Chapter 7: Delivery and Settlement

Question 1

Who manages the delivery of the UA if a future is held until delivery

Answer 1

The clearing house due to novation

Question 2

Closing contracts - 3 choices for holders of futures

Answer 2

1. Close the contract before expiry - avoid making/taking delivery and the holder realises profitt/loss. closed with an opposing trade
2. roll the position forward by closing the current position and establishing a new position for a later date
3. take delivery of the UA

Closing

Question 3

Closing contracts before expiry

Answer 3

• The decision to close is flexible to the holder and can be done any time up until maturity
• Closing can be cheaper as there is no requirement to store physical assets
• A close-out instruction must be issued by the holder which will determine which short can be used to close the long

Question 4

Methods of performing close outs - 4 methods (FIFO etc, flat busting settlements

Answer 4

• First in - first out (FIFO) = close out the oldest long position against the oldest short
• Last in, first out (LIFO) = close most recent trade against the oldest opposing position
• Maxiumum profit = close an equal number of long and shorts to maximise profit
• Maximum loss = close an equal number of longs and shorts to realise the max loss. Used to reduce credit risk and free up lines of credit

A position that has been closed is described as being flat
busting a settlement cancelling the closure process

Question 5

Profit+loss calculation for equity index F&O - ticks

Answer 5

Profit/loss = no.ticks moved X tick value X No. contracts

Losses are paid by mkt participants to brokers who then settle via clearing members, who settle in the CH

Question 6

Physical Delivery - when is closing price established, what is it call on ICE ftrs, who decided what assets etc can be delivered

Answer 6

• Open contracts at expiry will be delivered under exchange rules which can identify approed delivery points
• Closing price is established at the end of the last trading day of the contract (for ICEfutures EU this is called exchange delivery settlement price - EDSP)
• exchange rules define the quantity, type, locations and quality of assets in scope for delivery

Question 7

LMEsword and it’s Benefits - what is it/does it do, what does it issue for physical deliveries, +/-s

Answer 7

• LMEsword - LME secure electronic delivery system for LME warrants that need holding in a central repository - makies delivery easy as they have warehouses located globally.
• LMEsword provides assurance to investors that the correct quantity of their physical metal is stored at a location as the warrant acts like a collection note
• LMEsword warrants are transferable between members
• Makes admin more efficient
• removes the need to physically transfer warrants, reducing manual processes
• Immobilises warrants in a repository

Question 8

Tender process - what day is the UA delivered on, what contracts have T+1 tenders, notice days

Answer 8

• =when the futures seller tells the CH they are taking delivery
• If flexible, the holder can chose what, where, when to deliver
• UA is delivered on the delivery day
• Some contracts have T+1 tenders - EUREX eurobond future
• OTher contracts issue a first and last notice day before dleivery the UA
• CONTRACTS THAT ARE NOT BEING DELIVERED MUST BE CLOSED BY THE FIRST NOTICE DAY

Question 9

ICE 4 delivery stages

Answer 9

1. Seller of the short future tells ICE they want to deliver the UA
2. ICE Connect (clearing platform) matches the seller to a buyer randomly
3. ICE Clear Europe calculates the invoice amount and notifies the seller and buyer
4. Seller delivers the UA to the CH and pays the invoice - Buyer pays the invoice and CH delivers the asset

Question 10

Invoice amount (cost to deliver) calculation for physically delivered assets

Answer 10

Invoice amount=EDSP X scale factor X no. contracts

The scale factor converts the price quote to show the total value of assets being delivered.

Question 11

Invoice amount calculation for bond futures and 2 main differences

Answer 11

Invoice amount = (ESDP X price factor X scale factor X no. contracts) + accrued interest

2 differences to the normal assets:
1. price factor is used to convert EDSP of the notional bond to the actual bond being delivered
2. EDSP is quoted clean - ignores accrued interest at delivery

Question 12

Cash settlement for cash settled contracts - +/-s, what needs to be done to meet delivery reqs

Answer 12

• No physical UA but an exchange of cash instead that represent the profit/loss
• Cheaper as no delivery/storage costs
• Less admin as no delivery, storage, quantity/quality concerns
• To meet delivery obligations = pay last day’s variation margin
• Disadvantage - trading activity in the underlying mkt is likely to be affected by people trying to manipulate the EDS by unwinding their positions in the underlying mkt

Question 13

Exchange delivery settlement price (EDSP) - what system is used to prevent what, what is required for non physical futures, what do some mkts to do gauge prices when do ICE futures take EDSP reading

Answer 13

• ICE Europe’s term for a closing futures price
• The sole price any closing futures will be given
• Exchanges use an openly declared system that prevents mkt manipulation so the closing price truly represents the UA.
• For non physical futures, EDSP is the final variation margin payment required
• Some mkts use intra-day auctions to guage mkt prices to be sure they are accurate and EDSP hasn’t been manipulated
• ICE ftrs - long gilts - use mkt price at 11AM of the 2nd business day prior to settlement or the last notice day if the investors are made aware. Invoice amount for the gilt is then calculated by a price factor system that considers coupon

