1 Derivatives Flashcards
Define a futures contract. (4)
A standardised exchange-traded contract to trade
- a specified asset
- at a certain future time
- at an agreed price.
Outline the process of trading futures. (5)
- A buyer and seller agree to deal the exchange-traded derivative.
- Opposing contracts are created between each party and the clearing house of the exchange (who act as a counterpart to each trade).
- Each party deposits initial margin with the clearing house.
- The contract is marked to market daily, which may result in variation margin being payable.
- Most positions in futures markets are closed out before delivery by taking an opposite position.
What is the role of the clearing house in derivatives trading? (4)
- Once buy and sell contracts are matched by the exchange, the details of both parties are registered with the clearing house.
- Each party then has contractual obligation to the clearing house rather than each other.
- The clearing house guarantees each side of the bargain (it is party to every trade).
- This guarantee removes the credit risk of individual participants.
Discuss the role of margin in futures trading. (7)
- Margin is collateral that each party to a futures contract must deposit with the clearing house.
- It acts as a cushion against potential losses that the parties may suffer from adverse price movements.
- When a contract is first struck, initial margin is deposited by the broker with the clearing house.
- This is changed on a daily basis to ensure that the clearing house’s credit risk exposure is controlled.
- The process of daily margin changes in known as ‘marking to market’.
- A fall in value is topped up with additional payments of ‘variation margin’ to enable the clearing house to continue to give its guarantee.
- Increases in the value of the contract may be withdrawn by the broker, also on a daily basis.
Discuss how price limits protect the clearing house from excessive credit risk. (2)
- On any one trading day, if the price of a futures contract moves up or down, from the day’s opening price, by more than the price limit, the exchange halts trading in that contract.
- Trading may recommence on the next trading day, or later that day after a pause for traders to reflect on their positions and to allow variation margin to be collected.
How do clearing houses protect themselves against credit risk? (2)
- Collecting margin.
2. Price limits.
List five roles of a clearing house. (5)
- Counterparty to all trades.
- Guarantor of all deals.
- Registrar of deals.
- Holder of the deposited margin.
- Facilitator of the marking to market process.
What is meant by Closing Out a futures position?
- Most positions in futures markets are closed out before delivery by taking an opposite position.
- For example, a 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 contracts reach physical delivery.
What is meant by Open Interest?
This is the total number of long positions open at the exchange at any particular time.
Discuss Over The Counter (OTC) markets. (6)
- Many financial derivatives are traded over-the-counter by investment banks.
- Swap markets and currency forward markets are two very important OTC markets.
- Banks tailor a wide variety of derivatives to suit the needs of clients.
- They are less liquid and transparent than markets in exchange traded derivatives.
- There is a possible credit risk, reduced by collateral and contract terms as required by the CCP (Central Clearing Party).
- Typically transacted under documentation maintained by the ISDA (International Swaps and Derivatives Association).
What are the disadvantages of OTC markets? (4)
- Expenses are greater than for exchange traded derivatives.
- Positions cannot be easily closed out.
- Credit risk, as the bank may default.
- Lack of quoted market prices.
Compare futures and forward contracts. (8)
- Futures are exchange-traded whereas forwards are OTC.
- Futures are standardised whereas forwards are tailored.
- Index futures are available whereas forwards are normally based on a specific security.
- Futures are highly marketable whereas forwards lack marketability.
- The delivery price for futures is determined openly in a market place whereas for forwards it is negotiate privately.
- Futures involve clearing houses so there is no credit risk, but credit risk remains for forwards.
- Margin is paid daily for futures but not for forwards.
- Futures can be closed out prior to maturity but forwards are difficult to close out.
Give the formula for the payoff from a long position in a forward contract.
S(t) - K
where K is the delivery price and S(t) is the spot price of the asset at maturity
Give the formula for the payoff from a short position in a forward contract.
K - S(t)
where K is the delivery price and S(t) is the spot price of the asset at maturity
Give the formal for the payoff from the long position in a call option.
max[ S(t) - K ] - p
where
K is the delivery price
S(t) is the spot price at maturity
p is the option premium
