Assignment 2
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Assignment 2: Chapter 2 Naman Vaid (T00651393)
Thompson Rivers University
FNCE 3180: Assignment 2 Li Zhang
September 2023
Problem 2.10.
Explain how margin protects futures traders against the possibility of default.
Margin is a crucial risk management tool in the world of futures trading that helps protect traders
against the possibility of default. Futures contracts are legally binding agreements to buy or sell a
particular asset at a predetermined price and date in the future. Since these contracts often involve substantial amounts of money and carry inherent risks, margin requirements are enforced
to mitigate these risks and safeguard the integrity of the futures market.
Here's how margin protects futures traders against the possibility of default:
1.
Initial Margin: When a trader enters a futures contract, they are required to deposit an initial margin with their broker. This initial margin is a percentage of the total contract value and serves as collateral or a good faith deposit to cover potential losses. The specific margin percentage varies depending on the contract and asset being traded but is typically set by the exchange or regulatory authority.
2.
Variation Margin: After the initial margin is deposited, the value of the futures contract fluctuates daily based on market price movements. This leads to gains and losses for traders as the contract's market value changes. To ensure that traders can meet their financial obligations, daily settlement or variation margin is calculated. If a trader incurs a loss in their position, they are required to add funds to their margin account to cover these losses. Conversely, if they make a profit, the excess funds are returned to them.
3.
Maintenance Margin: In addition to the initial margin and variation margin, there is a maintenance margin requirement. If a trader's account balance falls below the maintenance margin due to losses, they are issued a margin call. This means they must deposit additional funds to bring their account balance back up to the initial margin level. Failure to do so can result in liquidation of the trader's position, potentially causing a default.
Now, let's see how these margin requirements protect traders against the possibility of default:
Risk Mitigation: Margin requirements ensure that traders have a financial stake in their positions, making it less likely that they will default on their obligations. The initial margin and ongoing variation margin ensure that traders have sufficient funds to cover potential losses as the market moves against their positions.
Daily Settlement: The daily settlement process helps prevent large losses from accumulating. It requires traders to settle their gains and losses daily, reducing the risk of a trader accumulating significant losses that they cannot cover.
Maintenance Margin: The maintenance margin requirement acts as a safety net. If a trader's account balance falls below this level, it triggers a margin call. This means that the trader is alerted to deposit additional funds, reducing the risk of default due to insufficient funds.
In summary, margin requirements in futures trading play a vital role in protecting traders against the possibility of default. They ensure that traders have the financial means to cover potential losses, minimize the risk of accumulating substantial losses, and provide a mechanism to address
account shortfalls through margin calls. These mechanisms collectively help maintain market stability and integrity.
Problem 2.11.
A trader buys two July futures contracts on frozen orange juice. Each contract is for the delivery of 15,000 pounds. The current futures price is 120 cents per pound, the initial margin is $6,000 per contract, and the maintenance margin is $4,500 per contract. What price change would lead to a margin call? Under what circumstances could $2,000 be withdrawn from the margin account? Contract Size = 15,000
Current Futures Price per pound - 120cents or $1.20
Total Contract Size bought = 15000 * 2 = 30000
Initial Margin = 6000 * 2 = 12000
Maintenance Margin = 4500 * 2 = 9000
The Value of the futures contract bought should go down by $ 3,000 to lead to a margin call.
Value Change = (Current Price - New Price) * 30,000 (Price decline is expected - Current Price > New Price) As value change should equal 3,000, therefore:
3000 = (1.20- P) * 30000
3000 / 30000 = 1.2- P
P = 1.2- 0.1 = $ 1.10
The price per pound needs to fall by 10 cents to $1.10 or 110 cents for margin call to happen.
Hence, the price should increase by 0.10 cents to $1.10 or 110 cents to be able to withdraw $2,000 from the margin account.
Problem 2.15.
At the end of one day a clearing house member is long 100 contracts, and the settlement price is $50,000 per contract. The original margin is $2,000 per
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contract. On the following day the member becomes responsible for clearing an additional 20 long contracts, entered at a price of $51,000 per contract. The
settlement price at the end of this day is $50,200. How much does the member have to add to its margin account with the exchange clearing house? Given that at the end of one day a clearing house member is long 100 contracts And the settlement price is $50,000 Per contract The original Margin is $2,000 Per contract NOW, here, The step1: clearing house member is required to Provide: 20 x $ 2,000.
Clearing house member is required to Provide = 20 × $2,000 = $40,000
As initial margin for the new contracts, step 2: There is a gain of (50,200 - 50,000) x 100.
