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FRM-1 Study Notes

Futures Exchange – Organization & Administration

  • Plays the role similar to a stock exchange. Defines the terms and conditions of the standardized futures contracts.
  • Most future exchanges are either membership organizations or shareholder form of organization
  • The exchange itself does not own any of the underlying commodities or instruments, and it does not take position in the futures or options contract
  • Exchange members – Only traders holding membership or trading rights or privileges on the exchange can participate in trading. Other traders must send their orders through a seat or trading rights. In an open-out-cry trading environment, various exchange members are:
    • Local – an exchange member who trades in the pit or ring, only for his own account
    • Scalper – an exchange member who buys and sells frequently, and creates liquidity
    • Term day trader – an exchange member who trades frequently, but has a flat position (zero) at the end of day
    • Floor broker – executes all the customers orders
    • Dual trading member – a member who trades for himself and also handles customer’s business
  • Clearing house – Guarantees performance on the exchange’s futures and option contracts. Settles gain and losses. And facilitates deliveries.
  • Clearing house acts as buyer to every seller and seller to every buyer.
  • Only a few exchange members are deemed as clearing house members. Applicants for clearing members have stringent financial and reputation requirements.
  • Original margin – The funds deposited by clearing members  with the clearing house  to support open contracts for clearance. Clearing members with customer accounts must set up two margin accounts: for customer margin account and clearing margin account (for its own funds).
  • Original margin requirement varies depending on the historical volatility of future prices
  • Variation margin – The funds paid to members who have gains on their future accounts; and collected from members who have losses on their accounts. It results due to daily marked to market of prices of futures contracts. (gain/loss = current settlement price – trade price)
  • Variation margin is collected/paid separately for the customer’s position and the clearing member’s own position.
  • Guaranty deposit – in addition to the original and variation margin provided by the clearing member for their own and customer’s accounts, the clearing member also maintains a guaranty deposit with the clearing house
  • Clearing house uses the guaranty deposit, to meet the financial obligation of a clearing member which defaults

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