts are tailor-made to suit the specific needs of two counterparties. The standardization of contracts increases the liquidity of futures markets in comparison to forward markets and also allows traders to enter into their positions with a certain degree of anonymity. 2. The holder of a futures contract is insulated from default risk due to clearing corporations and margin requirements. The owner of a forward contract has no guarantee that his counterparty will not default, and therefore forward holders must carefully evaluate each others’ credit risk before entering into a contract. 3. Since futures positions are marked-to-market at the close of trading, gains and losses on futures positions are realized daily, while gains or losses on a forward contract are not realized until the delivery of the asset. 25.3 a. i. Since the futures price of wheat is $5.10 per bushel at the end of trading on March 18, the delivery price on that date is $5.10 per bushel . ii. On the delivery date, the long and short positions in a futures contract transact with the clearing corporation at the current futures price. Therefore, you will pay the current futures price of $5.10 per barrel in order to receive the wheat. The difference between the price that you pay at delivery and the price at which you entered into the contract is reconciled by daily marked-to- market gains and losses. iii. On March 15, you entered into a long futures position in wheat at a price of $5.00 per bushel. Since the closing futures price is $5.03 per bushel, your account receives a cash inflow of $0.03 at the end of the day. Your position in wheat futures increases to $5.03 per bushel (= $5.00 + $0.03). On March 16, your opening long position in wheat futures is $5.03 per bushel. Since the closing futures price is $5.08 per bushel, your account receives a cash inflow of $0.05 at the end of the day. Your position in wheat futures increases to $5.08 per bushel (= $5.00 + $0.03 + $0.05). On March 17, your opening long position in wheat futures is $5.08 per bushel. Since the closing futures price is $5.12 per bushel, your account receives a cash inflow of $0.04 at the end of the day. Your position in wheat futures increases to $5.12 per bushel (= $5.00 + $0.03 + $0.05 + $0.04). On March 18, your opening long position in wheat futures is $5.12 per bushel. Since the closing
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Ch025 Derivatives & Hedging Risk - Chapter 25:...

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