Derivatives And Other Instruments Flashcards
1
Q
What is a derivative? (1)
A
- An asset where the underlying value derives from another products e.g. future and options
2
Q
What is a future? (5)
A
- A contract between two parties where one party agrees to buy something in the future and the other party agrees the opposite side of the trade
- The terms of the contract are agreed now e.g. price, quantity
- By fixing the price, the instrument provides certainty about future pricing
- Longing = buying. Shorting = selling. Long knows how much they will pay and short knows how much they will receive
- Contract is binding - price of delivery is set.
3
Q
What is an underlying asset? (5)
A
- Derives the value of a future - underlying or cash asset (gilts/currencies/commodities)
- Conditions of futures are specified/standardised because futures are traded on exchanges around the world
- Standardising opens markets and therefore provides liquidity
- Standardised Teresa re known as contract specifications
- Price is never standardised - price does however form part of the total agreement so is a feature of future contracts
4
Q
What are the features of a long position? (6)
A
- The future buyer of the underlying asset
- Thinks the price of the asset will rise
- If long position says they will buy £300 of copper in June 2026, they have to stick to this, regardless of price changes of the underlying asset
- The long position makes money in a rising market but loses money in a falling market
- Max gain: unlimited
- Max loss: limited to the price of the future
5
Q
What are the features of a short position? (7)
A
- The future seller of the underlying asset
- Short position thinks that the price of the asset will fall
- If an investor shorts copper future at £300, they have agreed to sell copped in June 2026 at that price
- Once agreed, short position must sell
- Short position makes money in a falling market and loses money in a rising market
- Max gain: limited to the price of the future
- Max loss: unlimited
6
Q
What is the delivery date? (2)
A
- Date on which the agreed transaction takes place
- Represents the end of the futures life
7
Q
What is fair value? (4)
A
- A theoretical arbitrage-free value of the future
- Based on the theory that a long future position, there is always another alternative. The alternative to buying wheat in the future is buying wheat today and holding it in a warehouse for 3 months
- However, buying wheat today incurs extra costs above the price of the asset - this is known as cost of carry e.g. interest rates, storage, insurance
- Fair value of future = cash price of underlying asset + cost of carry
8
Q
What is the cost of carry vs cash price of underlying asset? (2)
A
- Cost of carry: what it would cost to hold the asset until the delivery date e.g. finance charge, storage, insurance
- Cash price of underlying asset: what it would cost to buy the asset today (spot price)
9
Q
What is basis? (2)
A
- Quantifies the difference between the cash price of the underlying asset and the futures price
- Basis = cash price - future price
10
Q
What is contango? (3)
A
- Means the basis is negative e.g. cash price is less than the future price
- Future price indicates the cost of carry, basis is usually negative and the market is described as contango
- Neative basis is the norm where there is adequate supply e.g. ‘far’ (future) prices are higher than ‘near’ (spot) prices
11
Q
What is backwardation (back)? (4)
A
- Means the basis is positive
- Cash price is greater than the price of the future price
- Would occur if there was a temporary shortage of the underlying which would push up the cash/spot price today and produce a back market
- Can occur when there is an overall benefit of carry rather than cost of carry e.g. div yield on an equity or equity index is above interest rates
12
Q
What is contingent liability? (2)
A
- A transaction that describes a position where the investor faces a potential liability which is uncertain at the present time
- All futures transactions are contingent liability transactions
13
Q
What are the features of forwards? (6)
A
- Similar to futures - agreed conditions for the future transaction is set today.
- Key difference: futures are exchange tranced why forwards are OTC
- Advantage of forwards over futures: they offer a high degree of flexibility to the parties involved - no exchange to standardise in the terms of the contract
- Disadvantage: forwards are a direct counterparty risk with the opposite side of the trade - no central counterpart or formalised collateral payments system - credit worthiness of both parties is important.
