Question 2: What are the differences between over-the-counter (OTC) markets and organized exchanges?

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1 Question 1: What is the law of one price and arbitrage? Answer 1: The law of one price is a law that states the price of an asset should be equal in different markets once transaction costs are taken into account. Transaction costs would include items such as tax differences and transportation costs. Arbitrage is the situation that ensures the law of one price will prevail. If there is a difference in prices between two markets, an arbitrage opportunity will arise. The arbitrageur can buy the good or asset in the cheaper market and sell it for a riskless profit in the higher priced market. This continues to occur until the prices are identical in each market. Derivative instruments help ensure that arbitrageurs have the most efficient mechanisms available to make the transactions necessary to uphold the law of one price. Question 2: What are the differences between over-the-counter (OTC) markets and organized exchanges? Answer 2: Organized exchanges are physical places where traders meet to exchange assets. Examples of these types of exchanges include the New York Stock Exchange and the American Stock Exchange. Over-the-counter (OTC) markets do not require a physical meeting place between traders. Trades take place electronically over phone lines. OTC markets automatically match buy and sell orders. Even the organized exchanges now have an OTC nuance associated with them. The volume of trade of derivative instruments has grown exponentially on both markets over the past couple of decades. Question 3: What are the main differences between forward and futures markets? Answer 3: 1

2 Forward and futures markets perform very similar functions. They are both used for hedging purposes and also for speculative purposes. For many different assets, you may use either the forward or futures markets for hedging or speculative purposes. Some of the main characteristics of forward markets are as follows: they are not standardized (i.e., they can be customized by the parties involved) there is normally one specified delivery date they are settled when the contract expires Some of the main characteristics of a futures contract are as follows: they are traded on either an organized or OTC exchange they are settled daily through marking to market they trade as standardized contracts Question 4: What is meant by a limit order, a stop order, and a market order? Answer 4: A market order is one that is executed at the market price. A buyer would enter an order requesting that it be executed immediately at the market price. The buyer has no guarantee of what the transaction price will ultimately be. A stop order is an order when the purchaser designates a specific price at which to execute the order. If a person owns a stock and it is currently priced at $50 a share, the investor might place a stop order to sell at $45. This means that the stock will be sold once the price hits $45. This guarantees the investor of making a certain profit if, for instance, he or she bought it at $35. A limit order also specifies a specific price like the stop order. If an investor desires to buy a stock at $10, but not at a higher price, he or she can place a limit order for $10. Once the stock price reaches the $10, the order is then executed. Question 5: What two organizations play a key role in derivative markets? Answer 5: The Commodity Futures Trading Commission (CFTC) is a federal agency that has the primary responsibility of regulating futures markets. The CFTC licenses futures exchanges 2

3 and contracts. It also approves all terms and conditions of contracts and ensures that the contract has an economic interest. The National Futures Association (NFA) is a self-regulatory body. It is made up of individuals and firms involved in the trading of futures contracts. Its primary purpose is to prevent fraud, protect the public interest, maintain the integrity of the markets, and provide for free and fair markets. Both organizations investigate trading irregularities and provide valuable information to potential investors through their Web sites. Question 6: What are the functions of the clearinghouse? Answer 6: Every futures market has its own clearinghouse. The clearinghouse plays an important role in guaranteeing that the buyer and seller of a futures contract will perform as required by the terms of the contract. They have an excellent reputation. A major function of the clearinghouse is to maintain margins on accounts. They require that initial margins and maintenance margins be met. The clearinghouse also establishes a settlement price at the end of each trading day on each futures contract. This settlement price is very important because it is used for the daily marking to market that occurs. Question 7: What is the difference between a long hedge and a short hedge? Answer 7: In general, hedging is used for purposes of risk reduction. It is a type of insurance that buyers and sellers can engage in through various derivative instruments, such as forward and futures contracts. A long hedge involves taking a long position in a futures contract. This means that a person will purchase a futures contract that guarantees them a buying price in the future. For example, if a company knows it will need $1,000,000 euros in 3 months, it can enter a long position in a euro futures contract. This locks in a dollar price of euros, eliminating any currency risk in the transaction. A short hedge involves selling a futures contract. This means that a company locks in a price for something it might be receiving in the future. For example, a U.S. firm might be 3

4 receiving 3 million Japanese yen in 4 months. The firm does not know how many dollars this can be converted into in 4 months. If it sells a futures contract on yen, the firm will have locked in a yen/dollar price 4 months from now. In other words, the firm will know exactly how many dollars it will receive, thus eliminating any currency risk in the transaction. Question 8: What is the difference between a call option and a put option? Answer 8: Both calls and puts have many similarities. They both have exercise prices, time to expiration, and volatility measurements. The risk-free rate also influences the prices of each. A call option gives the buyer the right, but not the obligation, to buy an underlying asset at a predetermined price. The seller of the call has the obligation to sell the underlying asset at the exercise price. A put option gives the seller the right, but not the obligation, to sell the underlying asset at a predetermined price. The buyer of a put has the obligation to buy the underlying asset at the predetermined price. Many times students think that the call and the put are two different parts of the same trade; this is not true. Question 9: What are some of the underlying assets on which options are written? Answer 9: There is a wide variety of assets on which options are written. The list grows more each year. These assets include both real assets such as gold and financial assets such as stocks. The most popular option contract involves stocks. Not all stocks have options written on them. Firms actually do not have a say as to whether or not an option is available for their stock. The availability is based on the demands of traders and investors. Some of the other more popular assets include stock indices, futures contracts, and foreign currency. Question 10: What impact does asset volatility, interest rates, and times to expiration have on put and call options? 4

5 Answer 10: For both calls and puts, the effects of time to expiration are the same. The longer the time to expiration is, the higher the call/put price will be with everything else being equal. The more volatile an underlying asset is, the higher the call/put price will be. The higher the interest rate is, the higher the call price will be. Puts have an inverse relationship with interest rates. 5