P1.T3. Financial Markets and Products Bionic Turtle FRM Practice Questions Chapter 5. Exchanges and OTC Markets

Licensed to Christian Rey Magtibay at christianrey_magtibay@yahoo.com. Downloaded August 22, 2021.
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P1.T3. Financial Markets and Products
Bionic Turtle FRM Practice Questions
Chapter 5. Exchanges and OTC Markets
By David Harper, CFA FRM CIPM

www.bionicturtle.com
P1.T3.601. THE NEED TO CLEAR DERIVATIVES ......................................................................... 3

P1.T3.602. OVER THE COUNTER (OTC) DERIVATIVES ................................................................ 7
P1.T3.709. FUTURES CONTRACTS (CONTINUED) ....................................................................... 9
P1.T3.146. COLLATERALIZATION IN THE OVER-THE-COUNTER (OTC) MARKET ............................12
2

P1.T3.601. The Need to Clear Derivatives
P1.T3.602. Over the counter (OTC) derivatives
P1.T3.601. The Need to Clear Derivatives

Learning Objectives: Describe how exchanges can be used to alleviate counterparty risk.
Explain the developments in clearing that reduce risk. Compare exchange-traded and
OTC markets and describe their uses.
601.1. An exchange is a central financial center where parties can trade standardized contracts.
An exchange performs the following three key functions: product standardization, trading venue,
and reporting services. An exchange is different than a clearinghouse, however. An exchange is
a trade execution venue but clearing reduces counterparty risk (see http://trtl.bz/1ZZ7y7I). With
respect to the need for clearing and the reduction in counterparty risk, Gregory reviews the
following three definitions for clearing, margining and netting (although not necessarily in that
order):
I. The reconciling and resolving of contracts between counterparties and it occurs between
trade execution and settlement
II. This involves the offsetting of contracts, which is useful to reduce the exposure of
counterparties and the underlying network to which they are exposed
III. This involves exchange members receiving and paying cash or other assets against
gains and losses in their positions and providing extra coverage against losses in case
they default
IV. The completion of all legal obligations; e.g., when all payments have been successfully
made or the contract has been closed out
Which of the following is CORRECT?
a. I. refers to netting
b. II. refers to margining
c. III. refers to clearing
d. IV. refers to settlement
601.1. An exchange is a central financial center where parties can trade standardized contracts,
explains Gregory1. An exchange performs the following three key functions: product
standardization, trading venue, and reporting services. An exchange is different than a
clearinghouse, however. An exchange is a trade execution venue, but clearing reduces
counterparty risk (see http://trtl.bz/1ZZ7y7I).
With respect to the need for clearing and the reduction in counterparty risk, Gregory reviews the
following three definitions for clearing, margining and netting (although not necessarily in that
order):
1
John Gregory, Central Counterparties: Mandatory Clearing and Bilateral Margin Requirements for OTC
Derivatives (New York: John Wiley & Sons, 2014)
3
I. The reconciling and resolving of contracts between counterparties and it occurs between
trade execution and settlement
II. This involves the offsetting of contracts, which is useful to reduce the exposure of
counterparties and the underlying network to which they are exposed
III. This involves exchange members receiving and paying cash or other assets against
gains and losses in their positions and providing extra coverage against losses in case
they default
Which of the following is CORRECT?
a) I. refers to netting
b) II. refers to margining
c) III. refers to clearing
d) None of the above is correct
4
601.2. Consider the four counterparties illustrated below on the left (A, B, C and D) which
illustrates their initial bilateral credit exposures. An arrow indicates the direction of money owed.
For example, Counterparty D has a credit exposure of 100.0 to Counterparty C, while
Counterparty B has an exposure of 100.0 to entity D. Clearing rings can reduce bilateral
exposure.
As Gregory writes, "Clearing rings were relatively informal means of reducing exposure via a
ring of three or more members. To achieve the benefits of ‘ringing’, participants in the ring had
to be willing to accept substitutes for their original counterparties. Rings were voluntary but once
joining a ring, exchange rules bound participants to the ensuing settlements. Some members
would choose not to join a ring whereas others might participate in multiple rings. In a clearing
ring, groups of exchange members agree to accept each other’s contracts and allow
counterparties to be interchanged."2 In the OTC derivative market, the historical function of a
clearing ring is essentially performed by compression.
Assume a clearing ring achieves the configuration above on the RIGHT. Which of the following
is NOT NECESSARILY true about this application of the clearing ring?
a) Counterparty risk has been reduced

