how do OTC dealers offset risks they undertake in derivative contracts by futures?

CFA Level I Derivatives
#1

so CFAI modules state that OTC dealers offset there risk by either entering an opposing contract with other party or through futures. so if they take a position in futures they will undertake a large amount of transaction costs? plus if futures are quoted at such an attractive price that profits are posssible even after the transaction costs all the parties would hedge through futures themselevs instead of going to the OTC dealers? thanks

#2

They’re offsetting their risk from what sorts of transactions?

#3

well anything…i have read that in almost all derivative topics but lets take Foreign exchange expsoure for now…

can u explain it wiht the help of an example

#4

Well . . . let’s go through the list; if the OCT dealer has a:

  • long futures position, he can hedge it with a short futures position
  • short futures position, he can hedge it with a long futures position
  • long call, he doesn’t need to hedge it (but could with a short call)
  • long put, he doesn’t need to hedge it (but could with a short put)
  • short call, he can hedge it with a long call
  • short put, he can hedge it with a long put
  • pay fixed, receive floating swap, he can hedge it with a short interest rate forward
  • receive fixed, pay floating swap, he can hedge it with a long interest rate forward

It wouldn’t do to try to hedge a short option position (call or put) with a futures position; you’d essentially be trading a short call for a short put or vice-versa.

#5

As above but watch for convexity bias further down the curve.

NB you can arrange the basic futures-FRA-Swap relationship into a 3x3 matrix if it helps you remember. The futures are the only one you do the opposite of what you think because of the pricing convention is 100-rate.

#6

yes he can but maybe your not getting what i am trying to say…

lets say 1 am an englishmen and have imported some cars for which i have $50000 payable after 3 months…i am afraid of dollar rising against the pound…so i come to you(who is an OTC dealer) and we set a Forward contract where i will buy 50000 from you 3 months later at a set price say 1=.55pound…now my exposure to forex markets has gone away…but now u have that exposure and you need to hedge yourself from that,which can be done in 2 ways(there might be more am just asking the two most common ones)

1)you find another businnesman in usa(or an OTC dealer) who has pound payable after 3 month and you enter into an otc contract to sell him pounds 3 months later at a rate of 1$=.53 pounds…so u basically earned .02 pounds per dollar amount of the contract. This method makes all the sense and i have no querries whatsoever in this regard.

2)The curriculum says the OTC dealer can offset there risk by enterring the futures market.So in this particular situation you will buy the futures(againt the pound).Now for you to profit from the transaction you must find such exchnage rates that even after incurring all the transaction cost the exchange rate you find in the exchange is less than 0.55pound/.Now suppose such an exchange rate does exist why in the world Did i approach you when i could have bought the Futures at a more profitable rate in futures market(say 1$=.54pounds) against your 1%=.55 pounds.

thanks

#7

You didn’t understand it correctly. If I am a dealer, I have two customers-you and some xyz. You take a long with me as counterparty; xyz takes a short with me as counterparty. Essentially, I am hedged w.r.t both of you. Plus, I can charge both of you for assuming the counterparty risk- which is your brokerage costs. Note that it costs nothing to enter a forward contract, but then I never understood one thing- If it costs nothing to enter into a fwd contract, I might run away at maturity if I am the one who is losing. How does the dealer take care of counteroarty risk in that case?

#8

Margin account.

#9

I thought margin account was only for the futures market. Thanks for adding.

#10

Futures accounts always have margin accounts.

Forwards can have, if the parties agree. (They can do pretty much anything if the parties agree.) If I were dealing with someone I thought would run away, I’d insist on a margin account (or some sort of collateral).

#11

Cool!

#12

All of these are crap answers to original example, especially where FX is concerned. If a dealer enters into a forward transaction with a client, he has many options to offset his exposure. The most common way that outright FX forwards are offset is the interbank FX swaps market. (If you think about it an FX swap is equivalent to a loan in one currency vs borrowing in another, but don’t go into hedging the rate risks).

Back to mee20’s example and section 2 how to offset the exchange risks of a long 3m GBP/USD exposure. Yes a simplistic answer might be to sell the GBP/USD future. But it is unlikely the future has the exact same settlement date of the forward, maybe this is why the end user wanted to trade OTC in the first place. So adjustments would be needed to price it. Also, the notional on the future might be different and not divisible. Also, the variation margin on the future will not be offset daily by the mark on the forward position.

Another answer might be to lay off the risk into an option on forward GBP/USD. There are a multitude of possible strategies and options, whatever - the point is the dealer may already be holding an inventory or have a view on the vol.

The swaps answer would mean selling spot GBP/USD, which combined with the long forward position makes the dealer long the swap - this is synthetically equivalent to lending GBP for 3 months and simultaneously borrowing USD so he/she is exposed to the risk of sterling rates falling relative to USD rates. You could trade out of the swap.

Interest rate examples are more straight forward. For example if you expect to receive a floating rate interest payment in the future, sell the FRA or buy the future (you fix the rate to where it currently trades). If you expect to receive a series of floating rate payments sell the sawp - pay floating rate and receive fixed. If you are a bank and have a long forward-forward (lend for 3 months in 3 months time), then you are overborrowed and are positioned for rates to rise. To offset the risk in the derivatives market you could sell a FRA or buy futures.

#13

thanks…finally got the answer