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Derivative is:

Financial instrument whose value is dependent on
Or derived from
Value of another
Underlying asset.


Derivatives can be used to:

1. Risk control: credit risk 

2. Risk reduction: market risk

3. Risk enhancement: increase risk in order to enhance returns 

4. Transition Management: switch asset allocations
between different asset classes
without disturbing the underlying assets,
as part of transition management. 


Derivative Use acronym:



The derivatives market can be divided into

two distinct marketplaces,
. exchange- traded derivatives and
. over-the-counter derivatives.


in recent years regulators have been

encouraging derivative market participants either to transact deals on exchanges
or to centrally clear transactions.
aim is to
improve transparency and reduce counterparty risks.

Additionally, regulators have required
. banks
to hold additional capital
in respect of over-the-counter derivative transactions.


Exchanges generally focus on

. standardised derivatives
. high levels of supply and demand,
. Hence high levels of liquidity.


A futures contract is a

. standardised, exchange tradable contract
. between two parties
. to trade a specified asset
. on a set date in the future
. at a specified price. 


The price that you agree for a future is

. closely related to the price of the underlying asset.
. To distinguish between the futures market itself and the market in the underlying asset the terms
. cash market and spot market are often used when referring to the underlying market. 


Financial futures are

. based on an underlying financial instrument.
. include:
1  bond futures 

2  currency futures 

3  short interest rate futures 

4  equity index futures.


Commodity futures are

based upon a physical commodity,
eg gold or
pork bellies.


Operation of futures exchanges :

1 A contract 

2 Trading process
3 Margin
4 Delivery and open interest
5 Price limits


A contract

. make futures easily tradable,
. exchanges specify
. a standard “contract” for each type of future,
. details of which are set by the exchange. 


The futures contract will typically specify:

  the unit of trading 

  how the settlement price is to be determined 

  exact details of the underlying asset (ie type and quality) 

  the delivery date. 


All that the individual buyers and sellers of the contract have to agree is

the price, and

how many “contracts” to buy or sell.

not possible to deal in fractions of a contract.


“price” of the future is

the notional amount of money
that changes hands on the delivery date.
is agreed at the start of the contract although
no money passes from buyer to seller at the start


To ease administration, exchanges normally specify

a minimum price movement for a contract. known as the contract’s tick size.


In the share futures example

prices are quoted to the nearest $0.01 per individual share –
ie $1.99, $2.00, $2.01 etc.
Given that the notional size of the contract is 1,000 shares,
the tick value would be 1, 000 ¥ $0.01 = $10 per contract.


Only members of the exchange

are allowed to deal on the exchange.
Other investors need to use a member firm as a broker.
Trading process
When a buyer and a seller agree to deal an exchange-traded derivative,
opposing contracts are created between each party
and the clearing house of the exchange.


clearing house checks

buy and sell orders match .


Clearing House:

acts as “a party to every trade”.
simultaneously acts as if it
had sold to the buyer,
and bought from the seller.

becoming counterparty to both of the parties to the transaction.
guarantees each side of the original transaction,
subject to its capital resources.


clearing house gives two key advantages:

1. Through guarantee
⁃ clearing house largely removes counterparty credit risk
⁃ between the buyer and seller.
⁃ Exchanges have standardised legal documentation applied to buyers and sellers
⁃ entering into an exchange traded derivative. 

⁃ Neither buyer nor seller needs worry about the other party
⁃ contract is with the clearing house,
⁃ not with person with whom they agreed the trade. 

2. to “close out” their position can do so
⁃ without having to find original partner to the trade or
⁃ without trying to link a new partner to the old partner. 


clearing house keeps each trader informed of

1. all the contracts which the trader has outstanding (or “open”) with the clearing house.


Margin is

the collateral that each party to an exchange-traded derivative must deposit
with the clearing house.

acts as a cushion against potential losses,
which the parties may suffer
from future adverse price movements.

those which would arise if one party to the trade defaults on the agreement.


The risk that you default on the agreement to trade

may increase if the market moves against you.


each derivative broker deposits

margin with the clearing house,
whilst at the same time,
each investor will deposit margin with their broker.


margin essentially acts as

a good faith deposit.

transaction is first struck,
initial margin is deposited by the broker with the clearing house.

It is changed on a daily basis through additional payments of variation margin.