b) Counterparty A is indifferent (unaffected)
c) Counterparty B is indifferent (unaffected)
d) Counterparty D benefits
601.3. In a comparison between exchange-traded derivatives and over-the-counter (OTC)

derivatives, which of the following statements is TRUE?
a) Customized OTC derivatives are exotic and exotic products are not socially useful
b) Compared to an exchange-traded derivative, a customized OTC derivative offers better
liquidity but greater basis risk
c) Due to the leverage inherent in customized OTC derivatives, the total market value of
OTC derivatives is nearly 100% of their gross notional outstanding
d) Compared to an exchange-traded derivative, a disadvantage of OTC derivatives is their
relative lack of fungibility; i.e., difficulty in unwinding position or assigning to another
counterparty
2
5
Answers:
601.1. D. Settlement refers to "the completion of all legal obligations and can occur when
all payments have been successfully made or alternatively when the contract is closed
out; e.g. offset against another position." ... or simply "when all obligations are effected."
In regard to A, B and C each is false because: I = Clearing; II = Netting; and III = Margining.
Clearing occurs between execution and settlement. Margining refers to either initial or variation
margin. Netting refers to the offsetting of contracts.
601.2. C. False: While Counterparty A is unaffected and Counterparty B's exposure

remains 100, Counterparty B's exposure has switched from Counterparty D to
Counterparty C.
In regard to (A), (C) and (D), each is TRUE.
601.3. D. TRUE: Compared to an exchange-traded derivative, a disadvantage of OTC

derivatives is their relative lack of fungibility; i.e., difficulty in unwinding position or
assigning to another counterparty
The primary advantage of OTC products is that counterparties can tailor their contracts to match
their specific needs; e.g., risk, return, cash flow. This advantage is what is meant by the low
basis risk afforded to customized contracts. On the other hand, because OTC products are not
standardized, they lack fungibility. This is related to their relative illiquidity.
Discuss in forum here: https://www.bionicturtle.com/forum/threads/p1-t3-601-the-need-to-

