derivatives - futures and forwards
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Derivatives
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AGENDA
Derivative Markets and Instruments
Definition Purpose and Criticism
Role of Arbitrage
Forward Markets and Contracts
Future Markets and Contracts
Option Markets and Contracts
Swap Markets and Contracts
Risk Management Application of OptionStrategies
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AGENDA FOR DERIVATIVE MARKETS AND
INSTRUMENTS
Definition
Characterictics of various products
Purpose and criticism of Derivatives
Role of Arbitrage
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DEFINITION
Derivative is a financial instrument whose value is derived from the value onanother instrument called underlying asset.
Main types
Forwards and futures
Swaps
Options
Exotics
Trading
Exchange traded
OTC
Underling Stocks, indices, bonds, commodities, currency, rates
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Exchange traded Traditionally open-outcry system Switching to electronic trading Contracts are standardized Example:
- Europe: Liffe: http://www.liffe.com- US: Chicago Board of Trade
http://www.cbot.com
Over the counter (OTC) A computer- and telephone-linkednetwork of dealers Contracts can be non-standard
http://www.liffe.com/http://www.cbot.com/http://www.cbot.com/http://www.liffe.com/ -
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THE BIG PICTURE
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Derivatives are always a zero-sum game, one persons loss is anothers gain
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PURPOSE AND CRITICISM OF DERIVATIVES
Purpose
Risk Management
Price Information
Reduce transaction costs
Criticism Too risky (leverage)
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ROLE OF ARBITRAGE
Arbitrage refers to Riskless profit. Such profits are generally earned whensecurities are mispriced. Entering into arbitrage transactions ensures thatsecurities return to their fair values.
Arbitrage plays an important role in valuing securities.
Types: Law of one price states that securities with Identical cash flows must have the same price.
Portfolio of securities (with uncertain individual returns) has a certain payoff ==> then theportfolio should give risk free rate of return.
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QUESTION
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ANSWER
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QUESTION
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ANSWER
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QUESTIONS
1. Which of the following is not an advantage of Exchanges traded instruments
over OTC contracts?A. They do not carry default risk
B. They are tailor made instruments
C. They are liquid
2. Law of one price states that:
A. All securities with identical maturity should trade at the same price.B. All securities with identical cash flows should trade at the same price.
C. All securities with identical credit risk should trade at the same price.
3. Arbitrage profit can be earned when:
A. One has insider information
B. Securities are mispricedC. Securities have different maturity dates
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ANSWERS
1. Answer: B, They are tailor made instruments
2. Answer: B, All securities with identical cash flows should trade at thesame price.
3. Answer: B, Securities are mispriced
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AGENDA
Derivative Markets and Instruments
Forward Markets and Contracts Characteristics of Forward Markets
Settlement on Forward Contracts
Forwards on Equity and Bonds
Forward Rate Agreements (FRAs)
Future Markets and Contracts
Option Markets and Contracts
Swap Markets and Contracts
Risk Management Application of OptionStrategies
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AGENDA FOR FORWARD MARKETS AND
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AGENDA FOR FORWARD MARKETS AND
CONTRACTS
What is forward contract
Characteristics
Settlement of a Forward contract
Dealer versus end user
Forwards on Equity and bondsEurodollar Time Deposit market
Forward Rate Agreement(FRA)
Payoff of an FRA
Currency Forward contracts
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WHATS IS FORWARD CONTRACT
A Forward Contract is a way for a buyer or a seller to lock in a purchasing orselling price for an asset, with the transaction set to occur in the future.
In essence, it is a financial contract obligating the buyer to buy, and the seller tosell a given asset at a predetermined price and date in the future.
The buyer is often called long and seller is often called short.
No cash or assets are exchanged until expiry, or the delivery date of the contract.On the delivery date, forward contracts can be settled by physical delivery of theasset or cash settlement.
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http://www.wikinvest.com/wiki/Assetshttp://www.wikinvest.com/wiki/Assets -
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CHARACTERISTICS OF FORWARD MARKETS
Contract whereby parties are committed:
To buy (sell) An underlying asset
At some future date (maturity)
At a delivery price (forward price) set in advance
When contract is initiated: No cash flow
Forward price such that PV of the contract zero.
The party which agrees to buy the specified asset is said to take a long position, andthe party which agrees to sell the specified asset is said to take a short position.
Customization, difficulty of closing out positions, low liquidity : Forward contract is
always constructed with the idea that the participants will hold their position until thecontract expires.
The risk of contract default, credit risk.
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USES OF FORWARD CONTRACT
Forward contracts offer users the ability to lock in a purchase or sale pricewithout incurring any direct cost.
This feature makes it attractive to many corporate treasurers, who can useforward contracts to lock in a profit margin, lock in an interest rate, assist in cashplanning, or ensure supply of a scarce resources. Speculators also use forwardcontracts to make bets on price movements of the underlying asset.
