Exchanges:- Central market where standardized derivatives like futures and options can be traded.
Clearing is the process of reconciling and matching contracts between counterparties.
Margin—Margining involves posting cash or marketable security collateral by the member.
Initial Margin : Cash or liquid assets transferred by a member at trade inception.
Variation Margin : Cash posted by a member to cover the daily net change of the member’s position.
|EXCHANGE TRADED||OTC DERIVATIVES|
|Standardized Contracts.||Privately negotiated bilateral contracts.|
|Regulated||Little or no regulation|
|Contracts cannot be customized.||Contracts can be customized.|
|Little credit risk ( CCP Guarantee)||High credit risk (bilateral)|
|Contracts can easily be closed out.||Contracts cannot be closed out easily.|
|Derivatives are typically short termed & settled within a few days.||Derivatives are longer term with later settlements making clearing more challenging.|
|Clearing & settlement are done by CCP.||Clearing & settlement are done bilaterally.|
Classes of OTC Derivatives: –
Five classes of OTC:- Interest Rates, Forex Contracts, Equity, Commodity and CDS.
Interest Rate derivatives size is 80% of OTC derivatives market. This is misleading because are valued by notional value. Interest rate derivates are very low in risk as risk is posed by only net coupon cash flow. As a result transaction value is better approach for valuing OTC derivatives.
Mitigating Risk of OTC Derivatives:-
Credit risk is the Key risk in OTC market.
Options on Stock:- Short option requires risk mitigation due to high risk in trade. Margin requirements can be different in different markets.
Short Sale:- Margin requirements in short sale is in percentage of sale value. Initial margin of 140% of the sale proceeds collected is required. This percentage may vary based on volatility in the market . And maintenance margin of certain percentage say 120%required.
Margin requirement calculation in case of short sale.:-
Assume short sale of 100 shares at $ 15. If the margin requirement is 150% Initial and 120% in maintenance, margin to be posted should be $2250 (150% of sale proceeds is 150%(15X100).
If price falls by $3 , margin account balance will be $2250—($15-$13)X 100 =