3w FinEcon 2024fall v2

Summary

This script discusses the intricacies of futures trading, focusing on daily settlements and the simplicity of closing positions through offsetting trades. It explains how investors can manage their exposure by entering into opposite transactions to mitigate risk. The script also delves into the role of the exchange clearing house, detailing the margin requirements for brokers and the importance of daily settlement to prevent defaults. Additionally, it contrasts the centralized clearing of futures with the bilateral agreements common in the OTC market, highlighting the shift towards central counterparties (CCPs) for standardized OTC derivatives to reduce systemic risk post-financial crisis.

Takeaways

• 📈 Futures are settled daily, allowing investors to close out their positions without waiting until maturity.
• 🔄 To offset a future position, one can enter into an offsetting trade, which is a fundamental concept in both futures and forward contracts.
• 💵 The example of Caleb illustrates how a short position in FX forward can be offset by buying a similar contract from a counterparty.
• 🏦 The exchange clearing house plays a crucial role in the futures market, ensuring daily settlement and managing margin requirements.
• 💼 Brokers and clearing house members are responsible for providing initial and variation margins to manage credit risk.
• 📉 The daily settlement process involves transferring funds between the margin accounts of long and short traders based on price movements.
• 🚫 Margin requirements are essential to prevent defaults and protect against significant losses in the futures market.
• 🌐 The OTC market operates differently from the exchange market, with transactions governed by agreements like ISDA Master Agreements.
• 🔄 The 2007-2009 financial crisis led to a push for central clearing of standardized OTC derivatives through CCPs to reduce systemic risk.
• 📊 Open interest, settlement price, and trading volume are key metrics in the futures market, reflecting market activity and contract obligations.

Q & A

What is the main difference between futures and forwards?

Futures are standardized contracts traded on an exchange and settled daily, while forwards are customized contracts traded over-the-counter (OTC) and settled at maturity.

How can an investor close a futures position before maturity?

An investor can close a futures position by entering into an offsetting trade, which means taking the opposite position of the original contract.

What is the role of the exchange clearing house in futures trading?

The exchange clearing house acts as an intermediary between buyers and sellers, ensuring that trades are settled and margins are collected.

What are the two types of margins required by the exchange clearing house?

The two types of margins required are initial margin, which is a percentage of the contract value, and variation margin, which is adjusted daily based on gains or losses.

How does the margin flow work when the futures price increases?

When the futures price increases, the short trader's margin account funds are transferred to the long trader's margin account to cover the gain made by the long trader.

What is the purpose of daily settlement in futures markets?

Daily settlement helps to manage credit risk by ensuring that gains and losses are realized and settled daily, preventing the accumulation of large losses that could lead to default.

What is the main difference between bilateral clearing and central clearing?

Bilateral clearing involves direct agreements between two counterparties, while central clearing involves a central counterparty (CCP) that becomes the counterparty to each member, reducing the number of direct relationships.

Why was the requirement for central clearing introduced for standardized OTC derivatives after the 2007-2009 financial crisis?

Central clearing was introduced to reduce systemic risk and avoid default by ensuring that all parties post initial and variation margins, which helps to mitigate potential losses from counterparty failures.

What is the ISDA Master Agreement and why is it important in OTC markets?

The ISDA Master Agreement is a standardized contract that governs the terms of transactions between two parties in the OTC market. It is important because it provides a legal framework for managing credit risk and collateral.

What is open interest in the context of futures trading?

Open interest refers to the total number of outstanding futures contracts that have not been settled or closed by an offsetting trade.

How does the trading volume differ from open interest?

Trading volume refers to the number of contracts traded on a given day, while open interest represents the total number of contracts that are still open and have not been settled.

Outlines

00:00

🔄 Daily Settlement of Futures

This paragraph introduces the concept of futures being settled daily, allowing investors to close their positions without waiting for maturity. It uses the example of a seller or buyer entering into an offsetting trade to close their position. It also discusses the case of Caleb, who took a short position on an FX forward and then offset it by buying an FX forward from a counterparty, illustrating how short and long positions can be offset when counterparties are the same. The paragraph emphasizes that most futures contracts are closed before maturity through offsetting trades, and it mentions the role of the exchange clearing house in facilitating this process.