Many corporations and banks will use forward contracts to hedge price risk byeliminating uncertainty about prices.
For instance, coffee growers may enter into a forward contract with Nescafe tolock in their sale price of coffee, reducing uncertainty about how much they willbe able to make.
Nescafe benefits from contract because it is able to lock in their cost ofpurchasing coffee.
Knowing what price it will have to pay for its supply of coffee ahead of time
helps Nescafe avoid price fluctuations and assists in planning.
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http://www.wikinvest.com/wiki/Forward_Rate_Agreementhttp://www.wikinvest.com/wiki/Bankshttp://www.wikinvest.com/wiki/Hedginghttp://www.wikinvest.com/wiki/Hedginghttp://www.wikinvest.com/wiki/Bankshttp://www.wikinvest.com/wiki/Forward_Rate_Agreement -
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FORWARD CONTRACT: EXAMPLE
Underlying asset: Gold
Spot price: $980 / ounce
Maturity: 6-month
Size of contract: 100 ounces
Forward price: $990 / troy ounce
Profit/Loss at maturity
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Spot price 950 970 990 1010 1030
Buyer (long) -4,000 -2,000 0 +2,000 +4,000
Seller (short) +4,000 +2,000 0 -2,000 -4,000
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FORWARD CONTRACT: EXAMPLE
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$990
ST
Long Position
Gain/Loss
ST
Long Position
Gain/Loss
$990
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SETTLEMENT OF A FORWARD CONTRACT
A position in a forward contract can be settled depending on the type of contract:
Deliverable forward contract - Such contracts are settled by delivering the underlying
asset on expiry of the contract.
Cash settlement - Under this method the party which is on the loss side of the contractpays the amount of the loss to the other party terminate the contract.
The person who has a obligation to purchase the asset as per the contract(longposition) pays the person who has a obligation to sell the asset(short position) if theprevailing price is lower than the contracted price.
Terminating the position before expiration This can be done by entering into anothercontract which is opposite to the current contract. The time period of the new contractshould be equal to the time left till expiration of the current contract.
DEALER VERSUS END USER
The end users are typically corporations who want to hedge their risks.Dealers are like the market makers for forward contracts and include banks and other Non
banking financial companies. Dealers may enter into contracts with other dealers tohedge their own outstanding positions.
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FORWARDS ON EQUITY AND BONDS
For Equity Forward Contracts the underlying asset is a stock. Such contracts can be settledby physical delivery or by delivery of the stock.
One can also have a forward contract whose underlying is the stock index. Such contractsare settled in cash.
Forward on zero coupon bonds or coupon paying bonds are the same as Equity Forwardcontracts. But as bonds have a fixed life, the forward contract on bonds must expire beforethe underlying bonds mature.
T-bills are usually quoted at a discount to face value. This discount is annualised to arrive atthe settlement price.
Example:
$10 million face value T-bills with 100 days to maturity, priced at 2% discount.
Compute the dollar amount to be paid by long to settle the T-bill
2% * (100/360) = 0.556%
$ settlement price = (1 0.556%)*10 million = $9,944,444
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FORWARD RATE AGREEMENT(FRA)
A forward rate agreement (FRA) is an agreement that a certain rate will apply to a certain
principal during a certain future time period.
Forward contract to borrow (long) or lend (short) at a pre-specified rate.
A typical FRA is where interest at a predetermined rate, RK is exchanged for interest at themarket rate.
A 3-by-7 FRA means a120 day LIBOR starting 90 days from now.
Payment to the long at settlement:
= Notional Principal X (Rate at settlement FRA Rate) (days/360)
-------------------------------------------------------------
1 + (Rate at settlement) (days / 360)
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FRA EXAMPLE
FRA that Settles in 30 days
$1 million notional Based on 90-day LIBOR
Forward rate of 5%
Actual 90-day LIBOR at settlement is 6%
Explanation of the question; The 3 month spot rate agreed after 1 month is 5%, but after onemonth the 3 month forward rates become 6%. So extra payment to be made by the partywho has promised to give the loan at 5% is
(6% - 5%) * (90/360)* $1m = $2,500
This extra payment which will happen after 3months will be $2,500. Hence its presentvalue will be
PV: 2,500 / (1 + (90/360)*6%) = $2,463
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Let's set up the transaction:Dealer quotes a rate of 4% on this instrument and end user agrees. He is hopingthat rates will increase.
Expiration is in 90 days.
The notional amount is $ 5 million.
The underlying interest rate is the 180 LIBOR time deposit.
In 90 days the 180-day LIBOR is at 5%. That 5% interest will be paid 180 days later.
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Let's set up the transaction:Dealer quotes a rate of 4% on this instrument and end user agrees. He is hopingthat rates will increase.
