Reading 63: LOS c ～ Q1- 4 class, contract, should, black

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

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

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

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

A)   higher, lower, or equal.

B)   always higher.

C)   always lower.

D)   equal.

3.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)   forward and futures prices are the same.

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

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

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

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

C)   always the same at contract initiation.

D)   higher on physical assets and lower on financial assets.

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

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

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

The correct answer was A)

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.

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

A)   higher, lower, or equal.

B)   always higher.

C)   always lower.

D)   equal.

The correct answer was A)

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 highly 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.

3.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)   forward and futures prices are the same.

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

The correct answer was B)

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.

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

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

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

C)   always the same at contract initiation.

D)   higher on physical assets and lower on financial assets.

The correct answer was A)

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.