Chapter 5 - Exchanges and OTC Markets (FRM - Part 1 - Book 3)
Chapter 5 - Exchanges and OTC Markets
Chapter 5 - Exchanges and OTC Markets
Feature
Exchange-Traded Derivatives
OTC Derivatives
Terms
Standardized
Custom, negotiable
Maturity
Standardized
Negotiable, nonstandard
Liquidity
Strong
Weak
Credit Risk
Little (CCP guarantee)
High (bilateral)
1. What is the primary role of an exchange in derivatives trading?
A. To eliminate all market risks
B. To provide a central market with standardization and risk management functions
C. To lend money to trading entities
D. To offer physical delivery of all contracts
Exchanges offer a central and standardized marketplace for derivatives and also provide settlement and counterparty risk management functions.
2. What is the function of initial margin in the clearing process?
A. It acts as an upfront security deposit to mitigate against counterparty default
B. It is the daily profit or loss settled in cash
C. It represents the fee charged by exchanges
D. It is a tax paid to regulators
Initial margin is posted upfront to safeguard against potential default by a counterparty.
3. Which of the following best describes the role of netting in risk mitigation?
A. It guarantees profits from all trades
B. It is used to calculate brokerage fees
C. It consolidates multiple offsetting positions into a single payment
D. It replaces margining requirements
Netting reduces exposure by combining offsetting positions, resulting in a single net obligation.
4. What is the purpose of a central counterparty (CCP) in clearing?
A. To monitor insider trading activities
B. To lend money to defaulting counterparties
C. To replace brokers in all trades
D. To become the buyer to every seller and seller to every buyer, reducing credit risk
The CCP reduces credit risk by becoming the legal counterparty to both sides of a trade, eliminating direct exposure between trading entities.
5. What does variation margin represent in the clearing process?
A. Fixed fee charged during trade execution
B. Daily cash or asset transfers to reflect gains and losses
C. Monthly account maintenance charge
D. Tax levied on derivative transactions
Variation margin is transferred daily to settle mark-to-market profits or losses between counterparties.
6. Entity A owes $200,000 to Entity B, and Entity B owes $150,000 to Entity A. What will be the result of bilateral netting?
A. Entity A will pay $50,000 to Entity B
B. Entity B will pay $50,000 to Entity A
C. Both parties pay $200,000 each
D. No payments required
Under bilateral netting, mutual obligations are offset. Entity A's net obligation is $50,000 ($200,000 - $150,000).
7. Under no netting, Entity A has exposure of $3 million to B, and B has exposure of $2 million to A. If A defaults, what is B’s gross loss?
A. $1 million
B. $0
C. $3 million
D. $2 million
Under no netting, B is exposed to the full amount A owes ($3 million) regardless of what B owes A.
8. In a bilateral netting setup, if A owes B $6 million and B owes A $4 million, and A defaults, what is B's actual loss?
A. $6 million
B. $2 million
C. $4 million
D. $0
Bilateral netting reduces the gross exposure. B's net exposure to A is $2 million ($6M - $4M), so the loss is limited to $2 million.
9. Which of the following is true under multilateral netting with a CCP in place?
A. Each member settles directly with all other members
B. Margin requirements are eliminated
C. Exposures are calculated separately for each trade
D. All trades are cleared through the CCP, reducing exposure and simplifying settlement
A CCP nets trades across multiple members (multilateral netting), acts as the central counterparty, and simplifies credit risk and settlement processes.
10. In a multilateral setup with A, B, and C, if A defaults, and all trades are cleared via CCP, what is the loss to B and C?
A. Likely none, as the CCP absorbs the risk
B. B and C bear full losses of A’s exposure
C. B pays half and C pays half
D. B pays A’s total dues to the CCP
In a CCP-based multilateral netting system, members are not exposed directly to one another. The CCP manages defaults using margins and default funds.
11. What is the primary purpose of netting in financial markets?
A. To increase gross settlement obligations
B. To reduce counterparty risk and settlement obligations
C. To increase trading volumes
D. To avoid the need for margining
Netting helps reduce the number and value of payments between counterparties, thereby minimizing credit and settlement risk.
12. In a netting process, Entity X owes Entity Y $700,000 and Entity Y owes Entity X $500,000. What is the net obligation?
A. $700,000 from X to Y
B. $1,200,000 from Y to X
C. $200,000 from X to Y
D. $500,000 from Y to X
Netting reduces the mutual obligations to a single payment. Here, X pays Y the net difference of $200,000.