Expiration is in 90 days.
The notional amount is $ 5 million.
The underlying interest rate is the 180 LIBOR time deposit.
In 90 days the 180-day LIBOR is at 5%. That 5% interest will be paid 180 days later.
So: 5,000,000 ((0.05 - 0.04) (180/360)) = $ 47,6001 + 0.05 (180/360)
Because rates increased, the long party or the end user will receive $47,600 fromthe short party or the dealer.
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CURRENCY FORWARD CONTRACTS
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CURRENCY FORWARD CONTRACTS
A currency forward contract is a contract to exchange one currencyfor another at some future date at a per-specified rate.
These contracts can be settled in cash or by actual exchange of thecurrencies.
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Suppose there is a corporation which is USA based, hence their balance sheet isdollar denominated.
Corporation A has a foreign sub in Italy that will be sending it 10 million euros insix months.
Corp. A will need to swap the euro for the euros it will be receiving from the sub.
In other words, Corp. A has to be short euros and long dollars. It is long dollarsbecause it will need to purchase them in the near future. Corp.
A can wait six months and see what happens in the currency markets or enter
into a currency forward contract. To accomplish this, Corp. A can short the forward contract, or euro, and go long the
dollar.
Corp. A goes to Citigroup and receives a quote of .935 in six months.
This allows Corp. A to buy dollars and sell euros. Now Corp. A will be able to turn its10 million euros into 10 million * .935 = 935,000 dollars in six months.
Corp. A goes to Citigroup and receives a quote of .935 in six months. This allowsCorp. A to buy dollars and sell euros. Now Corp. A will be able to turn its 10 millioneuros into 10 million * .935 = 935,000 dollars in six months.
If the rate has increased to .95, Corp. A would still receive the .935 it originallycontracts to receive from Citigroup, but in this case, Corp. A will not have receivedthe benefit of a more favorable exchange rate.
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QUESTION
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ANSWER
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QUESTION
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ANSWER
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QUESTION
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QUESTION
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ANSWER
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ANSWER
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QUESTIONS
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QUESTIONS
1. A forward contract on an index is:
A. Settled by delivery
B. Cash settled
C. Is always rolled over
2. Forwards on bonds must always:
A. Expire before the bond matures.B. Expire after the bond matures.
C. Expire on the date of maturity of the bond.
3. Euro Dollar deposit is:
A. Euro denominated deposits outside US
B. Dollar denominated deposits outside US
C. Euro denominated deposits in US
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QUESTIONS (CONT )
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QUESTIONS (CONT...)
4. A 2-by-5 FRA means :A. A 60 day LIBOR starting 90 days from now
B. A 90 day LIBOR starting 60 days from nowC. A 60 day LIBOR starting 150 days from now
5. FRA that Settles in 30 days, $5 million notional Based on 120-day LIBOR, Forward rate of 5.5% Actual 120-day LIBOR at settlement is 7%
The PV isA. 25,000B. 27,349C. 24,429
6. Which of the following about Currency Forward contracts is not true:
A. They are always cash settledB. They can be cash settled or settled by delivery of the underlying currenciesC. The exchange rate between the currencies is specified at the beginning of the contract.
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ANSWERS
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ANSWERS
1. Answer: B, Cash settled
2. Answer: A, Expire before the bond matures
3. Answer: A, Euro denominated deposits outside US
4. Answer: B, A 90 day LIBOR starting 60 days from now
5. Answer: C, 24,429
(7% - 5.5%) * (120/360)* $5m = $25,000
PV: 25,000 / (1 + (120/360)*7%) = $24,429
6. Answer: A, They are always cash settled
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AGENDA
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AGENDA
Derivative Markets and Instruments
Forward Markets and Contracts
Future Markets and Contracts
Mechanics of Futures Market
Margins
Termination of Futures Contract
Types of Futures Contract
Option Markets and ContractsSwap Markets and Contracts
Risk Management Application of OptionStrategies
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AGENDA FOR FUTURE MARKETS AND CONTRACTS
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Characteristics of Futures
Margins
Marking to Market
Termination of Futures contract
Types of Futures
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CHARACTERISTICS OF FUTURES
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Fundamentally, Futures are similar to Forward contracts. They differ on the followingaspects:
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FORWARDS Not traded on exchanges Are private agreements between
two parties and are not as rigid intheir stated terms and conditions
Credit risk is high
High customization Settlement at the end of contractand on a specific date
Mostly used by hedgers that wantto remove the volatility of theunderlying, hence delivery/cashsettlement usually takes place
FUTURES
Traded on exchanges
Standard contracts
Clearing house and daily mark tomarket reduces credit risk
Settlement can occur over a range
of dates
Usually closed out before maturityand hardly any deliveries happen
CLEARING HOUSE
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CLEARING HOUSE
Each exchange has a clearing house.
