FINRA Series 3 Free Practice Questions 15

Long hedge
Long hedge can be viewed as a type of insurance policy since the transaction cost of the hedge is minimal. To understand how long hedges are used, consider a hypothetical cereal company that requires a steady supply of oats with which to create a consumable finished product. The availability of oats is highly dependent upon weather due to yield variability and transportation costs via river barge. The company can buy oats at the spot price of $3.33 per bushel, which is considered to be within a profitable range. However, at any price above $3.50 per bushel, the cost of production would exceed the price consumers are willing to pay for the cereal. The company has facilities to store about three months of supply. A contract for delivery of oats three months down the road is quoted on the CBOT at a price of $3.44 per bushel. The company is concerned that drought conditions may be more severe than predicted.

Speculators
Speculators enter into a transaction for the purpose of obtaining large profits through the assumption of considerable risk. Speculators participate in the market with the objective of profiting from price fluctuations, while hedgers seek to reduce the risk of such price fluctuations on an owned position. Speculators are often the counterparty to a hedge, accepting the price risk (and hoping to profit from it) that a hedger seeks to eliminate. Speculators are investors who do not seek to take ownership of the commodities traded. Hedgers, on the other hand, are typically engaged in the process of producing or consuming the underlying commodities that are hedged. By accepting risk, speculators increase the level of liquidity and capital available in a market.

Basis
Basis is the difference between the cash settlement price (also called the spot price) of a commodity or asset and the price specified in a futures contract for an equivalent commodity or asset. The contract used for comparison is typically one in which the underlying commodity or asset has the same or similar characteristics. The maturity date specified in the terms will also be as close as possible to the date for the spot price. Basis can also be calculated and applied to commodities or assets with dissimilar characteristics, such as time periods, delivery locations, and product grades. As the maturity date for a particular futures contract approaches, the basis is proportionately reduced based on the amount of time remaining until the maturity date. This narrowing of the difference between the cash settlement price and the one specified in the futures contract is known as convergence.

Bucketing and churning
Bucketing refers to an unscrupulous activity in which a broker or dealer confirms an order on behalf of a customer at an agreed upon price, but then executes the order at a more favorable price. The broker/dealer then keeps the difference. For example, assume that a broker confirms a trade price of X, but is able to execute the order at a trade price of X – 1. Instead of passing the reduced price on to the customer, the broker keeps the difference. Brokers who typically engage in such practices are known as bucket shops. Such activities are in violation of the NFA Part 2 rules governing the business conduct of members. Churning is the practice of trading by a broker/dealer in the discretionary account of a customer with the sole objective of increasing commissions. The broker/dealer does not give due regard to the effect his or her actions will have on the customer. Such activities are in violation of the NFA Part 2 rules governing the business conduct of members.

Carrying charges
Carrying charges (also referred to as the cost of carry) are those costs associated with the time period over which a financial instrument is held (usually an interest charge) or the costs incurred from receiving physical possession of a commodity or an asset (such as any interest on borrowed funds, insurance, delivery, storage, and other ancillary costs). The price of a futures contract typically includes (either directly or implicitly) carrying charges. A lack of carrying charges may indicate an arbitrage opportunity. Negative or positive carry exists when the difference between the cash price and the futures price is substantially different than the actual cost of carry. In the case of financial futures, negative carry occurs when the interest cost of holding a financial instrument is greater than the rate of return provided. Conversely, positive carry occurs when the interest cost of holding a financial instrument is less than the rate of return from the instrument.

Exchange and clearinghouse
An exchange and a clearinghouse are, respectively, the front and back ends of the futures trading process. An exchange has a responsibility (and the attendant regulatory burden) to manage the execution of the trading process on behalf of customers and exchange members. Most, but not all, members of an exchange are also members of an affiliated clearinghouse. A clearinghouse is an organization operated as either a separate but related entity of an exchange or, in the case of the Chicago Mercantile Exchange and the New York Mercantile Exchange, as a separate department within the exchange. A clearinghouse is primarily responsible for reconciling the trade data received from exchange members and initiating financial transactions to settle gains and losses. Clearinghouses also facilitate both the delivery process for hard commodities and the cash settlement of intangible commodities.

Commodity pool and commodity pool operator
A commodity pool is a type of entity, often a trust or a syndicate, that invests the aggregated funds of its participants in commodity-based futures and/or options contracts. The intent of pooling funds is to achieve greater leverage due to size (similar to a mutual fund) and thereby maximize profits. A commodity pool operator (CPO) is an individual or an entity that acts as an associated person on behalf of the pool investors to manage the funds. The CPO may be responsible for investment decisions. Or, such actions may be taken by a separately employed commodity trading advisor (CTA).

Pit and ex-pit
A pit is a designated area of an exchange, often constructed in the form of an arena, where the open outcry method of trading is used. The term ex-pit refers to the consummation of a futures transaction directly between buyer and seller, rather than on the floor of the exchange. For example, a trader who is short a commodity and agrees to accept delivery may work directly with the trader in the long position to determine and agree on the particulars of the delivery. Once completed, the exchange is notified of the agreement and the transaction is said to have taken place ex-pit, or outside of the exchange (or clearinghouse).

FCM and IB
A futures commission merchant (FCM), also known as a commission house or carrying firm, is an individual or organization that is actively engaged in the process of soliciting and accepting orders for futures and options contracts and executing such orders through an exchange. In addition, an FCM maintains an accounting system to establish individual customer accounts and accept payments for orders. An introducing broker (IB) is an individual or an organization that performs the same customer-facing activities as an FCM, but neither accepts nor accounts for customer payments. Therefore, an IB is required to maintain an affiliation or other relationship with an FCM, which will manage customer accounting and payment receipt. If an FCM agrees to act as a guarantor for the activities of an IB, the guarantor FCM must administer the customer accounting and payment receipts. Otherwise, an IB can use the services of any qualified FCM.

First notice day
For those exchanges that require delivery following the end of trading, the first notice day (FND) is the earliest day on which a seller can issue a notice of intent to deliver. The FND is typically the day after the last trading day. The seller is not required to issue a notice of intent to deliver on the FND, but cannot issue this notice before the FND. Some exchanges allow trading to continue concurrent with deliveries. For example, the CBOT-traded March 2018 corn futures have an FND of 2/28/2018, but the final trading day is 3/14/2018. In cases where delivery occurs only after the last trading day, the FND is important to a trader, as it may be the final day on which an offset can be initiated in order to liquidate a position and avoid a delivery. However, depending upon the rules of the exchange, a long trader may still sell a contract to offset a position by using a process called retender. In this case, the delivery notice is returned to the clearinghouse and assigned to another buyer.