- No central marketplace - difficult to value forwards and price information is not always available
- Examples are currency forwards, currency swaps
14
Q
What are the features of CFDs? (5)
A
- Term describes a cash settled derivative
- No physical delivery actually takes place - contract is settled for difference between the agreed price and the settlement price
- E.g. interest rate futures and futures in equities indices
- Many futures are physically settled meaning that at expiry the underlying asset is delivered (to the long position)
- Physically delivered derivatives include ICE Futures Europe long gilt
15
Q
What is arbitrage? (5)
A
- Process whereby investors make risk free profit by exploiting anomalies and inconsistencies in the prices between 2 related but different markets
- E.g. buying a cheaper car in Europe, paying additional import fees and selling it in the UK for a higher price for profit
- By exploiting inconsistencies between motor car prices in different markets, a quick profit can be made
- The same principle is use when arbitraging between an index and its derivative - if an investor can buy an asset and pay the cost of carry for less than the price on the future contract, there is an inconsistency in pricing
- Investor can spot this arbitrage opportunity and buy the asset and hold (cheap) and short the future (agree to sell as a higher price)
16
Q
What is closing out? (4)
A
The buyer of the future contract has 2 options
- Hold the future to expiry and then take delivery of the underlying (if physically deliverable)
- Sell the future before the expiry (known as closing out of the position)
- Closing out is achieved by entering in to a second equal buy opposite contract in order to offset the terms and conditions of the first
- Opening sale is closed out by a closing purchase
17
Q
What are roll contracts? (4)
A
Motivation
- Specifically linked to commodity contracts that proceed to the physical delivery of an asset on the delivery date of the contract
- Where the manager gains exposure to commodities through the use of futures, they do not want to take delivery (long) or make delivery (short). They do want to retain the exposure to the underlying commodity the contract gives. This is called rolling on the contract
- Rolling contracts involve 2 trades - one to close out the current contract that is approaching delivery and one to open a new position in a longer dated contract
- As the longer dated contract approaches delivery, it is rolled again - ad infinitude
18
Q
What is a roll yield? (3)
A
- Near dated contract being closed out and far dated contract being opened will not be priced the same.
- In a contango market, the far dated contract will be priced higher
- Where the manager is closing out of a long passions by going short and rolling the contract on by going long, this will incur a costs (roll yield). This is negative
19
Q
What is a roll yield? (3)
A
- Near dated contract being closed out and far dated contract being opened will not be priced the same.
- In a contango market, the far dated contract will be priced higher
- Where the manager is closing out of a long passions by going short and rolling the contract on by going long, this will incur a costs (roll yield). This is negative
20
Q
What is basic hedging? (6)
A
- Futures can be used to provide defensiveness in portfolio against adverse market conditions e.g. FTSE 100 future
- The number of contracts required is known as heading ratio
- In order to gain protection, a short hedge is constructed by selling
- The most liquid month is the nearest delivery date e.g if the hedge was created in Nov, Dec future would be used
- The size of the contract for FTSE 100 future is £5/0.5 bps
- Assumes that the portfolio will move the same way as the market
21
Q
What is beta hedging? (4)
A
- To incorporate any disproportionate changes in the portfolio relative to the market, a number called ‘Beta’ is used
- Beta = how much more or less volatile the index is against a portfolio
- E.g. A beta of 1.2 is 20% more volatile than the index it is measured against. A beta of 0.7 is 30% less volatile than the index it is measured against
- Beta value = number of contracts equirectangular for a basic hedge x beta of the portfolio
22
Q
What is an option? (1)
A
- Gives the buyer the right (not obligation) to buy or sell an underlying asset at a fixed price on or before a given date in the future
23
Q
What is the main difference between a future and an option? (4)
A
- Only the seller has an obligation while the buyer has a choice in putting or calling options
- Both the buyer and seller have obligations in futures
- Buyer of an option pays a premium to the seller to have the right to choice
- There is no premium paid when buying futures
24
Q
What is the term for buying/selling options? (2)
A
- Selling: put option
- Buying: call option
25
Q
What is the term for buying/selling options? (2)
A
- Selling: put option
- Buying: call option
26
Q
What is an exercise (strike) price? (1)
A
- The price at which the option specifies the underlying asset may be bought (and sold)
27
Q
What is a premium? (2)
A
- Options are not free, they must be paid for
- The price paid for an option is called the premium and is paid by the long position (buyer/holder)
28
Q
What is the writer of an option? (2)
A
- The term used to describe the seller of an option
- Short position
29
Q
What is the expiry date of an option? (2)
A
- The rights granted by an option do not last forever.
- The expiry date is the last day of the options life
30
Q
What is the expiry date of an option? (2)
A
- The rights granted by an option do not last forever.
