Sure, let's go through each line and provide an explanation, as well as an example where necessary:
LO 31.a: A long (short) futures position obligates the owner to buy (sell) the underlying asset at a specified price and date. Most futures positions are reversed (or closed out) as opposed to satisfying the contract by making (or taking) delivery.
Explanation: A long futures position means the investor agrees to buy the underlying asset at a predetermined price and date in the future. On the other hand, a short futures position means the investor agrees to sell the underlying asset at a predetermined price and date in the future. Most investors do not intend to actually take delivery of the asset or deliver it. Instead, they reverse or close out their positions before the contract's expiration by taking an opposite position in the same contract.
Example: Let's say Investor A buys one crude oil futures contract, agreeing to purchase 100 barrels of crude oil at $70 per barrel in three months. This is a long futures position for Investor A. Investor B sells (shorts) one crude oil futures contract, agreeing to sell 100 barrels of crude oil at $70 per barrel in three months. This is a short futures position for Investor B.
LO 31.b: The spot price of a commodity or financial asset is the price for immediate delivery. The futures price is the price today for delivery at some future point in time (i.e., the maturity date). The basis is the difference between the spot price and the futures price. As the maturity date nears, the basis converges toward zero. Arbitrage will force the spot and futures prices to be the same at contract expiration.
Explanation: The spot price is the current market price of an asset that can be bought or sold for immediate delivery. The futures price, however, is the price agreed upon today for delivery of the asset at a future date. The difference between the spot price and the futures price is known as the basis. As the delivery date approaches, the futures price and the spot price tend to converge, and at the contract's expiration, they should ideally be the same due to arbitrage opportunities.
Example: Suppose the current spot price of gold is $1,800 per ounce, and the futures price for gold delivery in three months is $1,850 per ounce. The basis would be $1,850 - $1,800 = $50. As the contract nears its expiration, the futures price and the spot price will tend to converge. If the spot price rises to $1,845 and the futures price remains at $1,850, the basis reduces to $1,850 - $1,845 = $5.
LO 31.c: The exchange maintains an orderly and liquid market by acting as the counterparty to each long or short-futures position. In the OTC markets, the central counterparty (i.e., exchange) becomes the counterparty to both parties in an OTC transaction.
Explanation: In exchange-traded futures markets, the exchange itself acts as the counterparty to every trade. When a buyer (long) and a seller (short) agree to a futures contract, the exchange ensures the fulfillment of the contract. This system provides transparency, standardization, and reduces counterparty risk. In contrast, in over-the-counter (OTC) markets, there may not be a centralized exchange, and participants face each other's credit risk. However, some OTC markets have central counterparties that act as an intermediary to guarantee the trades.
Example: In an exchange-traded futures market, if Investor A goes long on a gold futures contract, the exchange becomes the counterparty to Investor A. If Investor B goes short on the same gold futures contract, the exchange becomes the counterparty to Investor B. The exchange ensures that both sides meet their obligations under the contract.
LO 31.d: Increasing settlement prices over time indicate a normal market, while decreasing settlement prices over time indicate an inverted market.
Explanation: The settlement price of a futures contract is the price at which the contract is marked to market, determining the gains or losses for each party on a given day. In a normal market, the settlement prices tend to increase over time, reflecting an upward-sloping futures curve. This pattern is typical in commodities markets, where prices often rise over time due to factors like storage costs and carrying charges. In an inverted market, the settlement prices decrease over time, resulting in a downward-sloping futures curve. This situation is less common but may occur in certain financial markets.
Example: In a normal market scenario, the settlement prices for crude oil futures contracts might be $70, $72, $74, and $76 for successive delivery months. In an inverted market scenario, the settlement prices might be $80, $78, $76, and $74 for successive delivery months.
LO 31.e: A short can terminate the futures contract by delivering the goods. When the long accepts this delivery, the long pays the contract price to the short. This is known as the delivery process. In a cash-settlement contract, delivery is not an option, and the settlement amount is based on a mark-to-market process.
Explanation: In physically settled futures contracts, the short party has the option to deliver the underlying asset to the long party upon contract expiration. If the short party chooses to deliver, the long party is obligated to accept the delivery and pay the contract price. This is known as the delivery process. However, in cash-settled contracts, no physical delivery occurs. Instead, the contract is settled based on the difference between the contract price and the market price of the underlying asset at expiration, as determined through the mark-to-market process.
Example: In a physically settled wheat futures contract, the short party can deliver a specified amount of wheat to the long party at the contract's expiration. The long party is then required to pay the contract price per bushel for the delivered wheat. In a cash-settled S&P 500 index futures contract, no physical delivery of stocks occurs. Instead, the contract's value is settled in cash based on the difference between the contract price and the actual value of the S&P 500 index at expiration.
LO 31.f: Several different types of orders exist in the marketplace, including market, limit, stop-loss, stop-limit, and MIT orders. Market orders are orders to buy or sell at the best price available. Limit orders are orders to buy or sell away from the current market price. Stop-loss orders are used to prevent losses or to protect profits. Stop-limit orders are a combination of a stop and limit order. MIT orders are orders that would become market orders once a specified price is reached.
