Futures & Options - Midterm - Fall 1998

Answer 7 of 8 sections made up of three multiple choice pages and 5 essay/problem sections. Multiple choicequestions count off 2 points each, and each section of essay/problems is worth 14 points.

1) A "long" position in a futures contract is an agreement to I)____, while a "short" position in a futures contract is anagreement to II)____.

a. I) buy....II) sell b. I) buy....II) hedge c. I) sell....II) buy d. I) sell....II) hedge

e. I) sell....II) speculate

2) Long positions in debt-based futures are likely to make money when I)___________ and long positions in stockindex futures are most likely to make money when II)_____________ a. I) interest rates rise.....II) stock prices rise b. I) interest rates fall.....II) stock prices fall c. I) interest rates rise.....II) stock prices fall d. I) interest rates fall.....II) stock prices rise e. none of the combinations above are correct

3) If the stock market rises by the normal amount (approximately 10% next year, a speculator who is long the S&P 500is most likely to a. approximately break even b. make a substantial return on

her investment c. lose money

4) Which of the following is the best example of an "intracommodity" or calendar spread a. being long Value Line futures and short S&P 500 futures b. being short Value Line futures and long S&P 500 futures c. being long Mar. T-bond futures and short June T-bond futures d. being long Mar. T-bill futures and short June T-bond futures e. being long cash market stocks and short June T-bond futures

5) Which of the following is applicable to forward contracts but not to futures contracts?a. margin is required b. standardized delivery datesc. quantities are negotiable d. the exchange (or clearing corporation) guarantees against default by the counterparty

6) Assume that platinum is a "full-carry" market, that cash (spot) market platinum is selling for $400, and that the one-yr. T-bill rate is 5%? Transactions and storage costs arenegligible and the cost of borrowing equals the return on lending. What is your estimate of platinum futures pricesdeliverable in one year? a. less than $400 b. $400 c. between $401 and $405 d. $414 e. $420 f. >$420

7) Referring to 6 above, if platinum usually appreciates by the rate of inflation, which is 1.5% lower than the T-bill rate,is a long or short position in platinum futures more likely to make money?

a. long b. long c. they are equally likely to make money

8) An option is different from a futures position in which of the following ways?

a. options are not traded on exchanges, futures are.b. the buyer of an option can choose to let the option expire without taking action, while the buyer of a futures contract cannot.c. speculators typically use options contracts while hedgers typically use futures contracts.d. sellers of options have much less risk than sellers of

futures contracts.

9)

10) A "cross-hedge" is defined as a hedge in whicha. the futures contract is somewhat different in nature from the cash market being hedged.b. the loss on the hedge is so high that the hedger becomes very upset.c. the futures and cash market prices cross prior to the delivery date.d. the hedger hedges by using a spread position.

11) How could you expect to profit in the futures market if you had inside information on an impending breakthrough that will reduce the cost of refining crude oil to produce gasoline and fuel oil?

a. go long crude and short gasoline and fuel oilb. go long crude and long gasoline and fuel oilc. go short crude and short gasoline and fuel oild. go short crude and long gasoline and fuel oil

12) Variation margin can be defined as a. a deposit put up to initiate (begin) a futures position b. a deposit put up when a futures position is closed c. a deposit put up when a futures position loses d. the percentage of the initial margin that must be maintained

13) Which of the following statements is correct? a. The largest futures market is the New York Futures Exchange. b. Initial margin is always put up in cash, never T-bills. c. The margin requirement on an "intracommodity spread" posi- tion should be less than that on one long position by itself. d. "Open interest" is always equal to twice the volume traded. e. The "settle price" is the agreed-on price between the long and the short traders for any futures transaction.

14) True False The value of a "tick" for the S&P 500 futures contract is $250.

15) True False In a value (capitalization) weighted stock index, a change in the price of any one stock will affect the index by the same amount as a change in any other stock price.

16) Which of the following is not a characteristic of futures contracts? a. standard delivery date(s)

b. an exchange-backed guarantee that the contract will be honored.c. losses limited to initial paymentd. margin for both long and short positionse. ability to close out (offset) positions on a secondary market

17) "Basis" can be defined as "spot price minus futures price."

Which of the following is normally true about the basis?a. Its value is normally positive for precious metals.b. It tends to narrow as the delivery date approaches.c. Its value is normally positive for S&P 500 futures.d. Its value is normally negative for all futures.

e. It normally does not change as the delivery date approaches.

18) The dollar value of the initial margin on T-bond contracts is _______for T-bond futures ______ for T-bill futures.

a. higher...than b. lower...than c. the same...as

19) For the next 90 days, which of the following positions would bemore likely to provide the best insurance (hedge) against fallingvalues in a 30-yr., fixed-rate mortgage portfolio? A short position in a. T-bill futures b. T-note futures c. stock index futures, or a long position in d. T-bill futures e. T-note futures f.stock index futures

20) The expected return on a fully hedged stock portfolio is approximately equal to

a. the portfolio's dividend rate b. the T-bill ratec. the normal stock market appreciation of 10% or sod. zero e. the T-bond rate

21) If the beta of a $20 million portfolio is 1.2 and you wish to fully hedge this portfolio with S&P 500 futures tradingfor 1000, you should use approximately $____ million worth of contracts.

a. 16.67 or less b. 20 c. 24 d. 27 or more

IV.V.