- The expiry date is the last day of the options life
31
Q
What is the difference between European and American style of options? (2)
A
- European: the holder of the option can only exercise their rights on the expiry date only
- American: the holder of the option can only exercise their rights any time up to and including the expiry date
32
Q
What is the difference between European and American style of options? (2)
A
- European: the holder of the option can only exercise their rights on the expiry date only
- American: the holder of the option can only exercise their rights any time up to and including the expiry date
33
Q
What are the 4 basic option positions? (6)
A
- Long a call option: the right to buy the underlying
- Short a call option: a potential obligation to sell the underlying
- Long a put option: the right to sell the underlying
- Short a put option: a potential obligation to buy the underlying
- Writer/holder do not actually own the underlying asset - assume that options are all European style
- Profit and loss profiles all represent uncovered (naked) positions.
34
Q
Summarise long call position (6)
A
- The buyer pays a premium and is granted the right to buy the underlying asset on expiry if they wish
- The higher the price of the underlying asset at expiry, the more profit the buyer will make
- Buying call options is a bullish (or not bullish) strategy
- The max profit for a buyer is unlimited
- The max loss for a buyer is the premium
- The break even point (net profit/loss is zero) is strike price plus premium
35
Q
Summarise a short call position (5)
A
- The seller receives a premium and is required to sell the underlying asset on expiry if the buyer chooses
- The higher the price of the underlying at expiry, the more loss the seller will make
- Writing call options is a bearish strategy
- Max profit for the seller is the premium
- Max loss for the seller is unlimited
36
Q
Summarise a long put option (6)
A
- The buyer pays a premium and is granted the right to sell the underlying asset on expiry if they wish
- The lower the price of the underlying asset at expiry the more profit the buyer will make
- Buying put option is a bearish strategy
- The max profit for the buyer is the strike price minus the premium paid
- The max loss for the buyer is the premium
- The breakeven point is strike price minus premium
37
Q
Summarise short put positions (7)
A
- The seller receives a premium and is required to buy the underlying asset on expiry if they buyer requires
- The lower the price of the underlying at expiry, the more loss the seller will make
- Writing put options of the underlying at expiry, the more loss the seller will make
- Writing (selling) put option is a bullish strategy
- The max profit for the seller is the premium
- The max loss for the seller is the strike price minus the premium
- The breakeven point is the strike price minus premium
38
Q
Summarise the moneyness of an option (3)
A
- Out of the money (OTM): Call: asset price < strike price. Put: asset price > strike price
- At the money (ATM): Call: asset price = strike price. Put: asset price = strike price
- In the money (ITM): Call: asset price > strike price. Put: asset price < strike price
39
Q
How do you calculate the premium of an option? (1)
A
Premium = intrinsic value + time value
40
Q
What is the intrinsic value of an option? (3)
A
- The obvious value of an option - it is built in profit (ignoring all other costs) of a particular option where it to be exercised now
- For a call option this is the price of the share - the strike price. If share price (price you can sell it for) is above the strike price (price you can buy it for), the option has intrinsic value
- For a put option this would be the strike price less the price of the share. The strike price is the price you sell for and the share price is the price you buy for. If share price is below the strike price, there is intrinsic value.
41
Q
What is delta? (4)
A
- The measure of sensitivity of the option premium to changes in the underlying value of the asset
- Delta = change in price of the option premium / change in price of the underlying
- Delta is positive for calls and is always between 0 and +1
- Delta is negative for puts and is always between 0 and -1
42
Q
What is time value? (2)
A
- The amount over and above the intrinsic value than an investor will pay to buy an option because of what might happen to the price of the underlying between now and the end of the life of the option
- An option with a long time to expiry will have a considerable element of time value incorporated into tits price. The longer the period the higher the Tim value - more time for the price of the underlying to change
43
Q
What factors influence time value of options? (4)
A
- Volatility of the price of the underlying asset
- Interest rates
- The remaining life of the option
- All of these also have a sensitivity measure - referred to as the option Greeks - this tells us how much the option’s premium will be affected by a movement in these factors
44
Q
How does interest rates impact the time value of options? (3)
A
- Interest rates (equity options only).
- CALL: If IR rise, the time value and premium of call options will increase - the opposite happens when IR fall. - PUT: If IR rise, the time value of put options decreases. The opposite is true when IR fall. Rho measures the sensitivity of an option premium relative to a change in the IR.
45
Q
How does volatility impact the time value of an option? (2)
A
- The more volatile the price, the higher the time value and premium of call and put options.