Explanation: Traders and investors use different types of orders to execute trades in the futures market, each with its own purpose and conditions.
1. Market Order: A market order is an instruction to buy or sell immediately at the best available market price. The order is executed quickly, but the actual price obtained may differ slightly from the quoted price due to market fluctuations.
2. Limit Order: A limit order is an instruction to buy at a specific price or lower, or sell at a specific price or higher. It provides price control but does not guarantee execution if the market does not reach the specified price.
3. Stop-Loss Order: A stop-loss order is placed to limit potential losses. If the market price reaches the stop price, the order is triggered as a market order to sell (in the case of a long position) or buy (
in the case of a short position).
4. Stop-Limit Order: A stop-limit order is a combination of a stop order and a limit order. It is triggered at a stop price like a stop-loss order but is then executed as a limit order at a specified price or better.
5. MIT (Market If Touched) Order: An MIT order is an order to buy or sell at the market price once a specific trigger price is reached. It is similar to a stop order but becomes a market order when the trigger price is touched.
Example: Let's say the current market price for gold futures is $1,900 per ounce. A trader places a limit order to sell at $1,920. If the market reaches or exceeds $1,920, the order will be executed at $1,920 or a better price. If the trader wants to limit potential losses, they could place a stop-loss order at $1,880. If the market price falls to or below $1,880, the stop-loss order will trigger a market order to sell at the prevailing price.
LO 31.g: Futures contracts are settled daily; therefore, all gains/losses for a given year would be considered realized and, therefore, must be recorded each year (i.e., mark to market). Assuming a transaction qualifies for hedge accounting, the accounting rules permit gains/losses from the futures (that would otherwise be reported annually) to be deferred and reported simultaneously with the gains/losses on the hedged items.
Explanation: In futures trading, gains or losses are realized daily through the process of mark-to-market. At the end of each trading day, the settlement price is determined, and any unrealized gains or losses are converted into realized gains or losses. This daily marking-to-market results in the need to record the gains or losses in the financial statements each day.
However, if a transaction qualifies for hedge accounting, special accounting treatment is allowed. Hedge accounting allows certain derivative transactions, such as futures contracts, to be designated as hedges against specific risks. The gains or losses from these hedging instruments can be deferred and matched with the gains or losses on the hedged items (e.g., the underlying asset being hedged) in the financial statements. This matching ensures that the financial statements better reflect the economic impact of the hedging activity.
Example: Suppose a company uses crude oil futures contracts to hedge its exposure to fluctuations in crude oil prices. Without hedge accounting, the daily mark-to-market gains or losses on these futures contracts would need to be recorded in the company's income statement each day. However, if the company qualifies for hedge accounting, it can defer these gains or losses and match them with the gains or losses that arise from changes in the cost of crude oil, which is the underlying asset being hedged. This way, the financial statements better reflect the net impact of the hedging activity on the company's financial position.
Sure, here are some multiple-choice questions related to the provided information:
Question 1:
Which of the following best describes a futures contract?
a) A contract that obligates the owner to buy the underlying asset at a specified price and date.
b) A contract that obligates the owner to sell the underlying asset at a specified price and date.
c) A contract that allows the owner to buy or sell the underlying asset at any time during the contract period.
d) A contract that allows the owner to exchange one asset for another asset at a specified price and date.
Answer: a) A contract that obligates the owner to buy the underlying asset at a specified price and date.
Question 2:
What is the key difference between a spot price and a futures price?
a) Spot price is the price for immediate delivery, while futures price is the price for delivery at some future date.
b) Spot price is the price for delivery at some future date, while futures price is the price for immediate delivery.
c) Spot price and futures price are the same.
d) Spot price is the price at which a futures contract is closed out.
Answer: a) Spot price is the price for immediate delivery, while futures price is the price for delivery at some future date.
Question 3:
In an exchange-traded futures market, who acts as the counterparty to each trade?
a) The short party
b) The long party
c) The exchange itself
d) A central bank
Answer: c) The exchange itself
Question 4:
What type of order instructs to buy or sell at the best price available?
a) Limit order
b) Stop-loss order
c) Market order
d) Stop-limit order
Answer: c) Market order
Question 5:
Why do futures contracts settled daily require daily mark-to-market accounting?
a) To ensure that gains and losses are reported annually.
b) To maintain an orderly and liquid market.
c) To reduce counterparty risk.
d) To convert unrealized gains or losses into realized gains or losses each day.
Answer: d) To convert unrealized gains or losses into realized gains or losses each day.
Question 6:
What accounting treatment is allowed for gains/losses from futures contracts that qualify for hedge accounting?
a) The gains/losses are deferred indefinitely.
b) The gains/losses are reported annually.
c) The gains/losses are deferred and matched with the gains/losses on the hedged items.
d) The gains/losses are not recorded in the financial statements.
Answer: c) The gains/losses are deferred and matched with the gains/losses on the hedged items.
Remember, these questions are meant to test your understanding of the material. Feel free to review the explanations provided earlier to reinforce your knowledge.
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