CFA Level 1 - Derivative Investments Session 17 - Reading 62

CFA Level 1 - Derivative Investments Session 17 - Reading 62 (Notes, Practice Questions, Sample Questions) 1. For a futures trade: A)a single price is determined by supply and demand. (Explanation — There is no bid/ask spread in futures trades; the price for the trade is determined on the floor of the exchange and is the single price the long will pay the short for the asset at the termination of the contract) B)the buyer pays the bid price; the seller receives the ask price. C)the seller receives the bid price; the buyer pays the ask price 2. Which of the following statements about futures and the clearinghouse is least accurate? The clearinghouse: A)has defaulted on one half of one percent of futures trades. (Explanation — In the history of U.S. futures trading, the clearinghouse has never defaulted. Other information on the clearinghouse: The clearinghouse guarantees that traders in the futures market will honor their obligations. The clearinghouse does this by splitting each trade once it is made and acting as the opposite side of each position. The clearinghouse acts as the buyer to every seller and the seller to every buyer. By doing this, the clearinghouse allows either side of the trade to reverse positions later without having to contact the other side of the initial trade. This allows traders to enter the market knowing that they will be able to reverse their position any time that they want. Traders are also freed from having to worry about the other side of the trade defaulting, since the other side of their trade is now the clearinghouse. To safeguard the clearinghouse, the exchange requires traders to post margin and settle their accounts on a daily basis) B)requires the daily settlement of all margin accounts. C)guarantees that traders in the futures market will honor their obligations 3. Which of the following statements about futures markets is least accurate? A)Hedging is the prime social rationale for futures trading. B)Initial margin can only be posted in cash. (Explanation — Margin can be posted in cash, bank letters of credit, or T-bills) C)Futures markets allow market participants to discover the market's expectation of future cash market prices 4. Standardization features of futures contracts do not include the: A)delivery time. B)quality of the good that can be delivered. C)delivery price of the commodity. (Explanation — The delivery, or spot price at contract expiration, of a commodity is a variable and cannot be included in a futures contract. Quality and delivery time are both part of the standardized terms of a futures contract.) 5. All of the following are characteristics of futures contracts EXCEPT: A)they are liquid. B)the contract size is standardized. C)they trade in a dealer (over the counter) market. (Explanation — Futures contracts trade on organized exchanges; forward contracts are created by dealers.) 6. Which of the following statements regarding futures contracts is least accurate? A)The exchange sets the times of trading for futures contracts. B)Price fluctuations can be any amount. (Explanation — The minimum price fluctuation, called a ‘tick’, is set by the exchange. The other statements are true) C)The long will have gains when the futures price rises above the initial contract price. 7. An investor bought a futures contract covering 100,000 Mexican Pesos at 0.08196 and deposited margin of $320. The following day the contract settlement price was 0.08201. The new margin balance in the account is: A)$320. B)$314. C)$325 (Explanation — 320 + 100,000(0.08201 − 0.08196) = $325) 8. An investor sold ten March stock index futures contracts. The multiplier on the contract is 250. At yesterday’s settlement price of 998.40 the margin balance in the account was computed as $86,450. Today the index future had a settlement price of 1000.20. The new margin amount is: A)$81,950. (Explanation — 86,450 − 10 × 250 × (1000.2 − 998.4) = $81,950) B)$90,950. C)$86,900. 9. A trader is long four July gold futures contracts, each with a contract size of 300 oz. If the price of July gold increases from $380.20 to $381.00 per ounce the change in the margin balance will be: A)$240. B)$960. (Explanation — 4 × 300 × (381 – 380.20) = $960) C)-$960. 10. Most deliverable futures contracts are settled by: A)delivery of the asset at contract expiration. B)an offsetting trade. (Explanation — Most futures positions are closed out by an offsetting trade at some point during life of the contract.) C)a cash payment at expiration. 11. An offsetting trade is used to: A)close out a futures position prior to expiration. (Explanation — An offsetting/reversing trade is used to close out a futures position prior to expiration.) B)fully hedge a risk arising in the normal course of business activity. C)partially hedge the interest rate risk of a bond position. 12. Closing out a futures position prior to expiration: A)can be done by entering into an offsetting trade at the current futures price. (Explanation — Taking the opposite position in an equal number of contracts on the same asset with the same expiration date ends any further exposure under the original contract) B)can only be done by the long. C)removes price risk but not necessarily counterparty risk. 13. Prior to contract expiration the short in a futures contract can avoid futures exposure by: A)using an exchange-for-physicals. B)paying a cash settlement amount. C)entering into a reversing trade. (Explanation — Prior to expiration, a futures position (long or short) is closed out by an offsetting/reversing trade. The other methods are used to settle positions at contract expiration) 14. Which of the following statements about closing a futures contract through offset is most accurate? A)A low percentage of offsets take place ex-pit. B)The clearinghouse nets the position to zero. (Explanation — An offset trade must be conducted on the floor of the exchange through the clearinghouse. Exchange for physicals (EFP) involves private parties and takes place ex pit, or off the exchange floor.) C)In an offset, or reversing trade, a trader makes an exact opposite trade (maturity, quantity, and good) to her current position, either through the clearinghouse or a private party. 