Chapter 18 notes 2012 08 05


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Chapter 18 notes 2012 08 05

  1. 1. finlogIQ Knowledge for financial IQ STRICTLY PRIVATE AND CONFIDENTIALChapter 18Extended Settlement ContractsAugust 2012
  2. 2. Chapter summary and outlineThis chapter outlines the features of ES contracts, what types ofinvestors would invest in ES contracts, risks, contractspecifications, trading and settlement, calculation of profit andloss, mark-to-market, margining, managing positions and contra andmargin financing and what types of investors would not invest in EScontracts.Chapter outline:• What is an extended settlement (ES) contract?• What type of investors would invest in ES contracts• Risks of trading ES contracts• Contract specifications and trading and settlement of ES contracts• Calculation of profit and loss for ES contracts• Marking-to-market and margining• Managing positions• Comparing ES contracts with contra and margin financingfinlogIQ 2
  3. 3. What Is An Extended Settlement Contract(ES)?• An ES contract is a stock market transaction between two parties – a buyer and a seller• Contract contains details of the transaction: – The specific quantity (e.g. 1,000) of; – The specific security (e.g. Company A‟s shares) at; – The specific price (e.g. $10.00) for final settlement at; – The specific future date (i.e. when the contract matures or expires)• Investor taking a long position in an ES contract has the intention to purchase the underlying shares – Investor is not required to hold the position to maturity and may choose to liquidate the position through an offsetting trade in the same ES contract. – At expiration, if the position has not been offset, the contract is settled by physical delivery at the contracted price.• Investor taking a short position sells an ES contract to dispose the underlying security. – Can choose to close out the position through an offsetting trade in the same ES contract before expiration or settle by physical delivery to the buyer at the contracted price.• In Singapore, ES contracts are classified as futures contractsfinlogIQ 3
  4. 4. What Types of Investors Would Invest in ESContractHedgers• Use ES contracts to manage their cash market exposure by holding underlying stock and selling ES contracts to lock in prices.Speculative Investors• Trade ES contracts for capital gains with the benefit of leverage as well as an extended period for settlementArbitrageurs• Seek to take advantage of market inefficiencies by making simultaneous trades that offset each other and capture risk-free profits.finlogIQ 4
  5. 5. Risks of Trading ES ContractsLeverage• High degree of leverage in ES contracts magnifies gains as well as losses• Loss in percentage terms will be higher than the percentage price movement in the underlying asset.Example:The initial margin of an ES contract on Company ABC stock is 10% of the totalunderlying value. The table below shows the impact of a 5% change in price onthe ES investor.finlogIQ 5
  6. 6. Risks of Trading ES Contracts - 2Margin Calls• Entering into an ES contract, investor has to put up “Initial margin”• If market moves against the investor or margin levels are increased - additional funds at short notice to maintain the position in the ES contract• If investor fails to comply with a request for additional funds, broker may liquidate the position – Investor will be liable for any resulting deficit in the account• Risk in trading ES contracts is not just limited to initial margin deposit but to the entire downside of the fall in value of the underlying stock.Liquidity• No assurance that a liquid market will always exist for an ES contract.• Illiquid market can occur - few willing buyers and sellers – Can increase the risk of loss by making it difficult or impossible for an investor to liquidate an open position in the ES contract• Indicators of liquidity: – Volume of trading – Open interest (the number of open ES positions still remaining to be liquidated by an offsetting trade or satisfied by delivery of stock).finlogIQ 6
  7. 7. Risks of Trading ES Contracts - 3Volatility• Impact of market volatility on risk-return profile of the portfolioBuying-In• Taking a short ES position until contract expiration - investor is obligated to physically deliver the stock for settlement• If he does not have the required shares in his account on the due date, the Central Depository Pte Ltd (“CDP”) will buy-in shares on the market to satisfy the delivery obligation.• Buying-in starts the day after the due date (last trading day +4)Changes In Interests• Potential to translate into changes of interest in the underlying security• Position held in an ES contract therefore represents an economic interest in the underlying security and the Member and Trading Representative must record ES transaction in the register of securities.finlogIQ 7
