C.2 Futures Markets and Central Counterparties Flashcards
Characteristics of futures contracts
- Available on a wide range of underlyings
- Exchange traded
- Specifications need to be defined
- Settled daily
- Standard contract
- Range of delivery dates
- Almost always closed out before delivery/final cash
- Virtually no credit risk
Specifications for futures
- What can be delivered
- Where it can be delivered
- When it can be delivered
Futures and spot price relationship
As the contract approaches the maturity date, the futures price converges to the spot price
What is the margin
Is a cash or marketable securities deposited by an investor with his/her broker. The balance is adjusted to reflect daily settlement
What is the margin’s purpose
To minimize the possibility of a loss through a defaulted contract
What does the balance have to be in the margin account
Retail traders put in an “initial margin” and if the margin falls below “maintenance levels” then the retail trader must provide “variation margin” to bring the balance up to the initial margin
How do you close out a futures position
You enter into an offsetting trade
The margin cash flow when futures price increases
Short trader
- > Broker
- > Clearing House Member
- > Clearing House
- > Clearing House member
- > Broker
- > Long trader
Bilateral Clearing
Transactions governed by an agreement, typically an ISDA Master Agreement, between two sides
Credit Support Annex (CSA)
Defines the collateral that has to be posted by each side in a bilateral clearing
Central Counterparties (CCP)
Following the 2007-2009 crisis, standardized OTC transactions between financial institutions have to be cleared centrally through clearing houses known as CCPs
How does a CCP function
Similarly to an exchange clearing house. Members must provide an initial margin and variation margin, and if a company is not a member, they can clear its transactions through a member
Open interest
The total number of contracts outstanding (equal to the number of long positions or short positions)
Settlement price
The price just before the final bell each day
Volume of trading
The number of trades in one day
Delivery
When the contract isn’t closed out before maturity, then the delivery for the assets underlying the contract are delivered to settle. If there are alternatives to where/what/when, the short party chooses
Cash settlement delivery
Contracts are traded until a predetermined date. At that date, all are considered to be closed out.
Futures price patterns
- An increasing function of maturity: normal market
- A decreasing function of maturity: inverted market
- Partly normal, partly inverted
Trading volume vs open interest
If there is a large amount of trades completed (i.e. traders who enter into a position and close out on the same day) then a daily trading volume can > than either the beginning of day or end of day open interest
Types of orders
- Market order
- Limit
- Stop-loss
- Stop-limit
- Market-if touched
- Discretionary
- Time of day
- Open
- Fill or kill
Market order
Simplest order. A request that a trade be carried out immediately at the best price available
Limit order
A order can only be executed at this price or at a more favourable one
Stop-loss (Stop order)
An order that is executed at a particular price or less favourable one to stop losses
Stop-limit order
Combo of stop-loss and limit. The order becomes a limit as soon as a bid or offer is made at a price equal to or less favourable than the stop price
Stop-and-limit order
If stop price and limit price in a stop-limit order are the same
Market-if-touched (MIT)
Executed at the best available price after a trade occurs at a specified price or more favourable price. Basically becomes a market order once a specified price has been hit. aka board order
Discretionary order
Aka market-not-held. Like a market order except the broker can delay the trade in an attempt to get a better price
Open order
Aka good-til-canceled order. Is in effect until executed or until the end of trading in the contract.
Fill-or-kill order
Must be executed immediately on receipt or not at all
Purpose of regulating futures
Designed to protect public interest by preventing sketchy trading practices in individuals on the floor, the exchange, or outside groups
Corner the market
Investor group takes a huge long futures position and also tries to exercise some control over the supply of the underlying commodity. They don’t close out their long position at maturity, such that those in short positions don’t have enough commodity for delivery and become desperate to close out their positions which leads to large rise in futures and spot prices = $$$ for those in long positions
Hedge accounting
The gains or losses are generally recognized for accounting purposes in the same period in which the gains or losses from the item being hedged are recognized. This is unlike if it is not a hedge, where accounting standards would require changes in the market value of a futures contract to be recognized when they occur.
Is daily settlement for future or forward contracts
Futures
Characteristics of forward contracts
- An OTC agreement to buy/sell an agreement at a future time at a certain price
- Between two parties
- Non-standard contract
- Usually 1 specified delivery date
- Settled at end of contract
- Delivery or final cash settlement usually occurs
- Some credit risk
Foreign exchange quotes: futures vs forwards
- Futures: Exchage rates are quoted as the number of USD per unit of foreign currency
- Forward: Quoted in the same way as spot exchange rates. For the pound, euro, AUS dollar, NZ dollar, the forward quotes are the same futures (ie number of USD per unit of foreign currency). For every other currency, the forward quotes the number of units of the foreign currency per USD dollar
