3.1.1 Exchanges and OTC Markets

Forwards and Futures

1. Exchanges and OTC Markets

1.1 Exchange-Traded Markets

1.1.1 Operations of Exchange

An exchange market is a market where investors trade standardized contracts made by exchange.

Traditionally, derivatives exchanges have used what is referred to as the open-outcry system. This involves traders meeting on the floor of the exchange and indicating their proposed trades with hand signals and shouting.

However, with computers being used to match buyers and sellers. Sometimes electronic trading is initiated by computer algorithms without any human intervention at all.

Today, exchanges clear all trades between members through so-called central counterparties(CCPs).

Positions can be closed out by entering into offsetting positions.

Trades are settled daily by variation margin flowing from one side to other.

1.1.2 Central Counterparty

In derivatives trading, the central counterparty replaces bilateral liquidation, becoming the buyer of each seller and the seller of each buyer. If one party defaults, it can also ensure the completion of the transaction.

For a CCP to clear a product, several conditions must be satisfied:

• The legal and economic terms of the product must be standard within the market.
• There must be generally accepted models for valuing the product.
• The product must trade actively.
• Extensive historical data on the price of the product should be made available to enable initial margin requirements to be determined.

1.1.3 How CCPs Handle Credit Risk

Netting: a procedure where short positions
and long positions in a particular contract offset each other.

Daily settlement: trades made on an exchange are not settled at maturity. Instead, it marked to market day by day.

The exchange requires members to protect themselves by providing margin, which refers to the cash or assets transferred from one trader to another for protection against counterparty default.

Initial margin are funds or marketable securities that must be deposited with the CCP. It is set by the exchange and reflects the volatility of the futures price.

Members are also required to submit a defund fund as a loss protection. If the initial margin is not sufficient to cover a member’s losses during a default, the members’ default fund contributions will be used to cover the difference. If these funds remain insufficient, they are replenished by the default funds of other members.

Maintenance margin: the margin account balance is adjusted each day to reflect gains and losses. If the balance in the margin account falls below the maintenance margin level, the trader will get a margin call and will be asked for funds to bring the balance up to the initial margin level.

Variation margin: Used to bring the margin balance back up to the initial margin level. Each day, the losing member pays the exchange CCP an amount equal to the loss, while the profitable member receives an amount equal to the gain from the exchange CCP. These payments variation margin and usually occur daily.

1.1.4 Use of Margin Accounts

Buying on margin refers to the practice of borrowing funds from a broker to buy shares or other assets.

Options on stock: traders with short positions are therefore required to post margin.

Short sales: a retail trader who chooses to short a stock is required to post margin.

1.2 Over-the-Counter Markets

1.2.1 Operations of OTC Markets

OTC market participants can be categorized as either end users or dealers.
End users are corporations, fund managers, and other financial institutions.
Dealers are large financial institutions that provide commonly traded derivatives.

An advantage of OTC markets is that the contracts traded do not have to be the standard contracts defined by exchanges.

1.2.2 Ways to reduce credit risk in OTC markets

Bilateral Netting: Two market participants would enter into a master agreement applying all they traded, and treat all the transactions as a single transaction.

Example: Suppose now, Company B gets into financial difficulties. It will default on Transactions 1 and 3, but keep Transactions 2 and 4. How much will company A lose in transactions 1 and 3?

With netting: Company A will loss $20\text{million}$.
Without netting: Company A will loss $60\text{million}$ (The profits of transactions 1 and 3 are not available).

Transaction	Value to Company A	Value to Company B
1	+40	-40
2	-30	+30
3	+20	-20
4	-10	+10

Collateral: the credit support annex (CSA) of a master agreement between two parties specifies how the required collateral is to be calculated and what securities can be posted.

Special Purpose Vehicles (SPVs): SPV, also called Special Purpose Entities (SPE), are legal entities created typically to isolate a firm from financial risk.

Derivatives Product Companies (DPCs): were well-capitalized subsidiaries of dealers designed to receive AAA credit ratings.

Credit Default Swaps: these are insurance-like contracts between a protection buyer and a protection seller. The buyer pays a regular premium to the seller, and if there is a default by a specified entity (not the buyer or seller), the seller makes a payment to the buyer.

Monolines: are insurance companies with strong credit ratings, and they provide investor credit default wraps, i.e. financial guarantees.

Exchange Traded	OTC(over-the-counter)
Standardized	Customized
Backed by a clearing house	Trade with counterparty (default risk)
Trade in a physical exchange	Not trade in a central location
Regulate	Unregulated
Small trading volume	Large trading volume