Chapter 7 - Futures Markets (FRM - Part 1 - Book 3)
Chapter 7 - Futures Markets
Chapter 7 - Futures Markets
1. What is a futures contract?
A. A contract to buy or sell an underlying good at a future date at a variable price
B. A contract to exchange one commodity for another at a future date
C. A contract to buy or sell an underlying good at a specified price and date
D. A contract where the price of an asset is decided by the seller at contract expiration
A futures contract is an exchange-traded obligation to buy or sell a certain amount of an underlying good at a specified price and date.
2. What happens when the purchaser of a futures contract takes a long position?
A. The purchaser has contracted to buy the asset at the contract price at contract expiration
B. The purchaser is obligated to sell the asset at the contract price
C. The purchaser is not obligated to perform any transaction at expiration
D. The purchaser takes a short position and is required to sell at expiration
A long position means the purchaser has contracted to buy the asset at the contract price at contract expiration.
3. What is open interest in futures contracts?
A. The total number of contracts traded in a given day
B. The total number of long positions in a futures contract
C. The number of buyers for a futures contract
D. The number of sellers in a futures contract
Open interest refers to the total number of long positions in a given futures contract. It equals the total number of short positions as well.
4. When can the trading volume on a futures contract exceed its open interest?
A. When there are many positions being closed out or excessive day trading occurs
B. When there is no new trading activity in the market
C. When the open interest is calculated wrongly
D. When the price of the underlying asset increases
The trading volume on a futures contract can exceed open interest when there are many positions being closed out or if excessive day trading is occurring.
5. In the context of futures contracts, what does the term "going short" mean?
A. The seller of the contract takes a long position
B. The seller buys the asset at the contract price
C. The seller takes a short position, agreeing to sell at contract expiration
D. The seller holds the contract without obligation to buy or sell
Going short means the seller takes a short position and is obligated to sell the underlying asset at the contract expiration price.
6. What is the relationship between open interest and the number of long and short positions in a futures contract?
A. Open interest only reflects long positions in a futures contract
B. Open interest reflects the total number of contracts traded daily
C. Open interest equals the total number of long positions, which equals the number of short positions
D. Open interest only reflects short positions in a futures contract
Open interest equals the total number of long positions, which is the same as the total number of short positions in a given futures contract.
7. When a new futures contract is introduced, which of the following must the futures exchange specify?
A. Only the underlying asset of the contract
B. Only the delivery time of the contract
C. Underlying asset, contract size, delivery location, and delivery time
D. Only the delivery location and delivery time
When a new futures contract is introduced, the futures exchange must specify the underlying asset, contract size, delivery location, and delivery time.
8. What does the contract size in a futures contract specify?
A. The price at which the asset is bought or sold
B. The quality of the underlying asset
C. The time duration of the contract
D. The quantity of the asset that must be delivered to settle the contract
The contract size specifies the quantity of the asset that must be delivered to settle the futures contract (e.g., 5,000 bushels for one grain contract).
9. If the underlying asset for a futures contract is a commodity, what may the futures exchange specify?
A. The exact delivery date of the commodity
B. The acceptable quality level of the commodity
C. The price of the commodity in the market
D. Only the quantity of the commodity
When the underlying asset is a commodity, the futures exchange specifies the quality of the commodity that will be acceptable for settling the contract.
10. What does the delivery time in a futures contract refer to?
A. The month in which delivery is to take place
B. The exact date and time when delivery occurs
C. The time period during which the contract can be settled
D. The duration for which the futures contract remains valid
The delivery time refers to the month in which delivery is to take place for a futures contract (e.g., a December corn contract).
11. Some futures contracts are settled by cash payment rather than delivery. How is the settlement amount determined?
A. Based on the initial price of the futures contract
B. Based on the contract size
C. Based on the difference between the futures price and the market price at settlement
D. Based on the quality of the underlying asset
Some futures contracts are settled by cash payment, where the settlement amount is based on the difference between the futures price and the market price at the time of settlement.
12. What is the term used for the minimum price fluctuation for a futures contract?
A. Price limit
B. Tick size
C. Margin requirement
D. Position limit
The minimum price fluctuation for a futures contract is called the tick size, which is determined by the exchange.
13. If a grain contract has a tick size of ¼ cent per bushel and consists of 5,000 bushels, what is the minimum tick size for the contract?
A. $5
B. $50
C. $25
D. $12.50
The minimum tick size is calculated as $0.0025 × 5,000 bushels = $12.50 per contract.