13. Which of the following best defines bilateral netting?
A. All members settle their trades with a central party
B. A system that avoids all credit risk
C. Netting across unrelated markets
D. Offsetting obligations between two counterparties
Bilateral netting consolidates trades between two entities, reducing exposure by offsetting payables and receivables.
14. What is the main difference between bilateral netting and multilateral netting?
A. Bilateral involves two parties, multilateral involves multiple parties via a CCP
B. Multilateral requires no settlement
C. Bilateral does not reduce risk
D. Multilateral increases credit exposure
Bilateral netting offsets obligations between two entities; multilateral netting uses a central counterparty to net across several parties.
15. Which of the following is NOT a benefit of netting in derivative markets?
A. Reduces operational complexity
B. Increases gross exposure
C. Lowers credit risk
D. Reduces number of settlements
Netting decreases, not increases, gross exposures and streamlines settlement processes.
16. What is the primary purpose of variation margin in futures trading?
A. To settle the full value of the contract upfront
B. To reduce trading frequency
C. To settle daily gains and losses due to price changes
D. To pay commission to brokers
Variation margin settles the daily mark-to-market profit or loss, ensuring no accumulation of unpaid gains or losses.
17. Entity A enters a long futures contract to buy 50 barrels of oil at $80 each. At day's close, the price drops to $78. What is the variation margin amount?
A. $50 gain
B. $2,000 gain
C. $100 loss
D. $100 loss
Loss = (50 units × $2 drop) = $100. Entity A (the buyer) pays this amount to the CCP.
18. Which of the following best describes daily settlement in futures contracts?
A. Each day's profit or loss is settled before the next trading day
B. It occurs only on expiry of the contract
C. Settlements are made weekly
D. Only net gains are settled periodically
Daily settlement ensures all changes in contract value are settled at the end of each day, reducing default risk.
19. Entity Z has a short futures position on 200 units of silver at $25 per unit. The next day, the price falls to $24.20. What happens?
A. Entity Z pays $160 to CCP
B. Entity Z receives $160 as variation margin
C. Entity Z receives $20 as commission
D. Entity Z's position is automatically closed
Price drop benefits the short position. Gain = 200 × $0.80 = $160, which the CCP pays to Z, collected from the long counterparty.
20. Which of the following is true about the CCP in a variation margin process?
A. It accumulates profits and pays losses from its own funds
B. It charges variation margin at the end of the contract
C. It receives and redistributes cash flows between long and short positions daily
D. It ensures only short positions pay variation margin
The CCP collects variation margin from the losing party and pays it to the gaining party every day, keeping net cash flow at zero.
21. What is the primary purpose of the initial margin in futures contracts?
A. To increase broker profit
B. To pay daily losses to the exchange
C. To eliminate credit risk completely
D. To protect the CCP from potential losses if a member defaults
The initial margin is collected to ensure the CCP has funds to cover losses in case a member fails to meet obligations.
22. Member A posts ₹10 lakh worth of T-bills as initial margin. The CCP applies a 5% haircut. What is the effective margin amount considered?
A. ₹9.5 lakh
B. ₹10 lakh
C. ₹10.5 lakh
D. ₹0
The haircut reduces the value of securities. ₹10 lakh – 5% = ₹9.5 lakh is considered as usable margin.
23. A member fails to pay ₹1,00,000 variation margin. The initial margin was ₹80,000. What source does the CCP use next to cover the loss?
A. Other members’ margins
B. Exchange reserves
C. Default fund contribution of the defaulting member
D. Interest earned on the initial margin
Once the initial margin is exhausted, the member’s own default fund contribution is used before tapping into other sources.
24. A trader has a short October futures contract and a long December contract in the same asset. Which of the following is most likely TRUE?
A. Both contracts require separate margins with no adjustment
B. Margins may be reduced due to offsetting risks between the two contracts
C. Margins are doubled to protect against volatility
D. Only the longer-dated contract requires margin
Opposing positions in related contracts allow the CCP to apply netting, potentially reducing margin requirements.
25. Which of the following is TRUE regarding interest on margins held by the CCP?
A. CCPs pay interest on initial margin but not on variation margin
B. CCPs pay interest on all margin types
C. Interest is never paid on margins
D. CCP pays interest only on securities margins
Only initial margins typically earn interest. Variation margins are just transfers for mark-to-market gains/losses.
