05 - Derivatives Theory

Theory Questions

1. Compare and contrast a forward contract with a futures contract.

2. Discuss the relative merits and disadvantages of hedging, speculation, and arbitrage. Which of these is good for the economy?

3. What are the limitations of forward markets?

4. “A futures contract is more advantageous than a forward contract”—do you agree? If so, why?

5. What are the essential components of a futures contract?

6. What is the fundamental difference between initial margin and a variation margin?

7. How is a futures contract settled?

8. What is meant by open interest? What does the movement of open interest indicate?

9. How is a futures contract priced?

10. What is meant by systematic and unsystematic risk?

11. Do you think that index futures are better than stock futures? If so, why?

12. Why does the margin call occur? What happens if the margin call is not met by the investor?

13. Trading in stock futures versus trading in index futures—which is more risky and why?

14. List the code for months during which the contracts expire.

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• Equity futures are a form of derivative that, if used for hedging, requires a special hedge accounting treatment.
• A derivative is a financial security, such as an option or futures contract, whose value depends on the performance of an underlying security or asset.
  Futures contracts, forward contracts, options, and swaps are the most common types of derivatives.
• The accounting treatment under the U.S. GAAP is covered by the accounting standards FAS 115 and FAS 133. Under the International Financial Reporting Standards, IAS 39 deals with this topic.
• A forward contract is an agreement between two parties to buy or sell an asset at a predetermined future point in time at a predefined price. The essence of the contract is that the trade date and delivery date are distinctly different and the delivery date is a future date.
• A forward contract, being a derivative, is usually used to effectively hedge risk. However, some use it as a mere tool for taking a leveraged unidirectional position.
• A forward contract that is traded on an exchange is called a futures contract.
• Exchange-traded futures contracts are not issued like securities; they are actually created when one party buys a contract from another party.
• While both futures and forward contracts entail a promise to deliver an underlying asset on a future date, they differ in several respects.
• An investor can enter into a futures contract with any of three intentions in mind, namely hedging, speculation, or to get an arbitrage profit. The accounting treatment for hedging is different from the other two, which are classified for the purposes of this book as nonhedging activities.
• One of the key factors in a derivative instrument is that derivatives form an effective medium of transferring risk to a person with risk appetite from another person who wants to avoid risk.
• Arbitrage means taking advantage of a price differential between two or more markets. Arbitrage refers to the purchase and sale of similar products in two or more different markets in order to take advantage of price discrepancy. A person who engages in arbitrage is called an arbitrageur.
• Speculators in futures markets provide the essential function of assuming risk in the hope of getting a reward. The speculator has no intention of taking actual delivery of the securities purchased.
• The forward market has serious limitations including liquidity issues, counterparty risk issues, and lack of standardization.
• The futures market has the advantages of risk management, low transaction cost, performance guarantee by the clearinghouse, price discovery due to high liquidity, means of speculation, being well regulated, and providing enormous arbitrage opportunities.
• There are some important components that should be present in a future contract, such as the underlying asset, contract size, expiry, settlement terms, and margin details both initial margin and variation margin.
• The initial margin is the sum of money that should be deposited by a buyer or a seller to the stock exchange, typically meant to cover possible future loss in the position.
• The primary usefulness of a stock market index is that it provides a benchmark to compare the performance of the stock market with the performance of any other type of asset historically over a given period of time.
• Options on index futures provide a very powerful mechanism of hedging, allowing investors to manage their risk according to their risk appetite.
• Stock price movements are predominantly caused by two types of factors: news about the company and its performance, or news about the country itself. These are categorized as unsystematic and systematic risks, respectively.

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