- Vega measures the sensitivity of an option premium relative to a change in the volatility of the price of the underlying
46
Q
How does raining life of an option impact time value? (6)
A
- The longer the option has to expiry, the higher the time value of the option
- More time for the price of the underlying to change - as the life of an option passes, its time value decreases
- Time value does not decrease in a linear fashion - the closer the option is to expiry, the faster the time value will decay
- Longer dated options are higher priced than shorter dated options (assuming same underlying with same strike)
- Time decay works against the holder (buyer) and advantages the writer (seller). Writer can close out by buying at a lower price than they originally sold for
- Theta measures the sensitivity of an option premium relative to a change in the remaining life of the option
47
Q
How does time value impact moneyness? (3)
A
- Out of the money: the premium is made up entirely of time value e.g. there is no intrinsic value
- At the money: the premium is still made up entirely of time value and time value is at its greatest because of uncertainty (risk is at its greatest)
- In the money: the premium is made up of time value and intrinsic value
48
Q
How do you calculate the number of put options to buy to hedge against downside risk? (2)
A
- Number of puts to buy = value of portfolio/value of index option * beta
- Holding the asset and buying puts to hedge the position is called protective put
49
Q
What is a covered call? (5)
A
- Is made up of 2 independent positions: a short OTM call option and a long position in the underlying asset
- The strategy is normally used by fund managers to generate income in a static market
- A yield enhancement strategy
- Long position in the underlying covers the short call, in case the holder of the call option exercises their right to buy
- Premium received from writing the call generates the income
50
Q
Why are covered calls used? (3)
A
- If the call option is sold and the underlying is bought simultaneously, the premium received helps fund the purchase of the underlying stock
- A fund manager who already holds the underlying shares and believes prices are relative stables, can use the premium received from writing the call option to enhance the overall performance of the fund
- An investor who is worried about a fall in share price can use the cushion (downside protection) that the covered call provides. This will be cheaper than buying a put
51
Q
What is a protective put? (6)
A
- Made up of 2 independent position: a long position in the underlying asset and a long put option.
- The strategy is normally used by fund managers to hedge against a falling market
- Long position in the put protects the long position in case the underlying price falls
- The premium paid from buying the put reduces the income on the underlying position
- Protective put provide insurance for the buyer, allowing an upside gain whilst limiting losses
- The cost of the insurance is the option premium
52
Q
What are combinations? (2)
A
- Option strategies that involve a call and a put
- Two types of combinations: straddles and strangles
53
Q
Summarise a long straddle (6)
A
- Fund manager construct a long straddle to take advantage of an increase in the volatility of the underlying asset.
- Manager buys a call option and put option, both with same strike price.
- When volatility increases the premiums on the options increase.
- If options were bought before the increase in the premium, they can then sell the options (close out) at a profit.
- Max loss is the sum of the two payments
- Short straddle will profit from a fall in volatility
54
Q
What is a strangle? (5)
A
- Used to trade on the expectation of a change in the volatility of the underlying asset
- Fund manager would long as tangle if they expect volatility to rise and short if they expect it to fall
- Difference is that the strangle uses out of the money option
- Makes it cheaper for the buyer of the strategy
- Exposes the seller to less risk
55
Q
What are equity derivatives? (3)
A
- Futures on individual equities - ICE Futures Europea introduced universal stock futures - contracts to buy/sell the shares of a company at a pre-determined future date. Contracts on some shares are settled in cash while others are physically delivered
- Options on individuals equities - traded options both PUT and CALL available of the FTSE 100. Traded options are physically delivered
- Futures and options on equity indices - FTSE 100 Index future is settled at £10 per point and tick of 0.5 points and value of £5. It has delivery dates of March, Jun, Sept and Dec.
