To summarise the exchange and clearing process environment we
can say that:
1. Trades take place between exchange members.
2. Trades are made via the trading mechanism applicable to the
exchange.
3. Trades are matched either via the dealing system or through a
matching process.
4. The status of trades is often available in real time through a
trade processing/registration system or at a minimum by peri-
odic reports from the exchange.
5. Unmatched/alleged trades need to be resolved and repaired
within a set time frame or a member will incur fines.
6. Once matched both the buy and the sell elements of the trade
passes to the clearing system.
7. The clearing system allows clearing members to see the updated
positions and settlement obligations they have with the clearing
house.
8. The obligations are settled automatically at a predetermined
time via a secured payment system with a designated bank.
9. A failure to meet obligations to the clearing house would result
in the member facing ‘being put into default’.
10. The clearing member reconciles the positions and settlement
obligations shown by the clearing house to their own records.
Use of futures
Futures contracts are used for a variety of reasons such as specula-
tion or hedging, as well as strategies like asset allocation in fund
management and also for arbitrage opportunities.
If we consider that futures contracts are synthetic versions of the
underlying on which they are based we can easily see how they are
used by speculators and hedgers alike.
Take the case of a fund manager who is worried about the direction of
the equity market. Let us suppose that the equity exposure of the fund
is mainly in FTSE 100 stocks with a current value of £15 000 000. If
the index falls, the fund’s current good performance will be affected. The
fund manager believes that the UK equity market will fall gradually over
the next three months but then will recover to its current level.
The manager could sell the equity portfolio at the current level and
then repurchase the shares at the lower level. There are two problems
here. First, costs to the fund in terms of the broker’s commission for
selling and buying the shares. Secondly, what if the index does not fall?
52 Clearing and settlement of derivatives
The manager looks at the Euronext.liffe futures market where the
FTSE 100 Index Futures contract is listed. The manager knows from
the contract specification issued by the exchange that the size of the
contract is £10 the index point and the futures are trading at 5495,
which means one contract equals a value of £54 950. The manager
works out that to cover the portfolio value of £15 000 000 they
will need £15 000 000/£54950 or 272.97 rounded to 273 futures
contracts.
The manager sells (goes short) the futures contracts and in doing
so has ‘locked in’ a value for index of 5495 and thus the portfolio
value of the equity asset class. Now, if the index does fall, the loss on
the shares in the portfolio is offset by the gain on the short position
in the futures. If the index does not fall, the fund manager will buy
back the futures contracts as the hedge is no longer needed.
The advantages for the fund manager are that the portfolio itself
has not been disturbed, the commission on the futures trades will
be less than if the shares had been sold and then repurchased,
and if the market moves unexpectedly upwards the fund manager
can very quickly close out the futures and leave the fund to benefit
from the rise in the market. That would be more difficult and
potentially expensive if selling and then repurchasing the shares
were involved.
So futures contracts helped the fund manager hedge. Now let us
look at the case of the speculator.
Suppose you are generally bullish of the equity market but at the
moment you have only limited funds available, how can you benefit
from the rise in the market you are anticipating?
We saw above that a FTSE 100 Index Futures contract is trading at
5495 and the contract represents an exposure with a value of £54 950.
Because the contract is not settled on the basis of its full value but
instead it works on a margin basis in the form of a deposit plus a daily
settlement of the revaluation of the position, it will cost far less than
£54 950 to buy the same exposure to the market.
So the speculator gets an initial exposure worth £54 950 for a
seemingly ridiculous low outlay. Well that is absolutely true but, and
it is a big ‘but’, the speculator must be prepared and able to settle
immediately any losses that might occur. Let us look at an example:
The speculator buys 1 FTSE futures contract with a maturity in
Sep. @ 5495 at 10.00 a.m. in the morning. Around lunchtime there
is very bad news from America and the FTSE responds to the news
by falling quite rapidly to close at 5450, a fall of 45 points.
From the contract specification the speculator sees that each half-
point fall is the equivalent of £5 per contract. The speculators position
Futures processing 53
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