1. What are some of the major differences between futures and forward contracts? How do
these contracts differ from a spot contract?
A spot contract is an exchange of cash, or immediate payment, for financial assets, or any other type of assets, at the time the agreement to transact business is made, i.e., at time 0. Futures and forward contracts both are agreements between a buyer and a seller at time 0 to exchange the asset for cash (or some other type of payment) at a later time in the future. The specific grade and quantity of asset is identified, as is the specific price and time of transaction.
One of the differences between futures and forward contracts is the uniqueness of forward contracts because they are negotiated between two parties. On the other hand, futures contracts are standardized because they are offered by and traded on an exchange. Futures contracts are marked to market daily by the exchange, and the exchange guarantees the performance of the contract to both parties. Thus the risk of default by the either party is minimized from the viewpoint of the other party. No such guarantee exists for a forward contract. Finally, delivery of the asset almost always occurs for forward contracts, but seldom occurs for futures contracts. Instead, an offsetting or reverse transaction occurs through the exchange prior to the maturity of the contract.
3. Suppose an FI purchases a Treasury bond futures contract at 95.
a. What is the FI’s obligation at the time the futures contract was purchased?
You are obligated to take delivery of a $100,000 face value 20-year Treasury bond at a price of $95,000 at some predetermined later date.
b. If an FI purchases this contract, in what kind of hedge is it engaged?
This is a long hedge undertaken to protect the FI from falling interest rates.
c. Assume that the Treasury bond futures price falls to 94. What is the loss or gain?
The FI will...