26. Which of the following is a key feature of exchange-traded derivatives?
A. Fully customized terms and conditions
B. Standardized contract terms and central clearing
C. Privately negotiated settlement
D. No involvement of central counterparty
Exchange-traded derivatives are standardized and centrally cleared by a CCP, enhancing transparency and risk mitigation.
27. Which of the following best describes OTC derivatives?
A. Highly liquid contracts cleared through CCPs
B. Standard contracts listed on regulated exchanges
C. Bilaterally negotiated contracts with customization
D. Contracts traded only between brokers
OTC derivatives are tailored contracts negotiated directly between parties, without standard terms or centralized clearing.
28. What is the role of a CCP in the exchange-traded derivatives market?
A. Provides investment advice to traders
B. Matches buyers and sellers directly
C. Issues new derivatives contracts
D. Acts as the central counterparty to reduce counterparty risk
CCPs step between buyers and sellers, ensuring each side honors their trade obligations and managing credit risk.
29. Which of the following is a drawback of traditional OTC derivative contracts?
A. Higher counterparty credit risk due to bilateral settlement
B. Too much regulation makes them inefficient
C. Lack of customization options
D. Obligatory margin payments through CCPs
OTC derivatives are riskier because they are settled bilaterally without a CCP, exposing each party to default risk.
30. Why has there been a recent increase in the use of CCPs for OTC derivatives?
A. To allow for more customization in trading
B. To reduce systemic risk by centralizing clearing
C. To avoid margin requirements
D. Because bilateral clearing has become more popular
Regulatory reforms have pushed OTC derivatives into CCP clearing to reduce counterparty and systemic risk.
31. Which of the following classes of OTC derivatives had the highest notional principal outstanding as of December 2017?
A. Foreign exchange derivatives
B. Equity derivatives
C. Interest rate derivatives
D. Commodity derivatives
As of December 2017, interest rate derivatives had a notional principal outstanding of $426.6 trillion, representing 80% of the total notional principal of OTC derivatives.
32. Which OTC derivative class had the second-largest notional principal outstanding as of December 2017?
A. Equity derivatives
B. Foreign exchange derivatives
C. Credit default swaps
D. Commodity derivatives
Foreign exchange derivatives were the second-largest category, followed by credit default swaps.
33. Why can measuring OTC derivatives exposure through notional principal be misleading?
A. Because notional principal includes all transactions, not just the underlying assets.
B. Because it does not consider the risk of counterparty default.
C. Because notional principal does not reflect the transaction value.
D. Because notional principal does not account for coupon cash flows exchanged.
Measuring exposure through notional principal can be misleading because it does not take into account factors like coupon cash flows and transaction values.
34. Which of the following is typically a more useful measure for OTC derivatives than notional principal?
A. Total value of all outstanding contracts
B. Transaction value
C. Risk-weighted assets
D. Credit default swaps ratio
Transaction value is typically a more useful measure as it reflects the actual exchanged value rather than the notional principal, which can be misleading.
35. What is a key risk associated with interest rate swaps in OTC derivatives?
A. Counterparty default risk on the exchanged coupon cash flows
B. Risk of principal loss due to price fluctuation
C. Risk of illiquidity in the market
D. Risk of excessive margin calls from the counterparty
In interest rate swaps, counterparty default risk is a concern since only the coupon cash flows are exchanged, and one party may default on its obligations.
36. What does a negative value in an interest rate swap indicate?
A. The party is paying more interest than the other party
B. The transaction has no value
C. The swap has a negative value for one party
D. The swap is profitable for both parties
A negative value in an interest rate swap indicates that one party may have to pay more than expected, especially in the case of counterparty default or unfavorable market conditions.
37. Why are margin accounts required for short positions in stock options?
A. To limit the profit made by the seller
B. To ensure early settlement of the option
C. To mitigate the risk of being obligated to transact at an unfavorable price
D. To hedge interest rate fluctuations
Short positions in options expose traders to the risk of being forced to buy or sell at unfavorable prices. Margin ensures the trader can meet these obligations.
38. What is the typical margin requirement for a short sale?
A. 150% of the stock price
B. 100% of the stock price
C. 50% of the stock price
D. 125% of the stock price
A margin of 150% is typically required for short sales, which means the trader must post an additional 50% of the stock price.
39. What is the purpose of a maintenance margin in short sales?
A. To pay interest on cash balances
B. To allow the short seller to borrow shares
C. To settle the trade at maturity
D. To ensure the margin account balance does not fall below a minimum level
The maintenance margin ensures that the trader maintains enough funds to cover potential losses; if the balance drops below this level, a margin call is made.