  8. 8. Underlying Securities• General criteria for stock selection include: – Trading volume and market capitalisation – Sufficient liquidity – To mitigate the risks of market misconduct, such as market manipulation and cornering• In the event SGX decides, for any reason, that an underlying is no longer suitable for ES contracts, it shall: – Not list any new ES contract covering that underlying; – Have the discretion to prohibit Members from opening, or allowing their customers to open, any new position in the ES contract covering that underlying; – Have the discretion to direct Members to take action to offset, or require their customers to offset, any existing positions in the ES contract covering that underlying. – Remove any ES contract from quotation before the Last Trading Day (LTD) if all positions in such ES contracts have been offset. – If there are positions in such ES contracts that are not offset, SGX may require that such positions be cash settled immediately according to the terms prescribed by SGX, or restrict trading only to enable those positions to be offset.finlogIQ 8
  9. 9. Margin Requirement• Maintenance margin requirements• Outright and spread margins will be set in fixed tiers depending on stock volatility• Example: – For an ES on the shares of Company ABC, SGX may prescribe a 10% maintenance margin requirement. – This means that for an ES contract to buy or sell 1000 ABC Company shares priced at $10 each, the maintenance margin requirement is $1,000. – In addition, SGX has set minimum initial margins (IM) to be maintenance margins (MM) that is, it has prescribed an IM:MM ratio of 1. – However, Members are permitted to set higher margin requirements, including a higher IM:MM ratio than that prescribed by SGX.finlogIQ 9
  10. 10. Contract Months• ES contracts will commence trading on the 25th of the month that is immediately proceeding the spot month.• Each ES series will therefore have tenor of approximately 35 days.• By structuring the product this way, it provides a consistent overlap period for customers to „roll over‟ their positions in the ES contracts.finlogIQ 10
  11. 11. Settlement by Delivery of Underlying Securities• Settlement of ES contracts takes place by way of delivery of the underlying securities on the 3rd business day after the Last Trading Day.• At LTD+3, ES contracts are settled in the same manner as ready market contracts, and payment and receipt of the purchase and sale consideration respectively will take place in accordance with the current practice of the ready market.• If the seller of the ES contract does not have any or sufficient underlying securities of the ES contract on Settlement Date, CDP will commence buying-in of the underlying securities and the current procedures for buying- in under the CDP Clearing Rules will apply to such buying-in.finlogIQ 11
  12. 12. Corporate Actions• SGX may adjust the ES contract accordingly• Where the corporate action is widely anticipated (for instance dividend payout) and has a relatively small impact on the underlying, no adjustment will be made.• Adjustments may include early expiration of the respective ES contract.• In such a case, the Last Trading Day of the ES contract will be brought forward to a date before the ex-dividend date for the corporate action.Settlement Schedule through Depository AgentfinlogIQ 12
  13. 13. Use of Suspense Accounts and Sub-Accounts• Members must not: – Use suspense accounts to trade in ES contracts, and – Other than joint accounts, allow any account that has more than one beneficial owner to trade in ES contracts• Members will be permitted to use customer suspense accounts for trading of ES contracts provided that such accounts are used solely for the purpose of warehousing on an individual customer basis.• This means that one suspense account should not have more than one beneficial owner.finlogIQ 13