56
Q
What is a bond future? (4)
A
- Underlying asset is a notional (imaginary) bond e.g. ICE Long gilt future
- At the time of delivery, the relevant exchange announces a list of actual bonds that may be delivered. The short then selects a bond from the list of deliverable bonds created by the exchange and delivers it to the long in return for the delivery price
- Contracts are physically delivered
- Bond selected is referred to as the cheapest to deliver (CTD)
57
Q
What is an interest rate derivative? (4)
A
- IR futures - futures on the value of a rate of interest e.g. short term interest rate futures (STIR) traded on ICE
- Bets on the rate of interest that would be paid on a future date - can be used to speculate on changing rates or hedge against IR exposure
- Settle for cash and the price is quoted at 100 - 3 month interest rate - STIR quoted at 94.75 implies IR oF 5.25% (100-94.75)
- If you expect IR to rise, your would short a STIR future
58
Q
What are interest rate swaps (IRS)? (8)
A
- Agreements to exchange or swap payments on loans
- Agreements to swap cash flow
- Different methods of borrowing IRSs are useful - company may either borrow money at fixed or variable rates - fixed if it thought rates were going up and variable if it thought they would fall
- IRS allow companies to change borrowing styles during the term of the loan
- Term SONIA Reference Rate (TSRR) is calculated periodically (3 months)
- Company = payer
- Swap institution = receiver
- Payments are netted - payments are in the same currency
59
Q
What is an inflation swap? (2)
A
- Similar to fixed for floating rate swaps
- Half compounded fixed rate of inflation while other is actual variable rate of inflation
60
Q
What is a real rate swap? (1)
A
- Real rate coupon (e.g from an index linked gilt) and a nominal rate of interest
61
Q
What is a cross currency swap? (2)
A
- Allows a company to raise funds in one currency and convert them into another
- Unlike IRSs, in a currency swap the notional principal changes hands at the beginning of the swap and payments are made without netting
62
Q
What is an equity swap? (3)
A
- Investors can gain exposure to returns on equity without incurring additional costs e.g. tax/commission by entering into an equity swap
- Investor pays a rate of return, usually linked to a benchmark interest rate, on deposit in exchange for the percentage change in the chosen equity e.g. individual shares or a basket of shares put together specifically for the swap
- By making a cash deposit and buying an equity swap, this creates a synthetic equity fund without the extra cost of buying the equity
63
Q
What is a credit default swap? (5)
A
- Used to reduce credit exposure
- Buyer pays a premium to the swap bank and in return receives a cash payment should the default occur
- Can be based on single entities or a basket of single entities or an index where investors receive proportional compensation if a constituent company fails
- CDS continues even after a default event
- Some index CDS are structures as first loss / first tranche loss where full payment is made on first fail
64
Q
What is a constant maturity default swap? (2)
A
- The premium is reassessed at regular intervals rather than being fixed for the life of the swap
- Where risk of failure increases, the premium on the swap will increase
65
Q
What is a synthetic collateralised debt obligation? (5)
A
- No physical transfer of bonds or loans take place from the credit institution
- CDO gains exposure to credit risk by selling a CDS to the credit institution who holds the bonds or loan
- CDO is still being paid for bearing credit risk, just as it would do if it physically owned the bond
- Main advance is that a wider variety of loans become accessible to the CDO as no physical transfer is necessary
- Credit institution who would not normally pass on a particularly clients loan can now keep the loan but pass on the risk
66
Q
What is a credit linked note (CLN)? (5)
A
- Form of funded credit derivative
- Linked to a specific debtor or a pool of debtors and sold to investors
- Price of the note will be determined by the risk of the debtor(s)
- Note will pay coupons linked to the interest paid by the debtor(s) and will have a redemption value
- Issuer of the note is not obliged to pay the coupons or repay the debt if a specified event occurs
67
Q
What is a credit linked note (CLN)? (5)
A
- Form of funded credit derivative
- Linked to a specific debtor or a pool of debtors and sold to investors
- Price of the note will be determined by the risk of the debtor(s)
- Note will pay coupons linked to the interest paid by the debtor(s) and will have a redemption value
- Issuer of the note is not obliged to pay the coupons or repay the debt if a specified event occurs
68
Q
What are the risks of credit derivatives? (4)
A
- Unfunded credit derivatives - bilateral contract between two parties where each is responsible for making payments and any cash or physical settlement under contract is without recourse to other assets
- Funded credit derivative involves the protection seller making an initial payment that is used to settle any potential credit events
- Speculative and cash settled with no actual debt obligation being protected
- CDS market has become far bigger than the market for the asset on which it is based
69
Q
What is a commodity? (7)
A
- Wheat, metals, energy, oil - considered real and physical assets.
- Value changes with inflation
- Investment in commodity indices help to hedge against inflation
- They have a negative correlation with shares and bonds and allow diversification in the portfolio
- Geopolitical risks typically increase the value of commodities
- Supply increasing creates a fall in price
- Demand increasing creates a rise in price
70
Q
What are the different types of commodities? (4)
A
- Softs and agriculturals - most frequently traded products are grouped into ‘softs’ e.g. coffee, sugar and cocoa. Agriculturals includes wheat and barley. Derivatives on these can be traded in the UK on ICE Futures Europe
- Metals - traded actively in the cash market and constitute underlying assets in a range of derivative products. Precious metals - silver, gold, platinum - perform well when during economic uncertainty. Base metals - copper, nickel, zinc - perform well when economy is expanding.
