Derivs, Futures Market And Contracts

Front 1

Explain why futures prices must equal spot prices atexpiration of the futures contract. Pg 37, derivs

Back 1

The spot price by definition is the value of the asset ifdelivery were taken today. When thefutures expriation date arrives, the value of the asset being delivered is thespot price and therefore an arbitrage opportunity would exist if there were adifference between the spot and futures price of the asset at expiration.

Front 2

Explain how the value of a futures contract is determined. Pg 38-39, derivs

Back 2

At initiation of both a forward and futures contract, thevalue of the contract is zero, and as fluctuations in the market occur, thevalue of the contract changes. The important concept here is that (unlikeforward contracts) futures contracts are marked to market daily, so at the endof every day, the value of the futures contract returns to zero because themargin is adjusted for the change in the market. For this reason, the value ofa futures contract is simply the change in market value from the previous daysmark to market price.

Front 3

Explain why the value of forwards and futures differ. Pg 39- , derivs

Back 3

The things to think about here is if correlation between theunderlying asset and interest rates are positive or negative, and if thatrelationship would benefit a contract that was marked to market daily (future)or not marked to market (forward). Ifthe asset and interest rates are positively correlated than an increase in assetvalue would benefit the holder if marked to market daily because he wouldreceive a payment at the end of the day and have higher interest rates toreinvest. Further, if pos correlated, a decrease in asset value would requirethe long position to make a payment at what are now lower borrowing costs. Sofor assets that are positively correlated with interest rates, a FUTUREScontract is preferred and will be priced higher. If the assets are negatively correlated, this relationshipflips and it is a disadvantage for the holder to mark to market daily, thus theFORWARD contract is preferred and will be more expensive.

Front 4

Describe backwardation and contango, and how they arerelated to costs of storing/holding physical/financial assets. Pg 44, derivs

Back 4

Backwardation refers to a situation where the futures priceis lower than the spot price of an asset. This may occur if there are benefits to holding the asset (dividends,shortage of supply for manufacturers, etc) Contango refers to a situation where the futures price isless than the spot price and this refers to a situation where the costs ofholding the asset (storage costs, insurance on asset etc) are greater than thebenefits.

Front 5

Explain the concept of normal backwardation and normalcontango. Pg 44, derivs

Back 5

Normal backwardation: If we think about a futures contractas the transfer of price risk from the holder of the asset to the holder of thefutures contract, then the futures contract price should be at a discount tocompensate the contract holder for the price risk they are bearing. This discountis called normal backwardation.

Normal contango: If there are benefits to holding thefutures contract that are not gained by holding the underlying asset, thereshould be a premium on the futures contract and thus it should trade at apremium.

** This means that current futures prices are biasedestimators of future spot prices.

Front 6

Explain why it is problematic to use Eurodollar futures to create a pure arbitrage opportunity.

pg 47, derivs

Back 6

With a traditional futures contract, a riskless arbitrage opportunity can be created by selling a 77 day (for example's sake) future and buying a the underlying asset for 167 days. At expiration of the contract, the value of the future should be equal to the value of the underlying asset.

With Eurodollar futures, the underlying asset is not perfectly correlated with the contract, thus a perfect arbitrage opportunity cannot be created. However it is still a good estimation tool to be used.