Controversies around Derivatives

Question 1

Where can derivatives be traded?

Answer 1

1. on a recognised futures exchange

2. or between two parties in an over the counter (OTC) transaction.

Question 2

What’s wrong with OTCs?

Answer 2

not usually margined and hard to price

Question 3

Positives of ags commodity derivatives trading as futures on registered future exchanges

Answer 3

increase price transparency, contracts are margined on a daily basis reducing risk of contagion

Question 4

who does the efficient allocation of risk help?

Answer 4

the consumer. it reduces the cost of getting food to the table.

Question 5

derivatives also help…

Answer 5

facilitate price discovery

Question 6

how do derivatives help facilitate price discovery?

Answer 6

allocates world’s resources by determining prices needed to match supply and demand

Question 7

what do futures market prices depend on?

Answer 7

a continuous flow of information from around world and require lots of transparency

Question 8

what is a squeeze?

Answer 8

cornering a market/ market cornering.

Question 9

What’s an example of a market corner

Answer 9

When someone takes a long position in an expiring future position that is bigger than available supply of underlying commodity. The hedgers/specukators who are short of the contract would not be able to deliver. They would have no choice but to buy back their short position on the futures at a price set by the long

Question 10

If someone hedged her physical longs by selling futures, why can’t they just deliver those physical longs and not be forced to buy back the futures?

Answer 10

That can only happen if the person is short because they shorted to hedge physical longs has the EXACT amount to the Exact specification.

Question 11

The futures short may own physical sugar against his future position….

Answer 11

But he may not have the warehouse space to have it available in the 75 day shipment period

Question 12

How do exchange regulators stop market cornering?

Answer 12

They limit the size of the positions held by any one party on the futures market
They check that the trader has the offsetting physical position to justify the futures position

Question 13

What does the trader have to prove going into the expiry of the futures contract?

Answer 13

That her futures position was a hedge and not speculation

Question 14

What if the trader can’t prove its not speculation?

Answer 14

They have to reduce or liquidate or reduce their position?

Question 15

What is false messaging?

Answer 15

Sending incorrect price signals to market participants

Question 16

What is wash trading?

Answer 16

When two parties execute prearranged trades in an effort to print the market higher or lower. Or the prearranged trade eclipses other market participants from the opportunity to trade, bypassing competitive execution requirements

Question 17

What’s is spoofing

Answer 17

Someone could place an order to buy 1000t of cocoa on futures even though they don’t actually want it. They do this to make it seem like more demand is there

Question 18

Who gets the most blame for spoofing?

Answer 18

Computers. They might place an order to sell 1000 futures on coffee futures market but then turn around and start to buy as soon as the order was filled.

Question 19

What does a spoofing by a computer do on the market? If they sell futures and then buy them back as soon a sthey start getting filled?

Answer 19

It could push the market higher and force real buyers to pay more

Question 20

What is front running?

Answer 20

Buying or selling in front of a genuine market when you warn each other if a large order is about to hit allowing front team members to front run the order

Question 21

What would is excessive volatility?

Answer 21

Sharp price movements that occur when there is insufficient liquidity in the market

Question 22

When does excessive volatility occur?

Answer 22

When unexpected news comes out, leaving insufficient time to place offsetting orders
Or if a big hedge fund comes into the market on a quiet day and sells out a large speculative position. The selling could make a big drop in the market.

Question 23

How do exchanges stop excessive volatility?

Answer 23

With circuit breakers.

Question 24

How does the CFTC improve transparency?

Answer 24

They publish a number of commitment to traders reports - COT - that details positions held in each market

Question 25

What different market participants are there?

Answer 25

Commercials, large noncommercials, index funds and unreportables

Question 26

What’s a commercial?

Answer 26

Producer, trader, consumers who hedge their physical transactions on the futures market

Question 27

What’s a large non commercial?

Answer 27

Hedge funds or banks that take speculative position

Question 28

What’s unreportables?

Answer 28

Small traders, usually speculators, who’s position size falls below minimum reporting level set by CFTC

Question 29

What is the market make up?

Answer 29

Who holds what positions.

Question 30

When does the COT report come out?

Answer 30

Every Friday

Question 31

What does the COT include?

Answer 31

Options, separate out index funds, futures only

Question 32

What is a commodity index fund?

Answer 32

The money in the fund is invested in futures contracts based on a commodity price index

Question 33

What is the value of these indexes based on?

Answer 33

The value fluctuates in line with the prices of the underlying commodity futures, and thus value can be traded on an exchange

Question 34

What is the price index indicative of?

Answer 34

The broad commodity asset class or a specific subset of commodities like energy or agriculture

Question 35

No single commodity can compose less than/more than

Answer 35

No less than 2pc or more than 15pc of the index