Contd from Learning 3:
“Anyone who believes you can't change history has never tried to write his memoirs” says a famous Quote.
Well then am I here to write memoirs, I thought for a while. Well to make my thought simple, I again remembered another quote which says “A bad book is as much of a labor to write as a good one; it comes as sincerely from the author's soul”.
So, be it bad or be it good, I want to be sincere in translating my thought process. And let me not worry on how the write-up shapes up, but the article should reflect the immediate first thought and off course, if it could benefit some, then you are on a great road-track.
“So sir, it is great to note that you coming back to writing” Said J
I looked up while sipping my tea (supposed to be tea – as usual a tea kadai) and thought “When was I a full-fledged writer first”
Well, I was an editor of a house-journal in my previous concern and writing was one of my passion (not necessarily a forte), and it has been so- all through my years of growth and that was well reflected when I was working for this nice concern in Chennai. Being an IT professional and being a Project Manager, I was busy garnering more of business knowledge than executing the wonderful passion that I have. So, I decided that yes, it is time that I start writing.
M Joined us shortly. We took off to the nearby place where we settled in comfortably.
M: Sir, I was just wondering – rather pondering with one question that was put forth to me recently. It was a question at the grass root level, which I was not able to answer convincingly.
Me: What is that?
M: How do you elicit an example to showcase the risk in derivative trading?
Me: Haa..ha… ok – here it goes - Selling a contract with a derived value on top of an asset is similar to selling your CV with the contents derived from your experience. You might click sometime and you might not. Does this answer your question?
Both M and J gave out a loud laugh and I was sure that this should suffice a question of the order which is seldom put forth. (I would call it as a good basic question)
M: Last time, we discussed about Future contracts and the way it is traded in Exchange house. You promised that you will take a session on the exchange house protocols and other related concepts.
Me: That is right. I will do that. Btw- J – has M briefed you about Forwards and Futures.
J: Yes and further I read the blog as well. So, I am ready.
Me: Good. Primarily, There are two facets to how trading happens. One is called “OTC” and the other is called “Exchange house Governed” OTC stands for “Over the counter”. Contracts trading such as Forward contracts and Interest rate swaps come under OTC. Contracts such as Futures and Options come under Exchange house.
M: Ok…
Me: Basically, to ply in the Futures market, you need to open an account called “Margin”. Margin is an account to which where the traders will deposit a “Margin amount” as designated by the exchange house. This margin amount will be used as safe money, when the position of the contract falls on that day.
J: Sorry Narasimhan, I am not able to get it.
Me: Ok, let me make it more lucid. For anyone to start playing in the futures market, it is imperative that a “Margin” is created first. It is mandatory that the traders will have to keep some designated amount in that account. Is this clear first?
J: Yes
Me: Good. Next markets such as these will use Mark-to model to find the position of that contract on that day. Mark to Model – something like Mark-to –Market is an accounting methodology by which the position of the futures is calculated on that day. Based on this calculation, the position of the contract is decided. It is also called “Fair Value accounting”. If the position of the contract increases that day, then the respective profit will be credited to the Margin account. Likewise, if the position drops down, then the amount from margin will be used to settle for that day. If the amount in the margin is less than the designated amount, then a “Margin call” is made by the exchange house indicating that the trader must credit more amounts into the margin account.
M: Great. So, how does this Mark to Market model exactly work and I am sure it must be precise as well
Me: Well not exactly. In fact, Mark to Market works on Hypothetical value assessment and therefore have given room for accounting frauds. The most famous would be Enron scandal. Yes, there are financial standards which one has to adhere to. The latest is FAS 157 for fair value accounting.
J: FAS!!
Me: Financial Accounting standard
J: Oh! Ok…
M: Just a question out of curiosity. In OTC, what happens when the counter party does not honor the commitment?
Me: In such a case, they are governed by the ISDA contract. ISDA contract is a master agreement on basis of which OTC transactions are goverened. In the case when a counter party defaults in Exchange house, the counter party’s position is immediately closed and the clearing house is substituted for that counter party’s position. So, in nutshell, what does this mean?
M: Elimination of Credit risk
Me: Precisely Watson… (LOL!) This at the outset explains how the exchange governed market works. You have some terminologies like Expirations, Series and Basis, then initial market volatility. This we can take it up some other time.
J: I want to know about Options? Is this the right time to go for it?
Me: Sure – We can take it up as the next topic. Let us catch up tonight at the lakeside, where I can give you a brief insight into options.
