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FRM Part I · FRM Exam Part I · Introduction to Derivatives

A trader holds a long futures position on an exchange. The exchange's clearing house sits between buyers and sellers. Which statement best describes how this arrangement affects the trader's credit exposure?

The trader's counterparty is the clearing house, not the original seller, because of novation. Credit risk is reduced through initial margin and daily marking to market with variation margin, which stop losses from accumulating unpaid.

  1. AThe trader faces the original short counterparty's default risk until the contract expires
  2. BThe trader's exposure is to the clearing house, which is mitigated by margin requirements and daily settlementCorrect
  3. CThe trader has no exposure to any default because futures positions are never marked to market
  4. DThe trader's exposure is unlimited because the clearing house does not require collateral

Explanation

Through novation the clearing house becomes the counterparty to each side. Initial margin and daily variation margin limit the buildup of unpaid losses. The first option ignores novation; the third is wrong since futures are marked to market daily.

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