Chapter 2: Derivatives (1)

Question 1

The two derivatives markets

Answer 1

1. exchange-traded

2. over-the-counter

Question 2

Define a futures contract

Answer 2

A futures contract is an exchange-traded, standardised, and thus marketable, obligation to trade an underlying asset on a set date a few months later at a set price.

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Question 3

The roles of the Clearing house (5)

The clearing house to an exchange fulfills the following roles:

Answer 3

1. counter party to all trades
2. guarantor of all deals (removing credit risk)
3. registrar of deals
4. holder of deposited margin
5. facilitator of the marking to market process

Question 4

Open-interest

Answer 4

The number of contracts that have not been closed out at any one time is referred to as the open interest in that contract.

Question 5

Define a traded option

Answer 5

A traded option is a standardised and thus marketable agreement giving the holder the right but not the obligation to trade an underlying asset on a set date a few months later at a set price.

Question 6

Main advantage of the OTC market

Answer 6

The main advantage of the OTC market is the ability to tailor the contracts to the buyers’ precise requirements

Question 7

Main disadvantages of the OTC market (4)

Answer 7

1. low marketability
2. high dealing costs
3. lack of market values
4. greater credit risk

Question 8

Margin: (2)

Answer 8

1. Margin is the collateral that each party to an exchange-traded derivative must deposit with the clearing house.
2. It acts as a cushion against potential losses, which the parties may suffer from future adverse price movements.

Question 9

Name a few financial assets on which futures exist (6)

Answer 9

1. bonds
2. short interest rates
3. currencies
4. stock
5. market indices
6. commodities

Question 10

How is the credit risk exposure of the clearing house controlled? (2)

Answer 10

1. by the marking to market process

2. by the adoption of price limits by the exchange