004 - 4 Using Futures Markets Answers to Questions and...

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21 Answers to Questions and Problems 1. Explain how futures markets can benefit individuals in society who never trade futures. One of the main benefits that the futures market provides is price discovery; futures markets provide infor- mation about the likely future price of commodities. This information is available to anyone in the economy, because the prices are publicly available. It is not necessary to trade futures to reap this benefit. 2. A futures price is a market quoted price today of the best estimate of the value of a commodity at the expira- tion of the futures contract. What do you think of this definition? This claim is intriguing but controversial. If there is no risk premium embedded in the futures price, the statement is likely to be true. The definition implies that random holding of futures positions should earn a zero profit. This seems to be approximately true, but studies such as that by Bodie and Rosansky find posi- tive returns to long futures positions. While the claim may not hold literally, it does seem to be close to cor- rect. Further, those who reject the claim may have a difficult time in identifying futures prices that are above or below the future spot price. 3. Explain the concept of an unbiased predictor. A predictor is unbiased if the average prediction error equals zero. This implies that errors in the prediction are distributed around zero, and that the prediction is equally likely to be high as well as low. 4. How are errors possible if a predictor is unbiased? Saying that a predictor is unbiased merely claims that the predictions do not tend to be too high or too low. They can still be in error. For example, the futures price may provide an unbiased prediction of the future spot price of a commodity. Nonetheless, the errors in such a prediction are often large, because the futures price today can diverge radically from the spot price at the expiration of the futures. 5. Scalpers trade to capture profits from minute fluctuations in futures prices. Explain how this avaricious behavior benefits others. Scalpers trade frequently, attempting to profit by a tick here or there. In pursuing their profit, the scalpers provide the market with liquidity. Thus, a trader who wishes to take or offset a position benefits from the presence of scalpers ready to take the opposite side of the transaction. With many scalpers competing for business, position traders will be able to trade at prices that closely approximate the true value of the com- modity. Expressed another way, as scalpers compete for profits, they force the bid-asked spread to narrow, therefore contributing to the liquidity of the market. 4 Using Futures Markets
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6. Assume that scalping is made illegal. What would the consequences of such an action be for hedging activity in futures markets? Without scalpers, the liquidity of the futures market would be greatly impaired. This would imply a widen-
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This homework help was uploaded on 04/07/2008 for the course BA 4825 taught by Professor Danısoglu during the Spring '08 term at Middle East Technical University.

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004 - 4 Using Futures Markets Answers to Questions and...

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