14. What happens when a futures contract moves down by its daily price limit?
A. The contract is said to be limit down
B. The contract reaches its tick size
C. The contract is said to be limit up
D. The contract's position limit is reached
When a futures contract moves down by its daily price limit, it is said to be limit down.
15. What is the purpose of the position limit in a futures contract?
A. To determine the minimum tick size for the contract
B. To limit the number of contracts a speculator can hold to prevent undue market influence
C. To set the maximum price movement for the contract during the day
D. To determine the contract size
The position limit is set by the exchange to prevent speculators from holding an undue number of contracts and influencing the market.
16. What does the price limit in a futures contract refer to?
A. The maximum contract size
B. The minimum price fluctuation for the contract
C. The maximum price movement for a contract during a day
D. The underlying asset of the contract
The price limit refers to the maximum price movement for a futures contract during a trading day (e.g., wheat cannot move more than $0.20 from its close).
17. What is the term for the difference between the spot price and the futures price?
A. Spread
B. Discount
C. Basis
D. Forward point
The basis is defined as the spot price minus the futures price.
18. What typically happens to the basis as the futures contract approaches maturity?
A. It increases significantly
B. It converges toward zero
C. It becomes negative
D. It remains constant
As the futures contract nears expiration, the futures price converges with the spot price, and the basis approaches zero.
19. Why must the futures price equal the spot price at contract expiration?
A. Arbitrage opportunities would otherwise exist
B. The exchange sets both prices equal
C. Futures contracts are always settled in cash
D. Maintenance margin requires it
Arbitrage ensures that at expiration, the futures price and spot price converge, eliminating price differences.
20. What is the purpose of margin in a futures account?
A. To pay for the entire contract upfront
B. To act as a fee to the broker
C. To earn interest on investment
D. To ensure the investor can meet trading losses
Margin acts as collateral to cover any potential trading losses in a futures account.
21. What is marking to market in futures trading?
A. Predicting future market levels
B. Hedging against market movement
C. Adjusting the margin account for daily price changes
D. Updating the futures price weekly
Marking to market refers to the daily process of adjusting margin account balances based on daily price movements of the futures contract.
22. What happens if the margin account falls below the maintenance margin?
A. The position is automatically closed
B. A margin call is issued
C. Trading is suspended
D. The account is liquidated immediately
A margin call occurs when the account balance drops below the maintenance margin, requiring the trader to add funds.
23. What type of futures position results in an obligation to purchase the underlying asset at expiration?
A. A basis trading strategy
B. A long futures contract
C. A short futures contract
D. A covered hedging position
In a long futures position, the investor agrees to buy the underlying asset at the contract's maturity.
24. Futures contracts typically define which of the following elements?
A. Only the delivery procedure
B. Only the quantity of the underlying asset
C. Asset quality and quantity, along with delivery terms
D. None of the contract specifics
Futures contracts specify all relevant details such as asset quality, quantity, delivery location, and delivery date.
25. A trader enters a short gold futures contract at $1,300 per ounce with a contract size of 100 ounces. If gold closes at $1,290 on day 2, after falling from $1,295 on day 1, what is the variation margin for day 2?
A. $0
B. $250
C. $500
D. $1,000
The price dropped by $5 on the second day (from $1,295 to $1,290). Since each contract is for 100 ounces, the gain is 100 × $5 = $500. So, the variation margin credited is $500.
26. In the futures market, what role does the exchange play after a trade is executed?
A. It keeps a record of trade prices only
B. It directly connects buyers and sellers for settlement
C. It becomes the counterparty to both sides of the trade
D. It determines the final profit or loss on contracts
The exchange interposes itself between buyers and sellers, becoming the counterparty to each side, which ensures that obligations will be honored.
27. What is one of the key benefits for traders when the exchange acts as the counterparty in futures contracts?
A. Traders can exit their positions without contacting the original counterparty
B. Traders avoid paying margin on their trades
C. The exchange guarantees profits
D. Traders must maintain their position until delivery
Since the exchange is the counterparty, traders can reverse their trades by taking the opposite position at any time without dealing with the original counterparty.
28. How does the exchange help reduce counterparty risk in the futures market?
A. By issuing insurance for trades
B. By maintaining a direct contract between the original buyer and seller
C. By collecting tax from each transaction
D. By taking on the counterparty role and guaranteeing contract performance
The exchange mitigates default risk by being the counterparty to both sides of the trade, ensuring obligations are met regardless of the original trader’s financial condition.
