C.2 Futures Markets and Central Counterparties

Question 1

Characteristics of futures contracts

Answer 1

• Available on a wide range of underlyings
• Exchange traded
• Specifications need to be defined
• Settled daily
• Standard contract
• Range of delivery dates
• Almost always closed out before delivery/final cash
• Virtually no credit risk

Question 2

Specifications for futures

Answer 2

1. What can be delivered
2. Where it can be delivered
3. When it can be delivered

Question 3

Futures and spot price relationship

Answer 3

As the contract approaches the maturity date, the futures price converges to the spot price

Question 4

What is the margin

Answer 4

Is a cash or marketable securities deposited by an investor with his/her broker. The balance is adjusted to reflect daily settlement

Question 5

What is the margin’s purpose

Answer 5

To minimize the possibility of a loss through a defaulted contract

Question 6

What does the balance have to be in the margin account

Answer 6

Retail traders put in an “initial margin” and if the margin falls below “maintenance levels” then the retail trader must provide “variation margin” to bring the balance up to the initial margin

Question 7

How do you close out a futures position

Answer 7

You enter into an offsetting trade

Question 8

The margin cash flow when futures price increases

Answer 8

Short trader

• > Broker
• > Clearing House Member
• > Clearing House
• > Clearing House member
• > Broker
• > Long trader

Question 9

Bilateral Clearing

Answer 9

Transactions governed by an agreement, typically an ISDA Master Agreement, between two sides

Question 10

Credit Support Annex (CSA)

Answer 10

Defines the collateral that has to be posted by each side in a bilateral clearing

Question 11

Central Counterparties (CCP)

Answer 11

Following the 2007-2009 crisis, standardized OTC transactions between financial institutions have to be cleared centrally through clearing houses known as CCPs

Question 12

How does a CCP function

Answer 12

Similarly to an exchange clearing house. Members must provide an initial margin and variation margin, and if a company is not a member, they can clear its transactions through a member

Question 13

Open interest

Answer 13

The total number of contracts outstanding (equal to the number of long positions or short positions)

Question 14

Settlement price

Answer 14

The price just before the final bell each day

Question 15

Volume of trading

Answer 15

The number of trades in one day

Question 16

Delivery

Answer 16

When the contract isn’t closed out before maturity, then the delivery for the assets underlying the contract are delivered to settle. If there are alternatives to where/what/when, the short party chooses

Question 17

Cash settlement delivery

Answer 17

Contracts are traded until a predetermined date. At that date, all are considered to be closed out.

Question 18

Futures price patterns

Answer 18

• An increasing function of maturity: normal market
• A decreasing function of maturity: inverted market
• Partly normal, partly inverted

Question 19

Trading volume vs open interest

Answer 19

If there is a large amount of trades completed (i.e. traders who enter into a position and close out on the same day) then a daily trading volume can > than either the beginning of day or end of day open interest

Question 20

Types of orders

Answer 20

• Market order
• Limit
• Stop-loss
• Stop-limit
• Market-if touched
• Discretionary
• Time of day
• Open
• Fill or kill

Question 21

Market order

Answer 21

Simplest order. A request that a trade be carried out immediately at the best price available

Question 22

Limit order

Answer 22

A order can only be executed at this price or at a more favourable one

Question 23

Stop-loss (Stop order)

Answer 23

An order that is executed at a particular price or less favourable one to stop losses

Question 24

Stop-limit order

Answer 24

Combo of stop-loss and limit. The order becomes a limit as soon as a bid or offer is made at a price equal to or less favourable than the stop price

Question 25

Stop-and-limit order

Answer 25

If stop price and limit price in a stop-limit order are the same

Question 26

Market-if-touched (MIT)

Answer 26

Executed at the best available price after a trade occurs at a specified price or more favourable price. Basically becomes a market order once a specified price has been hit. aka board order

Question 27

Discretionary order

Answer 27

Aka market-not-held. Like a market order except the broker can delay the trade in an attempt to get a better price

Question 28

Open order

Answer 28

Aka good-til-canceled order. Is in effect until executed or until the end of trading in the contract.

Question 29

Fill-or-kill order

Answer 29

Must be executed immediately on receipt or not at all

Question 30

Purpose of regulating futures

Answer 30

Designed to protect public interest by preventing sketchy trading practices in individuals on the floor, the exchange, or outside groups

Question 31

Corner the market

Answer 31

Investor group takes a huge long futures position and also tries to exercise some control over the supply of the underlying commodity. They don't close out their long position at maturity, such that those in short positions don't have enough commodity for delivery and become desperate to close out their positions which leads to large rise in futures and spot prices = $$$ for those in long positions

Question 32

Hedge accounting

Answer 32

The gains or losses are generally recognized for accounting purposes in the same period in which the gains or losses from the item being hedged are recognized. This is unlike if it is not a hedge, where accounting standards would require changes in the market value of a futures contract to be recognized when they occur.

Question 33

Is daily settlement for future or forward contracts

Answer 33

Futures

Question 34

Characteristics of forward contracts

Answer 34

- An OTC agreement to buy/sell an agreement at a future time at a certain price - Between two parties - Non-standard contract - Usually 1 specified delivery date - Settled at end of contract - Delivery or final cash settlement usually occurs - Some credit risk

Question 35

Foreign exchange quotes: futures vs forwards

Answer 35

- Futures: Exchage rates are quoted as the number of USD per unit of foreign currency - Forward: Quoted in the same way as spot exchange rates. For the pound, euro, AUS dollar, NZ dollar, the forward quotes are the same futures (ie number of USD per unit of foreign currency). For every other currency, the forward quotes the number of units of the foreign currency per USD dollar