Chapter 7: Delivery and Settlement Flashcards
When does the clearing house become the counterparty?
After the trades have been confirmed and registered, known as novation
What is the role of the clearing house as counterparty?
Manages the contract delivery of open contracts between clearing members
Can enable the delivery of documents to represent the underlying assets
What is the role of the clearing house as guarantor?
The clearing house guarantees the performance of the trades carried out by its members and substantially reduces counterparty risk
How are warrants used in delivery?
Buyer of a warrant can present it to a LME-listed warehouse, and receive the amount and grade of metal
How can holders of future close contracts? (3)
Close out before expiry
Roll the position forward by closing out and opening in a new month
Deliver the underlying asset
What are the four methods for closing out contracts?
FIFO (First in, first out) - close out the oldest long position against the oldest short position
LIFO (Last in, first out) - close out the most recent trade against the oldest position
Maximum profit – close out an equal number of long and short positions to realise the maximum
amount of profit
Maximum loss – close out an equal number of long and short positions to realise the maximum loss.
This may reduce the build-up of credit risk and free up credit lines for further trading by the client.
What is “bust the settlement”
Reversing closing action and reopening a position
What is the formula for profit and loss for futures and options?
Profit/loss = number of ticks moved * tick value * number of contracts
What is physical delivery?
When contracts remain open at expiry
Physical asset may be delivered for final settlement
When must a participant close their open contract by to prevent delivery?
Before first notice day of the contract
What is the formula for the invoice amount?
EDSP * scale factor * number of contracts
What is the scale factor?
The amount of asset in a contract, e.g. Brent crude is 1,000 contract size
What is the formula for invoice amount for bonds?
EDSP * scale factor * price factor * number of contracts + accrued interest
What are the two additional fields in bond vs normal invoice amount?
Price factor - convert the EDSP on the notional bond for the bond actually being delivered
Accrued interest - assumes EDSP is quoted clean
What is cash settlement?
No exchange of underlying asset
Exchange of funds representing profit and loss
When can cash settlement be a disadvantage?
If participants seek to manipulate the EDSP
Why would participants want to avoid delivery?
May not be in possession of asset
Merely hedging or speculating
What is the EDSP?
Exchange Delivery Settlement Price
The price at which all outstanding futures are closed
What is the purpose of assignment of obligations?
What is assignment?
The process of obliging option sellers to perform their obligations
* A seller of an equity call is obliged to sell the shares at the option’s strike price.
* A seller of a bond call will potentially become the short to a bond future at the option’s strike price.
How do you instigate an assignment notice?
Must notify broker
Broker fills in an exercise notice that is delivered to the clearing house via clearing member
Who receives an assignment notice?
Clearing house assigns at random
What happens when you receive an assignment notice?
Formal notification that the terms of the contract must be fulfilled
Transaction then becomes a cash market transaction
What happens when you exercise an option on futures?
Holder and writer will be assigned a long/short futures position at the strike price
What is a cabinet trade?
When a trader closes out a position from a nominal amount to realize a loss for tax or accounting purposes
What is automatic exercise?
Clearing house will automatically exercise any option that is sufficiently ITM at expiry
When is an option sufficiently ITM for automatic exercise?
When doing so would cover commissions and exercise fees
Why is it normally not rational to exercise an option before expiry?
Because you only realize the IV, not the TV. Would make more sense to sell the option itself.
What are the 3 criteria for early exercise?
American-style option
Deep ITM - must have significant IV
Close to expiry - must have low TV
Why might someone take an equity option early?
To receive dividends/voting rights
How are controls departments for derivatives usually split by?
OTC and Exchange Traded
What is a deal ticket?
Record of all the terms, conditions and basic information of a trade agreement
What is a term sheet?
A document attached to deal tickets, used to help detail purpose and manage risk
Why must trade details and documentation be signed independently of the dealers?
Reduce the risk of fraud or unauthorized dealing
What is a master confirmation?
For parties with high mutual trading, a master confirmation can reduce administrative burden
What is a transaction supplement?
Trade details that will be attached with the master confirmation
When must trade details be reported?
No later than the working day following the conclusion of the contract
EMIR
What happens if an internally captured trade does not match the request from the client?
FO will work to either amend or cancel, and if not do subsequent trades to make up for it