Question 14

Exercise fof phyiscally deliverable options

Answer 14

• Holders decide to exercise the option they must inform the broker
• Broker completes an exercise notice and sends it to the CH via the clearing member
• CH assigns an option writer at random and sends them and assignment notice saying the contract must be fulfilled. The trade becomes a cash market transaction and is subject to commission fees
• Unlike futures the HOLDER starts the exercise process for options
  *

Question 15

Exercise of cash settled options

Answer 15

• Basically needs to transfer the option’s intrinsic value from the writer to the holder
• Options with futures style premium payments (ICE marekts) will variation margin will account for most of the IV
• However, OTCs will see the full amount due being paid at exercise

Question 16

Exercise of options on futures - impact on open interest

Answer 16

• Process is the same as cash settled options if exercised
• Only difference - writer will be assigned a long/short futures position at strike price
• Option being exercised will cause the open interest in the U futues contract increasing by the no. options being exercised

Question 17

Abandonment and cabinet trades

Answer 17

• Holder doesn’t exercise=writer’s obligations cease
• Holders tend to wait until the last minute to abandon an option.
• Traders sometimes close options out for a nominal amount to crystalise a loss to reduce tax liabilities - called cabinet trade

Question 18

Automatic exercise - which exchanges, what has to be filed to stop it

Answer 18

• Done by ICE clear EU and CME group
• Automatically exercises options that are sufficiently ITM at expiry, usually $0.01 per contract ITM.
• Sufficiently ITM means the profit will cover the delivery cost, premium etc
• Capped style options - have a profit cap that once teh UA price moves beyond the cap and the option is ITM at expiration, it is subject to automatic exercise
• Investors not wanting auto. exercise have to file a suppression notice with the CH. could be due to exercise fees making it unprofitable
  *

Question 19

Early exercise of options - 3 criteria

Answer 19

• Only American style options can exercise early at the decision of the holder
• Usually, options are not exercised early as the holder won’t benefit from the added TV, instead they are usually sold
  3 criteria to exercise early
  1. American style
  2. Deep ITM - must have siginificant IV
  3. Close to expiry/short dated - very little TV left

Equity options make sense to exercise early sometimes because of dividends or voting rights

Question 20

Importance of controls

Answer 20

• inefficines in processes are potentially greater fro derivs as they are geared.
• No standardised controls structure for derivs so internal audit teams typically devise the controls policy which external audit will review
  *

Question 21

Factors included in a controls regime

Answer 21

• Volume of transactions - due to the number of transactions firms will have specialist areas within operations to deal with the different types
• Range and prod complexity - expertise to meet the needs of the client
• valuations and risk monitoring - have systems to measure currrent positions vlaue and risk
• Reporting - must meet the requirements set by teh regulator

Question 22

Organisation of operations teams for derivs and processing and settlement of transactions

Answer 22

• Split between OTC and exchange traded typically
• Key objectives - efficiency, flexibility, security and control

Processing and settlement include
* Processing of deal tickets for deriv trades - record the basic details of the trade
* Any term sheets - indicate if a position is a hedge and is attached to deal tickets. If not recorded correctly the position will appear as a speculative position in the balance sheet

Question 23

Process flow of OTC transactions

Answer 23

• Trade capture and verification
• Position keeping and P+L analysis
• Confirmation and documentation
• Settlement
• Reconciliation

Question 24

Trade capture and verification

Answer 24

• Trades must be entered into systems immediately to track credit and mkt risk, also delays latter processes
• trade details must be entered correctly for the same reason as well as failed settlements, late booking of trades. This causes the following problems
  1. Innacurate risk monitoring
  2. Interest payments caused because of late settlement
  3. operational losses due to funding/timing difficulties
  4. poor quality client service
  5. rule breaches=fines or reg. consequences
  6. reputational loss
• Also, over-reliance on spreadsheets is an issue compared to using bespoke otc deriv dealing programs as spreadsheets are easy to make mistakes on or get corrupted etc

Question 25

Position keeping and profit/loss

Answer 25

• Documentation used to be agreed between counterparties ops team - reduces risk of unauthorsed trades/conflicts of interest from the trader/dealer
• Confirmation = written evidence of the transaction detailing the price, quantity etc. signed by botth parties to remove disputes. Incorporates ISDA definitions
• Master confirmations are used for parties that deal together regularly. trade details to be reported max 1 day after the contract concludes according to EMIR
• individuals and non EU counterparties are exempt from EMIR but usually have to comply with their own regs (dodd frank e.g.)
• IHS markit - similar to ISDA agreement
• Disagreements must be resolved immediatley and if confirmations are not recieved in a timely manner, must have escalation routes

Question 26

Settlement

Answer 26

• Settlement is more complex for OTC prods so timely settlement is preferred to reduce the risks that can arise from late settlement.

Question 27

Reconciliation

Answer 27

• Ensures trades are done within the firm’s limits set out in their trading mandate, like checking executed trades match client orders (with the small lee-way defined above)
• Internal trade capture records the execution of a trade and is completed by the trader before the confirmation is recieved from the counterparty
• Back office then check the internal capture matches the client’s trade. discrepancies are reported to FO who can cancel the trade/trade their way out of it to avoid losses
• Once the client shares the confirmation, back office will check and approve within 24 hours
• MO have limited involvement and typically manage mark to market valuation, reg. compliance and trading limit management, documenting FO’strading mandate

Question 28

DONE!