Question

1. Briefly explain two factors that affect the economic functions of futures market.

2. Define a Swap and list at least three types of Swap.

Answer 1

1.Two factors that affect the economic functions of futures market -

(a). Underlying price of commodities - Investors buying futures expect that underlying commodity price would rise in future and those selling futures expect that the underlying commodity price would fall in future. Any change in price of underlying commodity causes changes in trading in futures market.

(b). Cost of carry - Cost of carry is the money the buyer has to pay above the cost of the underlying commodity to procure the RIGHT to buy and carry it till expiry, before he converts into ownership. If cost of carry is high, people would hesitate to buy. Cost of carry is added to the cost of the underlying commodity.

2. Swaps, by definition, are exchange of two different types of cash flows. By different types we refer to different currencies or cash flows calculated by applying different interest rates. Swaps can be used to optimize funding costs for a particular funding strategy. A swap is an agreement between two parties called counterparties, who exchange set of cash flows over a period of time in the future. When exchange rate and /or interest rates fluctuate widely, the forward markets and the money markets do not function correctly. In such cases, swap arrangements may be used.

Three types of swaps -

(a). Plain vanilla swaps/ Interest rate swap

(b). Assets swaps

(c). Amortizing swaps