Answer 14 points worth of the following.

Explain the relationship of “marking to market” to variation margin.(4 points) (4 points)

Define “convergence.” (2 pts.)

VI.Explain how one might use stock index futures (including the Russell 2000) to play the “JanuaryEffect” defined as small stocks outperforming large cap stocks in Jan. When should one enter andexit? What contracts? What delivery (expiration) dates? (2 pts. for each of the previous threequestions.)

Using the stock index futures quotes provided, design and explain how your strategy for playing theJanuary Effect might work, using a numerical example that discusses how the no. of each contract isdetermined, and how much profit might be made in a “normal” year.(10 pts., including a 2 point bonus) VII.A. 8 points Refer to the accompanying S&P 500 futures quotation and provide the following: a. the number of long positions outstanding in the March contract and an explanation of what "open interest" is.

b. the relationship between volume and open interest: what might cause one to be higher than the other? c. the delivery price in dollars of one March contract.

d. the profit or loss that would have been made if a speculator had bought the March contract at its daily

low and sold it at its high.

B. 6 points If the cash S&P 500 is 800, the one-yr out S&P 500 is 832, the dividend rate on the S&P 500 is 2% of the cash index, and the one-yr. T-bill rate is 5%,explain what return an investor would make who did a cash and carry (buy) program trade. Assumethat the investor invests his/her own money rather than borrowing the funds to finance the purchaseof stocks.

B. 8 points Define/explain 4 of the following 6 terms.

Price discovery, implied forward rate, cross hedge, Tic

A2) 7 points - Define speculation and hedging, and explain how and why a hedge is used by givingan example of a "long hedge". 2) Explain what a spreader could do to make money if he was sure that the yield curve would become flat by December 1985. Use either T-bill or T-bond futures in explaining yourself. Does it make a difference whether the yield curve flattens at a lower or a higher level of interest rates?

II.

B) 17 points - Define and briefly discuss 8 of the 9 terms below

Convergence Basis ArbitragePrice discovery Day trader Put option

III.C1) 8 points - Define and briefly discuss 4 of the 5 terms below

1) Initial vs. maintenance margin2) Using "duration" in choosing hedge ratios.5) An example of a situation when one might want to use an intra- commodity spread.

C2) 7 points - Is the observed price in the gold futures market anunbiased estimator of future spot gold prices? Explain why or whynot.

C3) 2 points - Assume that gold is a "full-carry" market, that cash (spot) market gold is selling for $400, that the one-year repo rate is 6%, and that gold deliverable in one year in the futures market is trading for $612? Which of the following is most likely to occur? a. arbitragers will buy cash market gold and short gold futures b. arbitragers will buy cash market gold and go long gold futures c. arbitragers will short cashmarket gold and short gold futures d. arbitragers will short cash market gold and go long gold futures

B 1) Refer to the accompanying T-bill futures quotation from Barron's and provide the following: a - the dollar value of the open interest in the June 1986 contract and an explanation of what "open interest" is. b - the delivery price in dollars of the June 1986 contract. c - the profit or loss that would have been made if a speculator had bought the contract at its low and sold it at its high for the week.

2) Use world sugar or leaded gasoline futures in formulating a strategy based on the "butterfly spread" concept. What do you expect to happen and what could go wrong to thwart your money-making scheme? ______________________ Answer 4 of 6 sections. Each section is worth 25 points. Section A - Multiple Choice - Answer any 10 of the 11 questions.

2. Stock index futures contracts a. would require a long position that is not closed out by the end of the last trading day of the contract to buy a portfolio of stocks valued at $500 times the contractual price at which the position was contracted.

b. would require a long position that is not closed out by the end of the last trading day of the contract to buy a portfolio of stocks valued at $500 times the closing price on the last trading date of the contract. c. normally trade at prices that are lower than the stock indexes on which they are based. d. normally are valued at $500 times the index. e. are all traded on the Kansas City Board of Trade. f. include the S&P, NYSE, Major Market, and Value Line indexes, but the most popular is the Dow Jones contract. 3. "Program traders" are relatively large traders that a. spread between the T-bond and T-bill futures markets. b. buy and sell only on certain days of the month. c. use computer programs to tell them when to enter the foreign currency futures markets. d. enter into futures positions based on analysis of seasonal patterns in futures prices. e. would buy stocks and short stock index futures when the prices of the latter are significantly above stock indexes.

. 8 points - Assume the following conditions in the T-bill market. Cash market T-bill BDR: 181 days - 3.80%, 91 days - 4.00% Futures market rate for delivery in 91 days of a T-bill with 90 days remaining to maturity - 4.16%.

Calculate precisely whether you would be better off by buying the91-day cash T-bill or by creating an artificial 91-day T-bill bybuying the 181-day T-bill and shorting the T-bill future.

