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University of California, Davis

Fall 2007
FUTURES AND OPTIONS MARKETS
Midterm #1 (Version A) KEY

Please answer all questions on this exam. GOOD LUCK.

Points Score

1.

10

_____

2.

20

_____

3.

45

_____

4.

25

_____

Total 100
Your Name _____

__________________

________

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1. Value 10 points (5pts each). Please give short answers.
a) Explain the mark-to-market procedure and indicate why it is an important feature of futures
trading.
The mark-to-market procedure takes place every trading day. It is the process that the
clearinghouse brings each contract to the market price, which is the settlement price, from its
original trading price at the end of the day. For example, suppose an individual enters into a long
futures position in gold futures contract valued at &76,000. On the following day, if the market
moves against this person (the settlement price of gold futures was down to $750/oz. which means
the contract valued $75,000), the clearinghouse will call on this person to deposit an additional
$1,000.
This procedure is important to ensure the financial integrity of futures trading by preventing
default. Moreover, the clearinghouse never encounters a deficit or surplus because it brings each
contract to the market price and the book cleared every trading day.

b) The Chicago Mercantile Exchange trades a feeder cattle futures contract and the contract size is
50,000 pounds. Feeder cattle prices are quoted in terms of U.S. cents per pound. The near term feeder
cattle futures contract is currently around 111.5 cents per pound, so at this price level the total
contract value is approximately $55,750. At expiration, futures contracts often call for delivery.
However, this is not the case for the feeder cattle futures contract. Explain how settlement occurs
for any feeder cattle futures positions still open at expiration.
This is a case of cash settlement.
On the expiration date, the clearinghouse will assign you the opposite position to offset your
existing position at the settlement price.
If you hold a long position, you will be assigned a short position. If the price at the expiration date
is higher than $1.115/ pound, then you will gain some profits. If you hold a short position, the
clearinghouse will assign you a long position to offset your existing short position and you will have
to pay for your loss.

2. Value 20 points. Some economists believe that the Federal Open Market Committee will possibly
change the target for the federal funds rates at its meeting on October 31 st. What is the current fed

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funds rate? Following the meeting, if the rate is changed as of November 1st, what is the new rate the
Fed is likely to set?
Current rate
Expected rate

4.75%
4.5%

Suppose that October Fed Funds futures (CBOT) are trading at an index or 95.27 and November
futures are trading at 95.47. What is the probability (reflected in these futures prices) that the Fed
will lower its target for the federal funds rate as expected in November? Please show all your work.

Fed
futures

funds Index

Yield

October

95.27

4.73%

November

95.47

4.53%

Change from
current interest
rate.
-0.22%

So, the probability of a decrease in fed funds rate is 0.88

Probability of
0.25% decrease
-0.22/0.25=0.88

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3.Value 45 points (15 each) - SHOW YOUR WORK FOR PARTS a,b & c
Oct 19, 2007 Futures Prices (source: Wall Street Journal)
-----------------------------------------CME Japanese Yen: 12.5 million Yen, $ per 100Yen
MTH/ OPEN HIGH LOW SETTLE
DEC07 .8707 .8792 .8699
.8768
CBT Wheat 5,000 bu; cents per bu.
MTH/ OPEN
HIGH
LOW
DEC07 842.0
855.5
833.0

SETTLE
855.5

CME EuroDollar: $1,000,000; pts of 100%

---------------------------------------------a) Refer to December 2007 Japanese yen futures in the above table from the Wall Street Journal.
If you expect that the U.S. dollar will weaken relative to the Yen would you go short or long
Yen futures? Assume you purchased/sold one December contract at the settlement price in the
above table and then the futures price ends up at $.0089 per Yen when you liquidate your
position in December 2007. What is your profit (loss) from this trade? Assume you sold only
one futures contract and the brokerage fees are $50 per round turn.
If you expect that the U.S. dollar will weaken relative to Yen, it means your expect that the price
of Japanese Yen futures contract will rise. In order to make profit, you should go long now.
Go long (buy) 1 contract of Japanese Yen @
Liquidate your position (go short) @

