FMP5 - Exchanges and OTC Markets

Question 1

Describe how exchanges can be used to alleviate counterparty risk

Answer 1

Margin is required in exchanges to protect from counterparty risk, removes incentive to back out of a transaction for more favourable prices

Assets are traded from one party to another frequently to protect

Question 2

Explain the developments in clearing that reduce risk

Answer 2

• Netting where multiple trades collapsed into one so long and short positions offset themselves
• Variation margins where traders are paying to and from the CCP
• Initial margin being implemented at the start of each contract
• Default fund contributions (used if default and initial margin does not cover loss)

Question 3

Define netting and describe a netting process

Answer 3

Netting is where long and short positions in a particular context offset each other, essentially collapsing multiple trades into one net position)

Question 4

Describe the implementation of a margining process by CCP, explain the determinants of and calculate initial and variation margin requirements

Answer 4

Variation margin calculated by the difference to the futures price to current market price multiplied by size of position

Initial margin is set by the exchange and reflects the volatility of the price of the asset

Question 5

Describe the process of buying stock on margin without using CCP, and calculate margin requirements

Answer 5

Buying on margin without a CCP means borrowing funds from a broker to buy shares, broker will require initial and maintenance margin.

Maintenance margin is the minimum balance as a percentage of value of assets purchased

Question 6

Compare exchange-traded and OTC markets and describe their uses

Answer 6

OTC markets attractive because derivatives can be tailored to end users needs but much more exposed to credit risk than exchange-traded markets

Question 7

Describe the role of collateralisation in the OTC market and compare it to the margining system

Answer 7

OTC derivatives state how collateral must be posted to protect against default, where at the end of each trading day parties may be required to post extra collateral (very similar to margining)

Question 8

Explain the use of SPVs in the OTC derivatives market

Answer 8

SPVs are companies created by others to manage credit risk - if mother company goes bankrupt SPV should be able to manage obligations

Tend to have very high credit ratings