Tutorial 1 Q&A

Topic 1

1. What is a derivative instrument? How is it different from stocks and bonds?

Answer:
A derivative instrument is a financial asset that derives its __________________
from its underlying asset. The underlying asset could be a commodity or another
financial asset. Thus, unlike stocks and bonds that represent a direct claim,
derivatives can be thought of as claim on a claim.

2. The evolution of derivative instruments means that each new derivative is an

improvement on its predecessor. State the operational advantages(s) of (i) futures
over forwards, and (ii) options over futures/ forwards.

Answer:
Futures overcome that 3 problems of forwards:
(i) multiple __________________ of needs,
(ii) potential for price __________________, and
(iii) counterparty / default __________________;
whereas forwards / futures locked-in the underlying asset value, options had the
advantage that they provided both downside protection and upside profit potential.

3. What are the key categories of players in derivative markets? Briefly describe the
objective of each category of players.

Answer:
Hedgers, arbitrageurs and speculators.

Hedgers: to manage __________________;

Arbitrageurs: to take advantage of __________________; and
Speculators: to take __________________ based on their expectations.

4. How might the absence of speculators/ speculation hurt hedgers?

Answer:
(i) Reduced liquidity, reduced trading volume and so higher transaction
_____________.
(ii) Lack of counterparties for hedgers to pass on their __________________.

5. Differentiate between commodity and financial derivatives.

Answer:
Commodity derivatives have underlying assets that are commodities / tangible assets and
have __________________ settlement at maturity. Financial derivatives have financial assets
as their underlying and have __________________ settlement at maturity.

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 6. Outline some of the key types of risks and identify the appropriate derivative
instruments to manage the risk.

Answer:
(i) market/price risk: __________________ based on the appropriate underlying asset.
(ii) Interest rate risk: use 3 __________________ futures contracts.
(iii) Currency/ exchange rate risk: use _____________ forward contracts. Since
there are no exchange traded currency in Malaysia, Forwards would be the most
logical choice.

7. Differentiate between exchange traded and OTC instruments. Under what

circumstances might one prefer an OTC instrument to an exchange traded one?

Answer:
OTC instruments are __________________ over the counter instruments whereas
exchange traded instruments are __________________ and traded on a centralized
exchange.

8. Define what is meant by basis. State three situations that could result in non-zero
basis at maturity.

Answer:
Basis refers to the __________________ between forward/futures and spot prices.
By definition, basis should be zero at maturity unless there are mismatches.
Mismatches could arise from (i) asset mismatch, (ii) maturity mismatch, and (iii)
quantity mismatch.

9. A corporate treasurer who was long 3 month futures contracts on British pound
sterling for 400,000 pounds subsequently goes short 3 month pound forward contracts
for 400,000 pounds. Assume the exchange rate in both cases is equal. What is his net
position in British pound?

Answer:
Net position is __________________.

10. Explain the concept of leverage in the futures market.

Answer:
Leverage is the ability to make large profits (or losses) for relatively small outlays of
capital. In the futures market, leverage is made possible because of the system of
__________________ whereby for a small initial outlay, a trader has exposure to a
much larger sum and can make huge profits (or losses) from small variations in price.

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11. If the cash price for gold is US$400 per ounce, storage for one year is US$7 per
ounce and the risk free interest rate is 5% p.a., what is the fair value price of a gold
futures contract that expires six months from now? Show workings.

Answer:

F = S (1 + r + c y) t
F = __________________
F = 413.28

12. What is the importance of the speculator in the futures market?

Answer:
The trader/speculator provides trading volume and __________________ and
willingly takes on the risks hedgers try to avoid, in the hope of great profits (for the
trader/speculator).

13. Explain the meaning of the terms contango and backwardation in the context of
the futures market.

Answer:
Contango refers to the market situation in which futures prices are trading at a level
__________________ than cash prices. Backwardation is the opposite situation
futures prices are __________________ than cash prices.