0.008768 $/Yen
0.008900 $/Yen

Profit 0.000132*12.5 million Yen = $1,650

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b) Refer to the December 2007 EuroDollar Futures in the above table from the Wall Street Journal. If
you expected interest rates to rise would you go long or short EuroDollar futures? Assume you
purchased/sold one December contract at the settlement price in the above table and the EuroDollar
futures price rose to 95.785. What is the profit/loss outcome given that you entered the market at the
settlement price on October 19, based on your interest rate expectations? Assume only one contract
and a brokerage fee of $50.
Expecting the interest rates to rise is equivalent to expecting the price of EuroDollar to decrease.
So, you should enter into a short position (sell EuroDollar futures contract)
Go short 1 EuroDollar futures contract @
Liquidate your position
@
The market moved against you. This is a loss

95.295
95.785
=( 0.49)=49 basis point
Total loss =(49*$25)+$50
=( $1,275)

c) Consider the December Wheat futures contract in the above table. If you predict that the price of
wheat will rise, will you go "long" or "short" in the December 2007 contract? Assume you enter the
market on October 19 (at the settlement price) and then the price falls to 805.25. What is the profit
(loss) outcome? Assume you purchased/sold 5 futures contracts and the brokerage fees are $50 per
round turn per contract.
If you predicted the price of wheat will rise, in order to make a profit, you would go long in the
December 2007 Wheat futures contract.
Go long 1 contract
Go short to liquidate the position

@
$8.5550
@
$8.0525
Loss ($0.5025/bu*5,000 bu) = $2,512.5/ contract
Total loss ($2,512.5*5)+($50*5)= $12,812.5

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4. Value 25 points: 10 Questions @ 2.5 points each. Please circle the correct answer.
1. Which of the following is not a responsibility of the clearinghouse?
A. Match every buy and sell trade.
B. Determine the clearing margin for clearinghouse members.
C. Adjust the monetary value of open positions to reflect opening prices.
D. Make daily margin calls of clearinghouse members whose balances show a loss.
2. Which of the following is not an assumption made for Keynes' explanation of the Theory of
Normal Backwardation?
A. Speculators are "net long".
B. Speculators are risk averse.
C. Speculators are unable to forecast prices.
D. None of the above (all are the assumptions).
3. Trader A is "short" 15 coffee futures contracts and Trader B is "short" 7 coffee futures contracts.
What will happen to volume and open interest if Trader A sells 5 contracts to Trader B?
A. Volume is 5 and open interest is unchanged.
B. Volume is 10 and open interest increases by 5.
C. Volume is 5 and open interest decreases by 5.
D. Volume is 10 and open interest is unchanged.
4. The total net cost of storage is specified by the "Theory of Price of Storage" as a function of three
components. Which of the following is not one of the components?
A. physical costs of storage
B. risk aversion
C. convenience yield
D. transportation costs
5. Trader A is "long" 3 silver futures contracts and Trader B is "short" 3 silver futures contracts.
Trader A sells 2 silver contracts to Trader B. What has happened to open interest and volume?
A. Volume is 2 and open interest increases by 2.
B. Volume is 2 and open interest decreases by 2.
C. Volume is 3 and open interest remains unchanged.
D. Volume is 4 and open interest decreases by 2.
T F 6. The intersection of the demand and supply curves for storage can actually result in a negative
price of storage.
T F 7. When there is news of rising inflation, this tends to drive up the price of Treasury Bond
futures.
T F 8. According to the Theory of Normal Backwardation, hedgers do not compensate speculators
for assuming the price risk associated with futures contracts.
T F 9. At time of delivery, Treasury Bond futures are settled at the cash price instead of delivery.
T F 10. If the price for contracts with more distant delivery dates is higher than that for contracts
expiring earlier, the market is said to be in contango".