# Explain the role of a clearing house

EIFM Seminar 11 – week commencing Jan 10th 2022

Question 1: Suppose trader X bought one December gold futures contracts on COMEX division of the New York Mercantile Exchange on June 5. The gold futures price is \$600 per ounce on that day. The contract size is 100 ounces. The initial margin is \$2,000 per contract. The maintenance margin is \$1,500 per contract. Suppose the settlement price of Dec gold futures from June 5th to June 7th is shown in the table. Trader X closes out the position on June 7th at \$597. Between the opening and closing day, he keeps the position by meeting margin calls. Compute the daily gain (loss), cumulative gain (loss), margin account balance of and variation margin of trader X each day. Calculate his total return.

 Day Futures price (\$) Daily gain (loss) (\$) Cumulative gain (loss) (\$) Margin account balance (\$) Margin call (\$) 600 2,000 June 5 594 -600 -600 1,400(2,000) 600 June 6 587 -700 –1,300 1,300(2,000) 700 June 7 597 1,000 –300 3,000

Total return = -300/(2,000+600+700) = -9.09% in 3 days!

2. Explain the role of a clearing house in a futures market.

The principal role of the clearing house is to reduce default risk in futures markets. It does this in a variety of ways. First, all contracts entered into are contracts between a client and the clearing house. Thus, although there is in any deal with both a buyer and a seller, the buyer buys from the clearing house; the seller sells to the clearing house. The clearing house has the obligation to meet any default. The clearing house, then, acts to try to ensure that both parties to the deal can meet their obligations under the contracts. The major way of achieving this is through the system of margin payments, which requires the contracting parties to pay into accounts with the clearing house, sufficient funds to cover potential losses. The sums held in these accounts are adjusted daily to reflect price changes in the underlying asset market. In the jargon, the margins are ‘marked to market’.

Other actions are taken by the exchange to reduce default risk. For example, it is possible for large changes in price to take place in a single day’s trading and this cannot be covered by the system of daily margin payments. Therefore, in turbulent market conditions, the exchange can set price limits. Reaching these limits triggers the closure of the exchange for the day.

3. Given the information in the table below answer the following two question

 Intel Option Prices (Sept 12, 2016; Stock Price=19.56); Source: CBOE Strike Price Oct Call Jan Call Apr Call Oct Put Jan Put Apr Put 17.50 2.300 2.775 3.150 0.125 0.475 0.725 20.00 0.575 1.175 1.650 0.875 1.375 1.700 22.50 0.075 0.375 0.725 2.950 3.100 3.300

(a) What will be the proceeds and net profit to an investor who purchases the April expiration Intel calls with exercise price \$20 if the stock price at maturity is \$23? What if the stock price at maturity is \$17?

(b) Answer part (a) for an investor who purchases an April expiration Intel put option with exercise price \$22.5

(a) Denote the stock price at option expiration by ST, and the strike price by X.

Value at expiration = ST – X = ST – 20 if this value is positive; otherwise the call expires worthlessly

Profit = Proceeds – call premium = Proceeds – \$1.650

When ST = \$23, Proceeds = 23 – 20 = \$3 and profits = 3 – 1.65 = \$1.35

When ST = \$17, Proceeds = \$0 and profits = -\$1.65

(b) Value at expiration = X – ST = 22.5 – ST, if this value is positive; otherwise the put expires worthlessly.

Profit = Proceeds – put premium = Proceeds – 3.3

When S = \$23, Proceeds = 0 and profits = -\$3.3

When S = \$17, Proceeds = 22.5 – 17 = \$5.5 and profits = 5.5 – 3.3 = \$2.2

4. Explain the statement made by the Chairman of CBoT in the following extract:

‘The Chicago Board of Trade will launch an oats futures options contract on May 1. Options on oats will provide a variety of hedging possibilities. The American Oats Association in Minneapolis said that producers were more likely to use options than futures. According to the CBoT chairman, by purchasing options, a hedger can establish price ceilings and floors, and still benefit if cash prices change in his favour’.