Chapter 1: Derivatives Flashcards
Define a futures contract and outline the process of trading futures
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 exchange (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 variation margin being payable
Most positions in futures markets are closed out before delivery by taking an opposite position
Describe how the clearing house removes the credit risk of the individual participants to a futures trade
When 2 traders agree to deal, a contract is created
The buy/sell contracts are matched by exchange, and details registered with exchange’s clearing house
Following registration, each party has contractual obligation to clearing house, which 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
Outline the role for the margin deposited by derivative brokers with the clearing house in the context of futures trading
Margin is collateral that each party to futures contract must deposit with clearing house - acts as cushion against potential losses that parities 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 variation 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Increase in value of contract may be withdrawn by broker, also on daily basis
State another means by which a clearing house may protect itself against excessive credit risk
Price limits may also be used to protect clearing house from excessive credit risk
on any one trading day, if price of futures contract 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 variation margin to be collected
List 5 roles of clearing house
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
Explain what is meant by:
Closing out a futures position
Open interest
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 contracts reach physical delivery
Open interest
Total number of long futures positions open at the exchange at any time
Describe the over the counter markets
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 to clients
less liquid and transparent than markets in exchange-traded derivatives
Possible credit risk (may be mitigated by collateral and contract terms, as required by central clearing party)
Typically transacted under documentation maintained by the international swaps and derivatives assosication (ISDA)
State the main advantage and the four disadvantages of the OTC derivatives
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 easily closed out
credit risk as counter party may default
Lack of quoted market prices