6. The premium, or initial non-refundable fee paid to the writer of an option will normally be higher the a. more volatile the underlying security. b. nearer the expiration date of the option.

8. Over the last several months the British pound has moved from a low of around 1.1 pounds per dollar to the present 1.4 pounds per dollar. During the same period the dollar traded on British exchanges has moved from _____ dollars / pound to ____ dollars per pound. (Fill in the blanks to nearest two decimal places.) 9. The interest rate parity theory used to explain foreign exchange rates suggests that if country H with high interest rates and country L with low interest rates c spot exchange rate of 1H to 1L, the forward or futures rate of exchange will most likely be a. approximately the same. b. more than 1H per L. c. less than 1H per L. 10. A logical interest rate risk management technique for a typical savings and loan institution would be to a. go long interest rate futures contracts. b. agree to pay a fixed rate and receive a floating rate in an interest rate swap arrangement. c. buy call options on T-bonds and/or T-bond futures. d. buy British pounds and short German marks. 11. Which of the following would be likely to make money using spreads in Eurodollar/T-bill futures? a. buying Euros & shorting T-bills prior to an increase in the general level of interest rates. b. shorting Euros & buying T-bills prior to a decrease in the general level of interest rates. c. shorting Euros & buying T-bills prior to an economic cataclysm giving rise to a "flight to quality". d. All three of the above would normally work under the conditions described.

A. The S&P index closed last Friday at 209.94, while the March S&P futures contract closed at 213.40. Assume that there is three months left until delivery of the March contract and that dividends equal 4 percent on an annual basis. What is the implied yield to an investor who buys the stocks in the S&P index and shorts March S&P futures contracts? Show your work. Based on your calculations, explain what course of action you would advise a "program trader" to undertake - buy stocks and short the index futures, short stocks and buy the index futures, do nothing, or some other strategy. Explain the sequence of transactions you would advise the program trader to follow, or, if you think it advisable to sit tight, explain what would cause you to change your mind and act. Discuss the pros and cons of your advice, along with any potential problems that might foil your strategy. B.

C. Solvent Mutual Saving Bank can float debt with an average six months maturity at a cost of 6 month T-bill + 25 basis points. Alternatively, it can float 5 to 10 year debt at 100 basis points above the Treasury rate for comparable maturitiesvests primarily in fixed ratemortgages. Benefitus Finance Co. can issue six month debt at 75 basis points above the T-bill rate, but can issue 5 to 10 year debt at 50 basis points above the Treasury rate for those maturities. Benefitus specializes in car loans and other intermediate term loans. Can a mutually beneficial interest rate swap be arranged for

Solvent and Benefitus? Explain why or why not. If it can outline reasonable terms for the swap. If it cannot, explain what conditions would have to obtain for a mutually beneficial swap to be possible. Briefly discuss potential advantages and possible problems for a swap arrangement. D. ANSWER ANY THREE 1. Define and explain the "MOB" spread, what it is, and when it should work.

4. If the Mark is trading for $.40 in the cash market and $.42 in

the one-year-out futures contract, and government securities are yielding 8% in the U.S. and 6% in Germany, what might one do to maximize return over the one year period? E. ANSWER ANY THREE 1. If the Canadian dollar can be bought for $.75 and the French Franc can be bought for $.125, what is the equilibrium exchange ratio for Canadian dollars versus French Francs? If the U.S. dollar to Franc and U.S. dollar to Canadian ratios are as above, but the Canadian dollar buys 10 French Francs in Montreal, is there a possible arbitrage opportunity available? If so, describe; if not, explain why not.

If a speculator thinks that interest rates are going to fall by more than the market consensus would indicate, (s)he should a. short T-bill or T-bond futures b. short stock index futures c. go long (buy) T-bill or T-bond futures d. go long the distant gold contracts

The delivery of T-bonds into the T-bond futures contract a. is initiated by the long position. b. must occur on either Thursday or Friday. c. is for $1 mil. face value of bonds. d. is based on a standard of a 10% T-bond. e. requires T-bonds not callable or maturing for at least 15 years.

18) The yield curve is almost flat now, but you expect it to become normal in the near future. Whichof the following strategies is more likely to make money regardless of whether the yield curveflattens at a higher or lower level? a. go long T-bill futures b. go long T-bond futures c. go short T-bill futures c. go short T-bond futures d. go long T-bill futures and short T-bond futures e. go short T-bill futures and long T-bond futures

19) If delivery of a 7% T-bond occurs on a T-bond futures contract originally contracted at a price of 98-16, the price paid by the long at delivery (ignoring accruedinterest) will be

a. < $97,000 b. approximately $97,500 c. $98,500 or higher

20) If delivery occurs on a T-bill futures position originally contracted at 95.20 (4.80%), then the price paid will be

a. $95,200 b. $95,625 c. $952,000 d. $956,250e. $976,000 f. $980,000 g. $988,000 h. >$990,000

For which of the following futures contracts is delivery not possible?

a. T-bond b. T-bill c. gold d. S&P 500