006 - 36 Answers to Questions and Problems 1 Explain the risks inherent in a reverse cash-and-carry strategy in the T-bond futures market The

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Unformatted text preview: 36 Answers to Questions and Problems 1. Explain the risks inherent in a reverse cash-and-carry strategy in the T-bond futures market. The reverse cash-and-carry strategy requires waiting to receive delivery. However, the delivery options all rest with the short trader. The short trader will initiate delivery at his or her convenience. In the T-bond market, this exposes the reverse cash-and-carry trader to receiving delivery at some time other than the date planned. Also, with so many different deliverable bonds, the reverse cash-and-carry trader is unlikely to receive the bond he or she desires. (These factors are fairly common for other commodities as well.) In the T-bond futures market, the short trader holds some special options such as the wildcard and end-of-month options. The reverse cash-and-carry trader suffers the risk that the short trader will find it advantageous to exploit the wildcard play or exercise the end-of-month option. 2. Explain how the concepts of quasi-arbitrage help to overcome the risks inherent in reverse cash-and-carry trading in T-bond futures. In pure reverse cash-and-carry arbitrage, the trader sells the bond short and buys the future. The trader thereby suffers risk about which bond will be delivered and the time at which it will be delivered. If the trader holds a large portfolio of bonds and sells some bond from inventory to simulate the short sale, these risks are mitigated. Receiving a particular bond on delivery is no longer so crucial to the trader’s cash flows; after all, whichever bond is delivered will merely supplement the trader’s portfolio. Further, the timing of delivery presents fewer problems to the quasi-arbitrage trader. In selling a bond from inventory, as opposed to an actual short sale, the trader did not need to worry about financing the short sale for a particular time. Therefore, the selection of a particular delivery date by the short futures trader is less critical. While quasi- arbitrage helps to mitigate the risks associated with the reverse cash-and-carry trade, risks still remain, particularly the risks associated with the short trader’s options. 3. Assume economic and political conditions are extremely turbulent. How would this affect the value of the seller’s options on the T-bond futures contract? If they have any effect on price, would they cause the futures price to be higher or lower than it otherwise would be? Generally, options are more valuable the greater the price risk inherent in the underlying good. This is certainly true for the seller’s options on the T-bond futures contract. To see this most clearly, we focus on the wildcard option. Exploitation of the wildcard option depends on a favorable price development on any position day between the close of futures trading and the end of the period to announce delivery at 8 p.m., Chicago time. If markets are turbulent, there is a greater chance that something useful will occur in that time window on some day in the delivery month. The greater value of the seller’s options in this circumstancewindow on some day in the delivery month....
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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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006 - 36 Answers to Questions and Problems 1 Explain the risks inherent in a reverse cash-and-carry strategy in the T-bond futures market The

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