clear-derivatives-gregory.9277/
6
P1.T3.602. Over the counter (OTC) derivatives

Learning Objectives: Identify the classes of derivatives securities and explain the risk
associated with them. Identify risks associated with OTC markets and explain how these
risks can be mitigated.
602.1. Which OTC derivatives class has the LARGEST amount of gross notional outstanding?
a) Equity derivatives
b) Credit default swaps
c) Interest rate derivatives
d) Foreign exchange derivatives
602.2. Among the following, what is the MOST COMMON method for quantifying counterparty
risk into the price of a transaction?
a) Novation
b) Vertical setup
c) Trade compression
d) Credit value adjustment (CVA)
602.3. In regard to lessons of the global financial crisis (GFC), Gregory writes, "The OTC
derivative market developed other mechanisms [i.e., in addition to netting and margin
requirements] for potentially controlling the inherent counterparty and systemic risks they create.
Examples of these mechanisms are SPVs, DPCs, monolines and CDPCs. Although these
methods have been largely deemed irrelevant in today’s market, they share some common
features with CCPs and a historical overview of their development is therefore useful ... The
concepts of SPVs, DPCs, monolines and CDPCs have all been shown to lead to certain issues.
Indeed, it could be argued that as risk mitigation methods they all have fatal flaws, which
explains why there is little evidence of them in today’s OTC derivative market. It is important to
ask to what extent such flaws may also exist within an OTC CCP, which does share certain
characteristics of these structures.3"
In regard to the lessons of the crisis and these mechanisms--i.e., SPV, monolines and CDPC--
each of the following statements is true EXCEPT which is false?
a) A special purpose vehicle (SPV) transforms counterparty risk into legal risk
b) A key difference between CCPs and monolines/CDPCs is that CCPs require initial and
variation margin in all situations
c) A central counterparty (CCP) would almost certainly have prevented AIG by clearing
their trades and disbelieving their inflated AAA ratings
d) A key difference between CCPs and monolines/CDPCs is that CCPs have a "matched
book" and do not take any residual market risk (except when members default)
3
7
Answers:
602.1. C. Interest rate derivatives
Interest rate derivatives consistently swamp (i.e., contribute the majority of) all other categories.
Perhaps the best source is BIS https://www.bis.org/statistics/about_derivatives_stats.htm
602.2. D. Credit value adjustment (CVA)
Although historically banks treated counterparty risk in various ways, the modern approach is to
price counterparty risk into transactions specifically with a credit value adjustment (CVA).
Consequently, CVA is a sub-topic in the FRM Part 2, Topic 6 (Credit risk).
602.3. C. False, see below.
Gregory argues central counterparties (CCPs) would not have prevented AIG’s role in the global
financial crisis (CFC). He points out that pretty much all institutions believed that AIG was an
excellent counterparty with very good credit. There is no reason to suspect that a CCP would
have better insight than everybody else who trusted the inflated AAA ratings.
In regard to (A), (B) and (D), each is TRUE.
Discuss in forum here: https://www.bionicturtle.com/forum/threads/p1-t3-602-over-the-

counter-otc-derivatives-gregory.9286/
8
P1.T3.709. Futures contracts (continued)

Learning objectives: Explain the convergence of futures and spot prices. Describe the
role of a clearinghouse in futures and over-the-counter market transactions. Describe the
role of collateralization in the over-the-counter market and compare it to the margining
system. Identify the differences between a normal and inverted futures market. Evaluate
the impact of different trading order types.
709.1. Barbara is a value investor who bought 1,000 shares of Apple (ticker: AAPL) in 2014
when the share price was $95.00 and she considered them under-valued. In hindsight, her view
was correct as the shares currently (as of mid-2017) trade at $140.00. She now thinks the
shares are slightly over-valued. However, she does not want to sell them unless there is a
market crash. This is because she believes the shares are likely to trade in a range and may
even gain modestly in the future. However, she also believes there is something like a 10.0%
probability of a technology sector crash (a possibility enabled by the low interest rate regime). If
the technology sector does crash, she fears the AAPL shares could plummet. If the AAPL
shares drop, Barbara does wants to sell, however she does not want to sell in a panic at fire-
sale prices.
Specifically, if the shares were to quickly lose more than 13.0% of their current value, Barbara
will be eager to sell them. However, she also wants to ensure that she realizes a minimum
holding period return (HPR) of 30.0%; and to this HPR dividends have already contributed
6.0%. Therefore, she only wants to sell if the price appreciation (from her $95.00 cost basis) is
at least +24.0%. She justifies this conditional view on a belief that if the shares plunge too far
such that she cannot realize her HPR threshold, the market will have overreacted. In this case
of an over-reaction, she believes it will be better to avoid selling in a panic and instead she will
be better off to await an eventual recovery. Which of the following orders is most consistent
with her strategy?
a) A market order
b) A limit order at $121.80 plus a market order at $135.57
c) A stop-limit order with stop at $121.80 and limit at $117.80
d) Two stop-loss orders: a soft-stop at $121.80 and a hard-stop at $105.00
709.2. Each of the following statements about futures and/or forwards is true EXCEPT which is
false?
a) Margin requirements are the same on short futures positions as they are on long futures
positions.
b) In the case of a futures contract, initial margin typically does earn interest, but variation
margin does not
c) When an exchange clearinghouse or central counterparty (an OTC CCP) accepts a
transaction, it both cases it assumes the credit risk of both buyer and seller
d) The delivery period is the same across commodities and exchanges, in order to prevent
arbitrage, but the buyer (i.e., the long position) gets to make the decision on exactly
when to receive delivery within the delivery period
9
709.3. Which statement is TRUE about the shape of the commodities forward curve?
a) In a normal market (aka, contango), the basis is positive

