FRM schweser part 1 book 3 2013

FRM PART I BOOK 3:READING ASSIGNMENTSANDAIM STATEMENTS 3 FINANCIAL MARKETSANDPRODUCTS 20:Introduction Options,Futures,and OtherDerivatives 21:Mechanics of Futures Markets 22:HedgingStrat

FRM PART I BOOK 3:

READING ASSIGNMENTSANDAIM STATEMENTS 3

FINANCIAL MARKETSANDPRODUCTS

20:Introduction (Options,Futures,and OtherDerivatives)

21:Mechanics of Futures Markets

22:HedgingStrategies Using Futures

23:InterestRates

24:Determinationof ForwardandFuturesPrices

2ÿ-JnterestRate Futures

26: Swaps

27:PropertiesofStockOptions

28:Trading Strategies Involving Options

29: Fundamentals of CommoditySpot and FuturesMarkets:Instruments,

Exchangesand Strategies

30: Commodity Forwards and Futures

31: Foreign Exchange Risk

32:Corporate Bonds

33;TheRatingAgencies

SELF-TEST:FINANCIALMARKETSANDPRODUCTS

PAST FRM EXAMQUESTIONS

80

94

111

124143

FRM PARTI.BOOK 3: FINANCIAL MARKETS AND PRODUCT'S

©2013 Kajilan, Inc., d.b.a Kaplan Schweser AH rights reserved.

• Printed in the United Stares of America.

ISBN: 978-1-4277-4486-9 / 1-4277-4486-6

PPN: 3200-3231 Required Disclaimer:GARP®does not endorse, promote, review, or warrant the accuracy of the products or services offered by Kaplan Schweser of 1 ' R M related information, nor does it endorse any pass rates claimed

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READING ASSIGNMENTS AND AIM

STATEMENTS

ThefollowingmaterialisareviewoftheFinancial Markets andProductsprinciples designedto

addressthe AIMstatements setforthbythe GlobalAssociationofRiskProfessionals.

20 “Introduction,”Chapter1

21.“Mechanics ofFuturesMarkets,”Chapter2

22.“Hedging Strategies UsingFutures,”Chapter3

23 “InterestRates,”Chapter 4

24.“Determinationof Forward and FuturesPrices,”Chapter 5

25.“InterestRateFutures,”Chapter6

26.“Swaps,”Chapter 7

27 “Properties ofStock Options,” Chapter10

28.“Trading Strategies Involving Options,” Chapter1 1

HelyerteGeman,CommoditiesandCommodityDerivatives.Modelingand Pricingfor

Agriculturals,MetalsandEnergy(WestSussex,England.)JohnWiley& Sons,2005)

29 “Fundamentals ofCommoditySpot and FuturesMarkets:Instruments,Exchanges and

Strategies,” Chapter1

RobertMcDonald,Derivatives Markets,3rdEdition(Boston.Addison-Wesley,2013).

(page143)

30 “Commodity Forwards andFutures,”Chapter 6

Anthony Saundersand MarciaMillonCornett,FinancialInstitutionsManagement

ARiskManagementApproach, 7thEdition(NewYork.McGraw-Hill,2011).

31.“Foreign ExchangeRisk,”Chapter15

FrankFabozzi(editor),The HandbookofFixedIncomeSecurities,8th Edition(NewYork

ReadingAssignments andAIM Statements

Caouerte,Altman,Narayanan,andNimmo,Managing CreditRisk,2ndEdition(New

York.JohnWiley&Sons,2008)

33 “TheRatingAgencies,”Chapter 6 (page203)

Book 3 Reading Assignments and AIM Statements

AIM STATEMENTS

20. Introduction(Options,Futures,andOtherDerivatives)

Candidates,after completingthisreading,should beableto:

1. Differentiatebetween anopenoutcry systemand electronictrading,(page11)

2 Describe theover-the-countermarket,howitdiffersfrom tradingon anexchange,

and itsadvantages anddisadvantages,(pageII)

3 Differentiate between options,forwards,andfuturescontracts,(page12)

4 Calculate and identifyoptionand forwardcontract payoffs,(page1 2)

5 Describe,contrast,andcalculatethepayoffs from hedgingstrategiesinvolving

forwardcontractsandoptions, (page16)

6 Describe,contrast,and calculate thepayoffsfromspeculativestrategiesinvolving

futures and options,(page18)

7 Calculateanarbitragepayoffanddescribe how arbitrage opportunitiesare

ephemeral,(page 21)

8 Describesomeof the risksthat can aiisefromthe useofderivatives,(page21)

21 Mechanics of Futures Markets

Candidates,after completingthisreading, shouldbe ableto:

1 Define anddescribethekeyfeatures ofafuturescontract,includingtheasset,the

contractpriceandsize,deliveryandlimits,(page27)

2 Explain the convergence of futures andspotprices, (page29)

3 Describe the rationalefor marginrequirements andexplainhowtheywork

(page29)

4 Describe theroleofaclearinghouseinfuturestransactions,(page30)

5 Describethe roleof collateralizationintheover-the-counter marker andcompareit

tothe marginingsystem,(page31)

6 Identify and describethedifferences betweenanormalandinverted futuresmarket

(page31)

7 Describe the mechanicsofthedelivery processandcontrastit with cashsettlement

(page32)

8 Defineand demonstrate an understandingof the impact ofdifferentordertypes,

including:market, limit,stop-loss, stop-limit,market-if-touched, discretionary,

time-of-day, open,andfili-or-kill.(page33)

9 Compareandcontrastforwardandfuturescontracts,(page27)

22.HedgingStrategiesUsing Futures

Candidates,aftercompletingthisreading,shouldbeableto:

1 Defineanddifferentiatebetweenshort and longhedgesandidentify appropriate

uses,(page39)

2 Describe theargumentsfor and againsthedgingand thepotentialimpactof

hedgingonfirm profitability, (page39)

3 Define the basisand thevarious sourcesofbasisrisk,and explain how basis risks

arisewhenhedgingwithfutures,(page40)

4 Definecrosshedging,andcomputeandinterpret theminimumvariancehedge

ratioand hedgeeffectiveness,(page40)

5 Define,compute,and interprettheoptimal number of futurescontractsneeded to

hedgeanexposure, andexplain and calculatethe“tailing thehedge”adjustment

(page43)

Page 5

©2013Kaplan, Inc

Book 3

ReadingAssignments and AIM Statements

6 Explainhowto usestockindexfuturescontracts tochangeastockportfoliosbeta

(page44)

7 Describewhat ismeantby“rollingthehedgeforward”anddescribesomeof the

risksthatarisefrom sucha strategy,(page45)

23 InterestRates

Candidates,aftercompletingthisreading,should be ableto:

1 DescribeTreasuryRates,LIBOR,RepoRates,and whatis meantby the risk-free

2 Calculatethe valueof aninvestmentusingdaily,weekly, monthly, quarterly,

semiannual, annual,andcontinuouscompounding.Convertratesbasedon

different compounding frequencies, (page52)

3 Calculate the theoretical price ofacoupon paying bond usingspot rates,(page53)

4 Calculate forwardinterestratesfroma setofspot rates,(page 57)

5 Calculate thevalue of the cash flowsfromaforwardrate agreement (FRA).

(page 58)

6 Describethe limitations of duration and how convexityaddressessomeofthem

(page59)

7 Calculatethechangein abond’s price givenduration, convexiry, andachangein

interest rates,(page59)

8 Define anddiscuss themajor theoriesof theterm structureofinterest races

(page 62)

24 DeterminationofForwardandFuturesPrices

Candidates,after completing this reading, shouldbe ableto:

1. Differentiatebetween investment and consumptionassets,(page67)

2 Define short-selling andshortsqueeze, (page67)

3 Describethedifferences between forward and futurescontractsand explainthe

relationshipbetween forward andspotprices,(page68)

4 Calculatethe forwardprice,given theunderlyingassetsprice, withorwithoutshortsalesandyorconsideration totheincomeoryieldoftheunderlyingasset.Describe

anarbitrageargumentinsupportof theseprices,(page68)

5 Explaintherelationshipbetween forward and futuresprices,(page72)

6 Calculateaforwardforeign exchangerateusing theinterestrareparityrelationship

(page71)

