Explain Why Trading Derivatives on Centralized Exchanges Rather Than in Over-The-Counter Markets Helps Reduce Systemic Risk

Question:

Explain why trading derivatives on centralized exchanges rather than in over-the-counter markets helps reduce systemic risk. (LO1)

Answer:

Derivative instruments traded on centralized exchange are standardized which makes it easy to buy and sell. Centralized exchange act like an intermediary which means between the 2 parties ensuring that each party fulfill their part of the deal. The centralized exchange requires both parties to maintain a deposit with the exchange and the gains / losses are posted to the account on daily basis. Centralized exchange can monitor if trader is taking large positions on one side and restrict the trade by increasing the risk premium or not entering the contract itself. These features make centralized exchanges less risky and can absorb the losses with the trades.

On the other hand, trading on the OTC market possess threat to the liquidity. The instruments are customized which makes it difficult to buy and sell. The trade is bilateral between the buyer and seller, either of the party is not aware of the risks or positions taken by other party. There is lack of transparency in the OTC market. These factor make OTC market more prone to risk and overall threat to the economy in the whole. If the traders take huge positions in the market and are highly leveraged it will lead to huge disruption in the overall financial market.

Question:

You are completely convinced that the price of copper is going to rise significantly over the next year and want to take as large a position as you can in the market but have limited funds. How could you use the futures market to leverage your position? (LO2)

Answer:

If I by copper in the spot market hoping to sell at profit one year later, I will need to pay the entire amount for the copper. This will be expensive transaction.

Alternatively, I can enter into a futures contract to buy the copper (i.e take long position) at a specific price on a predetermined date. If the price of the copper rises, I will profit and the investment will be very small i.e the futures contract price.

I can enter into a call option and if the copper price increase the value of the call option will rise and I can sell the call option making profit. Again investment in buying a call option is very small. Added benefit of options is it has limited loss compared to futures.

Question:

If the U.S. dollar–British pound exchange rate is $1.50 per pound, and the U.S. dollar–euro rate is $0.90 per euro: (LO1)

a. What is the pound per euro rate?

b. How could you profit if the pound per euro rate were above the rate you calculated in part a? What if it were lower?