FINANCIAL RISK MANAGEMENT

Financial Risk Management

Financial Risk Management

Answer 1.1

Date

08-Jan-10

11-Jan-10

12-Jan-10

13-Jan-10

14-Jan-10

15-Jan-10

Price

$ 113,610

$ 115,180

$ 112,720

$ 112,950

$ 113,130

$ 113,580

[Source: http://markets.ft.com/tearsheets/performance.asp?s=1045492&ss=wsodIssue]

The Future Gold Markets

The physical bullion markets repel private bullion investment for reasons of cost, transparency and convenience. Because of this, and the more short term requirements of gold speculators, there is a thriving gold futures market.

Futures Risks

Apart from the obvious risk of prices going the wrong way there is one key risk in futures trading, which is the risk of default during the period from trade to future settlement date - leaving someone entitled to a profit but unable to collect it.

This problem is mitigated by "margin". Margin is money futures investors deposit at the demand of the clearer who seeks to prevent the risk of default from growing too big. It is calculated by comparing the original deal to the current market value of what was traded. The process is called marking-to-market and it results in a margin call to the person who has speculated badly, while a margin surplus grows at the account of the successful trader. The margin is collected and managed by a clearer on behalf of the exchange.

Margin deposited only needs to cover the likely potential loss on the trade which could occur in the time it would take for the clearer to collect more margin. So, for example, on a $400 gold price it might be thought that $20 was the largest likely intra-day move, and that margin could be collected before the next trading day. So to keep off risk the clearer would require the investor to put up margin of 20/400, i.e. about 5% of the contracted deal size.

In practice the margin calculation will vary from exchange to exchange and from clearer to clearer. It is ultimately up to each firm to decide how it implements a margin policy and it's always a compromise between risk and the attractiveness of the product to the client. At any rate, the result is that speculators only have to pay a fraction of the value of the contract's amount - as a variable down-payment. Provided they close their position before expiry they will never have to put up the rest of the money.

This means that the aggressive speculator can 'gear-up' his position by trading many times more gold than he could ever afford to pay for, and this makes futures very popular with people who have an appetite for bigger risks.

Usually investors only have to deposit about 2% of the full value of gold they want to buy, but their broker will retain the right to close them out without instruction if the market moves viciously against them. Meanwhile on a daily basis investors must quickly top up margin if the market has moved a little against them.

That is the simple basis of futures trading. It is not particularly complicated and need not be risky, but there are some points which deserve special mention.

Answer 1.2

Cash Flow = Ending Equity - Beginning Equity

Margin Call = Beginning Equity x Maintenance Margin

Maintenance Margin ...