Finance Questions
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Answer 1: Classification of Future Traders by Trading Style
Q1. Explain the classification of Future traders by trading style? (Marks-3)
There are three main trading styles in relation to futures contracts: scalping, day trading, and position trading. Based on these three trading styles, there are three types of futures traders; position traders, scalpers, and day traders.
Position traders are trend followers. They spot an investment and a trend that is associated with it, and then purchase and hold the investment in the expectation that the trend will peak for them to make profit. Successful position traders are characterized with the ability to identify in advance the right entry and exit prices and manage risk by utilizing stop-loss orders. Scalpers are traders who make profit by capitalizing on small price movements and swift sells if chance to make gains exist. Day traders, on the other hand, make single trades per day. In other words, they hold positions whether short or long, during trading day of financial securities.
Answer 2: Future Price
Futures Price = Spot price *(1+ rf)– d
rf = Risk-free rate
d – Dividend
= 60*(1+4/60) – 5.50
= 60*(1+0.067) – 5.50
= (60*1.067) – 5.50
= 64.02 – 5.50
= $58.52
Answer 3: Short hedge and a long hedge
A short hedge is a strategy used by investors and companies to protect themselves from losses due to the anticipated or real decline in an asset they own or produce. This involves the selling of futures contract. A short hedge will occur when an investor purchases a put option for the asset they already have. The put option acts as a sort of share-for-share insurance if your stock price goes down. In theory, the stock price dropping doesn’t cost you any money. Types of short hedges include;
i. General Market Index Put Options – put option purchased from a general market index, such as the S&P 500 or Nasdaq.
ii. Short selling – this is selling long stock position.
iii. Inverse ETFs - aims to generate a return that’s the inverse of the stock market index.
Long Hedge is a hedging strategy that producers or manufacturers use to lower the risk of price fluctuations. A producer or manufacturer uses such a strategy to lock the price of a commodity or input that they wish to buy in the future. One conducts a long hedge in order to lock in a price for an asset one must purchase in the future. This protects the holder of the futures contract from volatility in the underlying asset's price. If the spot price of the underlying asset moves in a direction more beneficial for the holder, he/she can sell the futures contract and buy the asset at the spot price.
Answer 4: Interest rate swap and currency swap
An interest rate swap is the exchange of cash flows between two parties based on interest payments for a particular principal amount. For an interest rate swap, the principal amount is not actually exchanged. Instead, the principal amount is the same for both sides of the currency and a fixed payment is frequently exchanged for a floating payment that is linked to an interest rate. In interest rate swap, only one currency is involved. The main focus of the interest rate swaps involves exchanging of interest payments between different parties (Li & Mao, 2003).
A currency swap is the exchange of both the principal and the interest rate in one currency for the same in another currency. The exchange of principal is done at market rates and is usually the same for both the inception and maturity of the contract. Currency swap involves two currencies. The main focus of the currency swaps involves the exchange of any amount in one currency to another currency.
Currency swaps are a foreign exchange agreement between two parties to exchange cash flow streams in one currency to another. While currency swaps involve two currencies, interest rate swaps only deal with one currency.
References
Ansi, A. & Ouda, O. (2009): How option markets affect price discover on the spot markets: A survey of the empirical literature and synthesis. International Journal of Business and Management.
Apte, Prakash (2012). International Financial Management. (5th ed.). McGraw Hill Publishing Company Ltd.
Li, H. & Mao, C. (2003). Corporate use of interest rate swaps: Theory and evidence. Journal of Banking & Finance.
Oltheten, E. & Waspi, G. (2012). Financial Markets: A Practicum. Great River Technologies