7.• Defineincome,storagecosts,and convenienceyield,(page72)

8. Calculate thefutures priceoncommodities incorporating income/storagecostsand/

orconvenienceyields,(page72)

9 Define andcalculate,using thecost-of-carrymodel,forwardpriceswherethe

underlyingasseteither doesordoesnothave interim cashflows,(page68)

10 Describethevariousdeliveryoptionsavailable in thefuturesmarketsand howthey

caninfluencefuturesprices,(page74)

11 Assessthe relationship betweencurrentfutures pricesandexpected futurespot

prices,includingtheimpactof systematicand nonsystematicrisk,(page74)

12 Definecontangoandbackwardation, interpret theeffectcontango orbackwardation mayhave ontherelationshipbetweencommodityfutures andspot

prices, and relatethecost-of-carrymodelto contangoandbackwardation,(page75)

Book 3

ReadingAssignments and AIM Statements

25 InterestRateFutures

Candidates,aftercompletingthisreading, should be ableto:

1. Identify themostcommonlyuseddaycount conventions,describethe markets that

eachoneistypically usedin,andapplyeachto aninterestcalculation,(page80)

2 Calculate theconversion ofadiscountrate to apriceforaU.S.Treasury bill

(page82)

3 Differentiate between thecleanand dirtypriceforaU.S.Treasury bond;calculate

the accruedinterest anddirtyprice onaU.S.Treasurybond,(page81)

4 Explainand calculateaU.S Treasurybondfuturescontractconversionfactor

(page83)

5 Calculate thecostofdeliveringabondintoaTreasury bond futurescontract.

(page83)

6 Describe the impact of the level and shape of theyieldcurveonthe

cheapest-to-deliver bonddecision,(page83)

7 Calculatethetheoretical futures price foraTreasure’bondfuturescontract.

(page84)

8 Calculatethefinalcontractpriceon aEurodollarfuturescontract,(page86)

9 DescribeandcomputetheEurodollarfuturescontractconvexityadjustment

(page86)

10 Demonstrate howEurodollar futurescanbeusedtoextend the LIBORzero curve.

(page87)

11 Calculate theduration-basedhedgeratioand describeaduration-based hedging

strategyusinginrerest rate futures,(page87)

12.Explainthelimitationsofusingaduration-based hedgingstrategy,(page88)

26 Swaps

Candidates,after completing thisreading,shouldbeableto:

1 Explain the mechanics ofaplainvanilla,interest rateswapandcompute itscash

flows, (page94)

2. Explainhowaplainvanilla interestrateswap.canbeusedtotransformanasset ora

liability and calculatetheresulting cashflow's,(page95)

3 Explain theroleoffinancialintermediaries in the swapsmarket,(page95)

4 Describe the roleofthe-confirmationinaswaptransaction,(page95)

5 Describe the comparativeadvantageargument'forthe existenceofinterestrate

swapsand explainsomeof thecriticismsof thisargument,(page96)

6 Explainhowthe discountratesin aplainvanillainterestrateswaparecomputed

(page97)

7 Calculate thevalueofaplainvanillainterest rateswap basedon twosimultaneous

bond positions,(page97)

8 Calculate thevalueofaplainvanillainterest rateswap fromasequence of forward

rate agreements(FRAs).(page99)

9 Explainthe mechanicsofa currencyswap andcompute itscashflow’s, (page101)

10 Describe the comparativeadvantageargumentfor theexistence of currencyswaps

(page103)

1 .Explain howacurrencyswapcanbeusedtotransforman assetorliability and

calculatetheresultingcashflows,(page103)

12.Calculatethe valueofacurrencyswap basedontwosimultaneousbond positions

(page101)

13 Calculatethevalueofacurrencyswap basedon asequence of FRAs (page102)

Book 3

ReadingAssignments and AIMStatements

14 Describe rhe role ofcredit riskinherentinanexistingswap position,(page104)

15 Identifyanddescribeothertypesof swaps, includingcommodity,volatilityand

exoticswaps, (page104)

27 Propertiesof Stock Options

Candidates,aftercompletingthis reading,shouldbe ableto:

1. Identify thesixfactors that affectanoptionspriceand describe how thesesix

factorsaffectthepriceforbothEuropeanandAmerican options,(page111)

2 Identify, interpretandcomputeupper and lower bounds for option prices

(page113)

3 Explain put-callparityandcalculate,using theput-callparityonanon-dividend¬payingstock,the valueofaEuropeanand Americanoption,respectively,(page114)

4 ExplaintheearlyexercisefeaturesofAmericancall andputoptionson a

non-dividend-payingstockanddie price effect earlyexercisemayhave,(page116)

5 Explaintheeffectsof dividendsontheput-callparity, the bounds ofputandcalloptionprices,and the earlyexercisefeature ofAmerican options,(page119)

28 TradingStrategies InvolvingOptions

Candidates,aftercompletingthisreading,shouldbeableto:

1 Explainthe motivationto initiate acoveredcalloraprotectiveput strategy.

(page128)

2. Describeandexplain theuseand payoff functionsof spreadstrategies,includingbull spread,bearspread,box spread, calendar spread, butterflyspread,anddiagonal

spread, (page329)

3 Calculatethepayoffsof variousspread strategies, (page129)

-4 Describeandexplaintheuseandpayofffunctions of combination strategies,

•includingstraddles,strangles,strips, aridstraps,(page133)

5 Computethepayoffsof combination strategies, (page133)

29 FundamentalsofCommoditySpotandFuturesMarkets:Instruments,Exchangesand

Strategies'

•Candidates,after completing thisreading,should be ableto:

1. Define “billof lading.”(page145)

2 Define the majorrisks involvedwithcommodityspot transactions,(page146)

3 Differentiate between ordinary and extraordinarytransportationrisks (p,£ge146)

.4, Explainthe majordifferences betweenspot,forward,andfuturestransactions,

markets, andcontracts,(page144)

5 Describethe basiccharacteristics and differences betweenhedgers,speculators,and

arbitrageurs,(page146)

6 Describean“arbitrageportfolio”andexplainthe conditions foramarkettobe

arbitrage-free,(page147)

7 Describe rhesrructureof the futuresmarket,(page145)

8 Define basis risk and thevarianceof thebasis,(page148)

9 Identifyacommonlyused measurefordeterminingtheeffectivenessofhedginga

spotposition withafuturescontract,andcomputeand compare the effectiveness of

alternativehedges using thismeasure,(page148)

10 Defineanddifferentiate betweenanExchangefor Physicalagreementandan

Alternative DeliveryProcedure,(page149)

11 Describe volumeand open interest andtheirrelationship liquidityandmarket

Book 3

ReadingAssignments and AIM Statements

30 CommodityForwardsandFutures

Candidates,after completing this reading, should beableto:

I. Define commodity terminology’suchasstorage costs,carry markets, leaserate,and

convenienceyield, (page155)

2. Explain the basic equilibrium formula for pricing commodityforwards,(page155)

3 Describeanarbitragetransaction incommodityforwards,andcomputethe

potential arbitrageprofit,(page157)

4 Define theleaserateand explain howitdetermines theno-arbitragevalues for

commodity forwards andfutures,(page160)

5 Definecarrymarkets,andexplainthe impact ofstorage costsandconvenience

yieldsoncommodity forwardpricesandno-arbirragebounds,(page162)

6 Compute the forward priceofacommodity withstorage costs,(page162)

7 Compare theleaseratewiththeconvenienceyield,(page164)

8 Identify factors thatimpactgold,corn,electricity,natural gas,andoil forward

prices,(page164)

9 Defineandcompute acommodity spread, (page167) _

10.Explainhow basis riskcan occurwhenhedgingcommodity price exposure

(page167)

11.Evaluate thedifferencesberweenastriphedgeandastackhedgeand explain how

these diflerencesimpact riskmanagement,(page168)

12 Describeexamplesof cross-hedging,specificallytheprocess of hedgingjetfuelwith

crudeoiland using weatherderivatives,(page169)

13 Explainhowto create asynthetic commodity position, anduse it toexplain

the relationshipbetweenthef orward price and the expected futurespotprice

(page155)

