Market Risk

What happens when a futures contract reaches its expiration date?

Trader must :

• Offset it by doing the opposite trade (most common),

• Roll it to a later contract, or

• Settle it physically or financially (receive or deliver the commodity or cash).

What is price discovery? How it works

• It’s how buyers and sellers decide the price of a product together.

• They make offers and deals until they agree on a price that works for both. (bid and asks)

Who are speculators and what is their role in the market?

Traders who buy and sell commodities to profit from price changes, not to use the actual goods.

Their role is to add liquidity and help prices reflect supply and demand.

Who are hedgers and what do they want to protect against?

Traders or businesses that buy or sell commodities to protect themselves from price changes. They want to protect against losses caused by prices going up or down unexpectedly.

What is the difference between pit trading (Floor trading) and electronic trading?

• Pit trading is done face-to-face with hand signals in a physical location.

• Electronic trading is done online via trading platforms. It is faster, more accessible.

What does trading volume show?

How many contracts or units were bought and sold during a certain time period, indicating how active the market is. (High volume = High liquidity = High activity)

What is open interest?

Total number of active (not yet closed) futures or options contracts in the market at a given time.

What is offsetting a futures contract?

Exiting your position by taking an equal but opposite trade.

For example, if you sold 2 contracts, you buy 2 back before expiration.

What is rolling a futures contract?

Closing an expiring futures contract and replacing it with one in a later month to maintain your market exposure.

What happens if you don’t roll or offset a futures contract?

You are required to settle the contract, which may involve:

• Physical delivery (receiving or delivering the actual commodity), or
• Cash settlement (paying or receiving the difference in value).

Why is volume useful for traders?

Because it shows how much of a commodity or asset is being bought and sold, helping them understand market activity and price strength.

What can rising open interest tell you about a trend?

Strong trend is continuing because more traders are entering and supporting the current price movement.

What does falling open interest during a price trend suggest?

Traders are closing positions and the trend may be weakening or coming to an end.

What needs to happen for open interest in a futures market to increase?

new buyers and new sellers must enter the market by opening new positions.

What needs to happen for open interest in a futures market to decrease?

traders must close their trades instead of opening new ones.

What are the main types of speculators in the futures market, and how do they differ?

• Individual Traders: Trade their own money using online platforms; independent with fast access to markets.

• Proprietary Trading Firms (Prop Shops): Trade the firm’s money using advanced tools and training, often doing high-frequency trades.

• Hedge Funds: Use complex strategies and borrowed money (leverage) aiming for big returns in any market direction.

• Portfolio or Investment Managers: Manage big funds and use futures to control risk or change how much the fund is invested in the market without selling assets.

• Market Makers: Always ready to buy and sell, making profits from the bid-ask spread and providing market liquidity.

What’s the difference between volume and open interest?

Volume = how many contracts traded during a session. Open Interest = total number of active contracts that haven’t been closed yet

How does price discovery benefit small traders?

By ensuring that everyone sees the same price, regardless of size. It makes markets fair and transparent for both small and large participants.

What is the formula for calculating tick value in a futures contract?

Tick Value = Tick Size x Contract Unit

A futures contract for crude oil has a tick size of $0.01 and a contract unit of 1,000 barrels. What is the tick value?

Tick Value = 0.01 x 1,000 = $10/ contract

What is the formula for calculating the notional value of a futures contract?

Notional Value = Contract Size x Futures Price

A COMEX gold futures contract has a size of 100 troy ounces. If the price is $1,950 per ounce, what is the notional value?

Notional Value = 100 x $1’950 = 195’000$

How do you calculate profit or loss (PnL) on a futures position?

PnL = (Sell Price - Buy Price) x Contract Size

You bought 1 copper futures contract at $3.50 and sold it at $3.70. The contract is for 25,000 pounds. What is your profit?

PnL = ($3.70 - $3.50) x 25’000 = $5’000

Two traders create a new futures contract where one buys and one sells. What happens to open interest?

Open interest increases by 1, because a new contract was opened.

A trader sells a futures contract to close their position, and the buyer is opening a new position. What happens to open interest?

The open interest stays the same because one position closes(-1) and another opens(+1) → 0

Two traders both close existing positions in a transaction. What happens to open interest?

Open interest decreases by 1.

How is open interest calculated?

Open Interest = Contracts Opened – Contracts Closed.

What is the formula for roll yield in futures trading?

Roll Yield = Nearby Contract Price - Next Contract Price

The March crude oil contract is trading at $74.50, and the April contract is at $75.10. What is the roll yield? Is it positive or negative?

Roll Yield = 74.50 - 75.10 = -0.60 The roll yield is –0.60, which means rolling costs money (this is contango).

What is the hedge ratio formula used to determine how many futures contracts to hedge a position?