05:01

💼 Margin Requirements in Futures Trading

The second paragraph delves into the mechanics of margin requirements within the exchange clearing house. It explains that members of the exchange clearing house, including brokers, are required to provide initial margin and daily variation margin. The initial margin is a percentage of the volume, while the variation margin is settled daily based on gains and losses. The paragraph also discusses how non-member companies must channel their business through a member with exchange market membership, who in turn requires margin from the broker. It describes the margin cash flow when future prices increase or decrease, affecting long and short traders differently, and how this settlement occurs on a daily basis.

10:02

📉 Managing Risks in OTC Markets

The third paragraph shifts focus to the OTC market, contrasting it with the exchange market. It discusses how transactions in the OTC market are governed by agreements between parties, such as the ISDA Master Agreement, which includes a Credit Support Annex defining collateral requirements. The paragraph highlights the post-2007 financial crisis requirement for standardized OTC derivative transactions to be centrally cleared through a Clearing House known as CCP. It explains the rationale behind using CCPs, which is to mitigate systemic credit risk and default risk, and contrasts bilateral clearing with central clearing, showing how CCPs simplify the process and reduce counterparty risk.

15:06

🏦 Central Clearing and Its Impact on OTC Derivatives

This paragraph further explores the operation of CCPs, comparing them to exchange clearing houses and emphasizing their role in requiring initial and variation margins from members. It discusses how non-member companies can clear transactions through a member and the regulatory background for using CCPs in OTC derivative products, which is primarily to remove potential default risks. The paragraph also explains the difference between bilateral and central clearing, using a diagram to illustrate how central clearing simplifies the process and makes obligations between parties clear, thus reducing counterparty risk.

20:09

📊 Understanding Key Terminology in Futures Trading

The fifth paragraph introduces key terminology in futures trading, such as open interest, which refers to the total number of contracts outstanding. It uses an example to explain how open interest is calculated and how it relates to long and short positions. The paragraph also defines other terms like the settlement price, which is used for daily settlement, and trading volume, which is the number of trades in a day. It provides a hypothetical scenario where a person trades a gold future, affecting their portfolio and the open interest.

25:09

🔄 Portfolio Adjustments and Their Effects

The final paragraph discusses the impact of trading activities on an individual's portfolio, specifically focusing on the example of trading a gold future. It illustrates how selling a gold future contract can result in a zero contract position for the seller, and similarly for the buyer. The paragraph emphasizes the dynamic nature of trading and how it can quickly change an investor's position in the market.

Keywords

💡Futures

Futures are financial contracts that obligate the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and price. In the context of the video, futures are discussed as a means for investors to speculate on the future value of an asset or to hedge against price fluctuations. The script mentions that futures are settled daily, allowing investors to close out their positions without waiting until maturity.

💡Settled Daily

Settled daily refers to the process where the gains or losses on futures contracts are settled on a daily basis rather than at the end of the contract period. This is important for managing risk and reflects the mark-to-market process used in futures trading. The script explains that this daily settlement allows for the closing out of positions and helps in managing the risk associated with holding futures contracts.

💡Offsetting Trade

An offsetting trade is a transaction that is made to reverse an existing position in a financial instrument, such as a futures contract. The video script uses the example of Caleb taking a short position on an FX forward and then offsetting it by buying an FX forward from a counterparty. This action neutralizes the initial position, illustrating how traders can manage their exposure in the market.

💡Initial Margin

Initial margin is the minimum amount of money that must be deposited by a trader when entering into a futures contract. It serves as a form of collateral to ensure that the trader can cover potential losses. The script discusses how brokers provide initial margin to the exchange clearing house, which is a critical component of managing risk in the futures market.

💡Daily Variation Margin

Daily variation margin is the amount of money that must be deposited or withdrawn from a trader's margin account on a daily basis based on the change in the value of their futures positions. This process is part of the daily settlement and is designed to ensure that the losses of one party are covered by the gains of another, maintaining the integrity of the market. The video script explains how this mechanism works between brokers and the exchange clearing house.