  14. 14. Contra Trades• ES series of the same underlying and contract month will be permitted for contra between the Member and its customers.• As soon as a contra is specified by the Member, the profit and loss can be settled immediately between the Member and customer as per the current contra procedures.• Members can choose to either: – Credit (debit) trust account with the profit (loss), and correspondingly debit (credit) the member‟s own cash balance (i.e. member‟s own money injected into the pool of customer margin collateral) manually; – Settle the profit and loss with the customer outside the system as per current practice.• For margins imposed by Member to customer, contra contracts will be excluded from margining.• However, margin calculation by CDP would include the contra contracts as settlement between CDP and Member for these contracts would only occur on LTD+3.finlogIQ 14
  15. 15. Clearing Fees and GST• A clearing fee of 0.04% on the value of the contract, subject to a maximum of SGD 600• Prevailing Goods and Services Tax (GST) on brokerage and clearing feesES Location on the Trading Screen• ES contracts will appear on the mainboard screen and located immediately after the respective underlying shares.finlogIQ 15
  16. 16. Calculation of Profit and Loss for ES contracts Examples do not take into account the broker‟s commissions or CDP clearing fees which are payable whenever the investor enters into an ES contracts tradefinlogIQ 16
  17. 17. Marking-To-Market And MarginingDaily Mark-to-Market• Process – At the end of each day, all open positions in ES contracts will be revalued or marked to their respective Valuation Prices by the CDP ie “marked-to-market”. – Main objective of carrying out MTM is to limit the exposure of CDP to price changes and prevent huge losses from accumulating until maturity of the ES contracts. – Must have sufficient funds or credit facilities in its accounts to cover MTM losses• Valuation Price – In calculating the mark-to-market losses or gains must use the Valuation Price as determined by SGX – Represents official price of ES contracts prescribed by SGX – Valuation Price of an ES contract affected by • The last traded price; • Bid and offer spread at the close of market; • Price data derived from pricing models, as selected or established by SGX from time to time.finlogIQ 17
  18. 18. Marking-To-Market And Margining - 2Key Margining Concepts• Initial Margins – Minimum amount required to be deposited by customers for positions in ES contracts. – The minimum amount is distinct from and in addition to the Variation Margins requirement which will also apply to the ES positions. – Must not allow a customer to incur any new trade in ES, unless the minimum Initial Margins for the new trade are deposited or the Members/Trading Representatives have reason to believe that the minimum Initial Margins will be deposited within 2 market days from the trade date. – Members must not under any circumstances enter into a financing arrangement with a customer in respect of that customer‟s margins requirements which would allow the customer to trade without meeting the margin requirements prescribed by SGX.finlogIQ 18
  19. 19. Marking-To-Market And Margining - 3Key Margining Concepts (cont)• Maintenance Margins – Component of Required Margins which must be maintained in a customer‟s account subsequent to the deposit of Initial Margins for that customer‟s positions in ES contracts. Required Margin = Maintenance Margin + Variation Margin – Computed by multiplying the prescribed margin rate with the value of the ES contract. – Contract value will be derived based on the last traded price of the underlying security in the ready market. – Initial margin is then computed by multiplying the maintenance margin by the IM:MM ratiofinlogIQ 19
  20. 20. Marking-To-Market And Margining - 4Key Margining Concepts (cont)• Variation Margins – That component of Required Margins comprising the mark-to-market gains and losses, in relation to the price at which the ES contract was bought or sold, arising from the daily valuation of the ES position. – Will have to be computed daily based on outstanding contract and Valuation Price including intra-day cycle on Settlement Day, i.e. LTD+3. – Variation Margins are not required for contra trades or if the Member permits a customer to realise a gain or loss pursuant to executing a trade to offset an existing position. – A profit in the ES will reduce the amount of Variation Margins while a loss will increase the amount of Variation Margins. – A mark-to-market gain from an ES trade may be used to offset other margin requirements of the same customer.finlogIQ 20
  21. 21. Margining on Gross Basis• CDP computes margin requirement on a gross basis.• Long and short positions belonging to different customers do not cancel each other out in the calculation of a Member‟s overall margin requirement.Example:• A Member carries 80 long contract positions and 100 short positions for two separate customer accounts.• Under gross margining, the Member would be margined by CDP for all 180 open positions.finlogIQ 21