Hedge Ratio = Value of risk / Notional Value

What is the purpose of Governance & Internal Controls in trading?

To make sure trading follows rules, manages risks, and prevents mistakes or fraud.

What is the Delegation of Authority (DOA)?

Framework for trader to know what is allowed to trade on a day to day basis without asking for additional permission.

Name and explain three types of limits used in governance.

• Volume Limits: Max amount you can trade.

  Focus: How much you can trade.

• Risk Limits: Max risk you’re allowed to take.

  Focus: How risky your positions can be.

• Drawdown Limits: Max loss from peak before stopping.

  Focus: How much you've lost over time from your highest point.

• Credit Limits: Max money risked with one client.

  Focus: How much trust (credit) you give to others.

Why is reporting risk and performance important in the Middle Office?

helps the company monitor risk levels, check trader or desk performance, and connect risk with finance for better control.

What is the goal of a trading DOA?

To provide clear daily trading limits for traders, so they can operate independently but always within approved risk boundaries.

Whose responsibility is it to ensure pre-deal checks are completed?

It is the Front Office (traders and sales) responsibility to ensure pre-deal checks are completed before making a trade.

What is KYC and when must it be completed?

means checking who your customer is, and it must be done before doing business with them

It is required for:

• New customers

• Any inactive customers (no trade for over 3 years)

Name four types of pre-deal compliance checks.

1. KYC (Know Your Customer): Verifying who the customer is to prevent fraud or illegal activity.

2. Credit check: Making sure the customer has enough credit to trade.

3. Sanctions screening: Checking that the customer or transaction is not on any banned or restricted lists.

4. Trading limits verification: Confirming the trade doesn’t exceed allowed risk or volume limits.

What are 'volumetric limits' in a DOA?

Maximum amount a person can trade or approve without needing to ask for permission.e.g., 10,000 barrels of crude per day).

What are 'liquidity limits'?

rules that stop a trader from trading too much in markets where it’s hard to buy or sell quickly (without liquidity).

Because if few people are buying or selling, you might:

• Change the price too much

• Not find someone to trade with

• Be stuck with your trade

Why are drawdown limits important in a DOA?

They help stop big losses and protect the company by forcing a trader to pause or get approval after losing too much. (Maximum amount a trader can losses before intervention)

What does a DOA typically include for option traders?

• The types of options they can trade (e.g., calls, puts).

• The maximum size or volume of trades allowed.

• The maximum risk or loss limits.

• Approval levels needed for larger or riskier trades.

• Authority to enter, modify, or close positions within set limits.

How do Governance, Internal Controls, and DOA all work together?

• Governance sets the rules

• Internal Controls make sure rules are followed

• DOA decides who can make decisions and approve actions

all working together to manage risk and control decisions.

What is a hedger in the futures market and what is their main purpose?

Someone who uses futures contracts to protect themselves from price changes in an asset they already own or need to buy. Their main purpose is to reduce the risk of losses from unfavorable price movements.

Why Hedgers Use Futures?

Protect from:

• Rising input costs (fuel, steel)
• Falling sales prices (gold, grain)
  Futures reduce uncertainty.

Which are the type of Hedgers?

• Buy-side: Buys commodities and worries prices will rise (e.g., a bakery buying wheat locks in price).

• Sell-side: Sells commodities and worries prices will fall (e.g., a farmer selling wheat secures a good price).

• Merchandisers: Both buy and sell to manage profit risk (e.g., a grain trader hedging purchases and sales).

What is Merchandiser's Risk?

The risk that the price difference between buying and selling a commodity (the spread) changes, which can reduce their profit.

Which external Changes Affecting Hedgers (costs/revenues.)

Commodity prices

Exchange rates,

Interest rates → (Market risk)

What are three key effects of high trading volume in financial markets?

• The bid-ask spread is smaller, so trading is more cost-efficient.

• Order execution is faster due to higher market liquidity.

• Price movements are smoother with fewer price gaps or slippage.

1. Price Risk

   • Speculative Trading: You can lose money if the market price moves against your trade.

   • Physical Trading: The price of the product might drop before you sell it, so you earn less.

2. Operational Risk

   • Speculative Trading: Mistakes with computers, systems, or people can cause problems with trades.

   • Physical Trading: There can be delays or issues with shipping, storage, or handling of goods.

3. Counterparty Credit Risk

   • Speculative Trading: The other person or company in the trade might not pay or complete the deal.

   • Physical Trading: The buyer might not pay, or the seller might not deliver the product.

4. Regulatory Risk

   • Speculative Trading: New trading rules can stop or limit what you can do.

   • Physical Trading: Governments can change laws, add taxes, or ban exports/imports, which affects your trade.

What are the main risks in (1) speculative trading and (2) physical trading for price, operations, credit, and rules?