31 ForeignExchangeRisk

Candidates,after completingthisreading, shouldbe ableto:

1 Calculateafinancial institutions overallforeign exchangeexposure, (page176)_

2 Explain howafinancialinstitutioncould alteritsnetpositionexposuretoreduce

foreign exchangerisk,(page1 76)

3- Calculateafinancial institutionspotential dollargain orloss exposuretoa

particularcurrency,(page176)

4 Identifyand describethedifferent typesofforeignexchangetradingactivities.'

(page177)

5- Identifythe sourcesof foreignexchangeHading gainsandlosses,(page178)

6 Calculatethepotential gainorloss fromaforeigncurrencydenominated

7 Explain balance-sheethedgingwithforwards,(page180)

8 Describe howanon-arbitrageassumption in theforeignexchangemarketsleads

totheinterestrateparitytheorem;usethistheoremtocalculateforwardforeign

exchangerates,(page183)

9 Explain why diversificationinmulticurrency asset-liabilitypositions couldreduce

portfoliorisk,(page184)

10 Describe the relationshipbetweennominalandrealinterestrates,(page184)

Book 3

ReadingAssignments and AfM Statements

32 Corporate Bonds

Candidates,after completing thisreading,should be ableto:

1 Describeabondindenture andexplain theroleof thecorporate trusteeina bond

indenture,(page190)

2 Explainabond’smaturitydate andhowitimpacts bondretirements,(page190)

3 Describe themain typesofinterestpayment classifications,(page191)

4 Describe zero-couponbonds,therelationshipbetweenoriginal-issue-discountand

reinvestmentrisk,and thetreatmentofzeroes inbankruptcy,(page191)

5 Describethe various securitytypesrelevantforcorporate bonds,including:

• Mortgagebonds

• Collateraltrustbonds

• Equipmenttrustcertificates

• Debenture bonds (includingsubordinatedand convertibledebentures)

• Guaranteedbonds(page192)

6 Describethemechanisms by whichcorporatebondscanbe retired beforematurity,

includingcall provisions,sinking-fundprovisions,maintenance and replacementfunds,and tenderoffers,(page194)

7 Describeanddifferentiate between creditdefaultriskandcredit spreadrisk

(page195)

8 Describeevent riskand whatmaycause itincorporate bonds,(page196)

9 Define high-yield bonds, anddescribetypesof high-yieldbond issuers and someof

thepaymentfeatures peculiartohighyield bonds,(page196)

10.Define and differentiate betweenanissuerdefaultrateandadollar defaultrate.

-11.Definerecoveryratesanddescribe therelationshipbetweenrecoveryratesandseniority,(page198)- • - -

33 The RatingAgencies'

Candidates,aftercompletingthisreading, should be ableto:

1 Describethe role of rating agenciesinthe financialmarkets,(page203)

2 Explainmarketandregulatoryforces that haveplayedarol.einthegrowthofthe

rating agencies,(page203) •

3 Describearatingscale,define creditoutlooks,and explainthedifferencebetween

solicitedandunsolicited ratings, (page204)

4 Describe StandardandPoor’sandMoody’s rating scalesanddistinguishbetween

investmentandnoninvestmentgraderatings,(page204)

5 Describe the difference betweenan issuer-payandasubscriber-pay modeland

describeconcernsregardingthe issuer-paymodel,(page205)

6 Describe andcontrastthe processfor ratingindustrialandsovereigndebtand

describe howthedistributionsof theseratingsmaydiffer,(page206)

7 Discuss the ratingsperformance forcorporate bonds,(page207)

8 Describe therelationshipbetween the rating agencies and regulatorsandidentifykeyregulationsthat impact the rating agencies and theuseofratingsin the market

(page207)

9 Discuss someof rhe trendsand issuesemerging from thecurrentcreditcrisisrelevanttotherating agenciesand theuseof ratingsin themarket,(page208)

The following is a review of the Financial Markets and Products principles designed to address the AIM

statements set forth byGARP®.This topic is also covered in:

Topic20

EXAM FOCUS

In thistopic,we presentthebasicconceptsofderivative securitiesand derivativemarkets.For

theexam,knowthebasicderivativeterms aswellasthetermsrelated toderivativemarkets

Also,be ableto computepayoffs forthedifferent derivativesecuritiesandbeableto create

ahedgeand knowhowtotake advantage ofanarbitragesituation Asindicated bythetitle,

this topicprovidesan introductiontothe upcomingderivativesmaterial

DERIVATIVEMARKETS

AIM20.1:Differentiate betweenanopenoutcrysystemand electronic trading

Anopen outcry systemand electronictradingsystem aredifferent formsoftrading

securities(matching buyers withsellers) The openoutcry system (e.g.,CBOT)isthemore

traditionalsystem,which involvestraders actuallyindicatingtheir tradesthroughhand

signals and shouting Electronic trading doesnotinvolveanactual “physical” exchange

location,but ratherinvolves matching buyersandsellers electronicallyvia computers

(e.g.,NASDAQ)

AIM 20.2:Describe theover-the-counter market,howitdiffersfrom tradingon an

exchange, anditsadvantages and disadvantages

Anover-the-counter(OTC)marketdiffersfromatraditional exchange Itisacustomized

trading market which utilizes telephone and computerstomake trades This market

typicallyinvolvesmuch larger trades than traditionalexchanges.ThemosttypicalOTC

tradeisconductedoverthe phone.Sincetermsarenotspecified byan“exchange,”

participants have moreflexibilitytonegotiatethemostmutuallyagreeableorattractive

trade

TheOTCmarketisseveraltimesthe sizeofthetraditional exchangemarket.Forexample,

in2007,theOTCmarketwasover $500 trillion, while theexchange-tradedmarket was

under$100trillion

Advantages ofover-the-countertrading:

• Termsare not setby any exchange

• Participants have flexibilitytonegotiate

• In theeventofamisunderstanding,callsarerecorded

CrossReferencetoGARP AssignedReading-Hull,Chapter1

Disadvantages of over-the-countertrading:

• O I'C trading hasmorecredit risk thanexchange reading.Exchangesareorganizedin

sucha waythat credit riskiseliminated

BASICSOFDERIVATIVE SECURITIES

AIM 20.3: Differentiate between options, forwards, and futurescontracts.

Anoptioncontract isacontractthat, inexchange for the option price,givestheoption

buyer theright,butnotrheobligation,tobuy(sell)an asset attheexerciseprice from

(to)theoptionseller (buyer) withinaspecifiedtimeperiod,ordependingonrhetypeof

option,aprecise date(i.e.,expirationdate) Acalloptiongives the option holder the right

topurchase theunderlyingassetbyacertainspecifieddateforaspecified(inadvance)price

Aputoptiongives theoptionholder the righttosellthe underlyingassetbyaselecteddate

-Aforwardcontractisa contractthatspecificsthe priceand quantity ofan asset tobedelivered sometime inthefuture.Thereisnostandardizationfor forwardcontracts,

and thesecontractsaretradedin theover-the-counrermarket.Onepartytakesthelong

position,agreeingtopurchasetheunderlyingasset at afuturedateforaspecifiedprice,while theotherpartyistheshort,agreeingtosell theasset onthatsamedateforthat same

price.Forwardcontracts areoften usedinforeignexchangesituationsasthesecontractscan

be usedtohedgeForeigncurrency risk

Afuturescontract is amore formalized,legallybindingagreement tobuy/sellacommodity/

financialinstrument inapre-designatedmonth in the future,at apriceagreedupontoday .

bythebuyer/seller.Futurescontracts arehighlystandardized regarding-quality,quantity,deliverytime,and locationforeachspecificcommodity Thesecontracts arctypicallytraded

on anexchange

Professor’sNote: Rememberthatafuturescontract is anobligaiion/promiseto

actuallycompletea transaction , whilean optionissimply therighttobuy/sell

AIM 20.4:Calculate and identifyoption and forwardcontractpayoffs.

Call Option Payoff

Thepayoffon acalloptiontothe option buyeriscalculatedasfollows:

Cj- =max(0,Sy —X)

where:

Cy =payoffoncalloption

ST =stockpriceatmaturity

Topic20 Cross Reference toGARP Assigned Reading-Hull,Chapter1

(0,Sj-X}].Weshouldnotethat

Thepayofftotheoptionselleris— Cy[i.e

max {0,S{ -X),wheretime, t,isbetween0andT, isalso thepayoffif theownerdecidesto

exercise thecall option early(inthecaseofan Americanoption aswewill discusslater).