💡Clearing House

A clearing house is an intermediary between buyers and sellers in a financial exchange, ensuring that each party meets their obligations. In the context of the video, the clearing house is responsible for the daily settlement of gains and losses and the collection of margin from market participants. It plays a crucial role in reducing counterparty risk and maintaining the stability of the futures market.

💡OTC Market

The OTC (Over-The-Counter) market refers to financial instruments that are traded directly between two parties, without going through a centralized exchange. The video script contrasts the OTC market with the exchange market, highlighting that while futures are traded on exchanges, similar contracts like forwards and swaps can be traded OTC. The script also discusses the role of ISDA Master Agreements in governing OTC transactions.

💡Central Counterparty (CCP)

A Central Counterparty (CCP) is an entity that interposes itself between the buyer and seller in a transaction, becoming the buyer to the seller and the seller to the buyer. This reduces counterparty risk by ensuring that each side of the trade has a single, reliable counterparty. The video script explains how CCPs operate in the OTC market, requiring initial and variation margins similar to exchange clearing houses.

💡Open Interest

Open interest refers to the total number of outstanding contracts that have not been settled or closed in a particular futures market. The video script uses the example of a gold futures contract to illustrate how open interest can change as new contracts are traded. It is an important indicator of market activity and can provide insights into the strength of market sentiment.

💡Settlement Price

Settlement price is the price at which the gains and losses on futures contracts are calculated at the end of each trading day. This price is used for the daily settlement process and is crucial for determining the value of open positions. The script mentions that the settlement price is just before the final settlement day and is used for daily settlement, which is a key aspect of managing risk in futures trading.

Highlights

Futures are settled daily, allowing investors to close out positions without waiting for maturity.

Closing out a future position is simple, achieved by entering into an offsetting trade.

The example of Kepco selling FX forward to hedge against future USD cash flow.

Caleb's strategy of taking a short position on FX forward to offset future cash flows.

The concept that offsetting trades can be used to close out positions in both futures and forwards.

The role of the exchange clearing house in managing margins and ensuring daily settlement.

Different margin requirements between brokers and the clearing house, and their significance.

How margin cash flows work when future prices increase or decrease, affecting long and short traders.

The purpose of margin requirements in preventing defaults and managing credit risk.

The difference between futures traded on an exchange and similar contracts traded OTC.

The importance of the ISDA Master Agreement in OTC transactions and its role in credit support.

The shift towards central clearing of standardized OTC derivatives post-financial crisis.

How CCPs operate similarly to exchange clearing houses with initial and variation margins.

The regulatory push for CCPs to reduce systemic credit risk in the OTC market.

The distinction between bilateral and central clearing in terms of risk management.

The concept of open interest as the total number of outstanding contracts.

Explanation of trading volume and how it differs from open interest.

The impact of new trades on an individual's portfolio and the concept of settling positions.

Transcripts

uh original level such

as initial

mod okay

yeah yeah key points about our future

uh Futures are

settled

daily

yeah the investors you know either a

seller or buyer uh don't have to wait

until maturity they are settled

daily closing out a future position is

very

simple just uh enter into an offsetting

uh

trait let's say uh in know in K of

case e

here is

sold FX

forward

right against

what

USD

amount that he will receive

in 3

months you still remember that you know

K made a Cav gimchi and he uh

exported some uh the cabage into uh USA

so

finally de is done and uh he will uh you

know he will receive uh $5

million from USA in 3 months which means

each cash flow uh will be happening in

three months that's why uh to make a

hatching uh one uh you know what is one

way was kep you know

cop but taleb uh took a short position

on FX forward

now now you know he he like to offset

how he can do that he just

buy

FX

for yeah well this is uh in in theory

because uh you know we are talking about

the future but the Caleb case was you

know forward but either like uh you know

future or forward and count in know

counter party is the same then sold FX

future to like uh you

know ABC yeah ABC like counterparty and

buy FX forward

[Music]

