Exchange-traded vs over-the-counter markets — MCQs

An issuer requires a nonstandard exercise amount and expiration but wants a contingent rather than mandatory future transaction. The most appropriate instrument is:

A risk manager compares forward commitments with contingent claims. Which statement best describes their contractual exposures?

Meridian Capital Markets advises institutional clients on derivatives and also maintains a small portfolio of hedging positions. Senior analyst Arjun Patel is reviewing four transactions and asks an associate to distinguish carefully among a derivative's initiation price, its current value, and its settlement mechanics. Unless otherwise stated, interest rates are effective annual rates, markets are frictionless, and all counterparties can borrow or lend at the stated rates. Three months ago, a client entered a nine-month long forward on a non-dividend-paying equity. The contracted delivery price is USD 101.00 per share. The equity now trades at USD 104.00, six months remain until settlement, and the current risk-free rate for the remaining term is 5.00% per year. The contract requires physical settlement, but the current value is determined using the equivalent cash-settlement value. Patel next compares an exchange-traded futures contract with an otherwise similar over-the-counter forward. The futures contract is marked to market daily through a central counterparty and requires initial and variation margin. He states that the settlement arrangement materially limits the amount of unsecured exposure that can build up between the parties, although it does not make the contract free of every form of counterparty or liquidity risk. Meridian also holds a receive-fixed, pay-floating interest rate swap with USD 50 million notional principal. Exactly one annual net settlement remains. The contractual fixed rate is 4.00%, the current market fixed rate for an otherwise identical one-year swap is 5.00%, and the appropriate annual discount rate is 5.00%. For valuation, the floating side is represented by the current market fixed rate, so the remaining net cash flow can be valued directly. The notional principal is not exchanged. Finally, a commodity producer asks Meridian to determine the no-arbitrage one-year forward price of an industrial metal. The current spot price is USD 80.00 per unit, the effective annual risk-free rate is 4.00%, and storage for the full year must be prepaid today at USD 2.00 per unit. The metal generates no income and has no convenience yield. The producer can buy and store the commodity or transact in the forward market under identical financing conditions.

A portfolio manager owns a broad equity index, requires protection against losses below a specified level, and wants to retain gains if the index rises. The manager should most likely:

A portfolio manager wants to limit losses on an equity holding while retaining appreciation above its current price. The derivative position most appropriate for this objective is:

An analyst comparing a purchased European call with a long forward should most likely conclude that:

Meridian Asset Management uses derivatives to obtain market exposure and manage portfolio risk without immediately trading the underlying securities. A derivatives analyst is reviewing several positions for consistency with no-arbitrage pricing and the firm's daily valuation procedures. The first position under review is a new six-month forward on a broad equity index. The index pays a diversified stream of dividends that Meridian models as a continuous yield. Both the risk-free rate and dividend yield are assumed constant over the contract's life, and transaction costs, taxes, and short-selling restrictions are ignored. The contract requires physical-equivalent cash settlement based on the difference between the index level and the delivery price at maturity. Meridian also holds an existing long forward on the same index. The contract was entered into at zero value and now has three months remaining. The analyst must determine its current value using the current spot index, the original delivery price, and the remaining maturity. The firm's policy is to value existing forwards as the difference between the present values of the underlying-equivalent position and the contractual payment rather than treating the current forward price as an immediate cash settlement amount. A separate tactical portfolio is long exchange-traded index futures. These contracts are marked to market each business day through Meridian's margin account. The daily change reported in Exhibit 1 occurred after the position had been established, and no contracts were added or closed during the day. The analyst must report the variation-margin cash flow from Meridian's perspective. Finally, Meridian is valuing an over-the-counter interest rate swap immediately after a settlement date. Meridian receives a fixed annual rate and pays a floating annual rate on the same notional principal. Because the floating rate has just reset, the floating-rate leg is valued at par. The fixed leg is valued using the bond-replication approach, with all remaining cash flows discounted at the current par swap rate. Credit risk, funding valuation adjustments, and transaction costs are excluded. The relevant contract terms and market inputs are provided in Exhibits 1 and 2.

Meridian Derivatives Fund uses forwards, futures, and swaps to modify market exposures without immediately trading the underlying securities. Portfolio manager Elena Ruiz asks an analyst to review several positions using no-arbitrage valuation. Transaction costs, taxes, bid–ask spreads, and counterparty default are ignored. Interest rates and the present values of all income payments are known with certainty. The first review concerns equity forwards. The fund is considering a new long forward on a dividend-paying share and also holds an existing long forward on another share. Ruiz reminds the analyst that the delivery price of a newly initiated forward must make its initial value zero. For an existing contract, however, the original delivery price is fixed, so changes in the spot price, remaining income, interest rate, and time to maturity can produce a positive or negative value. Exhibit 1 provides the required data. Each forward covers one share and permits delivery only at maturity. The second review concerns contract settlement. Meridian uses an exchange-traded futures contract whose gains and losses are settled through a clearinghouse at the end of each trading day. Ruiz asks the analyst to distinguish this process from the settlement of an otherwise comparable forward contract. She notes that the clearing arrangement reduces bilateral counterparty exposure but does not prevent the futures settlement price from changing. Finally, Meridian holds a plain-vanilla interest rate swap with the terms in Exhibit 2. The floating payment is based on the applicable six-month reference rate, and the floating rate has just reset. Payments are exchanged on a net basis, and the notional principal itself is not exchanged. The analyst values the swap using the bond-equivalence approach. Under this approach, a receive-floating position is represented by a long floating-rate bond, and a pay-fixed position is represented by a short fixed-rate bond. Because the floating rate has just reset, the floating-rate bond is valued at par. All rates in Exhibit 2 are annualized, and the fixed-rate coupon for each six-month period equals one-half of the annual fixed rate.