kmf229

Compared to the price on an otherwise identical forward contract, the price of a futures contract is:

A) always the same at contract initiation.

B) lower when asset price changes are positively correlated with interest rate changes.

C) higher when asset price changes are positively correlated with interest rate changes.

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A positive correlation between asset price changes and interest rate changes makes the mark-to-market feature attractive to a futures buyer. This leads to a higher futures price compared to the forward price on an otherwise identical contract.

kmf229

When interest rate changes are negatively correlated with the price changes of the asset underlying a futures/forward contract:

A) futures prices are higher.

B) forward prices are higher.

C) futures prices may be higher or lower depending on the risk-free rate and price volatility.

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A negative correlation between asset price changes and interest rate changes makes the mark-to-market feature unattractive to a futures buyer. This leads to a lower futures price, compared to the forward price on an otherwise identical contract.

kmf229

Compared to futures prices on a six-month contract, forward prices on an identical contract are:

A) always higher.

B) higher, lower, or equal.

C) equal.

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Futures prices may be higher or lower than forward prices on a contract with identical terms, depending on the correlation between interest rate changes and the price changes of the underlying asset. When interest rates and asset values are positively correlated, the futures price tends to be higher, and when interest rates and asset values are negatively correlated, the futures price tends to be lower.

kmf229

To initiate an arbitrage trade if the futures contract is underpriced, the trader should:

A) borrow at the risk-free rate, buy the asset, and sell the futures.

B) borrow at the risk-free rate, short the asset, and sell the futures.

C) short the asset, invest at the risk-free rate, and buy the futures.

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Click for Answer and Explanation

If the futures price is too low relative to the no-arbitrage price, buy futures, short the asset, and invest the proceeds at the risk-free rate until contract expiration. Take delivery of the asset at the futures price, pay for it with the loan proceeds and keep the profit. For Treasury bill (T-bills), shorting the asset is equivalent to borrowing at the T-bill rate. To initiate an arbitrage trade if the futures contract is underpriced, the trader should:

A) borrow at the risk-free rate, buy the asset, and sell the futures.

B) borrow at the risk-free rate, short the asset, and sell the futures.

C) short the asset, invest at the risk-free rate, and buy the futures.

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Click for Answer and Explanation

If the futures price is too low relative to the no-arbitrage price, buy futures, short the asset, and invest the proceeds at the risk-free rate until contract expiration. Take delivery of the asset at the futures price, pay for it with the loan proceeds and keep the profit. For Treasury bill (T-bills), shorting the asset is equivalent to borrowing at the T-bill rate. To initiate an arbitrage trade if the futures contract is underpriced, the trader should:

A) borrow at the risk-free rate, buy the asset, and sell the futures.

B) borrow at the risk-free rate, short the asset, and sell the futures.

C) short the asset, invest at the risk-free rate, and buy the futures.

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If the futures price is too low relative to the no-arbitrage price, buy futures, short the asset, and invest the proceeds at the risk-free rate until contract expiration. Take delivery of the asset at the futures price, pay for it with the loan proceeds and keep the profit. For Treasury bill (T-bills), shorting the asset is equivalent to borrowing at the T-bill rate.

kmf229

All of the following are examples of the monetary benefits or costs of holding an asset underlying a futures contract EXCEPT:

A) storage and insurance costs for storing gold.

B) having a ready supply of the asset for business purposes.

C) dividend payments from a portfolio of stocks.

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Having a ready supply of an asset for business purposes is a non-monetary benefit of holding the asset. This convenience yield can result in backwardation.

kmf229

The return from the non-monetary benefits of holding the asset underlying a futures contract is (are) called:

A) negative-storage costs.

B) the non-monetary return.

C) the convenience yield.

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The return from the non-monetary benefits of holding the asset underlying a futures contract is called the convenience yield.

kmf229

Consider two assets with identical storage costs. For the asset with the greater convenience yield, the percentage difference between the no-arbitrage price and the spot price will be:

A) greater at contract initiation but the same at expiration.

B) greater throughout the term of the contract.

C) lower any time prior to expiration.

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The net costs of holding an asset are Net Costs = Storage Costs – Convenience Yield. When the convenience yield is higher, net costs of carrying (storing) the asset are lower, and the futures price will be lower. The difference between the spot price and the futures price is zero at expiration for any asset.

kmf229

Backwardation refers to a situation where:

A) the futures price is below the spot price.

B) the futures price is above the spot price.

C) long hedgers outnumber short hedgers.

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Backwardation refers to a situation where the futures price is below the spot price. For backwardation to occur, there must be a significant benefit to holding the asset, either monetary or non-monetary.

kmf229

Which of the following best defines backwardation? The market is said to be in backwardation if:

A) the cash price exceeds the futures price.

B) the futures price exceeds the cash price or the distant futures price exceeds the nearby futures price.

C) the futures price exceeds the cash price.

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Backwardation occurs when there is a convenience, or security, associated with holding the spot asset, usually when it is uncertain whether the asset will even be available in the future. Backwardation is rare with financial futures.

kmf229

A situation where the futures price is below the spot price of the asset is called:

A) backwardation.

B) contango.

C) negative carry.

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A situation where the futures price is below the spot price of the underlying asset is called backwardation.