from ABC counterparty then

short position and long position could

be exactly you know

offset because uh you know

counterparties are the

same this is uh you know basic idea so

uh that idea also applies in the future

market so entering into offsetting uh

tradeit and uh uh you know the contract

can be closed up so in the future Market

the most contract are closed before

maturity which means they don't have to

uh wait until uh you know sett date

before uh you know set date they just uh

make they just make you know offsetting

a trade to close up and which means this

is pull out any

obligation arising from yeah Futures

Contract yeah exchange clearing uh house

which means still and you and

broker and

krx yeah we talked about margin uh you

know uh over here and between uh uh

andx that is some also some margin

requirements right so exchange Clearing

House has members uh exchange clear

house members you know there are many

members and including a broker you are

facing exchange clear house had members

who provide initial margin and daily

variation margin so where initial and

VAR margin between between who and who

broker and CarX so you are as a you

know retail investor well you know you

don't worry about uh this

part this is purely between a broker and

CarX so looking at the you know margin

uh I mean looking at the daily uh

settlement on loss and uh you know gain

every day

between uh you and broker such a

mechanism

also working between a broker and

KX like initial margin and daily uh

margin requirement initial margin is

yeah let's say uh 1 uh%

of like uh

volume and broker has to provide to KX

and the daily uh variation margin this

is uh settled uh on a daily basis

upon

gain and

loss so this is another layer of uh you

know credit uh mtig and this

is part of like the daily uh

s

broker who not the members then must

must Channel their business through a

member who has membership in The

Exchange Market so the member would then

require a margin from the

broker

okay margin cash flow when a future

price increase or

decrease let's say uh price increase

future price increase

then who made gain long Trader right who

who made the loss short Trader so short

Trader uh you know they mean they they

have a margin so my you know sum of

money from margin account go this

way and

finally comes into yeah long Trader

pocket this is the margin

flow all

right what if uh in a future price

decrease then in this

case who may loss long

Trader so some of money from long Trader

margin

account

goes

out and comes

into this

way this happened on a daily basis

that's why you know a settled a

daily in uh future or

market and one uh Point uh regarding uh

in know daily uh settlment or initial

margin so if you are you

know onee contract if you buy onee

contract

say

future price

decrease yeah future price

decrease and you

are wrong

Trader so future price keeps going

down and your long Trader your

loss your your

loss your loss will

be going down

means uh your amount of loss

increase but but uh let's uh let's uh

you know make agreement

uh there will be uh no uh you know sett

until one year

and uh for the entire year uh future

price keeps going down and you as a long

uh Trader long investor your loss uh

will be uh you know keep increasing loss

amount keep increasing then final uh at

the end of

maturity you uh your loss let's

say 1 million

dollar this is your

loss but uh you don't have a

money how did there and that contract

will be uh you know uh bankrupt will

broken so that is the default to to

avoid such a you know

uh such a you know outcome to such a

case

KX or any in know exchange uh Market

they have to operate they have to run

you know margin uh requirements like uh

day by day they don't have to wait until

you know so much loss increase further

and further this is one simple mechanism

to remove any uh default you know loss

from any contract or upon you know

investor

bankruptcy got

it now you know we are talking about the

OTC market rather than Exchange Market

so we you know future traded in Exchange

Market but a similar future type

contract traded in uh outside OT outside

of exchange that is uh we uh you know

already you know the last uh week that

that is

forward this is trade outside OTC so

transaction governed by an well this is

one example yeah swap is also and

transaction governed by an agreement so

once I mean if you are in know TR any uh

forward in OTC market and the

transaction should be governed by an

agreement between uh you and your

counterparty there should to be a signed

agreement so typically Isa

yeah in know placee like uh you know

make a a suchar on uh Isa what is uh

what does stand for and uh what uh what

form uh you know what Association it is

and uh how I mean what types of uh you

know agreement uh

ISTA uh uh maintain and uh renew and Etc

so ISTA Master agreement between two

sides this is

studying and uh there is a credit

support and I already uh you know

explained in the first work uh CSA

credit support Annex defines the

collateral that has to be posted by each

side this is for bilateral

clearing yeah CCP and OTC market so

following uh the

2007 to uh 2009 crisis soall

Global

Financial

Rices there has been a requirement for

standardized standardized OTC derivative

transaction between financial

