Question

Identify or define each of the following terms.

a)    The difference between futures price and expected spot price in the future

b)    The contract size of ethanol futures traded on Chicago Mercantile Exchange=?

c)    Swap bank

d)    Long position in put

e)    The minimum value (lower bound) of American call, assuming no dividend=

Answer 1

(a) Futures are derivative contracts, on an undelying asset, wherein couter parties enter into agreement such that the buyer will be obligated (converse for seller) to buy the underlying asset at a predetermined future date. The futures contract are standardised in terms of contract size and maturity and are traded on exchange floors. The futures price refers to the traded price of such a future contract. On the other hand expected spot price in future is simply the expected price of the underlying asset at some time in future.

(b). The ethanol futures contract size is 29000 gallons which approximate 1 railcar capacity.

(c) Swap bank is the financial intermediary which stands as a broker between two counterparties to swap agreement. The intermediary will deal with each counterparty separately, hence the couterparties, most likely, will be anonymous to each other, and will have their respective risk on the swap bank who in turn will earn a commission for matching and facilitating the transaction

(d). A long position in put option gives the purchase of put option the right to sell the underlying asset (as per the contract size) at a predetermined price (known as strike price). It is used to benefit from the fall in prices (below the strike price level) since the put buyer has the right to sell (not the obligation) at the strike price and the put seller will have to honour the contract. The pay out of long put is = Max [(strike price - expiry price - premium), - premium].

(e) For a call option with value C, spot price S, strike price K and risk free rate is r then the lower bound for C will be = S-K(1+r)^t where t is the time to maturity. If the C is lower than this value, then there will be a possible arbitrage where in a trader can short call at C, but the stock at S and put the residual money at r for time period t.