Derivatives Chapter 6 & 7

Question 1

Major Exchanges and Clearing Houses

Answer 1

Question 2

Structure of the Clearing System

structure

some info on each part

Principal to principal guarantee

types of guarantee

Answer 2

Structure: image

Clearing House: guarantees the clearing member. but this does not extend to clearing member clients.

Clearing member: guaraneed by the clearing house, but does not extend to clearing member clients. can be either invidivual or genmeral clearing member.

Individual clearing member: can clear trades for selves and clients

General clearing member: can clear trades for selves, clients, and NCMs

Non-Clearing Member: give trades up, cannot clear trades.

Principal-to-Principal Guarantee: djd It is up to clearing members to manage their own exposure.

Types of guarantee: mutual (UK, clearing members contribute to a central default fund ). Independent (USA, just responsibility of clearing house).

Question 3

Guarantee

Covering Lossess (if the clearing member defaults)

Central Default fund

Answer 3

Covering Lossess (if the clearing member defaults), the Clearing House does/has:

• Defaulting member’s margin
• Central Default Fund (mutual gurarantee ONLY) CLEARING HOUSES DON’T HAVE THIS!
• Insurance

Central Default fund (‘clearing fund’)

• every clearing member contributes
• contribution is based on trading activity (uncovered risk)

Question 4

Price Limits

Position Limits

Answer 4

Price Limits: stops prices moving too far too fast. Operatid on selected ICE Futures contracts.

Position Limits: prevent dominant positions in a market place. Not used in UK

Question 5

Margin

Answer 5

Clearing house margin:

• INITIAL: margin you pay on day one, ‘goodwill deposit’
• VARIATION: daily ‘market to market’ (the day to day price change of the underlying asset that is charged, it is either debit or credit depending on your closing price).

Margin payment: cash at Variation Margin.

• Settles through LCH Clearet: PPS Protected Payment System
• by 9am the day following the margin call

Client margin:

• must be as least as much as clearing house margin

Question 6

Types of Margin

initial: aim, elements of/ adjustments to initial margin: sanning, spread, spot, intra-day
variation: what it is and calculation of it

Answer 6

margins are all abour protecting the clearing house!

INITIAL MARGIN: aims to protect clearing house from worst case loss of one day.

Elements of/ adjustments to initail margin:

• Scanning risk : calculated by SPAN (on ICE Clear Europe). Main element.
• Spread margin: inter-commodity credits
• Spot month margin: ensures adequate funds available for delivery
• Intra-day margin: sudden jumps in volatility, calculated by IDRiS (intra day risk system)

VARIATION MARGIN: daily ‘market-to-market’ by reference to settlement prices.

calculation of variation margin:

ticks moved on the day X tick value X number of contracts

MAINTENANCE MARGIN: in the US, there is no real difference between initial and variation margin. what is it????

Question 7

A trader goes short 5 FTSE 100 futures at 5240.

Initial margin is £400 per contract.

At the end of the day, the settlement price is 5270.

What is the toal margin payable?

Answer 7

INITIAL: 5 x £400 = £2000

VARIATION: 30 x 10 x 5 = £1500

sum = £3500

Question 8

Collateral and Credit Lines

acceptable collateral: initial margin may be covered using?

What are the extra things to take note of?

Credit lines: what is it & when are deals rejected?

Answer 8

acceptable collateral: initial margin may be covered using?

• cash (in eight major currencies)
• acceptable collateral:
• bank guarantees
• certificaes of deposit (£ and $ denominated)
• government bonds

Note:

• undated bonds not acceptable
• bonds must be denominated in the currency of the issuing country (e.g. £ denom gilts)
• swiss government bonds not acceptable
• collateral is marketed-to-market daily (subject to a ‘haricut’)

Credit Lines: where a member extends credit to a client to cover margin requirements. Deals in excess of a credit line are REJECTED.

Question 9

Prime Brokers

typical services offered by prime brokers

Answer 9

Typical services:

• capital introduction: introducing a hedge fund to quialified hedge fund investors
• office space leasing and services: sub-letting blocks of commercial real estate to hedge fund tennants
• risk management advisory services: provision of risk analysis technology and consultancy services
• consulting services: typically to ‘start up’ hedge funds e.g. regulatory requirements.

Question 10

Exercise of Physically Deliverable Options

choices for the holder of an option

Answer 10

choices for the holder of an option:

• offset: eneter into an opposite option ‘in the same series’
• excercise:
  1. option holder notifies broker of intention to exercise
  2. broker sends ‘exercise notice’ to the clearing house (via clearing memeber if different from the broker)
  3. clearing house ‘assigns’ an option writer and sends them an ‘assignment notice’
  4. transaction becomes a cash market transaction

Early exercise? : not normally rational, wastes time value

Automatic exercise: terms of early exercise set by the exchange. exercise takes place on last trading day. most likely for ITM options. Suppression notice: prevents automatic exercise.

abandon: don’t do it… holder suffers/writer keeps premium