The clearing house guarantees that the traders in the future market will honor
their obligations.
The clearing house does this by splitting each trade once it is made and acting asthe opposite side of each position.
By doing this, the clearing house allows either side of the trade to reversepositions at the future date without having to contact the other side of the initialtrade.
This allows traders to enter the market knowing that they will be able to reversetheir position.
Traders are also freed from having to worry about the counterparty defaultingsince the counterparty is now the clearing house.
In the history of US futures trading, the clearing house has never defaulted on a
trade.
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MECHANICS OF FUTURE MARKETS
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Specifications of a contract
Asset: If asset is acommodity, exchangespecifies the asset incomplete detail: grade,quality, size, shape,colour, etc
Contract size: The amountof the asset to bedelivered
Delivery arrangement:place of delivery
Delivery month
investor broker trader Exchange
Margins
Margin account.: investordeposits a certain amount ofmoney with the broker in themargin account
Initial margin: the initialamount deposited in themargin account
Maintenance margin: issomewhat below the initialmargin. The minimumamount after which amargin call is sent to the
investor. After margin callinvestor has to top hismargin account to the initialmargin
MARGINS
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A person is required to deposit Margin money with his broker to undertake trades in thefutures market.
Initial Margin is the amount that is to be deposited even before the first trade takes place.
Maintenance Margin is the minimum amount of margin that has to be maintained in themargin account.
If the margin account falls below the maintenance margin due to change in the market priceof the security, then the investor will have to bring in additional margin to bring it back to thelevel of Initial margin. This additional margin is known as Variation Margin.
If the account margin exceeds the initial margin requirement, funds can be withdrawn or
used as initial margin for additional positions.
MARKING TO MARKET
Marking to market involves adjusting the margin account to reflect the change in the price ofthe underlying security.
The exchange imposes price limits within which the future contracts can be traded. If acontract has a daily price limit of five cents, and it is current price is $2.50, then the contracthas made a limit move. If the contract price hits above $2.55 the contract has said to be limit up.
If the contract price hits below $2.45 the contract has said to be limit down.
As no trade will take place the price is said to have locked limit.
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TERMINATION OF FUTURES CONTRACT
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Future contracts can be terminated in any one of the followingways:
Delivery
Cash settlement
Offsetting trade
Exchange of physicals Ex-pit (outside exchange) transaction
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TYPES OF FUTURES
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TREASURY BILL FUTURES
Based on $1 million face value T-bills maturing in 90 days. Price quote = 100 Annualized discount rate in %
Cash settled
TREASURY BOND FUTURES
Traded for Treasury bonds with maturities >15 years.
Deliverable contract.
Face value of $100,000.
Are quoted as a percent and fractions of 1% (measured in 1/32 nds) offace value.
The Short position holder has an option to deliver any of the severalbonds to satisfy the contract terms. This least expensive product isalso known as the cheapest-to-deliver-bond.
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TYPES OF FUTURES (CONT...)
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EURODOLLAR FUTURES $1 million face value
Based on 90-day LIBOR
Price quote = 100 annualized LIBOR in %
Cash settled
Minimum change = 1 tick = 0.01% => $1 million*0.01%/4= $25
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QUESTION
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ANSWER
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Q
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ANSWER
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Types of Futures (Cont...)
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STOCK INDEX FUTURE
S&P 500 is the most popular Index Future
Trades in Chicago
Settles in cash as it is not possible to physically deliver theindex
Multiplier of 250
Value of contract = 250 * index level
CURENCY FUTURE
Much smaller market than currency forwards
Price is stated in USD/unit
E.g. Size of peso contract is MXP 225,000, euro contract is EUR145,000
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QUESTION
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ANSWER
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QUESTIONS
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1. If the margin account falls below the maintenance margin the investors has tobring in additional amount to increase the margin level to:
A. Maintenance Margin
B. Variation Margin
C. Initial Margin
2. Adjusting the margin account to reflect the change in the price of theunderlying security is known as:
A. Daily margin
B. Marked to Market
C. Settlement Margin
3. Which of the following is not a way of settling a future contract:
A. Mutual agreement of the parties to the contract
B. Exchange of underlying physicals
C. Entering into offsetting trade
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QUESTIONS (CONT...)
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4. Treasury bond futures are traded with maturities:A. Less than 15 years
B. More than 15 years
C. More than 10 years
5. Minimum Price change for a Eurodollar futurecontract is:
A. $50 per $ 1 million contract
B. $25 per $ 5 million contract
C. $25 per $ 1 million contract
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ANSWERS
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1. Answer: C, Initial Margin
2. Answer: B, Marked to Market
3. Answer: A, Mutual agreement of the parties to the
contract
4. Answer: B, More than 15 years
5. Answer: C, $25 per $ 1 million contract
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