003 - 3 Futures Prices Answers to Questions and Problems 1....

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11 Answers to Questions and Problems 1. Explain the function of the settlement committee. Why is the settlement price important in futures markets in a way that the day’s final price in the stock market is not so important? In futures markets, the settlement committee determines the settlement price for each contract each day. The settlement price estimates the true value of the contract at the end of the day’s trading. In active mar- kets, the settlement price will typically equal the last trade price. In inactive markets, the settlement price is the committee’s estimate of the price at which the contract would have traded at the close, if it had traded. The settlement price is important, because it is used to calculate margin requirements and the cash flows associated with daily settlement. In the stock market, there is no practice comparable to daily settlement, so the closing price in the stock market lacks the special significance of the futures settlement price. 2. Open interest tends to be low when a new contract expiration is first listed for trading, and it tends to be small after the contract has traded for a long time. Explain. When the contract is first listed for trading, open interest is necessarily zero. As traders take positions, the open interest builds. At expiration, open interest must again be zero. Every contract will have been fulfilled by offset, delivery, or an EFP. Therefore, as the contract approaches the expiration month, many traders will offset their positions to avoid delivery. This reduces open interest. In the expiration month, deliveries that occur further reduce open interest. Also, EFPs typically reduce open interest. This creates a pattern of very low open interest in the contract’s early days of trading, followed by increases, followed by diminution, followed by the contract’s extinction. 3. Explain the distinction between a normal and an inverted market. In a normal market, prices for more distant expirations are higher than prices for earlier expirations. In an inverted market, prices for more distant expirations are lower than prices for earlier expirations. 4. Explain why the futures price converges to the spot price and discuss what would happen if this convergence failed. The explanation for convergence at expiration depends on whether the market features delivery or cash set- tlement, but in each case, convergence depends on similar arbitrage arguments. We consider each type of contract in turn. For a contract with actual delivery, failure of convergence gives rise to an arbitrage oppor- tunity at delivery. The cash price can be either above or below the futures price, if the two are not equal. If the cash price exceeds the futures price, the trader buys the future, accepts delivery, and sells the good in the cash market for the higher price. If the futures price exceeds the cash price, the trader buys the good on the cash market, sells a futures, and delivers the cash good in fulfillment of the futures. To exclude both types of arbitrage simultaneously, the futures price must equal the cash price at expiration. Minor discrepancies can 3 Futures Prices
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exist, however. These are due to transaction costs and the fact that the short trader owns the options
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003 - 3 Futures Prices Answers to Questions and Problems 1....

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