29. Which of the following best explains why trading volume might exceed open interest on a given day?
A. All contracts are held until expiration
B. Many traders open and close positions within the same day
C. The number of contracts is doubled each day
D. Trading volume is counted monthly
Day traders can enter and exit trades multiple times within the same day, causing trading volume to exceed open interest.
30. In which type of futures market do settlement prices increase over time?
A. Normal market
B. Inverted market
C. Backwardated market
D. Arbitraged market
A normal futures market is characterized by rising settlement prices as the delivery date moves further into the future.
31. What does an inverted futures market indicate about the settlement prices?
A. Prices are stable across all maturities
B. Prices increase at a fixed rate
C. Settlement prices decrease over time
D. Short-term prices are unknown
In an inverted futures market, longer-term contracts are priced lower than near-term contracts, reflecting falling settlement prices over time.
32. What is the most common method of terminating a futures contract before delivery?
A. Waiting for the first notice day
B. Entering into an offsetting trade
C. Filing an intent to deliver
D. Cash settlement
The most common way to exit a futures contract is to make a reverse or offsetting trade in the market, not by actual delivery.
33. What determines the price paid or received during physical delivery in a futures contract?
A. Contract price at trade initiation
B. Spot market price
C. Most recent settlement price
D. Average price over the contract period
The exchange requires delivery to be made at the most recent settlement price, not the original contract price.
34. Which of the following is true about cash-settled futures contracts?
A. They involve physical delivery at expiration.
B. Delivery is optional, based on trader preference.
C. The long pays the short at contract expiration.
D. They are marked to market based on final settlement price.
Cash-settled futures do not involve delivery; gains and losses are settled based on the final day’s settlement price.
35. What is the main drawback of a market order?
A. The transaction price may differ significantly from the expected price.
B. It is only valid for one day.
C. It requires prior approval from the exchange.
D. It is not executed unless confirmed by the specialist.
Market orders are executed at the best available price, which can sometimes vary widely from the price the investor had in mind, especially in fast-moving markets.
36. What distinguishes a discretionary order from a standard market order?
A. It has a fixed execution time.
B. It guarantees a better price.
C. The broker has discretion to delay the transaction to seek a better price.
D. It is placed only during opening hours.
Discretionary orders allow the broker to delay execution in hopes of achieving a better price, unlike a regular market order which is executed immediately.
37. Where is a limit buy order typically placed in relation to the current market price?
A. At or above the current price
B. Below the current market price
C. Exactly at the closing price of previous day
D. Based on historical average
A limit buy order is set below the current market price to purchase the asset only if it drops to the limit level or below.
38. Who is responsible for turning over limit orders to the specialist?
A. Market maker
B. Floor trader
C. Clearing house
D. Commission broker
Limit orders are handed over to the specialist by the commission broker, who handles the customer’s order execution on the floor.
39. What is the primary purpose of a stop-loss-sell order?
A. To sell a stock if its price falls to a specific level, limiting losses.
B. To guarantee profit from a rising stock.
C. To delay the sale until the end of the trading day.
D. To buy more shares if the price falls.
A stop-loss-sell order helps an investor limit potential losses by automatically selling a stock once it hits a pre-determined lower price.
40. What kind of order is typically used with a short sale to limit losses if the stock price increases?
A. Stop-loss-sell order
B. Stop-loss-buy order
C. MIT order
D. Fill-or-kill order
A stop-loss-buy order is placed with a short position to limit losses if the price of the stock begins to rise.
41. Which of the following best describes a stop-limit order?
A. A market order with a cancellation condition
B. A limit order that executes at the end of the trading day
C. An order that becomes a limit order once a stop price is reached
D. A combination of a limit order and an MIT order
A stop-limit order turns into a limit order once the stop price is reached, and it only executes at the specified limit price or better.
42. What happens with a Market-if-Touched (MIT) order?
A. It becomes a limit order when the price is reached.
B. It cancels if not filled by the end of the day.
C. It requires approval from the exchange.
D. It becomes a market order when the price is reached.
A Market-if-Touched (MIT) order becomes a market order when the specified trigger price is touched or bettered.
43. What is true of a Good-til-Canceled (GTC) order?
A. It stays active until it is either executed or canceled by the trader.
B. It is valid only for one trading day.
C. It must be re-entered daily.
D. It is automatically canceled if the price doesn't move.
A Good-til-Canceled (GTC) order remains in effect until it is either executed or explicitly canceled by the trader.