b) In an inverted market (aka, backwardation) the basis is negative
c) An inverted market (aka, backwardation) might be explained by negative interest rates
but does not necessarily imply negative rates
d) In a contango (aka, normal) market with a static forward curve, the price of a futures
contract will INCREASE as time to maturity approaches zero
10
Answers:
709.1. C. True: A stop-limit with a stop at $121.80 and a limit at $117.80. The stop is set
13.0% below the current price and the limit ensures a 30.0% HPR as (117.8 - 95.0)/95.0 =
24.0%.
In regard to (A), (B) and (D) each is false

 In regard to (A), a market order is carried out immediately (but Barbara does not want
to sell unless there is a crash)
 In regard to (B), this choice doesn't make sense: the limit order (to sell) is so far below
the current price that it can be immediately executed
 In regard to (D), there is no such thing as a soft- versus hard-stop
709.2. D is doubly false. Delivery periods are defined by the exchange and vary by
contract. Also, the short position gets to make the decision on exactly when to receive delivery
within the delivery period
In regard to (A), (B) and (C), each is TRUE.
709.3. C. True: An inverted market (aka, backwardation) might be explained by negative

interest rates but does not necessarily imply negative rates. This is because the full cost of
carry model is given by F(0) = S(0)*exp[(r + u - q - y)*T] such that income and/or convenience
yield can explain backwardation.
In regard to (A), (B) and (D), each is FALSE.

 In regard to (A), contango is when F(0) > S(0) such that basis, B = S(0) - F(0,T), is
negative
 In regard to (B), backwardation is when F(0) < S(0) such that basis, B = S(0) - F(0,T), is
positive
 In regard to (D), in contango and a static forward curve, the forward price will decrease
as maturity approaches. This is why we say that during contango (backwardation) the
roll yield is negative (positive)
Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t3-709-futures-

contracts-hull-chapter-2-continued.10539/
11
P1.T3.146. Collateralization in the over-the-counter (OTC) market

AIM: Describe the role of collateralization in the over-the-counter market and compare it
to the margining system.
146.1 A company must post collateral with a financial institution and the threshold level (in the
collateralization agreement) is $10.0 million. Instead of cash, the company posts bonds as
collateral subject to a 15% haircut. The value of the contract, at the beginning of the day, is $9.0
million to the financial institution. By the end of the day, the marked-to-market value of the
contract to the financial institution has increased to $11.2 million. What is the impact on the
collateral?
a) No margin call
b) The company must post $1.41 million in cash
c) The company must post $1.02 million value in bonds
d) The company must post $1.41 million value in bonds
146.2 Which best describes the typical margin call in an over-the-counter (OTC) trade with a
bilateral collateralization arrangement?
a) The counterparty with negative current exposure must post collateral to the counterparty
with positive current exposure such that total collateral value net of haircuts exceeds the
threshold by the current exposure
b) The counterparty with positive current exposure must post collateral to the counterparty
with negative current exposure such that total collateral value net of haircuts exceeds
the threshold by the current exposure
c) The counterparty with negative potential future exposure (PFE) must post collateral to
the counterparty with positive PFE such that total collateral value net of haircuts exceeds
the threshold by the PFE
d) The counterparty with positive PFE must post collateral to the counterparty with negative
PFE such that total collateral value net of haircuts exceeds the threshold by the PFE
146.3 An over-the-counter (OTC) bilateral derivatives contract that employs a collateralization