-max

Thepricepaid forthe call option,C0,isreferredto asthecallpremium.Thus,theprofitto

the optionbuyeriscalculatedasfollows:

Figure1depictsthepayoffandprofitfor thebuyerandseller ofacalloption

Figure1 :Profit Diagramfor aCallat Expiration

Cross Reference to GARPAssigned Reading-Hull,Chapter1

Put Option Payoff

Thepayoffona putoption iscalculatedasfollows:

Pr =max (0,X-ST)

where:

PT =payoffon putoption

ST =stock priceatmaturity

X =strike price ofoptionThepayofftotheoptionselleris-P-j-[i.e., -max(.0,X- ST)j.We shouldnotethat

max(0,X—S(),where0< t < T,isalso thepayoffif theownerdecidestoexerciserheputoption early

Thepricepaid for theputoption,P0,isreferred toas theputpremium.Thus,rheprofitto

theoptionbuyeriscalculatedasfollows:

Figure2: ProfitDiagram foraPutatExpiration

-Topic 20

Cross Reference to GARPAssignedReading-Hull,Chapter1

.

Example: Calculating profit andpayoffsfrom options

premiumis $350,and theputpremiumis$2.50 s - f

ForwardContractPayoff

The payoffto alongposition in aforwardcontractiscalculatedasfollows:

Cross Reference to GARPAssigned Reading- Hull,Chapter1

Figure 3 depictsthepayofffor thelongandshortpositions inaforwardcontract.

Figure 3: Forward ContractPayoff

buyingacall option

Cross Reference to GARPAssigned Reading-Hull,Chapter1

Hedgersuseforwardcontracts tolockinthe price of theunderlyingsecurin'.Forward

thatmayhave hadpositiveresultsintheeventthat theposition wasleftunhedged.Option

downside protection thatthehedgerseeks and allowing for pricemovementinthedirection

that could yield positive results Thisinsurancedoesnotcomewithouta cost,aswe

describedearlier, sincehedgersarerequiredtopaya premiumtopurchaseoptions

2. Thevalueof the€10M in U.S dollarsatmaturity given that thecompany didnot

hedgetheexchangeraterisk and diespot rate atmaturityis 1.2$/€. |

Cross Reference to GARP AssignedReading—Hull,Chapter1

Example: Hedgingwitha putoption

Suppose.chatail myestofoÿnsoneshare*ofABCstock pricedat$3<„rr

AIM20.6:Describe,contrast,and calculate thepayoffsfromspeculativestrategies

involvingfutures and options

Speculatorshaveadifferentmotivationforusing derivativesthan hedgers Theyuse

derivativestomakebetsonthe market,while hedgerstry toeliminateexposures

Themotivationfor using futuresinspeculationisthatthelimitedamountofinitialinvestmentcreatessignificantleverage.Theamountofinvestmentrequiredforfuturesisthe

amountof the initialmarginrequired bytheexchange Thisisgenerallyasmall percentage

ofthenotionalvalueof theunderlying,andTreasurysecurities can typically be postedas

margin.Futurescontractscanresultinlargegainsorlargelosses,andcontractpayoffsare

Topic20 CrossReferenceto GARPAssignedReading - Hull, Chapter 1

Optionsalsocreatesignificant leverageas investors onlyneedtopaythe option premium to

purchaseanoption instead ofthefacevalueoftheunderlying Options differfrom futures

in that options haveasymmetricalpayoffs.Gainscan bequitelargegoinglongoptions, but

lossesfromlong optionpositionsarelimitedtotheoptionpremium

Example:Speculatingwith futures

eurosin thespot marketat 0.80$/€ orpurchasetwofuturescontracts at0.83$/€withan

initial margin ofS10,000.Compute theprofitfromthe following:

1 Purchasingeurosin thespotmarket if thespot rateinthree monthsis0.S5$/€; .

|g i

2 Purchasing euros'irithespotmarketifthespot ratein three monthsis0.75$/€

3.«Purchasingthefuturescontractifthe*spotrateinthreemonthsis0.85$/€•;

4.' Purchasirigjhe;futur(ÿcontractifdiespotfateinthrqemonthsis0.75,v|/€:

Asummaryof these fourtransactionsisasfollows:

-Purchase Euros in Spot Market Purchase LongForwardPosition Investment

Profit ifspot at maturity

CrossReference to CARPAssigned Reading-Hull,Chapter1

Professor’sNote:Sinceoption contracts aretradedin amountsof100options,

Ifogl the transactionsin#3and #4 above would entail thepurchajeof100call

optioncontracts (t.e., 10,000/100 - 100).

'

/'4‘

u*m

Asummary ofthese foitrtransactionsis as"follows: 3jr

PurchaseStock Purchase Call OptionShares/Calloption 1,000 • 10,000

mmrni

Topic20 Cross Reference to GARPAssigned Reading-Hall,Chapter1

ARBITRAGEOPPORTUNITIES

AIM 20.7:Calculatean arbitrage payoffand describehow arbitrage opportunities

.areephemeral.

Arbitrageursarealsofrequentusersof derivatives.Arbitrageursseekto earn a risk-free

profit in excessof the risk-freeratethroughthediscovery andmanipulationofmispriced

securities.Theyearnarisklessprofitbyenteringintoequivalent offsettingpositionsin one

ormoremarkets Arbitrage opportunities typically donotlastlongassupplyand demand

forces will adjustpricestoquicklyeliminate the arbitragesituation

c.

•

Assume stockDhbtradesontheNcw.YorkStockExchange(NYSE)and theTokyo*Stock

Exchange(TSE).Thestock currently tradesontheNYSEfor$32andontheTSEfor •

¥2,880.Given thecurrentextharigeTafeis0:dÿ0S$/¥,determine ifanatbilrage profitis

Example:Arbitrage of stocktradingon two.;exchanges

$32-RISKFROM DERIVATIVES

AIM 20.8: Describesomeof the risks thatcanarisefromtheuseof derivatives

Derivativesareversatileandcanbe used forhedging, arbitrage,andpure speculation

If,however,the“bet"onemakesstartsgoingin thewrongdirection,theresultscanbe

catastrophic.Additionally,theriskexiststhatatrader with instructionstohedgeaposition

mayactuallyusederivativestospeculate.Thisriskisknownasoperational risk Controls

needtobecarefully established and monitoredwithinbothfinancial andnonfinancial

corporationsto preventmisuseofderivatives Risk limitsshouldbeset,and adherenceto

risk limitsshould be monitored

COMMON TERMS RELATEDTODERIVATIVES

Thefollowingsectiondiscussescommontermsassociated withderivatives Many of these

forwardas youprogressthroughthederivatives material

Topic 20

Cross Reference to GARPAssigned Reading-Hull, Chapter 1

Aderivative security isafinancialsecurity(e.g., options) whose valueisderivedinpartfromanother security’scharacteristicsorvalue This other securityisreferred to astheunderlying

Amarket makeristheindividual that “makesamarket”in a security.Themarket makermaintainsbid andoffer pricesin a givensecurityandstands readytobuyorselllotsofsaidsecurity,atpubliclyquoted prices

A spot contractisan agreement tobuy/sellan assettoday.Aforwardcontractspecifiesthe

price/quantityofan asset tobe deliveredonorbeforeafuturepre-specifieddate.Afutures

contractisalegally bindingagreement to buy/sell acommodityorfinancialinstrument ina

designatedfuturemonthat apreviously agreedupon pricebyrhe buyer/seller

Acall optiongives itsholder rherighttobuyaspecifiednumberofsharesof theunderlying

securityatthe given strikeprice,on orbeforetheoptioncontract’sexpirationdate.Aput

•priongives theinvestortheright tosellafixed numbeiof sharesatafixed pricewithinagivenpre-specifiedtimeperiod.An investormaywishtohave the optiontosell sharesofa

stockat a certainprice and time in ordertohedgeanexistinginvestment

AnAmerican-styledoptioncontractcanbe exercisedanytimebetween issue dateand

expiration date.Incontrast, aEuropean-styled optioncontract maybeexercisedonlyon theactual expirationdate American optionswill beworthmorethanEuropeanoptions when

rherightto earlyexercise is valuable, andtheywill haveequalvaluewhenitisnot.