44. Which type of order must be executed immediately or else it is canceled?
A. MIT order
B. Fill-or-kill order
C. GTC order
D. Stop-limit order
Fill-or-kill orders must be executed immediately in full, or the trade is canceled altogether.
45. What does the mark-to-market process involve for futures contracts?
A. Recording gains and losses daily as realized in earnings
B. Recording gains and losses only when the contract expires
C. Deferring all gains and losses until the next fiscal year
D. Recording gains and losses only if they are over a certain threshold
Futures contracts are marked to market daily, meaning all gains and losses are recorded as realized on a daily basis.
46. How does the mark-to-market process typically impact a firm's earnings?
A. It smoothens earnings over time
B. It defers gains and losses
C. It increases earnings volatility
D. It eliminates the need for hedge accounting
Mark-to-market accounting records gains and losses daily, which increases the volatility in reported earnings.
47. When can hedge accounting be applied to futures contracts?
A. When the firm expects consistent profits
B. When the hedge is documented and proven to be effective
C. Only when the contract duration is less than a year
D. When the tax rules permit it
Hedge accounting can be applied if the hedge is properly documented and there is a reasonable economic relationship between the hedging instrument and the hedged item.
48. What is the advantage of using hedge accounting for futures?
A. Futures are not marked to market
B. Earnings volatility increases significantly
C. Losses are hidden from investors
D. Gains and losses are deferred and matched with the hedged item
Hedge accounting allows deferring recognition of gains/losses until the hedged item also affects financials, reducing earnings volatility.
49. Which of the following is true regarding tax and accounting treatment of hedge transactions?
A. A hedge may qualify for accounting but not for tax purposes
B. Tax treatment always matches accounting treatment
C. Hedge accounting rules apply universally across jurisdictions
D. Tax and accounting rules for hedges are identical globally
The rules for hedge treatment can differ significantly between accounting and tax standards and across jurisdictions.
50. Which of the following is a key difference between forward and futures contracts?
A. Only forwards involve financial assets
B. Futures are only used by retail investors
C. Both are traded on exchanges
D. Forwards are OTC contracts, while futures are exchange-traded
Forwards are private over-the-counter (OTC) contracts between two parties, whereas futures are standardized contracts traded on organized exchanges.
51. How do futures contracts manage counterparty risk compared to forwards?
A. Futures are cleared through exchanges with no counterparty risk
B. Futures have higher counterparty risk
C. Both carry equal counterparty risk
D. Forward contracts eliminate all risk through central clearing
Futures contracts are cleared through exchanges which act as intermediaries, eliminating counterparty risk. Forwards are bilateral and carry default risk.
52. What is a characteristic of forward contracts compared to futures?
A. Settled daily through mark-to-market
B. Traded in high volumes on exchanges
C. Customized and settled only at expiration
D. Highly liquid and easily offset
Forward contracts are privately negotiated and typically customized to meet the needs of the parties, with settlement occurring only at expiration.
53. Which of the following statements about futures contracts is TRUE?
A. Futures are difficult to cancel due to lack of liquidity
B. Futures are standardized and liquid, allowing easy offset
C. Futures are tailored to the specific needs of two parties
D. Futures settle only at expiration, just like forwards
Futures contracts are highly liquid due to their standardization and exchange-traded nature, making them easy to cancel or offset in the market.
54. Which of the following is NOT a feature of futures contracts?
A. Traded on organized exchanges
B. Standardized in terms of size and maturity
C. Marked to market daily
D. Privately negotiated and tailored contracts
Futures contracts are standardized and exchange-traded. The feature listed in option D is characteristic of forward contracts, not futures.
55. What does a long futures position obligate the holder to do?
A. Buy the underlying asset at the futures price on the maturity date
B. Sell the underlying asset at market price
C. Hold the asset indefinitely
D. Avoid delivery by any means necessary
A long futures position obligates the holder to buy the underlying asset at the specified price on the contract’s expiration date.
56. What is the “basis” in futures trading?
A. The difference between bid and ask price
B. The difference between the spot price and the futures price
C. The average of spot and futures prices
D. The profit on a futures trade
The basis is defined as the spot price minus the futures price. As the contract nears maturity, the basis converges to zero.
57. What happens to the basis as the futures contract approaches expiration?
A. It increases
B. It becomes volatile
C. It converges toward zero
D. It reverses direction
Due to arbitrage opportunities, the futures price and spot price converge at expiration, making the basis zero.
