Using Derivatives
1. Futures contracts are based on standardized instruments, are traded on organized exchanges, require margins with daily marking to market, and are typically closed prior to expiration. There are typically a variety of expiration dates. Forward contracts are normally negotiated between two parties and thus are specialized to the needs of each party. They do not require marking to market and typically are not offset prior to the closing date.
2. All hedging involves some risk in the sense that cash prices (rates) do not move in exactly the same manner as do futures prices (rates), and a hedger cannot always take a futures position that exactly offsets the cash position in dollar terms. The dominant risk is basis risk. In the case of hedging the interest cost of new borrowing, a bank loses on balance sheet when interest rates rise. The bank should thus sell futures contracts as a hedge. Once the hedge is in place, the bank is still subject to basis risk that the actual rate paid on the new borrowing will not change by the same amount and in the same direction as the rate on the futures contract.
3. With initial margin the trader has a position, but does not own any underlying asset. The term downpayment suggests that the margin represents a partial investment in some asset which is not the case with futures. The purpose of margin is to ensure that participants can cover losses if prices move adversely. In this context, margin is a performance bond.
4. The trader will initially make a $1,300 margin deposit. Each basis point change is worth $25 times two contracts or $50. The respective gains (losses) compared to the initial margin are: ($550); ($1,350); $200; and $900. These figures should be added to $1,700 to get the margin account value. On November 12, you would be asked to kick in $50 to bring the margin account back to its $800 minimum level. On November 19, you would make another margin deposit of $850 to meet the...
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