Alongposition,referstoactuallyowningthesecurity, whileashort positionis when a

person sellsa securityhe doesnot own.An investortakingashort positionanticipatesa

dropippriceofthesecurity • Theexercise,orstrikeprice,isthe priceatwhich thesecurityunderlyinganoptions

-contractmaybebought/sold

Expirationdate is the jastdateonwhichanoption may be exercised

The bidpriceisthe “quotedbid,” orrhehighestprice, whichadealeriswillingtopayto

purchaseasecurity.Thisisessentiallythe available priceatwhichaninvestor cansell shares

ofstock.Theofferprice is thepriceatwhichthe securityisofferedforsale,also knownas

the “asking price.” Thebid-askspreadisthedifference between the ask(a.k.a.offer)price

andthe bid price

Hedgersreduce their risks typicallythroughtheuseofforwardcontracts oroptions.Byusingforwardcontracts,the traderisattemptingtoneutralize risk byfixingthe price the

hedgerwill pay/receivefortheunderlyingasset.Optioncontracts, in contrast, are moreof

aninsurancepolicy

Speculatorswant totakeapositioninthemarketand profit fromthis position.Speculators

areeffectivelybettingonfuturepricemovement.Whenaspeculatoruses futures,thereis alargepossiblegain/loss Speculatingusing optionsislessriskysincethe maximumlossisthe

costof theoptionitself

lopic 20

Cross Reference to GARPAssigned Reading- Huil, Chapter 1

KEY CONCEPTS

AIM 20.1

theirtrades through hand signals Electronic trading involvesmatchingupbuyers and sellers

electronically

AIM20.2

Theover-the-counter(OTC)market is usedfor largetrades,andatypicalOTCtrade

isconductedoverthephone Termsare not set byan"exchange,” giving tradersmore

flexibility'tonegotiate mutually agreeablererms.TheOTCmarket hasmorecredit risk

Exchangesareorganizedtoeliminate credit risk

AIM 20.3

Acall optiongivesitsholder therighttobuyaspecified numberofsharesof theunderlying

securityat thegiven strikeprice, onorbeforethe optioncontract’sexpirationdate,while

aputoptionistherighttosellafixednumberofsharesat afixedpricewithin agiven pre¬

specifiedtimeperiod

Aforwardcontract isan agreement tobuyorsellan asset at apre-selectedfuturetimefora

certain price ’

Afuturescontract is a more formalized,legallybindingagreement tobuy or sella

commodity orfinancialassetinapre-designatedmonth inrhefuture, at apriceagreed

upon today by thebuyer/seller.

AIM 20.4

Thepayoffonacalloptiontothe option buyeriscalculatedasfollows:

Gaily=max(0,S-r- X)

where:

ST =stock priceatmaturity

X=strike price ofoption

Thepayoffon aputoptioniscalculatedasfollows:

PutT =max (0,X-Sy)

where:

Sy =stock priceat maturity

X=strike price of option

Page23

©2013 Kaplan, Inc.

Cross Reference to GARPAssigned Reading—Hull,Chapter1

Thepayoffto alongposition inaforwardcontract iscalculatedasfollows:

payoff= S-j- -Kwhere:

ST =spotpriceat maturity

K=delivery priceAIM 20.5

Hedgersusederivativestocontroloreliminateafinancial exposure.Futureslockin the

priceof the underlyingsecurityand donotallowforanyupside potential Options hedgenegative pricemovementsandallowfor upside potentialsincethey haveasymmetric

payouts.

AIM20.6Speculatorsusederivativestomake betson themarket.Futures requireasmall initialinvestment,whichistheinitialmarginrequirement.Futurescontracts canresultinlarge

gains orlargelossesasfutureshaveasymmetricalpayoutfunction

AIM 20.7

Arbitrageursseektoearnarisklessprofitthroughthe discovery andmanipulationof

mispricedsecurities Risklessprofitisearned byentering intoequivalentoffsettingpositions

in oneor moremarkets Arbitrageopportunitiesdonorlastlongastheactof arbitrage

bringsprices backintoequilibrium quickly

AIM 20.8

Derivativesareversatileinstruments and can beusedforhedging, arbitrage,and purespeculation Controlsneed tobecarefullyestablishedto preventmisuseofderivatives Risklimitsmustbecarefullyestablished andscrupulouslyenforced

B tradesaremade in sucha way as toreducecredit risk.

C participantshaveflexibilitytonegotiate

D in theeventofamisunderstanding,callsarerecorded between parties

Whichof thefollowingstatementsregardingfuturescontracts is mostlikelycorrect?

Abusinesswithalong exposureto an assetwould hedge this exposure by either

enteringinto a:

A longfuturescontract orbybuyingacall option

B long futurescontract orbybuyinga putoption

C shortfuturescontract orbybuyingacall option

D short futurescontract orbybuyinga putoption

Which ofthefollowingstatementsisleast likelycorrect regarding theuseof

derivatives?

A Misuseofderivativesis not a verysignificant risk

B Risklimitsfor derivativesshouldbeset,andadherencerotheselimits should be

monitored

C Duetoleverageinherent inderivatives,ifabet goeswrong,resultscanbe

catastrophic

D Thereis arisk that tradersmayusederivatives forunintended purposes

Anindividualthatmaintainsbidandofferpricesin agiven securityandstandsready

tobuyorselllotsof saidsecuriryisa(n):

Anagreementsold overanexchangetobuy/sellacommodityorfinancialinstrument

at adesignated future dateisknownas a(n):

Cross'Referenceto CARPAssigned Reading-Hull,Chapter1

CONCEPT CHECKER ANSWERS

1 B Exchangesareorganizedto reduce creditrisk.The other answerchoicesareadvantagesof

over-the-counter trading

D A business with alongexposure to an asset wouldhedgethe exposure by eitherenteringinto

a shortfuturescontract orby buyinga putoption

3 A Misuseof derivativescan be asignificantriskfor firms thatengage inderivatives trading

4. D Amarket makermaintainsbid andofferpricesin a security and standsreadytobuyor sell

lotsofthegivensecurity.

5 C A futures contract is an agreementsoldon anexchangetobuy/sellacommodityorfinancial

instrument in adesignated futuremonth.

2.

The following is a review of the Financial Markets and Products principles designed to address the AIM

statements set forth by GARP This topic is also covered in:

Topic 2

EXAM FOCUS

In thistopic,candidatesshouldfocusontheterminologyoffuturesmarkets,howfuturesdiffer

fromtowards,themechanicsof margindeposits,andtheprocessofmarkingtomarket.Limit

price moves,deliveryoptions, andconvergence ofspot pricestofuturespricesarealso likely

topics Learntheways afuturesposition can be terminatedpriorto contractexpiration

and understand how cashsettlement isaccomplished by thefinal mark tomarketat contract

expiration

exam

AIM21.1:Define and describe the key features ofafuturescontract,including the

AIM21.9: Compareand contrastforwardandfuturescontracts.

Futurescontracts areexchange-traded obligationstobuyorsellacertainamountofan

underlyinggoodat aspecifiedprice and date Theunderlyingassetvariesfrom agricultural

productstostockindices Most futurespositionsare norheldtotakedeliveryof the

underlying good.Instead,theyareclosedout orreversed priorrothesettlementdate

Thepurchaserofafuturescontract issaid tohave gonelongortakenalong,position, while

the seller ofafuturescontract issaidtohavegoneshort or takenashort position For

price.Futurescontractsare used byspeculatorstogain exposuretochangesinthepriceof

theassetunderlyingafuturescontract Ahedger,in contrast,willusefuturescontracts to

reduceexposureto{tricechangesintheasset (i.e.,hedge theirassetpricerisk).Anexample

is awheat farmerwhosells wheatfuturestoreducethe uncertaintyabouttheprice ofwheat

atharvesttime. —

Openinterestisthetotalnumberof longpositions inagiven futurescontract.Italsoequals

the total numberofshort positions inafuturescontract.Anopeninterestof200would

implythatthereare200 short positions in existenceand200longpositionsin existence.

