Question

1. Differentiate between cash settlement and physical settlement with respect to futures market.

2. Briefly explain the concepts of margins, marking to market, and open interest in terms of futures market.

3. Compare and contrast forward markets and futures market.

4. Define a Swap. Explain briefly the role of swaps in the development of financial markets.

5. What is currency swap? Compare simple currency swap with comparative advantage currency swap.

Answer 1

1]

With physical settlement

At the maturity date of the futures contract, the contract is settled by actual physical delivery of the underlying asset. The long position takes delivery of the asset, and the short position delivers the asset.

With cash settlement

At the maturity date of the futures contract, the contract is settled in cash. The difference between the price at which the futures contract is bought/sold, and the price of the futures contract at maturity is credited or debited to the margin account of the short/long position. If the futures price at maturity is higher than the futures purchase price, the long position gains and their account is credited whereas the short position loses and their account is debited. The opposite is done if the futures price at maturity is lower than the futures purchase price.

2]

When a futures contract is traded, the trader is not required to put up the entire contract value upfront. Only a portion of the contract value is required to be deposited with the broker/exchange. This is portion is called margin.

Marking to market is the process of calculating the daily profit/loss of the futures positions for each trader, and crediting/debiting their margin account at the end of the day. Since the entire contract value is not paid upfront by futures traders, marking to market ensures that traders have adequate margin to carry their futures contracts every day. If their margin balance falls below the minimum level after marking to market, a margin call is made.

Open interest is the total number of futures contracts outstanding. They are the "open" positions which are carried by traders, and not closed out by taking offsetting positions.

3]

Forward markets are over-the-counter, which means that forward contracts are not traded on exchanges, but between counterparties in the over-the-counter market. Thus, forward markets are not standardized in terms of contract sizes, maturity dates etc. Forward markets are not marked to market daily like futures markets. Since forward markets are over-the-counter, there is higher counter party risk in this market.

Futures markets function on exchanges and are standardized in terms of contract sizes, maturity dates etc. Futures markets are marked to market daily. Since forward markets function in regulated exchanges, there is lower counter party risk in this market.

4]

A swap is a derivative contract which involves two parties exchanging the cash flows of two different assets/liabilities/financial instruments on a specified date or multiple specified dates. There is a notional amount for the swap contract which may or may not be exchanged by the parties at the initiation/termination of the contract.

Swaps play an important role in the development of financial markets :

• They enable risk management
• They allow market participants to get around legal restrictions
• They provide liquidity in illiquid markets
• They enable lower borrowing costs