40. What is a variation margin in the context of margin trading?
A. The amount of profit made from a trade
B. The additional funds required to bring the margin account back to the initial margin
C. The difference between buying and selling price
D. A fee charged for holding a position overnight
A variation margin is the amount an investor must add to the margin account to restore it to the initial margin level when it falls below the maintenance margin.
41. An investor buys 400 shares at $50 each using 60% initial margin. What is the total amount borrowed from the broker?
A. $12,000
B. $10,000
C. $8,000
D. $6,000
Total purchase = 400 × $50 = $20,000. Initial margin = 60%, so investor puts $12,000. The borrowed amount = $20,000 − $12,000 = $8,000.
42. An investor purchases 300 shares at $60 with 50% margin. If the stock drops by $10, what is the new margin account balance?
A. $7,000
B. $6,000
C. $5,000
D. $4,500
Initial value = 300 × $60 = $18,000. Margin = $9,000, borrowed = $9,000. If price drops $10, new value = $15,000. Margin balance = $15,000 − $9,000 = $6,000.
43. After a price fall, the share value is $13,000 and borrowed amount is $10,000. What is the margin ratio?
44. A margin call is triggered when stock value falls below $11,250 and the required maintenance margin is 25%. If current margin is $2,000, how much variation margin is needed?
A. $1,750
B. $2,125
C. $2,500
D. $812.50
Required margin = 25% × $11,250 = $2,812.50. Current margin = $2,000, so variation margin = $812.50.
45. In bilateral OTC markets, if Party A has a mark-to-market loss of $250,000 by end of day, how is collateralization used to manage the risk?
A. Party A will receive $250,000 in cash as margin
B. Party A must pay $250,000 in cash to Party B
C. Party B must pay $250,000 in cash to Party A
D. No payment is required until maturity
Under collateralization, the party with a mark-to-market loss (Party A) must pay the loss amount to the counterparty (Party B) to manage credit risk.
46. A trader has a collateral agreement that requires daily settlement. If their position gains $75,000, what happens?
A. The trader will receive $75,000 in cash
B. The trader must deposit $75,000 in cash
C. The trader must roll over the position
D. No action is taken
The daily settlement feature of collateralization ensures gains are realized in cash daily. Hence, the trader will receive $75,000.
47. A parent firm with a BBB rating wants to issue securities for a project but aims to reduce funding costs. What strategy is most suitable?
A. Issue debt directly under its name
B. Take a bank loan at a high interest rate
C. Create an SPV and issue securities through it
D. Issue equity instead of debt
SPVs are created to improve creditworthiness and reduce funding costs. The SPV may get a AAA rating, better than the parent firm.
48. An SPV pools mortgage loans and issues securities. If mortgage default rates rise, what is the likely impact on investors?
A. Higher interest payouts to compensate
B. No change, SPV shields investors from risks
C. Investors receive shares in the underlying properties
D. Cash flows to investors will reduce
In structured finance, investors are exposed to credit risk of the underlying pool. Defaults reduce available cash flow, affecting investor payments.
49. In OTC markets, to mitigate risks from selling options, a trader must deposit margin equal to:
A. 50% of option value plus interest
B. 25% of option value and a stock spread
C. 100% of option value plus a spread based on stock price or strike
D. Only the intrinsic value of the option
Central counterparties (CCPs) require full coverage of the option value plus additional margin based on volatility or strike levels to prevent default risk.
50. A trader executes a short sale at $80. If the price increases to $90, what happens to the margin account?
A. The margin balance increases by $10 per share
B. The margin balance decreases by $10 per share
C. No change, as profit is realized
D. The trader gains $10 per share
In a short sale, rising stock prices create a loss for the trader, reducing the margin account value.
51. A short sale triggers a margin call when:
A. The stock price falls below the exercise price
B. The trader fails to borrow the shares
C. The broker increases the interest rate
D. The margin account falls below the maintenance margin
A margin call occurs when the trader’s margin balance is insufficient to cover the required maintenance level, often due to adverse price movements.
52. An investor buys shares worth $50,000 using 60% margin. What is the amount borrowed from the broker?
A. $20,000
B. $20,000
C. $30,000
D. $60,000
If 60% margin is used, the investor contributes $30,000 and borrows the remaining $20,000 from the broker.