Itispossible,on anygiven day, for the tradingvolumeon a contract tobehigherthan its

openinterest.

TRADING FUTURES CONTRACTS

Toillustrate howafuturescontractiscreated,letsuse a contract ongoldas anexample

Eachcontract represents100troy ouncesand is quotedon aper-ouncebasis.Supposean

investorinstructsabrokertosellonefuturescontract ongold withanApril deliverydate

At about thesametime anotherinvestor instructs abrokerto buyanidenticalfutures

Page27

©2013 Kaplan.Inc.

Topic2 J

CrossReference to GARPAssigned Reading- Hull,Chapter2

sell100 ounces ofgoldatthefuturespriceat contractexpiration Thebuyerofthefutures

contracthasalongfutures position and isobligatedtobuy100ouncesof goldatthe

futurespriceatmaturity.They agreeonapriceof$993.60 perounce.Thetwopartiesin

thisexamplehavenoideaofoneanother’sexistencebecause theclearinghouse(discussed inAIM21.4)takes the opposite side of everytransaction.In the futures market thereisalwaysthesamenumberoflongandshort positions Thismeansthat ifalongpositionwins,the

correspondingshort position loses

CHARACTERISTICS SPECIFIEDIN AFUTURES CONTRACT

Futurescontractsaresimilartoforwardcontractsinthat both allowfora transaction torake

placeat afuturedateat apriceagreed upontoday.Thedifference between thetwo isthat

forwardcontracts areprivate,customizedcontracts,while futurestradeonanorganized

exchange and havetermsthatarehighlystandardized.When anewfuturescontractis

-introducedtothemarketplace,thefuturesexchangemustspecifytheexact termsof the

• Qualityoftheunderlyingasset.Whentheunderlyingassetfor thecontractisafinancial

asset,suchasJapaneseyen,the definition of theasset isstraightforward.However,whentheunderlyingassetisacommodity, there may be different levels of quality for thatgoodavailable in themarketplace (e.g., differenttypesofwheat) Thefuturesexchange

stipulatesthequalityofagood that willbeacceptable forsettlingthecontract.

• Contract size.Thecontractsizespecifies thequantityoftheassetthatmustbe delivered

tosettleafuturescontract(e.g.,onegraincontract=5,000 bushels).

• Deliverylocation The exchangespecifiestheplacewhere deliverywill takeplace

* Deliverytime.Futurescontracts arereferred tobythe monthinwhich deliveryistotakeplace (e.g.,-aDecembercorn contract).Somecontracts are notsettledbydeliverybutby

paymentin cash,basedonthedifference between thefutures priceand the market price

atsettlement '

• Price quotationsand ticksize.Theexchange determineshow the price ofa contractwill

be quotedaswellastheminimum pricefluctuationfor thecontracr,which isreferredto

asthe ticksize.Forexample,-grainisquotedindollarsperbushel,and the minimumtick

size is 14centperbushel Sinceagraincontractconsistsof5,000 bushels,theminimum

ticksize is$12.50(= 5,000 x $0.0025)petcontract.

-Dailyprice limits.Theexchangesetsthemaximum pricemovementfora contractduring

aday.For example, wheatcannotmove more than$0.20fromitsclose thepreceding

day,foradailypricelimit of$1,000.Whenacontractmovesdown byitsdaily price

limit, it issaidtobe limit down Whenthecontractmovesup byitspricelimit,itissaid

tobelimit up

• Positionlimits Theexchangesets amaximumnumberofcontractsthataspeculatormayholdinorderto preventspeculatorsfromhavinganundue influenceon the market.Such limits donotapplytohedgers

Topic 21

Cross Reference to GARPAssigned Reading—Hull, Chapter 2

FUTURES/SPOT CONVERGENCE

AIM21.2:Explaintheconvergence of futures andspot prices

Thespot(cash) priceofacommodityorfinancialassetisthepricefor immediate delivery

The futures priceisthe price today for deliveryatsome future pointin time (i.e.,the

maturitydate).Thebasis is thedifference between thespotprice and the futuresprice

basis=spotprice—futures price

Asthematuritydatenears,the basisconvergestowardzero.At expiration,thespotprice

mustequal the futurespricebecause thefutures price has become the price todayfor

delivery today,which is the sameasthespot.Arbitragewillforcethepricestobe thesame

Example:Why thp futures pricemustequal*the spot priceatexpiration

/V T ' ,.

Suppose diecurrentSjÿtpricekifsiiverds$4,65*Demom’tratepy.arbitrgge;that

futures-price ofafutures silvercontractthat expires,inone,minutemustequal*

Answer:

'

would be$4.70-$4.65=$0.05.Becausethe4contract maturesin oneminute,

virtuallynorisktothis arbitrage trade -ÿ "

Supposeinsteadthefutures price was$4.61.Nowwewould buy the silver

deliveryof thesilver by paying$4.61,and thensell the silveratthespotprice

Ourprofitis $4.65-$4.61=$O.O4s,0nteagain,thisisa risklessarbitragetn

Therefore,in orderto preventarbitrage,thefutures priceatthematurityofthe cc

mustbe equaltodiespotpricÿof$4(65 '

Marginiscashorhighlyliquid collateral placedin an account toensure thatanytrading

losseswillbemet.Markingtomarketisthe daily procedure of adjusting themarginaccount

balancefordailymovementsinthefuturesprice.Theamountrequiredtoopenafutures

positioniscalledtheinitial margin Themaintenancemarginisthe minimum margin

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©2013 Kaplan, Inc

CrossReferencetoGARP Assigned Reading-Hull,Chapter2

accountbalance requiredtoretainthefutures position Whenthe marginaccountbalance

fallsbelow the maintenancemargin, theinvestorgets amargincall,and hemustbringthemarginaccountbacktothe initialmarginamount.Theamount necessary todothisisalliedthe variationmargin

Example: Margin trading

Atthe endof the first day,thelossiscomputedas($99']-$993.6)100=-$260, sowhen

$260depositedinthe,sellers,marginÿaccount.TheBuyers(long)marginaccountbalance

S-lpffl £ afsStU K60)0>'T‘“mar6i'‘aCC°U"'bJ"“f“ tl"!Sh°"P“I‘i“ “

willgeta margincallsincethemarginaccotvntbalatjce is (ess thanthe maintenance

Dependingontheclient,brokersmayrequiretheposting ofabalancein the margin

accountmore thanthemaintenancemarginrequirementsestablishedbyexchanges For

example,hedgersareusually requiredto postsmallermargins thanspeculators.Toensurethat thedaily cash flowsarewithdrawnof contributed appropriately, the exchange hasa

CLEAJRINGHOUSE

AIM21.4: Describe theroleofaclearinghousein futurestransactions

Each exchange hasaclearinghouse Theclearinghouseguaranteesthat tradersinthefutures

marketwillhonortheirobligations.The clearinghousedoesthisbysplittingeach tradeonce

it is madeand actingastheoppositesideofeach position Theclearinghouseacts asthe

buyerto everysellerand thesellertoeverybuyer Bydoingthis,theclearinghouseallowseithersideof thetradeto reversepositionsat afuture datewithouthavingto contacttheothersideof rhe initial trade This allows tradersto enterthemarketknowingthat they

Cross Reference to GARPAssignedReading-Hull Chapter 2

counterpartydefaultingsincethecounterparty isnowthe clearinghouse Inthehistory of

U.S futurestrading,theclearinghousehas neverdefaultedonatrade

Theclearinghousehas members that collateralizeit,ensuring thatnodefaultstakeplace All

trades eventually gothroughtheclearinghousemembers,whomusthaveaclearingmargin

postedattheclearinghousein thesamewayaninvestorhasamarginaccountwithabroker

Thisensuresthattheclearinghouseisliquid enoughatalltimestohonorall obligations

imda futuirst.onrrac.rs.