  22. 22. Margin CalculationOutright MarginingExample 1: Margin Calculations – Outright MarginingBuying ES ContractsCompany: Company FQuantity: 1000finlogIQ 22
  23. 23. Margin Calculation - 2Spread Margining• When investors hold both a long and a short position in ES contracts of different contract months of the same underlying security, they only need to put up one side of the maintenance margin instead of two separate maintenance margin amountsfinlogIQ 23
  24. 24. Margins For Positions Which Have Been Offset• Variation Margins will be collected by CDP from Members for all trades.• Positions which have been offset will, under normal conditions, not require Maintenance Margins.• SGX permits Members to elect to pay gains to or collect losses from their customers earlier than LTD+3 where such customers have taken action to offset positions in ES contracts.Example 1:• Investor A makes a profit of $400 from buying and selling Company A‟s ES contracts.• The investor can use this profit to put up as margin for the next trade.• For instance, Investor A decides to purchase 5 lots of Company B‟s ES contracts, requiring him to put up a margin of $1,000.• Instead of putting up $1,000, Investor A can use the profits from the trading of Company A‟s ES contracts to offset.• Therefore, he will only need to top up $600.finlogIQ 24
  25. 25. Margins For Positions Which Have Been Offset-2Example 2: Margin Calculations - New PositionfinlogIQ 25
  26. 26. Acceptable Forms of Margin Collateral• Forms of collateral acceptable by CDP – Cash; – Letters of credit to the order of CDP in a form and from a bank acceptable to CDP (and in accordance with such procedures as may be prescribed by CDP); or – Any other instruments as may be approved by CDP from time to time, all of which must be and remain unencumbered.• Hair-cut rates prescribed by CDP – CDP will limit the acceptable forms of collateral that Members post to cash and letters of credit denominated in SGD.• Forms of collateral to be provided to members by their customers – Cash; – Government securities; – Selected common stocks• Haircut apply, where appropriate, to the particular form of collateralfinlogIQ 26
  27. 27. Margin Calls• If the Customers Asset Value falls below the Required Margins – Member and Trading Representative must call for additional margins from the customer to bring the Customer Asset Value to no less than the sum of Initial Margins and Variation Margins within 2 market days from the date the Customer Asset Value falls below the Required Margins. – “Customer Asset Value” refers to the moneys and market value of assets in a customer‟s account subject to such hair-cut as specified by SGX.finlogIQ 27
  28. 28. Margin Calls - 2Example 1:• The required margin when the valuation price is $9.50 is $1,450. Since the margin holding of the investor is $1,200, the investor will receive a margin call. However, the investor has to top up to the level of Initial Margin + Variation Margin, which adds up to $1,640. Therefore the margin call amount would be $440 ($1,640 - $1,200).finlogIQ 28
  29. 29. Margin Calls - 3Example 2:• Margin calls shall be made within one market day after the occurrence of the event giving rise to the margin calls.• If a Member or Trading Representative, as the case may be, is unable to contact a customer to call for margins, a written notice sent to the customer at the most recent address furnished by the customer to the Member shall be deemed sufficient.• Members may impose stricter requirements than those prescribed by SGX on Initial and Maintenance Margins, hair-cut rates for collateral, payment periods for customers to deposit collateral, and the frequency of valuations of customers‟ positions and collateral.• Trading Representatives are required to comply with such stricter requirements imposed by their Members.finlogIQ 29
