Chapter 7: Delivery and Settlement

Question 1

When does the clearing house become the counterparty?

Answer 1

After the trades have been confirmed and registered, known as novation

Question 2

What is the role of the clearing house as counterparty?

Answer 2

Manages the contract delivery of open contracts between clearing members
Can enable the delivery of documents to represent the underlying assets

Question 3

What is the role of the clearing house as guarantor?

Answer 3

The clearing house guarantees the performance of the trades carried out by its members and substantially reduces counterparty risk

Question 4

How are warrants used in delivery?

Answer 4

Buyer of a warrant can present it to a LME-listed warehouse, and receive the amount and grade of metal

Question 5

How can holders of future close contracts? (3)

Answer 5

Close out before expiry
Roll the position forward by closing out and opening in a new month
Deliver the underlying asset

Question 6

What are the four methods for closing out contracts?

Answer 6

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.

Question 7

What is “bust the settlement”

Answer 7

Reversing closing action and reopening a position

Question 8

What is the formula for profit and loss for futures and options?

Answer 8

Profit/loss = number of ticks moved * tick value * number of contracts

Question 9

What is physical delivery?

Answer 9

When contracts remain open at expiry
Physical asset may be delivered for final settlement

Question 10

When must a participant close their open contract by to prevent delivery?

Answer 10

Before first notice day of the contract

Question 11

What is the formula for the invoice amount?

Answer 11

EDSP * scale factor * number of contracts

Question 12

What is the scale factor?

Answer 12

The amount of asset in a contract, e.g. Brent crude is 1,000 contract size

Question 13

What is the formula for invoice amount for bonds?

Answer 13

EDSP * scale factor * price factor * number of contracts + accrued interest

Question 14

What are the two additional fields in bond vs normal invoice amount?

Answer 14

Price factor - convert the EDSP on the notional bond for the bond actually being delivered
Accrued interest - assumes EDSP is quoted clean

Question 15

What is cash settlement?

Answer 15

No exchange of underlying asset
Exchange of funds representing profit and loss

Question 16

When can cash settlement be a disadvantage?

Answer 16

If participants seek to manipulate the EDSP

Question 16

Why would participants want to avoid delivery?

Answer 16

May not be in possession of asset
Merely hedging or speculating

Question 17

What is the EDSP?

Answer 17

Exchange Delivery Settlement Price
The price at which all outstanding futures are closed

Question 18

What is the purpose of assignment of obligations?

Question 19

What is assignment?

Answer 19

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.

Question 20

How do you instigate an assignment notice?

Answer 20

Must notify broker
Broker fills in an exercise notice that is delivered to the clearing house via clearing member

Question 21

Who receives an assignment notice?

Answer 21

Clearing house assigns at random

Question 22

What happens when you receive an assignment notice?

Answer 22

Formal notification that the terms of the contract must be fulfilled
Transaction then becomes a cash market transaction

Question 23

What happens when you exercise an option on futures?

Answer 23

Holder and writer will be assigned a long/short futures position at the strike price

Question 24

What is a cabinet trade?

Answer 24

When a trader closes out a position from a nominal amount to realize a loss for tax or accounting purposes

Question 25

What is automatic exercise?

Answer 25

Clearing house will automatically exercise any option that is sufficiently ITM at expiry

Question 26

When is an option sufficiently ITM for automatic exercise?

Answer 26

When doing so would cover commissions and exercise fees

Question 27

Why is it normally not rational to exercise an option before expiry?

Answer 27

Because you only realize the IV, not the TV. Would make more sense to sell the option itself.

Question 28

What are the 3 criteria for early exercise?

Answer 28

American-style option
Deep ITM - must have significant IV
Close to expiry - must have low TV

Question 29

Why might someone take an equity option early?

Answer 29

To receive dividends/voting rights

Question 30

How are controls departments for derivatives usually split by?

Answer 30

OTC and Exchange Traded

Question 31

What is a deal ticket?

Answer 31

Record of all the terms, conditions and basic information of a trade agreement

Question 32

What is a term sheet?

Answer 32

A document attached to deal tickets, used to help detail purpose and manage risk

Question 33

Why must trade details and documentation be signed independently of the dealers?

Answer 33

Reduce the risk of fraud or unauthorized dealing

Question 34

What is a master confirmation?

Answer 34

For parties with high mutual trading, a master confirmation can reduce administrative burden

Question 35

What is a transaction supplement?

Answer 35

Trade details that will be attached with the master confirmation

Question 36

When must trade details be reported?

Answer 36

No later than the working day following the conclusion of the contract
EMIR

Question 37

What happens if an internally captured trade does not match the request from the client?

Answer 37

FO will work to either amend or cancel, and if not do subsequent trades to make up for it