COLLATERALIZATION

AIM 21.5:Describe the role of collateralizationinthe over-the-counter marketand

compareittothe marginingsystem

The over-the-counter(OTC)maiket includes the tradinginall securitiesnotlistedon one

oftheregistered exchanges This marketis subjectto agooddealofcreditrisksincethe

party onthe other side ofanOTCcontractcould default:on itspayments.One wayto

reduce thiscredit riskisbymeansof collateralization Collateralizationisbasicallyamarked

tomarketfeature for theOTCmarket where any lossissettledincashattheendofthe

trading day.A cashpayment ismadetothepartywithapositiveaccountbalance.Thisis

asimilarsystem totradingonmarginwhere the futurestraderneedsto restorefunds ifthe

valueofthecontractdropsbelow die maintenance margin

NORMALANDINVERTEDFUTURESMARKET

AIM21.6:Identifyanddescribethedifferences betweenanormal andinverted

'

futures-market

The settlementpriceisanalogoustotheclosingpriceforastockbut isnotsimplythe price

of the last trade.It-isanaverageoftheprices -ofthe.trades duringthe lastperiodoftrading,

calledthe closingperiod,'whichissetbytheexchange.Thisfeatureofthe settlement price

preventsmanipulation bytraders The settlement priceisusedtomake margincalcularions

attheendof each trading-day

Dependingonthe direction of futuresserdementprices,themarket may be normalor

inverted.Increasingsettlementpricesover timeindicatesanormalmarket Conversely,

decreasing settlementpricesovertimeindicatesaninverted market

Topic 2 1

Cross Reference to CARPAssigned Reading-• Huil,Chapter2

THE DELIVERY PROCESS

AIM21.7: Describe themechanics of the deliver)' process andcontrastitwith cashsettlement

There arefourwaystoterminateafuturescontract:

1 Ashortcanterminatethecontractbydeliveringthe goods When the longacceptsthisdelivery, he pays thecontractpricetothe short Thisiscalled delivery The locationfor delivery(forphysicalassets),termsof delivery, and details of exactly whatistobedeliveredareallspecifiedinthenoticeof intentiontodeliverfile Each exchangehas

specificrulesas totheconditionsformakingan intenttodeliver.However,the pricepaidorreceived willbe dictated by thesettlementperiodontheexchange-determined

last tradingdayof thecontract.

2 Inacash-settlementcontract,deliveryisnot anoption.The futuresaccountismarked

tomarketbasedonthesettlementpriceonthe last day oftrading

3 Youmay makea reverse, oroffsetting,tradeinthefutures market Withfutures,theother side ofyourpositionisheld by the clearinghouse—ifyoumake anexactopposite

trade (maturity,quantity,and good)to your currentposition,theclearinghousewillnet

your positionsout,leaving you withazero balance.This ishowmostfuturespositions

aresettled.Thecontractpricecandiffer between thetwo contracts.If you initiallyare

longonecontract a t$970 perounceofgold andsubsequentlysell(i.e„taketheshortpositionin) anidenticalgoldcontractwhenthepriceis$950perounce,$20multiplied

by thenumberofouncesofgold specifiedin thecontractwillbe deductedfromthemargindeposits)inyouraccount.Thesaleofthefuturescontractends the exposureto

futurepricefluctuationsonthefirstcontract.Yourposition has been reversed,orclosed

out,byadosing trade

4 A position mayalso be settled throughanexchange forphysicals.Hereyoufindatraderwithanopposite positiontoyour own anddeliver the goodsand settleup

betweenyourselves,offthefloor of the exchange(i.e.,anex-pittransaction).This is the

sole exceptiontothefederal law thatrequiresthatalltrades takeplaceonthe flooroftheexchange.Youmustthencontacttheclearinghouseand tell themwhathappened

Anexchangefor physicals differsfromadeliveryin that the tradersactually exchange

thegoods,thecontractisnotdosedonthe floorof the exchange,andthetwotradersprivatelynegotiatethetermsof thetransaction.Regular delivery involves onlyone

trader and theclearinghouse

Cross Reference to GARP Assigned Reading-Hull,Chapter2

TYPESOFORDERS

AIM 21.8:Defineanddemonstrateanunderstandingof the impact of different

ordertypes,including:market,limit,stop-loss,stop-limit,market-if-touched,

discretionary,time-of-day,open, andfill-or-kill,

There areseveraldifferenttypesof ordersinthemarketplace:

Marketorders areorderstobuyor sellatthebest price available.A discretionary order isa

market orderwherethebrokerhas the optiontodelaytransactionin search ofabetter price

Limitordersareorderstobuyorsellawayfrom thecurrentmarket price.Alimitbuyorder

isplacedbelow thecurrentprice A limit sell orderisplacedabove thecurrentprice.Limit

ordershavea timelimit,suchas instantaneous,oneday,one week,onemonth,orgoodtill

canceled.Limitordersareturnedovertothe specialist by thecommissionbroker

Stop-lossordersareusedto preventlossesorto protectprofits Supposeyou ownastock

currentlyselling for $40 Youareafraidthatitmaydropin price, andifir does,you want

yourbrokertosellit, therebylimitingyourlosses You would placeastoploss sell orderat a

specificprice (e.g.,$35);ifthestock pricedropstothislevel,yourbrokerwillplaceasell

market order.Astop loss buyorderisusuallycombinedwithashort saletolimitlosses If the

stock price risestothe“stop”price, thebrokerenters amarker ordertobuythestock

Variationsontheseordertypesalso exist.Stop-limitorders areacombinationofa stopand

limit order.Thestopprice and limit pricemustbe specified,so that once thestoplevelis

reached, or bettered,theorderwouldturnintoalimit orderandhopefullytransact atthe

limitprice.Market-if-touchedorders, orMil orders, areordersthat-would becomemarket-

-ordersonce aspecifiedpriceisreachedinthemarketplace .

Forthose orders that remainoutstandinguntilthedesignated pricerangeisreached,the

trader makingthe order needstoindicatethetimeperiod for the order(time-of-day order) '

Good-till-canceled(GTC)orders(a.k.a.openorders)areorders thatremain openuntil

theyeithertransact or arecanceled.Apopularmethod of submittingalimit orderis tohave

itautomatically canceledattheendofthetradingdayin which it wassubmitted.Fill-or-kill

ordersmustbeexecuted immediatelyorthetrade willnottake place

REGULATORY,ACCOUNTING,ANDTAXFRAMEWORKS

Regulation

In the UnitedStates,the CommodityFuturesTradingCommission (CFTG)isresponsible

forregulatingfuturesmarkets TheCFTC licenses futures exchangesaswellastraders who

offer futurestradingservicestothe public Italsoapprovesnewfuturescontractsandany

revisionstoexisting futurescontracts.When approvingcontracts,the agencyensuresthat

Inaddition,theCFTCisresponsibleforcommunicatingpricestothepublic,addressing

public complaints,and taking disciplinaryactions againstmembers whoviolatefutures

exchange rules

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©2013Kaplan,Inc.

Topic 2 1

CrossReferencelo GARPAssigned Reading-Hull,Chapter2

Otherregulatorybodies that influencethefutures markets includetheNational Futures

Association(NFA),theSecurities andExchangeCommission(SEC),the FederalReserveBoard,and the U.S TreasuryDepartment TheSEC, Fed,andTreasuryDepartmentare

mainly concernedwith howfutures trading impactsspotmarker tradinginstocks andbonds The NFA hasamoreprominentrole by attemptingto preventfraud andensuring

that futures marketsoperateinthe bestinterestsof thepublic Examplesof futures tradingfraud include cornering themarket(i.e.,takingexcessivelong positions whileinfluencing

thesupply ofthe commodityunderlyingthelongfuturescontracts)andfront running

(tradersusing privilegedinformationtotradein theirownaccountsbeforecustomer

accounts).

Accounting

When accounting forchangesinthe market value ofafuturescontract,changesmustbe

recognizedwhen theyoccur Theexceptiontothisaccountingstandardiswhenafutures

fromahedginginstrumentberecognizedin theSameperiodasgains/losses from theasset

beinghedged

Under FAS 133[FinancialAccounting Standard Board(FASB)Statement No.133], thefairmarketvalueof all derivativecontracts mustbe includedon the balance sheet Inaddition

to morepositiontransparency,FAS133 placesstricterguidelineson theuseofhedge

accounting Tousethis accountingmethod, itmustbe shownthat thehedginginstrument

frequentlyandeffectivelyoffsets the intended risk exposure

Taxes

RegardingU.S.taxregulations,differencesariseduetothenatureoftaxablegains/losses

andthe timing of realized gains/losses Forcorporate,taxpayer’s,capital gainsaretaxed

atthesameleveiasordinaryincomeandcapitallossesarerestricted.Fornon-corporate

taxpayers,capitalgainsaretaxedatthesamelevelasordinaryincome,butlong-term

gains(investmentsheldover oneyear)aresubjectto a maximum15%tax rate.Anotherdifferenceisthatcapitallossesaredeductiblefornon-corporate taxpayers.