15. Which method is NOT an appropriate way to close out a futures contract? A)Reverse trade. B)Delivery. C)Default. (Explanation — Default is failure to perform as required under the contract.) 16. All of the following are methods to close out a futures position EXCEPT: A)delivery of the underlying commodity. B)allowing the contract to expire without taking action. (Explanation — A futures contract cannot expire without any action being taken. If the contract has not been closed out through an offsetting trade, then one party must deliver the underlying commodity and the other party must purchase the commodity.) C)through an exchange for physicals with another trader. 17. Which of the following statements about closing a futures position is least accurate? A)Few futures positions are settled by delivery of cash or assets. B)Closing a position through delivery refers exclusively to the physical delivery of goods. (Explanation — Delivery can also occur through cash settlement of gains and losses. The other statements are true. Approximately one percent of futures transactions are closed through actual delivery or cash settlement.) C)Except for exchange for physicals (EFP) transactions, futures contracts must be closed on the exchange floor. 18. Which of the following statements about closing a futures position through delivery is most accurate? A)Depending on the wording of the contract, a trader may close a contract by either delivering the goods to a designated location or by making a cash settlement of any gains or losses.(Explanation — The other statements are false. Physical deliveries and cash settlements combined represent less than one percent of all settlements. An exchange for physicals differs from a delivery in that: The traders actually exchange the goods. The contract is not closed on the floor of the exchange. The two traders privately negotiate the terms of the transaction.) B)Although the popularity of physical delivery has decreased over time, delivery by cash settlement remains the most popular method of closing a futures position. C)Delivery is also known as exchange for physicals (EFP). 19. An exchange-for-physicals, as it pertains to futures contracts: A)is another term for delivering an asset to satisfy a futures contract. B)is another term for accepting delivery of an asset to satisfy a futures contract. C)involves an agreement off the floor of the exchange. (Explanation — An exchange-for-physicals involves an agreement between long and short contract holders to settle their respective obligations by delivery and purchase of an asset. It is executed off the floor of the exchange and reported to exchange officials who then cancel both positions.) 20. Which of the following statements regarding Treasury bond futures is least accurate? A)Upon delivery, the long pays the short the futures price divided by the conversion factor for the bond the short chooses to deliver. (Explanation — The delivery price for Treasury bonds under the contract is multiplied by the conversion factor for the bond the short chooses to deliver. The other statements are true.) B)They are a deliverable contract. C)The contract size is $100,000. 21. At the Chicago Board of Trade, futures on foreign currencies have a contract size fixed in: A)foreign currency units and are priced in dollars per foreign currency unit. (Explanation — In the U.S., futures contracts for foreign currencies have a contract size fixed in foreign currency units (e.g. 125,000 Euros) and are priced in dollars per foreign currency unit (e.g. $0.08341 per Peso).) B)dollars and are priced in dollars per foreign currency unit. C)dollars and are priced in foreign currency units per dollar. 22. Which of the following statements about futures contracts on U.S. exchanges is least likely accurate? A)Prices of currency futures contracts are quoted as U.S. dollars per unit of the foreign currency. B)A $100,000 Treasury bond futures contract that settles at 102-16 represents Treasury bonds worth $102,500. C)If annualized 90-day LIBOR decreases from 3.64% to 3.58%, a long position in a $1 million Eurodollar futures contract loses $150. (Explanation — The long position in a Eurodollar contract gains value when LIBOR decreases. Price quotes on Eurodollar futures are calculated as 100 minus annualized 90-day LIBOR in percent. A change in 90-day LIBOR of 0.01% represents a $25 change in value on a $1 million Eurodollar futures contract. If LIBOR decreases from 3.64% to 3.58%, the contract price increases six ticks from 96.36 to 96.42, so the long position gains 6 × $25 = $150. Treasury bond futures that have a face value of $100,000 are quoted as a percent of face value with fractions measured in 1/32nds. A bond futures quote of 102-16 represents 102 16/32, or 102.5% of $100,000, which is $102,500. Currency futures contracts are set in units of the foreign currency and stated as USD/unit.) 23. Which is the only type of commodity where trading in forward contracts is larger than trading with future contracts? A)Foreign currency. (Explanation — Trading in foreign currency forwards is far larger than the trading in futures. For example, with international trade, businesses can hedge against adverse currency fluctuations. But each business arrangement is unique, and most require the flexibility of a forward, whose terms are not standardized, that meets their special needs) B)Agricultural. C)Interest rate.