Financial Innovations

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Financial Innovations
Final Exam
Part 1
Case Study
(Worth 50 Points out of 150 Total)

Case Study in Futures Valuation, Futures Spreads and related Arbitrage

Today is November 25, 2022. It is the last trading day and expiration day for the BAKKT November 25,2022 Physically Settled Monthly Bitcoin Futures Contract. To promote Bitcoin and Bitcoin Futures trading, for the next 35 days there shall be no fees or commissions, or delivery charges levied on traders by the BAKKT Exchange and or your Broker / Futures Commission Merchant (FCM). Thus, there is no fee trading available for the next 35 days. You decide to take advantage of this no fees trading special by doing the following trades: You buy the November 25, 2022, BAKKT Bitcoin Future Contract for $10,000.00 / and you simultaneously sell the December 30,2022 BAKKT Monthly Bitcoin Future Contract for $10,100.00. At the end of today’s trading the Nov 25, 2022, Contract expires, and you take electronic delivery of 1 Bitcoin stored digitally in the BAKKT Bitcoin Warehouse. You remain with a short position in the Dec 30, 2022, Bitcoin Futures contract at $10,100.00. You intend to deliver your Bitcoin at the expiration of the Dec 30, 2022, contract to satisfy your commitments/obligations under that contract. There are 35 days between November 25 and December 30. The margin on a short futures contract is $4,000.00.

After reading the scenario above, please answer the following questions and explain.

1.) What is the total initial capital invested in the strategy above? How is it determined?

2.) How do we calculate the periodic (35 day) rate of return for this strategy? Please assume that the Bitcoin Spot Price and the Futures Price stay the same until they suddenly converge at $10,100 at the expiration day and time of the December Contract.

3.) How do we calculate the annual rate of return for this strategy given the similar fact pattern as above, but we would now need to annualize the periodic return?

4.) What happens to our initial capital commitments, and our projected rate of return as Bitcoin Futures Rally? Explain.

5.) What is the primary risk faced by a trader or investor in this strategy with respect to their ability to fund their margin and capital commitments to the trade?