Smith International

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Chapter 14 Homework

2. What advantages do future contracts have over forward contracts?

The most important advantage of future contracts is that at the expiration date, the price of the contract converges to the price of the underlying asset to be delivered. If the future contract is selling below the contract price, there will be many investors trying to buy for that low price and sell it to a higher price in order to get a quick profit. However this will increase the price of the contract to its normal price. This means it is arbitrage, which guarantees that the price of a future contract at expiration equals the price of the underlying asset to be deliver.

4. What are the advantages and disadvantages of using options contract rather than future contract?

The advantages using option contracts are that you have the ability to take advantage of favorable price moves, because the option gives the investor the right, not the obligation, to buy or sell an underlying commodity. In the future contract, however you don’t have that option and instead you only have an advantage if price moves favorable. Another advantage is that it has limited risk, because the maximum loss the investor can have is when the option is purchase. One of the big disadvantages of using options is that you have to pay a premium, and thus you may yield a lesser return.

7. What are the advantages and disadvantages of using interest-rate swaps?

One of the advantages of using interest rate swaps is that they allow the institutions to convert fixed-rate assets into rate-sensitive assets without affecting the balance sheet. Also interest rate swaps can be written for longer maturities than those written for financial futures and future options that usually have shorter maturities. Also the premiums paid are lower than those for options. One of the big disadvantages of interest rate swaps is that they lack of liquidity in the market, and they are also subject to the default risk....
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