Finance-Theory · Unit 11 · Video 2 · Interactive Practice

Futures Cap Credit Risk at One Day: Closing Out, Netting and Clearing Credit Default Swaps

IKey Formulas

Formula	Name	What it means
$Q\,\lvert S_t - F \rvert$	Forward: amount owed, unpaid	$Q$ units at forward price $F$ , with today's spot $S_t$ standing in for the price at delivery (the sum due at delivery, before discounting); nothing is paid until delivery, so it can build up over the whole life of the contract
$\Delta_t = Q\,(P_t - P_{t-1})$	Futures: daily settlement	Each evening one day's move in the futures price $P_t$ passes between margin accounts, so the unpaid amount never exceeds one day's move
$(+1) + (-1) = 0$ , $Q\,(P_{\text{sell}} - P_{\text{buy}})$	Closing out a long	Selling the same delivery month leaves no commitment; the gain or loss is the sell price minus the buy price, already settled day by day
$\text{delivered} = \sum \text{net longs} = \sum \text{net shorts}$	Netting	A trader whose buys equal their sells is netted out and takes no delivery

Key Insight: A futures contract is a forward whose gain or loss is paid every evening, so nobody is ever owed more than one day's move.

IIForward Exposure Builds; Futures Exposure Resets Every Evening

Under the soybean forward the loss sits unpaid until delivery; under futures it is paid each evening.

Trading day 21

💡 A credit default swap is essentially a forward on a borrower's credit: when the market premium moves away from the fixed contract premium, the gap is value one side owes the other, and without daily settlement it builds up unpaid. Central clearing for credit default swaps began in March 2009, when the Securities and Exchange Commission granted the Intercontinental Exchange's clearing house temporary exemptions to act as a central counterparty.

IIIClosing Out Ends the Obligation, Not the Loss

Selling the offsetting December contract leaves no commitment, and whatever marking to market already took stays taken.

Close out on day 8

IVNetting: Only Net Positions Reach Delivery

The clearing corporation nets each trader's buys against sells; only the net positions are delivered.

VQuiz Questions

Problem 1 · Forward Versus Futures Exposure

Given: A chocolate maker agrees in a forward contract to buy 20 tonnes of cocoa at $3,150 a tonne. Three weeks later the spot price is $2,780 a tonne; take it as the price at delivery and ignore discounting. The same position held instead as two 10-tonne cocoa futures contracts had a largest one-day price move of $95 a tonne over those three weeks.

Under the forward, how much does the chocolate maker owe but has not yet paid?

Under the futures contracts, what is the most that was ever unpaid just before an evening's settlement?

✅ Correct! The forward lets the whole $7,400 sit unpaid; the futures contracts pay each day's move through margin, so at most one day's move, $1,900, is ever outstanding.

❌ Check the multiplication. The price gap is $370 a tonne, and 20 × $370 is four digits, not three.

❌ Not quite. What is owed is the gap between the agreed price and today's price, not the value of the cocoa at either price.

❌ That is the forward's number. Under futures the earlier days' moves have already been paid through margin; only the current day's move is ever unpaid.

❌ Not zero. Settlement happens each evening, so until then the loss from that day's move is owed but not yet paid.

❌ That is one contract. The position is two 10-tonne contracts, 20 tonnes in all.

❌ Check the forward. Multiply the quantity by the gap between the agreed price and the current price.

❌ Check the futures. The unpaid amount is at most the quantity times one day's move: 20 × $95.

Show solution

Forward. No money moves until delivery, so the whole change in value is owed and unpaid:

20 × ($3,150 − $2,780) = 20 × $370 = $7,400, owed by the chocolate maker (the long) to the seller.

Futures. Each evening the day's gain or loss is settled through margin, so the unpaid amount never exceeds one day's move. The largest daily move was $95 a tonne on 2 × 10 = 20 tonnes:

20 × $95 = $1,900.

The chocolate maker's total loss is the same $7,400 either way; the difference is that under futures all but the current day's part has already been paid.