institution to be cleared centrally

through Clearing House known as CCP

Central

counterparties so even though uh you

know uh OTC

derivatives product are traded outside

of exchange but uh there are certain uh

requirement uh how those uh product uh

have to be

cleared through Clearing

Houses the operation of CCP is very

similar to that of exchange Clearing

House

because uh this also require initial

margin and variation margin

Etc and it has members who provide

initial margin based on their

outstanding contact with CCP and the

varation margin if not a members a

company can clear its transaction

through a

member what was the background uh you

know a major uh countries regulatory

body in use CCP

on OTC uh derivative

product uh one of the main reason

is uh they have to uh remove any uh

potential uh def loss from counterparty

that was the main uh the reason because

during uh the financial crisis even

reman brothers and uh what else major

soft even reman Brothers you know went

on bankrupt bankruptcy and many uh you

know swap dealers uh uh suffered a lot

of russes and and also their spread

rating uh you know were downgraded and

they could uh couldn't borrow uh you

know enough sufficient money from the

market so which means

uh which means in OTC uh you know Market

the risk uh will you know prisk will

like

escalated uh due to you know shortage of

funding by swap

dealer So to avoid uh such a in know

systemic uh cred risk default margin

and I mean the margin rule such

as uh in a

CCP uh was introduced that was the

background let me show you you

know how U bilateral and Central

clearing are

different this uh this is Central uh

clearing whoever you know you answerer

uh uh uh trade we

finally

you you have novated your

transtion to uh

CCP right after that

CP ought to be counterparty to any

member

right this this is the same uh

mechanism

with

exchange however this

one by lateral uh clearing uh so you

know it looks so

complicated and uh you you over here and

you do FX for with this count party you

do a

s with the discount party you do Equity

uh forward with Discount Party you do uh

you

know

uh uh what else you know you do uh you

do Bor uh B forward uh you know another

counterparty and uh you

know this investor uh can do uh you know

try many OTC dires with many

other uh counterparties such as that are

so

complicated uh clearing

uh should happen because uh you know

this is contract between uh two

counterparty there are so many different

uh contract already uh traded between

two counter party so this uh

diagram uh and this you know snapshot

shows you

that how you know B bilateral

clearing uh you know PR in the OTC

market but if you uh you know

transform this vieral clearing into CCP

clearing such as Central clearing and uh

it looks very

simple looks very simple and

uh

also the

obligation of obligation that each uh

counter party has to SLE has to post has

to receive what uh with CCP is very

clear yeah this is one uh way of this

idea is one way to reduce uh you know

potential C risk or you know avoid or

remove any uh uh default uh risk from

the uh Market but still not all the OTC

uh product uh cleared are cleared

through uh CCP so some uh standardized

uh product Del the product are

cleared through uh CCP but not not all

of them not all of in in

Korea CD

CD

swap yeah this uh OTC derivative is a

main product to be uh cleared through

CCP

but other than this still are so many

different OTC product traded outside of

exchange but uh I know not all of them

are are through uh

CCP yeah some uh terminology you need to

understand uh you know some terminology

uh open

interest uh total number of contract

outstanding so you

buy one o of bold

future

old future

right uh the maturity one

year let's Suppose there are two people

uh you and your friends

which means your

friends this is

long your

front has uh short position one on of

for okay right after you

know B

and you have uh you know one o of gold

feature and your friend as a short

seller he has one o of

gold but

settle uh settle final settle should be

should be at the end of one year this

you know one year after so which

means this is

outstanding future and also this is

outstanding future as a short how many

uh you know open

interest one

contract you know this uh you know we

call it open interest so total number of

contract outstanding that are that is

you know that is Biance but the only one

contract is outstanding equal to Long

position or equal to number of long

position or number of short position

yeah here it's one contract is open

interest

outstanding settle price the price just

before the final b h day and used for

daily uh settlement process and volume

of trading uh number of trades in one

day

yeah here

only yeah one uh one uh contract which

is open interest and then uh you know

trading volume is one

contract what if what

if this it

today what if uh

tomorrow

no I think

uh yeah

tomorrow and

you sort one o of gold future to your

friend which means your friend bought

one o of gold from

you so

tomorrow one o of

gold

picture yeah you you are sold out and

then your friend bought one o of

gold

so look

at your

portfolio uh one o of gold you had but

you sold one o of gold so

finally yeah

zero

contract and your friend also zero