Chapter 1: Derivatives

Question 1

Define a futures contract and outline the process of trading futures

Answer 1

Futures contract

A standardised exchanged traded contract to trade a specific asset at a certain future time at an agreed price

Futures trading

• A buyer and a seller agree to deal the exchanged traded derivative
• Opposing contacts are created between each party and the clearing house of the exchance (who act as counterparty to both trades)
• each party deposits initial margin with the clearing house
• contract is marked to market daily, which may result in variaiton margin being payable
• Most positions in futures markets are closed out before dlivery by taking an opposite position

Question 2

Describe how the clearing house removes the credit risk of the individdual participants to a futures trade

Answer 2

• When 2 traders agree to deal, a contract is created
• The buy/sell contracts are matched by exchange, and details registered with excahnge’s clearing house
• Following registration, each party has contractual obligation to clearing house, whicch acts as a party to every trade, In turn clearing house guarantees each side of the original bargain
• Through this guarantee, clearing house removes credit risk of individual participants - chance that one of them might renege

Question 3

Outline the role fo the margin deposted by derivative brokers with teh clearing house in teh context of futures trading

Answer 3

• Margin is collateral that each party to futures contract must deposit with clearing house - acts as cushion against potential losses that partiies may suffer from future adverse price movements
• When contract first struck, initial margin is deposited by broker with clearing house
• This is changed on daily basis to ensure that clearing house’s exposure to credit risk is controlled
• Process of daily margin changes known as marking to market
• Fall in value is topped up with additional payments of variaiton margin to enable clearing house to continue to give its guarantee
• Increase in value of contract may be withdrawn by broker, also on daily basis

Question 4

State another means by which a clearing hosue may protect itself against excessive credit risk

Answer 4

• Price limits may also be used ot protect clearing house from excessive credit risk
• on any one trading day, if price of futures contraact moves up or down, from day’s opening price, by more than price limit then exchange halts trading in that contract
• trading may recommence on next trading day or later that day, after a pause for traders to reflect on their positions and to allow variaiton margin to be collected

Question 5

List 5 roles of clearing house

Answer 5

• Counterparty to all trades
• guarantor of all deals (removing credit risk)
• Registrar of deals
• holder of deposited margin
• facilitator of the marking to market process

Question 6

Explain what is meant by:

1. Closing out a futures position
2. Open interest

Answer 6

Closing out a futures position

• Most positions in futures markets are closed out before delivery by taking an opposite position
• For example, buyer of a contract can later close out his position by selling an equivalent contract. His net position is then nil
• Only a relatively small proportion of contraacts react physical delivery

Open interest

Total number of long futures positions open at the exchange at any time

Question 7

Describe the over the counter markets

Answer 7

• Many financial derivatives are traded over the counter by investment banks
• Swaps market and currency forward markets are two very important OTC markets
• Banks tailor wide variety of derivatives to suit needs ot clients
• less liquid and transpatent than markets in exchange-traded derivatives
• Possible credit risk (may be mititgated by collateral and contract terms, as required by central clearin party)
• Typically transacted under documentation maintained by the international swaps and derivatives assosication (ISDA)

Question 8

State the main advantage and the four disadvvantages of the OTC derivatives

Answer 8

Advantage of OTC derivatives

• Can be tailored to suit investor’s requirements

Disadvantages of OTC derivatives

• Expenses greater than for exchange - traded derivatives
• positions cannot be eaily closed out
• credit risk as counter party may default
• Lack of quoted market prices