This variation margin ensures that the clearing house’s exposure to counterparty risk is controlled.

exposure can increase after the contract is struck
through subsequent adverse price movements.


The investor's margin account balance with his broker

goes up and down each day
by the amount of his profit or loss.

he needs only to top it back up to the initial margin level if
it falls below a specified level – the maintenance margin.
also referred to as variation margin and

any margin in excess of the initial margin
can again be withdrawn.


both parties to the future deposit a

returnable initial margin
in the form of
(on which the clearing house will pay interest)
in the form of acceptable securities
(eg the underlying asset or Treasury bills).


Minimum initial margin is

generally set by the clearing house
to be between 5% and 20% of the contract’s value.

This amount is based on
the likely maximum overnight movement
in the contract’s price.


the underlying asset price is likely to change.

suppose that the price of the underlying asset goes up.
good news for the buyer of the future
because he has agreed to buy the (now more valuable) asset at a specified fixed price.

The seller of the future is in the opposite position
and is facing a loss.
the contract is marked to market at the end of each day
to reflect these profits and losses.


process of daily margin requirement changes is known as

marking to market.
this process of daily calculation of the market value of
a trader’s position,

any fall in value will
need to be topped up with
additional payments of cash
(or other acceptable margin)
to enable the clearing house to continue to give its guarantee.


Increases in the value of a contract are

paid out to the investor,
also on a daily basis.


delivery is

The settlement process in futures markets .


Close out is:

Most positions in futures markets are closed out before delivery
by taking an opposite position.

a buyer of a contract can
later close out his position
by selling an equivalent contract.
net position is then nil.


Standardisation rationale

The ability to close out a position
by entering into an equal and opposite trade is why contracts are standardised.

As a result, only a relatively small proportion of contracts reaches physical delivery.


even those futures contracts that reach delivery are

normally settled “for cash”,
rather than by delivery of the physical asset.
because it is
often costly and
difficult to physically deliver the
underlying asset.


overall cash settlement is based on

the difference between the market price of the asset
at the delivery date
and the futures price agreed at the start of the contract.


profit or loss

up to the close of play
on the day prior to the delivery date
will already have been reflected in the margin account balance
via the marking to market process.

profit or loss is then added
to the profit or loss on the settlement day itself
to give the overall profit or loss.


exchange delivery settlement price (EDSP)

market price of the asset needs to be
precisely defined and

the exchange does this for futures
that can be cash settled

by publishing an exchange delivery settlement price (EDSP) –

the final settlement price,
against which
all outstanding cash settled futures are settled


open interest is:

number of contracts outstanding at any one time
Given that most contracts don’t reach physical delivery, the
open interest over the lifetime of a particular futures contract will,
most likely,
reduce towards zero as delivery approaches.


State the maximum profit, and the maximum loss, that can be made by:
1. buying a future (taking a long futures position) 

2. selling a future (taking a short futures position) 

1. The maximum profit is unlimited.
⁃ The worst possibility from the buyer’s point of view is that
⁃ the price of the underlying asset drops to zero.
⁃ Therefore the maximum loss is
⁃ the price agreed for the future. 

2. The seller is in the opposite position.
⁃ The maximum profit is
⁃ the price agreed for the future.
⁃ The maximum loss is unlimited. (
⁃ Although if the seller owns the underlying asset, then the
⁃ unlimited loss on the future will be matched by an unlimited profit from the underlying asset.) 


Price limits controls

Margin is one method by which
clearing house addresses default or credit risk.

To ensure orderly markets,
futures markets may also have price limits.
any one trading day,

if the price of a futures contract moves up or down,
from the day’s opening price,
by more than the price limit
then exchange will halt trading in that contract.


Price limit trading recommencement

Trading may recommence
on next trading day or
restart that day,
after a pause
for traders to reflect on their positions and
to allow variation margin to be collected.
price limits are another means by
which to protect the clearing house from excessive credit risk.


Role of the clearing house

1  counterparty to all trades 

2  guarantor of all deals (removing credit risk) 

3  registrar of deals 

4  holder of deposited margin 

5  facilitator of the marking to market process. 


two main reasons why trading volumes in futures increase close to delivery:

1. speculation increases as to the likely settlement price 

2. traders not wanting to reach settlement close out their positions.