Workshop title- Lecture 3- Derivative Markets/Products

Workshop 3-Week 4
Read the articles on Moodle under workshop folder for week 3
and answer the following questions
1. What does the phrase often-opaque markets used in the article
Defusing Derivatives refer to? Are opaques markets a good or a
bad thing? Justify your answer. [50 words]
Opaque refers to the fact that the markets are not transparent. Research
shows that the markets are more liquid when broker identifiers are not
published.
2. Why do the big banks think the new trading rules for derivatives to
be unnecessary? (See the article Defusing Derivatives) What do
you think? [70 words]
They stand to lose out on business if all plain vanilla derivatives are
centrally cleared. With markets not so opaque pricing will be more
competitive? They are worried about the clearing houses becoming too
big to fail.

3. Compare and contrast OTC trading of derivatives (with CCP clearing)

with the trading of derivatives on an exchange. Your answer must
consider (but is not limited to) the following: (1) Who uses these
markets,(2)What contracts are traded on each market,(3) How the
markets developed (were there any differences?). In addition your
answer should comment on this:
"If all OTC trading moves to be centrally cleared by CCCPs, there will
be no difference between exchange-traded and OTC traded
derivatives."
Financial
Times
[100
words]

(i)OTC markets are both used by banks, corporations, and individuals. But
its mainly institutions using the OTC market
(ii) OTC: swaps (interest rate and currency), options (equity, FX, interest
rate, commodity etc), forwards (interest rate, FX), credit derivatives (CDS,
CDO, CMO) etc
Exchange traded: options, futures and some exotics.
The major difference is that exchange traded contracts must be highly
standardised in order to bring about the required liquidity to make the
market function Well.

(iii)OTC markets began with interest rate swaps. Exchange traded markets
attract a lot of attention but in fact OTC markets are more important in
terms of volumes of trade and the value of the trades (OTC approx 85,
Exchange approx 15 percent of volume)

With CCCP clearing dealers can continue to make profits as market

makers. If moved to an exchange dealer, they become price takers and
wont make as much profit. When centrally cleared OTC derivatives, it
could reduce systemic risk. CCPs increase the transparency and liquidity
and with increased market participation, the depth of CC OTC derivatives
(as compared to non-centrally cleared)
The exchange allows price discovery through matching of buy and sell
orders whereas the OTC market does not.

4. What are the changes that have been implemented by the Dodd
Frank Act in the United States (US) with regard to derivatives only?
Briefly explain the significant areas that have had a direct impact.
[100 words]
Swap dealers and major swap market participants will now be required
to execute derivatives transactions on an organized exchange or swap
execution platform for all derivatives the regulators designate for
mandatory clearing.
Essentially, all derivatives will be affected by the new regulation, with a
few exceptions.
Topics affecting (OTC) derivatives in the Dodd-Frank Act include:
Registration of swap dealers and major swap participants;
Push-Out Rule;
Swap clearing and execution;
Swap reporting;
Margin;
The Volcker Rule, which is in Title VI.

5. What are the possible negative consequences for the markets of

companies that can prove that they are using derivatives to hedge
risk related to their business, not being cleared through CCPs? [50
words]
Difficult to ascertain whether a company is actually hedging or not.

6. By making reference to the article titled "Fear of bank exposure to

commodity derivatives drives the decline", you are required to
analyze the comments in the article. In particular, you should
discuss if, in your view " the recent volatility in the global market
following the slowdown of China is related to the large exposure of
banks to derivatives and that derivatives can cause mass
destruction". You should use examples to further substantiate your
answer. [150 words]

Benefits: allows investors to achieve pay-offs that could not otherwise

be achieved or achieved at greater cost.
The risks come from not understanding exposures and the leverage
that derivatives involve. Managing risks comes from understanding
exposures, being able to measure them and being able to allocate
capital accordingly.