Risks of Derivatives Flashcards
How do exchanges minimise risk through legal obligations?
derivatives
Member firms must agree to the terms and conditions to participate in the exchanges (this can include margin requirements and setting up direct debits to cover collateral)
Who enforces the legal risk of OTC derivatives?
ISDA - International Swaps and Derivatives Association
How do the ISDA enforce legal contracts?
Create a bilateral agreement that both parties must agree to before opening a trade.
What is the ISDA’s point of contention in CDSs?
What constitutes a default event
What event lead to the scrutiny of CDS default events (credit events)
Hedge fund induced a homebuilder to miss a payment in exchange for favourable refinancing
In return the hedge fund received a CDS insurance premium and profit
In response to the CDS incident what did the ISDA institute?
Narrowly tailored credit event supplement - it sought to better define what a default event was
What did the failure to pay supplement do?
If a failure to pay does not result in the deterioration in the creditworthiness of a firm, it is not a default event.
e.g. the hedge fund default would not of counted
What did the outstanding principal balance supplement do?
If an asset was issued at a discount, the value of the CDS payment will be benchmarked against the discounted value.
What 5 things can constitute a credit event?
1) Default
2) Bankruptcy
3) Fall in asset value / price
4) Merger / Demerger
5) Debt restructuring
What constitutes a debt restructuring credit event?
If the priority or status of an asset is changed (asset covered under CDS) then a payment is due.
Once a CDS payout is made, what happens to the swap?
It is closed
What two ways can a contract be settled?
Cash
Physical
Why are CDSs bespoke and what can be tailored?
They trade OTC
What the trigger points are
Relevant to the characteristic of the underlying
What is a contango?
When the cash price of an asset is less than the forward price
Also known as a premium
What assets are normally in contango?
Why?
Physical commodities
Futures prices reflect the cost of carry making them greater than the spot price.
Why can assets normally in contango fall into backwardation?
Supply disruptions
Seasonality
Also known as a discount
What is backwardation?
When the cash price of an asset is greater than the forward price
What assets are usually in backwardation and when?
Bonds and STIRs
When long term interest rates are greater than short term interest rates
What happens to contango and backwardation as time to expiry convirges on 0
They narrow until reaching 0 at maturity
What is basis risk?
Basis risk in commodities and futures refers to the risk that the difference between the spot price of the commodity and the futures price (the basis) will change unfavorably.
When are clearing houses at most risk
When a liability is uncertain, e.g. an option
What 4 ways do clearing houses protect against risk?
1) Only deal with member firms
2) Require Margin
3) Use their own financial resources (e.g. credit line with a consortium of banks or have a default account
4) Insurance policies
What is initial margin?
The margin required to be posted at the outset of a trade.
What can be placed as initial margin
Cash or collateral (an asset with value)
Who doesn’t need to post initial margin?
Buyers of options
Loss is limited to premium
How is initial margin calculated?
Volatility - what is the most an asset could move in a single day
If a clearing house determines the most a FTSE forward could move is 300 points, what is the initial margin?
300 * £10 = £3,000
When is initial margin calculated.
Why does this mean that it can require topping up?
Calculated daily and collected each morning before the market opens.
Increased volatility means more margin may be required to be comfortable.
Intra-day margin
Members have direct debits which the clearing house will use to increase margin.
What are spreads and how do they effect initial margin?
Spreads refer to having a position in the same asset or correlated assets which offset the margin required.
E.g. long July ftse future and short a September FTSE future, these positions offset and will reduce the margin
What is an example of a spread through correlated assets?
Brent Crude and Oil and Gas Futures
When else might initial margin increase?
Why is this done?
Approaching expiry
Reduce short term speculative pressures
Force less capitalised speculators to close out positions and reduce risk.
Ensure delivery can be made / received.
What are the three types of margin?
1) Initial
2) Variation
3) Maintenance
How is variation margin calculated?
Ticks Moved * Tick Price * Contracts
How is ticks moved calculated?
Todays close - Yday’s close / tick size
What is the hedge ratio, what problem does it fix?
Calculates the number of contracts needed to fully hedge a position.
Fixes the assumption that the portfolio has a Beta of 1.
Have to sell more or fewer contracts based on the volatility
What is the formula for hedge ratio?
Portfolio Value / Futures Value * h
Where h is beta
How is H calculated in the hedge ratio?
Volatility / Duration
Can be either portfolio or future
What is risk that arises in a hedged portfolio called?
Residual Risk
Arises even in a portfolio with the corerct hedge ratio
What are 2 examples of residual risk?
How can risk still arise?
1) Using the incorrect hedge ratio as a result of incorrectly assessing the beta
2) Unsystematic risk within the portfolio that the hedge cannot eliminate
Unsystematic risk can only be eliminated by further diversification
What does Unsystematic risk within the portfolio that the hedge cannot eliminate mean?
Company specific factors that a future cannot hedge - e.g. management risk or a product fails.
Index future moves with the market as a whole, not individual companies
