Margins

Clearing house
Clearing house acts á intermediary in future transactions, and guarantees the performance of the parties
to each transaction

Brokers who are not member themselves must channel their business through a member

The main task : keep track all transactions that take place during a day and calculate net positions of
each of its members

Credit task: Traders who did not meet margin calls were closed but still owed their brokers money.
Some did not pay and as a result some brokers went bankrupt because, without their clients’ money,
they were unable to meet margin calls on contracts they entered into on behalf of their clients

 Margin cash flows when futures price increases:

Short trader => Broker => Clearing member house => Clearing house => Clearing house member
=> Broker => Long trader (help to reduce the default risk)
 Margin cash when futures price decrease

Over-the-counter market
Banks, or other large financial, financial institutions, fund managers, and corporations are the main
participants on OTC derivatives markets.

 Once an OTC trade has been agreed, the 2 parties can either be present it to a central
counterparty (CCP) or clear the trade bilaterally
o An CCP is like an exchange clearing house. It stands between the 2 parties

OTC derivatives transactions; central counterparty

 Mambers of the CCP have to provide both initial margin and daily variation margin, and are also
required to contribute to a guaranty fund
 Once the OTC derivative transaction has been agreed> present to CCP => CCP accept transaction
=> counterparty to both A&B
 Transactions are valued daily

Bilateral clearing

 Those OTC transactions that are not cleared througgh CCPs are cleared bilaterally
 In the bilaterally cleared OTC market, 2 companies A and B usually enter into a master
agreement covering all their trades

Chapter 3: Determination of Future and forward prices

Types of rates
An interest rate in a particular situation defines the amount of money a borrower promises to pay the
lender
For any given currency, many different types of interest are regularly quoted. Including mortgage rates,
deposit rates, prime borrowing rates

Types of rates:

 Treasury rates
 Overnight rates
 Repo rates

Treasury rate
 Rate on instrument issued by a government in its own currency
 It is usually assumed that there is no chance that the country will not go bankrupt

Overnight rates:
 Banks are required to maintain a certain amount of cash, known as a reserve, with the central
bank
 The reserve requirement for a bank at any time depends on its outstanding assets and liabilities
 At the end of the day, some financial institutions typically have surplus funds in their accounts
with the central bank while others have requirement for funds
 This leads to the borrowing the lending overnight

Repos rates:
 Repurchase agreement is and agreement where a financial institution that owns securities
agrees to sell them for X and buy the, back in the future (usually the next day) for a slightly
higher price, Y
 The financial institution obtain a loan
 The rate of interest is calculated from the difference between X and Y and is known as the repo
rate
 The repo rate involves very little credit risk
o If the borrower does not honr the agreement, the lending company simply keeps the
securities
o If the lending company does not keep to its side of agreement, the original owner of the
securities keeps the cash provided by the lending company

LIBOR (London Interbank Offered Rate)

 Is the rate at which a AA-rated estimates it can borrow money in an unsecured basis from
another bank at 11 am
 Several currencies and maturities
 There is not enough borrowing between banks for a bank’s estimates to be determined by
market transactions

Risk-free rate
The usual approach to value derivatives involves setting up a riskless portfolio and the return of the
portfolio should be risk-free
The risk-free reference rates created from overnight rates are the ones used in valuing derivatives:
consider an interest rate quoted at 10% with semiannual compounding. With m=2 and Rm=0.1. The
equivalent rate with continuous compounding is: 2*ln(1+0.1/2) = 0.0976

Midterm test after Chapter 3