There is a gain of = ($50,200 − $50,000) × 100 = $20,000
on the existing contracts, step 3: There is also a loss (51,000 - 50,200) x 20 = $16,000 on the new contracts, step 4: The number must therefore add,
= 40,000 - 20,000 + 16,000 = $36,000 to the Margin account. Answer is $ 36,000
Problem 2.25
Trader A enters futures contracts to buy 1 million euros for 1.1 million dollars
in three months. Trader B enters in a forward contract to do the same thing. The exchange (dollars per euro) declines sharply during the first two months and then increases for the third month to close at 1.1300. Ignoring daily settlement, what is the total profit of each trader? When the impact of daily settlement is considered, which trader does better?
Trader A enters a future contract to buy 1 million euros for 1.1 million dollars i.e., Exchange rate
of 1.1$/€. Trader B does the same, but he entered into a forward contract rather than a future contract. Now, after 3 months of ignoring the daily settlement the Dollars per Euro Exchange rate is 1.1300. so now the total Profit or loss of each trader (excluding daily settlement) is calculated by:
Profit / Loss = Settlement Price – Contract Price
= 1130,000 – 1100,000 = $30,000 profit
When daily settlement is considered, futures contracts require daily adjustments based on the mark-to-market process. This means that if the exchange rate moves against the trader during the
first two months, they will incur daily losses. If the exchange rate, then moves in their favor during the third month, they would incur daily gains.
Trader A (Futures Contract):
During the first two months when the exchange rate declines, Trader A incurs daily losses.
During the third month when the exchange rate increases, Trader A incurs daily gains.
The total profit or loss for Trader A would depend on the specific daily movements and the net impact of these daily adjustments. Without knowing the daily exchange rate movements, we cannot determine Trader A's total profit or loss with daily settlement accurately.
Trader B (Forward Contract):
In the forward contract, the rate was fixed at the outset, so there are no daily adjustments. Trader B's profit or loss remains zero.
In summary, Trader B's profit or loss remains zero regardless of whether daily settlement is considered because they entered a forward contract with a fixed exchange rate. Trader A's total profit or loss with daily settlement depends on the daily fluctuations in the exchange rate, and without knowing those specific daily movements, we cannot determine Trader A's total profit or loss accurately. However, Trader B is in a more predictable and risk-averse position due to the fixed exchange rate in the forward contract.
Problem 2.26
Explain what is meant by open interest. Why does the open interest usually decline during the month preceding the delivery month? On a particular day, there were 2,000 trades in a particular futures contract. This means that there
were 2,000 buyers (going long) and 2,000 sellers (going short). Of the 2,000 buyers, 1,400 were closing out positions and 600 were entering into new positions. Of the 2,000 sellers, 1,200 were closing out positions and 800 were entering into new positions. What is the impact of the day’s trading on open interest?
Open interest in the context of futures markets represents the total number of outstanding or unclosed futures contracts for a particular underlying asset or commodity. It indicates the total number of contracts that have been entered into by market participants but have not yet been
offset by an opposite trade (i.e., not yet closed out). Open interest is a key metric used to assess the liquidity and overall market activity in a futures contract.
Open interest often declines in the month preceding the delivery month for several reasons:
Contract Expiration: As the delivery month approaches, traders who do not intend to make or take physical delivery of the underlying asset may choose to close out their positions to avoid potential delivery obligations. This can reduce open interest.
Rolling Over Positions: Many traders roll over their positions from the expiring contract month to a contract with a later expiration date to maintain their exposure to the asset. This process involves closing out positions in the expiring contract and simultaneously opening new positions in the next contract month, which may lead to a temporary decrease in open interest in the expiring contract.
Speculators and Hedgers: Speculators, who do not intend to make or take delivery, often close their positions before delivery month to avoid the risk associated with delivery. Hedgers, on the other hand, may choose to hedge with physical delivery, leading to a reduction in open interest as their positions are resolved through delivery.
Impact of the day's trading on open interest:
On a particular day with 2,000 trades in a futures contract, it's essential to differentiate between the type of trades (closing out positions or entering new positions) to determine the impact on open interest:
Buyers (Going Long):
1,400 were closing out positions.
600 were entering into new positions.
Sellers (Going Short):
1,200 were closing out positions.
800 were entering into new positions.
To calculate the impact on open interest, consider the following:
Closing out positions: These transactions reduce open interest because they involve offsetting existing contracts. So, the total reduction in open interest due to closing out positions is 1,400 (long) + 1,200 (short) = 2,600 contracts.
Entering into new positions: These transactions increase open interest because they create new contracts. So, the total increase in open interest due to entering new positions is 600 (long) + 800
(short) = 1,400 contracts.
To find the net impact on open interest for the day's trading, subtract the reduction from the increase:
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Net Impact on Open Interest = Increase - Reduction Net Impact on Open Interest = 1,400 - 2,600
= -1,200 contracts
The day's trading resulted in a decrease of 1,200 contracts in open interest. This means that 1,200
contracts were closed out, reducing the total number of outstanding contracts in the market.
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