  30. 30. Acceptance of Orders During Margin Call• Only allow a customer who has been subject to a margin call to incur a new trade when the additional margins are on deposit or forthcoming within two market days from the trade date or date on which the margin call is triggered (T+2).• After it calls for margins from a customer, if it fails to obtain the necessary margins from the customer by the close of the market on T+2: – The member will not accept orders for new trades for the customer. – orders which would result in the customer‟s Required Margins being reduced may be accepted by the Member or Trading Representative; – may take actions as the Member or Trading Representative deems appropriate, without giving notice to the customer, to reduce its exposure to the customer. – May include liquidation all or such part of the customer‟s collateral or taking action to offset all or such part of the customer‟s positions – Immediately take such action to offset all or such part of the positions of the customer to rectify the deficiency.finlogIQ 30
  31. 31. Acceptance of Orders During Margin Call - 2Definition of terms• Risk increasing trade – Establishment or closure of a position in an ES contract which increases a customer‟s Maintenance Margins requirements (e.g. closing one leg of a spread position);• Risk neutral trade – establishment of a position in an ES contract which does not impact a customer‟s Maintenance Margins requirements (e.g. spread trades that do not impact Maintenance Margins requirements);• Risk reducing trade – Closure of a position in an ES contract which reduces a customer‟s Maintenance Margins requirements (e.g. liquidation of a naked open position).finlogIQ 31
  32. 32. Acceptance of Orders During Margin Call - 3• During the period of T+1 and T+2 (i.e. within the T+2 Period) – If the Member or Trading Representative receives indication from the customer that margins are forthcoming within T+2:• During the period of T+1 and T+2 (i.e. within the T+2 Period) – If the Member or Trading Representative receives indication from the customer that margins are forthcoming after T+2 or that no funds are forthcoming:-finlogIQ 32
  33. 33. Acceptance of Orders During Margin Call - 4• During the period of T+1 and T+2 (i.e. within the T+2 Period) – Beyond the T+2 Period, allowable trading activity beyond the T+2 Period:-finlogIQ 33
  34. 34. Excess Margins• Refers to amount of Customer Asset Value in excess of the sum of the Initial Margins and Variation Margins.• May allow their customers to withdraw Excess Margins provided such withdrawal will not cause the deposited collateral or Customer Asset Value to be less than zero.Example:• Using the same illustration (Investor A in Company A shares), when the Valuation Price rose to $10.20, the margin holding for the customer is $1,640.• Excess Margin is the amount in excess of Initial Margins + Variation Margins = $616 ($1,640 - $1,024).finlogIQ 34
  35. 35. Excess Margins - 2finlogIQ 35
  36. 36. Reporting of Under-Margined Accounts• Members shall immediately notify the MAS and SGX when any account of a customer (other than the licensee‟s own proprietary account) does not comply with the Required Margins or is under-margined by an amount which exceeds the Member‟s aggregate resources.finlogIQ 36
  37. 37. Managing PositionsNew Position Reporting Requirement• As a safeguard against market manipulation and cornering: – report positions, at the customer level, which are in excess of certain prescribed thresholds.• Monitoring thresholds may be imposed on any account: and may include: – Maximum number of lots of long positions that have not been offset, in gross or net, in any ES contract; and – Maximum number of lots of short positions that have not been offset, in gross or net, in any ES contract.Global Position Limits• SGX will monitor the level of global or industry-wide positions throughout the ES contract life – Especially period leading up to the expiry of the contract – When delivery of the underlying will take place if the contracts have not been offset – Critical to management of settlement riskfinlogIQ 37
  38. 38. Managing Positions - 2Global Position Limits (cont)• Excessive positions threaten market integrity or create the risk of a cornered market in the underlying, SGX shall have the right to impose on the Member such measures as it deems necessary or desirable, such as: – Maximum number of lots of long positions that have additional margin requirements; – Offsetting existing positions• In determining the monitoring thresholds and appropriate risk management measures, considerations include: – Matters relating to any position, including the number of issued shares, free float, liquidity or volatility of the underlying; – Financial position of the Trading Member; – The Trading Member‟s credit exposure to a single customer; – Any such other factors that SGX deems necessary to maintain a fair, orderly and transparent market.finlogIQ 38
  39. 39. Comparing ES Contracts With Contra andMargin FinancingfinlogIQ 39