Chapter 2: Derivatives (1) 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 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
Describe how the clearing house removes the credit risk of the individdual 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 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
Outline the role fo the margin deposted by derivative brokers with teh clearing house in teh 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 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- Increase in value of contract may be withdrawn by broker, also on daily basis
State another means by which a clearing hosue may protect itself against excessive credit risk
- 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
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 contraacts react 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 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)
State the main advantage and the four disadvvantages 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 eaily closed out
- credit risk as counter party may default
- Lack of quoted market prices