agreement and a modest, non-zero threshold eliminates which risk(s)?
a) Counterparty risk
b) Market risk
c) Operational risk
d) None of the above
12
146.4 According to Hull4, which is true about the role of collateralization (collateral requirements)
agreements in the Long-term Capital Management (LTCM) case study?
a) LTCM was stuck with leveraged counterparties who could not post their collateral to
LTCM, which created a liquidity crunch for LTCM
b) The inability of leveraged LTCM to post collateral forced the close-out of positions at
steep loses; but, if the positions could have remained open, LTCM could have survived.
c) Prior to LTCM, there was neither widespread use of collateral nor ISDA standardization;
the LTCM case prompted both growth in use and development of ISDA documentation
d) Contrary to popular wisdom, Hull asserts that collateral arrangement played almost no
role (“de minimis”) in the LTCM case study
4
John C. Hull, Options, Futures, and Other Derivatives, 10th Edition (New York: Pearson Prentice Hall,
2017)
13
Answers:
146.1. D. The company must post $1.41 million in bonds. The company must post collateral
in excess of the threshold. In this case, $11.2 - $10 million = $1.2 million. The company can
post $1.2 million in cash (not a given answer!) or the company can post the bonds, but as they
have a 15% haircut, requires: $1.2 million / (1-15%) = $1.41 million; i.e., $1.4 million * 85% =
$1.2 million.
146.2. A. The counterparty with negative current exposure must post collateral to the
counterparty with positive current exposure such that total collateral value net of
haircuts exceeds the threshold by the current exposure
The counterparty with positive current exposure is the one whose gain is at-risk of default. The
party with negative mark-to-market therefore delivers the collateral. Current exposure is the
typical basis for exposure as that is based on the current mark-to-market value of the position;
PFE is future-oriented and highly dependent on model assumptions (there is no reason to
expect the counterparties to derive the same PFE).
146.3. D None of the above.

The threshold is similar to a line of credit and subject to counterparty (default) risk. Further,
collateralization does not eliminate operational and market risk.
146.4. B. The inability of leveraged LTCM to post collateral forced the close-out of
positions at steep loses; but, if the positions could have remained open, LTCM could
have survived.
Discuss in forum here: http://www.bionicturtle.com/forum/threads/l1-t3-146-collateralization-in-

the-over-the-counter-otc-market.4391/
14

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P1.T3. Financial Markets and Products

Bionic Turtle FRM Practice Questions

Chapter 5. Exchanges and OTC Markets

By David Harper, CFA FRM CIPM

Chapter 5. Exchanges and OTC Markets

P1.T3.601. THE NEED TO CLEAR DERIVATIVES ......................................................................... 3

Chapter 5. Exchanges and OTC Markets

P1.T3.601. The Need to Clear Derivatives

Which of the following is CORRECT?

Which of the following is CORRECT?

a) Counterparty risk has been reduced

601.3. In a comparison between exchange-traded derivatives and over-the-counter (OTC)

601.2. C. False: While Counterparty A is unaffected and Counterparty B's exposure

In regard to (A), (C) and (D), each is TRUE.

601.3. D. TRUE: Compared to an exchange-traded derivative, a disadvantage of OTC

Discuss in forum here: https://www.bionicturtle.com/forum/threads/p1-t3-601-the-need-to-

P1.T3.602. Over the counter (OTC) derivatives

602.1. C. Interest rate derivatives

602.2. D. Credit value adjustment (CVA)

602.3. C. False, see below.

In regard to (A), (B) and (D), each is TRUE.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/p1-t3-602-over-the-

P1.T3.709. Futures contracts (continued)

a) In a normal market (aka, contango), the basis is positive

In regard to (A), (B) and (D) each is false

In regard to (A), (B) and (C), each is TRUE.

709.3. C. True: An inverted market (aka, backwardation) might be explained by negative

In regard to (A), (B) and (D), each is FALSE.

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t3-709-futures-

P1.T3.146. Collateralization in the over-the-counter (OTC) market

146.3 An over-the-counter (OTC) bilateral derivatives contract that employs a collateralization

146.3. D None of the above.

Discuss in forum here: http://www.bionicturtle.com/forum/threads/l1-t3-146-collateralization-in-

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