Fortaxpurposes, futurescontractsareconsidered closed ourattheendofeach year This

givesrisetoa60/40 rulefornon-corporate taxpayerswhere capitalgains/lossesaretreated

as 60%longtermand40% shortterm.Thisrule, however,doesnotapplytohedging

activities.Using futuresforhedgingpurposesmustbe declaredonthesameday the

transactionisentered Gains/lossesonhedgingtransactionsaretaxedatthe samerateas

ordinaryincome.

Topic 21

Cross Reference to CARP Assigned Reading- Hull, Chapter 2

KEY CONCEPTS

AIM 21.1

Along(short)futurespositionobligatesthe ownertobuy(sell) theunderlyingasset at a

specifiedpriceanddate.Mostfutures positionsarereversed (orclosedout) asopposedto

satisfyingthecontractby making(ortaking)delivery

AIM21.2

Thespotpriceofacommodityorfinancialasset isthe pricefor immediate delivery The

futurespriceisthe price todayfor deliveryat somefuture pointintime(i.e.,thematurity

date).The basisisthedifferencebetween thespotprice and thefuturesprice As the

futurespricestoberhesame at contractexpiration

AIM21.3

Futuresaretradedonmargin(leveraged):

* Initial margin isthenecessarycollateraltotrade thefutures.

* Maintenance marginistheminimumcollateralamountrequiredto rerain trading

privileges

4 Variation marginisthe collateralamountthatmustbedepositedtoreplenish themargin

accountbacktotheinitial margin

Thefutures marketis azero-sumgamein that theshortslossesarethelongsgains andvice

versa Gains and lossesduetochangesinfuturespricesarecomputedatthe end of each

tradingdayin aprocessknownasmarkingtomarket

AIM 21.4

Theclearinghousemaintainsan orderlyandliquidmarketbyactingasthecounterparty to

eachlongorshortfuturesposition

AIM 21.5

Collateralizationis ameansof reducing credit riskinover-the-counter(OTC) contracts.

AIM 21.6

The futuressettlementpriceis anaverageof rhe prices ofthetradesduringthelast period

oftrading,called the closing period.Itisusedtomake margincalculationsat theendof

eachtrading day.Increasingsettlementpricesover timeindicateanormalmarket,while

decreasingsettlement pricesover timeindicateaninvertedmarket

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Cross Reference toGARPAssigned Reading Hull, Chapter 2

AIM 21.7

Ashortcanterminatethe futurescontract bydeliveringthegoods.Whenthelongaccepts

thisdelivery,hepaystheconrractpricetotheshort Thisisknown asthe delivery process

Inacash-settlementcontract,deliveryisnot anoption

AIM21.8Severaldifferenttypesoforders exist inthe marketplace including:market, limit,stop-loss,stop-limit,andmarket-if-rouchedorders Market ordersareorderstobuyorsellatthe bestpriceavailable.Limitordersareorderstobuyorsell awayfromthecurrent market price

Stop-lossordersareusedto preventlossesorto protectprofits

AIM21.9Futurescontracts aresimilartoforwardcontractsin thatbothallowforatransactiontotake

placeat afuturedateat apriceagreedupon today The differencebetween thetwois that

forwardcontracts ateprivate, customizedcontracts,whilefuturestrade onanorganized

exchangeandhavetermsthatarehighlystandardized

Whichof thefollowingarecharacteristicsspecifiedbyafuturescontract?

I Assetquality andassetquandty

II, Deliveryarrangementsanddeliverytime

A I only

B II only

C Both I and II

D NeitherInorII

1.

2

An investorentersinto ashortposition in agoldfuturescontractwith thefollowing

characteristics:

* Theinitial marginis $3,000.

• The maintenance margin is$2,250.

If thepricedropsto $1,295 atthe end ofthe first dayand$1,290 atthe endof the

-second day, whichofthefollowingisclosesttothevariationmargin requiredatthe

endofthe secondday?

A $0.

-B $250

- C $500

D $1,000.

Which ofthe’followingitems'arefunctionsof theclearinghouse?

I Determinewhichcontractstrade.'

II Receivemargindepositsfrombrokers

A Ionly

B II only

C Borh1andII

D NeitherInorII

D Alloftheabove

Foradditional Book3,Topic21practice questionssee:

5

Self-TestQuestions:#1(page213)

PastFRMExam Questions:#1—2(page222)

Cross Reference to CARPAssignedReading-Hull.Chapter2

CONCEPT CHECKER ANSWERS

B When an investor isobligatedtobuytheunderlyingasset in afuturesposition, it is alongfuturesposition.

1.

2 C Delivery time, assetquality',asset quantity, anddeliveryarrangements are allcharacteristicsspecified by the futurescontract.

3 A Notethat theinvestor in this question has a short position thatprofits frompricedeclines

The short position margin accounthas increasedby $1 ,000 overthetwodays,sothereis no

variationmargin required

•4 B Theclearinghouseacts asbuyerto everysellerand seller to every' buyer, thus virtually

eliminating default risk It alsocollectsmarginpaymentsfrom clearingmembers (brokers).

Determining whichcontractswilltrade is afunctionof the exchange,not theclearinghouse

5 D Allofthese orders requirethatthe pricereach a certain rangebefore being activated.Ifthe

pricenever reaches that range, the order will never beactivated

The following is a review of the Financial Markets and Products principles designed to address the AIM

statements set forth byGARP®.This topic is also covered in:

Topic22

EXAM FOCUS

Fururescontracts areused extensivelyforimplementinghedgingstrategies.Thistopic

presentsthe calculationsfordeterminingtheoptimalhedgeratioand showshowto useit

todetermine the numberof futurescontractsnecessarytohedgeaspotmarketexposure

Thistopicalso addressesbasis risk,thechangein therelationship betweenspotprices and

futurespricesover ahedgehorizon.Basis risk arisesbecauseanassetbeing hedgedmaynot

beexacdythesameastheassetunderlyingthefuturescontract.

HEDGING WITH FUTURES

AIM 22.1:Define anddifferentiatebetween shortandlonghedges and identify

appropriateuses

A short hedgeoccurs when thehedgershorts(sells) afuturescontract tohedgeagainsta

price decreaseindie existing longposition.Whenthepriceof thehedgedasset decreases,

the shortfuturespositionrealizesapositivereturn,offsettingthedecline inassetvalue

Therefore,ashorthedgeisappropriatewhen you have along position andexpectpricesto

decline

Along hedgeoccurs when thehedger buysafuturescontract tohedgeagainstanincrease in

the valueoftheassetthat underliesashort position In thiscase,anincrease in thevalue of

the shortedassetwill resultinalosstotheshortseller.Theobjective ofthelonghedgeisto

offset the lossinthe shortpositionwithagain fromthelong futuresposition Alonghedge

isthereforeappropriatewhenyouhaveashort position andexpectpricestorise

Advantages and Disadvantages of Hedging

AIM 22.2:Describetheargumentsforandagainsthedgingandthepotential

impact ofhedgingonfirmprofitability.

The objective ofhedgingwithfuturescontracts is toreduce oreliminatethepriceriskof

an assetoraportfolio.Forexample,afarmerwithalargecorncrop thatwill beharvested

in afewmonthscould waituntiltheendof the growingseasonand sellhis cornatthe

prevailingspotprice, or hecould sellcornfutures and “lockin”the priceof hiscornat

apredetermined rare.Bytakingashort position inacornfuturescontract,thefarmer

eliminates—or ar leastreduces—exposuretofluctuatingcornprices.Thisisanexample ofa

shorthedge,wherethe userlocksin afuture sellingprice

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