Well then am I here to write memoirs, I thought for a while. Well to make my thought simple, I again remembered another quote which says “A bad book is as much of a labor to write as a good one; it comes as sincerely from the author's soul”.
So, be it bad or be it good, I want to be sincere in translating my thought process. And let me not worry on how the write-up shapes up, but the article should reflect the immediate first thought and off course, if it could benefit some, then you are on a great road-track.
“So sir, it is great to note that you coming back to writing” Said J
I looked up while sipping my tea (supposed to be tea – as usual a tea kadai) and thought “When was I a full-fledged writer first”
Well, I was an editor of a house-journal in my previous concern and writing was one of my passion (not necessarily a forte), and it has been so- all through my years of growth and that was well reflected when I was working for this nice concern in Chennai. Being an IT professional and being a Project Manager, I was busy garnering more of business knowledge than executing the wonderful passion that I have. So, I decided that yes, it is time that I start writing.
M Joined us shortly. We took off to the nearby place where we settled in comfortably.
M: Sir, I was just wondering – rather pondering with one question that was put forth to me recently. It was a question at the grass root level, which I was not able to answer convincingly.
Me: What is that?
M: How do you elicit an example to showcase the risk in derivative trading?
Me: Haa..ha… ok – here it goes - Selling a contract with a derived value on top of an asset is similar to selling your CV with the contents derived from your experience. You might click sometime and you might not. Does this answer your question?
Both M and J gave out a loud laugh and I was sure that this should suffice a question of the order which is seldom put forth. (I would call it as a good basic question)
M: Last time, we discussed about Future contracts and the way it is traded in Exchange house. You promised that you will take a session on the exchange house protocols and other related concepts.
Me: That is right. I will do that. Btw- J – has M briefed you about Forwards and Futures.
J: Yes and further I read the blog as well. So, I am ready.
Me: Good. Primarily, There are two facets to how trading happens. One is called “OTC” and the other is called “Exchange house Governed” OTC stands for “Over the counter”. Contracts trading such as Forward contracts and Interest rate swaps come under OTC. Contracts such as Futures and Options come under Exchange house.
M: Ok…
Me: Basically, to ply in the Futures market, you need to open an account called “Margin”. Margin is an account to which where the traders will deposit a “Margin amount” as designated by the exchange house. This margin amount will be used as safe money, when the position of the contract falls on that day.
J: Sorry Narasimhan, I am not able to get it.
Me: Ok, let me make it more lucid. For anyone to start playing in the futures market, it is imperative that a “Margin” is created first. It is mandatory that the traders will have to keep some designated amount in that account. Is this clear first?
J: Yes
Me: Good. Next markets such as these will use Mark-to model to find the position of that contract on that day. Mark to Model – something like Mark-to –Market is an accounting methodology by which the position of the futures is calculated on that day. Based on this calculation, the position of the contract is decided. It is also called “Fair Value accounting”. If the position of the contract increases that day, then the respective profit will be credited to the Margin account. Likewise, if the position drops down, then the amount from margin will be used to settle for that day. If the amount in the margin is less than the designated amount, then a “Margin call” is made by the exchange house indicating that the trader must credit more amounts into the margin account.
M: Great. So, how does this Mark to Market model exactly work and I am sure it must be precise as well
Me: Well not exactly. In fact, Mark to Market works on Hypothetical value assessment and therefore have given room for accounting frauds. The most famous would be Enron scandal. Yes, there are financial standards which one has to adhere to. The latest is FAS 157 for fair value accounting.
J: FAS!!
Me: Financial Accounting standard
J: Oh! Ok…
M: Just a question out of curiosity. In OTC, what happens when the counter party does not honor the commitment?
Me: In such a case, they are governed by the ISDA contract. ISDA contract is a master agreement on basis of which OTC transactions are goverened. In the case when a counter party defaults in Exchange house, the counter party’s position is immediately closed and the clearing house is substituted for that counter party’s position. So, in nutshell, what does this mean?
M: Elimination of Credit risk
Me: Precisely Watson… (LOL!) This at the outset explains how the exchange governed market works. You have some terminologies like Expirations, Series and Basis, then initial market volatility. This we can take it up some other time.
J: I want to know about Options? Is this the right time to go for it?
Me: Sure – We can take it up as the next topic. Let us catch up tonight at the lakeside, where I can give you a brief insight into options.
J: Sir, You were also planning to talk on this ID card plans which the Government has planned to launch.
Me: Yes, that is a good initative. See my blog tommorow, there will be an article on that. Then we will talk...
Adios….
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