- Energy products - oil, natural gas. Derivatives on these are traded in ICE and in the US on NYMEX. Reference rates are published in Platts
- Exotics - weather and emissions trading (cap on companies as to the amount of pollutants that can be emitted)
71
Q
Summarise cryptocurrency (5)
A
- Distributed ledger technology
- An alternative asset class whose returns show little correlation to traditional asset classes
- Extremely volatile
- Lack of backing from the government and central banks, as well as lack of regulator
- Chicago Mercantile Exchange has bought Bitcoin and Ether features to the more traditional market
72
Q
What are the features of fiat currency? (11)
A
- Backed by the government
- Can be in the form of physical money, notes, coins or electronically
- Needs intermediaries
- Stored in banks
- Supply controlled by central bank
- Easy to track transfers
- Can be expensive to transfer
- Limits on subdivision e.g 100th
- Open to forgery
- Country/region specific
- Established and accepted
73
Q
What are the features of cryptocurrency? (12)
A
- No government interference
- Digitally encrypted
- Decentralised currency
- Digital wallet
- Supply controlled by algorithms or pre-set limits
- Anonymous
- Lower storage and transfer costs
- Minimal restriction on subdivision
- Cannot be forged - blockchain
- International
- Risk of legal/regulatory challenge
- Concern over environmental impact of the energy used in blockchain encryption
74
Q
What are the 4 main commodity derivatives? (4)
A
- S&P GSCI - Goldman Sachs Commodity Index: constructed by using components based on their liquidity and is weighted in relation to their global production levels. 24 commodities in the index - energy 60%+ over the weight. Agricultural commodities - 15% and base metals - 11%. Livestock and precious metals are the remainder
- BCOM - Bloomberg Commodity Index: relies on the liquidity of individual commodities and dollar adjusted production levels averaged over five years. Caps on the wights of individual commodities (15%) and sectors (33%)
- RICI - Rogers International Commodity Index: calculated from 38 commodities from nine international exchanges in four countries. The eligible commodities are decided by RICI committee. This index is the most diverse of commodities indices
- TR/J CRB - Thomson Reuters/Core Commodity CRB: made up of 19 commodities as quoted on NYMEX, CBOT, KME, CME and COMEX. These are sorted into 4 group of liquidity, each with different weightings
75
Q
What is shorting? (1)
A
- Selling a stock that a seller does not own but is promised to be delivered by the seller
76
Q
What is the risk of shorting? (4)
A
- Speculative
- Losses can be infinite. No limit to how high the price of the shorted stock can rise, giving unlimited potential losses
- Needs to be closed out. Stock will need to be returned at some point to the investor that originally owned it
- Arrangement fees. More intermediaries will be involved in these transactions than are in a standard purchase or sale
77
Q
What is the role of a SBLI? (6)
A
- Used to provide liquidity in the secondary market
- Assists firms with short positions in a security - SBLI creates stock of security to deliver in T+2
- Market maker contacts the SBLI to ensure that the stock is available to the firm
- Stock is received from large institutional investors such as pension funds for a fee (artificial dividend). The pension fund loses the benefits attached to the securities e.g. voting rights/dividends which are transferred to the investor
- Market maker then settles the position with the investor
- The pension fund may request this back in the future - market market must ensure that this is available
78
Q
Summarise LCH: Clearnet (4)
A
- One derivatives contract has been agreed by both parties, there is the risk that at least one will not meet their obligation (counterparty risk)
- Derivatives trades one LME and ICE Futures are cleared/counterparty risk is removed by a clearing house - LCH Clearnet, LME Clear and ICE Clear Europe
- LCH Clearnet - owned by its member firms
- LCH protects its members against the risk of default but is also exposed to risk should one party not fulfil its obligation
79
Q
What is margin? (5)
A
- Margin covers LCH Clearnet against risk when acting as a central counterparty
- Two types of margin: variation and initial
- Variation: relates to previous days gains and/or losses made on open derivative positions. Variation is paid by the loser of an open position and received by the winner of open position
- Initial: deposit of good faith, usually payable by both sides of a derivative contract. This is deposited with LCH to cover the risk of member defaulting
- Buyers and seller of futures and writers (sellers) of option are required to make margin payments covering initial and variation margin
