choose to shift their
risk to market speculators.
The concept of arbitrage. Derivatives make it easier to arbitrage away mispricing in the
markets.
Trading efficiency. Traders may find trading financial derivatives more attractive than trading
the underlying security. Trading market index futures may be cheaper and easier than taking
a position in a diversified portfolio, and interest rate futures may be a good substitute for a
portfolio of Treasury securities. Derivative markets are frequently more liquid and offer lower
transactions costs than the actual securities markets.
1.B: Futures Markets
a: Distinguish between a speculator and a hedger.
Traders can be described as speculators (meaning they accept the market’s risk in pursuit
of profits) or hedgers (meaning they trade futures to reduce some pre-existing risk exposure).
Short hedgers would be firms who own the asset (like wheat) and want to reduce their risk by
selling the asset now (short the wheat) in the futures market. Long hedgers would be firms
who are short the asset (like a baker who has promised to deliver bread) and want to reduce
their risk by buying the asset now (going long wheat) in the futures market.
b: Distinguish between volume and open interest.
The open interest is the number of contracts that are currently in existence. An open interest
of 100 would imply that there are 100 short positions in existence and 100 long position in
existence. Activity in the futures markets is measured by trading volume. Trading volume
can represent either a new contract being created between a buyer and seller or an existing
contract being traded by one of the existing traders to a new trader.
c: Discuss how the standardization of futures contract promotes market liquidity.
A major difference between forwards and futures is that futures contracts have standardized
contract terms. Futures contracts specify the quality and quantity of good that can be
delivered, the delivery time, and the manner of delivery. The exchange also sets the minimum
price fluctuation (which is called the tick size). For example, the basic price movement, or tick,
for a 5,000-bushel grain contract is a quarter of a point or $12.50 per contract. Contracts also
have a daily price limit, which sets the maximum price movement allowed in a single day. For
example, wheat cannot move more than 20￠ from its close the preceding day. The maximum
price limits expand during periods of high volatility and are not in effect during the delivery
month. The exchange also sets the trading times for each contract.
d: Discuss the role of the clearinghouse in trading futures contracts.
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