58. What is the initial margin in a futures contract?
A. The collateral required to enter a futures position
B. The maximum loss allowed
C. The broker’s commission
D. The price of the futures contract
The initial margin is the required collateral posted when opening a futures position to cover potential losses.
59. What does marking to market mean in futures trading?
A. Paying taxes on futures contracts daily
B. Calculating delivery fees
C. Setting the spot price daily
D. Recording daily gains or losses based on the futures price
Marking to market means adjusting the margin account to reflect gains or losses based on daily changes in futures prices.
60. What does it mean that the futures market is a zero-sum game?
A. There are no transaction fees
B. One party’s gain is exactly another party’s loss
C. Both parties always break even
D. Futures markets always produce net losses
In a zero-sum game like futures trading, the gains made by long position holders are equal to the losses of the short position holders, and vice versa.
61. How does an exchange maintain an orderly and liquid futures market?
A. By acting as the counterparty to every long and short position
B. By adjusting the futures price daily
C. By collecting taxes from traders
D. By limiting the number of traders
Exchanges maintain liquidity by acting as the counterparty to all trades through a clearinghouse, eliminating counterparty risk.
62. What does an increasing trend in futures settlement prices typically indicate?
A. A backwardated market
B. A volatile market
C. A normal market
D. A bear market
A normal market is characterized by higher futures prices for contracts with later maturities, indicating an upward-sloping price curve.
63. In futures trading, what is the “settlement price”?
A. The first price of the day
B. The price at or near the close of the trading day
C. The highest price of the day
D. The average price of the week
The settlement price is typically based on the price at or near the close of the trading session and is used for marking to market.
64. What does trading volume in a futures quote represent?
A. Total number of contracts in existence
B. Number of traders active in the market
C. Dollar value traded
D. Number of contracts traded during the day
Trading volume reflects the number of futures contracts that changed hands during a particular trading day.
65. How is a futures contract typically terminated by the short party?
A. By delivering the underlying asset
B. By buying an option
C. By extending the maturity
D. By stopping the margin payment
The short can terminate the contract by delivering the underlying asset as per the contract terms.
66. What distinguishes a cash-settlement futures contract from a physical-settlement one?
A. In cash settlement, the underlying is exchanged physically
B. Cash settlement only applies to options
C. Cash settlement involves no physical delivery, only cash differences based on mark-to-market
D. Physical settlement allows no early termination
In cash-settled futures, contracts are settled by paying the difference in value rather than delivering the actual underlying asset.
67. What is a market order in the context of futures trading?
A. An order to buy or sell at a specified price away from the market price
B. An order to buy or sell only after a certain price is reached
C. An order to buy or sell at the best price available
D. An order that becomes a market order once a price threshold is reached
A market order is executed immediately at the best available price, with no specific price constraints.
68. What is the primary purpose of a stop-loss order?
A. To lock in profits
B. To prevent further losses or protect existing profits
C. To specify a price for buying or selling away from the market
D. To automatically execute a market order once a price is reached
A stop-loss order is used to prevent further losses or to secure profits by triggering an order when the market moves against the position.
69. Which type of order combines the features of a stop order and a limit order?
A. Stop-limit order
B. Market order
C. Limit order
D. MIT order
A stop-limit order triggers a limit order once a specific stop price is reached, combining both a stop and a limit order in one.
70. What is the difference between forward and futures contracts?
A. Futures contracts are private, while forwards are standardized
B. Forward contracts are traded on exchanges, while futures are not
C. Forward contracts have no credit risk, while futures have significant credit risk
D. Forward contracts are private, customized contracts with more credit risk, while futures are standardized and traded on organized exchanges
The key difference is that forward contracts are private and customized, carrying more credit risk, while futures contracts are traded on organized exchanges with standardized terms.
71. How are futures contracts settled daily?
A. All gains and losses are recorded daily through a process called marking to market
B. The contract is settled only at maturity
C. Only the initial margin is settled daily
D. The underlying asset is delivered daily
Futures contracts are settled daily by marking to market, where gains and losses due to price movements are recorded at the end of each trading day.
72. What is the purpose of hedge accounting in futures contracts?
A. To calculate the profit and loss from futures daily
B. To defer and report gains/losses from futures simultaneously with the gains/losses on the hedged items
C. To remove all credit risk associated with futures positions
D. To settle all futures contracts in cash
Hedge accounting allows for deferring the reporting of futures gains/losses and aligning them with the corresponding gains/losses of the hedged item.