Problem 2 · The Loss After Closing Out

Given: A trader buys 4 December corn futures (5,000 bushels each) at $4.60 a bushel. The futures price falls to $4.25, and she closes out by selling 4 December contracts. By December settlement the futures price has recovered to $4.70. Find her total gain or loss on the position.

✅ Correct! She bought at $4.60 and sold at $4.25 on 20,000 bushels: the obligation is gone, and the $7,000 loss was already debited from her margin account as the price fell.

❌ That is what holding to December would have given. After she closed out she had no position left, so the recovery to $4.70 did not reach her.

❌ Closing out ends the obligation, not the loss. She could not sell at $4.60; she sold at $4.25, and marking to market had already taken the difference.

❌ That is one contract. She held 4 contracts of 5,000 bushels each.

Show solution

Position. +4 long December and −4 short December: net 4 − 4 = 0 contracts, so she has no commitment to take delivery in December.

Quantity. 4 × 5,000 = 20,000 bushels.

Gain or loss. ($4.25 − $4.60) × 20,000 = −$0.35 × 20,000 = −$7,000, a loss of $7,000.

Marking to market debited this from her margin account day by day while the price fell from $4.60 to $4.25. The later rise to $4.70 happens after she has no position, so it neither helps nor hurts her.

Problem 3 · Netting at Settlement

Given: Every December wheat trade on the exchange is between these four traders (numbers of contracts):

Trader	Bought	Sold
Grower	0	50
Speculator X	35	35
Speculator Y	20	8
Mill	38	0

If nobody closes out, how many contracts go to delivery?

Speculator Y wants no wheat. What does Y do before delivery?

✅ Correct! Only net positions are delivered: the grower's 50 short against the mill's 38 and Y's 12 long. Y closes out by selling its net 12.

❌ That counts gross trading. The clearing corporation nets each trader's buys against sells first; X's 35 and 35 cancel completely.

❌ One long is missing. Speculator Y bought more than it sold, so it also holds a net long position.

❌ Wrong direction. Y is net long 12; buying more would make it net long 24.

❌ Too many. Y has already sold 8 of its 20; selling 20 more would leave it net short 8.

❌ Futures are not cancelled by phone. Every trade faces the clearing corporation; Y leaves by making the offsetting trade.

❌ Net first. Compute bought − sold for each trader, then add up the net longs.

❌ Check Y's net position. Y bought 20 and sold 8.

Show solution

Net positions (bought − sold):

Grower: 0 − 50 = −50 (net short 50)
Speculator X: 35 − 35 = 0 (netted out, no delivery)
Speculator Y: 20 − 8 = +12 (net long 12)
Mill: 38 − 0 = +38 (net long 38)

Check: total bought = 0 + 35 + 20 + 38 = 93 = 50 + 35 + 8 + 0 = total sold, as every contract has one buyer and one seller.

Delivered: net longs 12 + 38 = 50 = net shorts 50. Of 93 contracts traded, 50 go to delivery.

Speculator Y is net long 12, a commitment to take 12 contracts' worth of wheat. It closes out by selling 12 December contracts: 20 − (8 + 12) = 0.

Problem 4 · A Credit Default Swap as a Forward

Given: A pension fund buys five-year protection on a manufacturer's debt from a dealer, paying a fixed premium of 1% of the notional a year. Eighteen months later the manufacturer's credit has worsened sharply, and the market now charges 4% a year for the same protection. The swap is not centrally cleared. Which statement is correct?

✅ Correct! The fund holds protection now worth 4% a year for which it pays only 1%. Like a forward, the swap has moved in the fund's favour with nothing yet paid, the credit exposure clearing and daily margin were brought in to cap.

❌ Wrong side. The fund locked in protection at 1% that now costs 4%; the contract has moved in its favour, just as a long forward gains when the price rises.

❌ The premium is fixed. It was set when the swap was struck and does not move with the borrower's credit, so paying it settles none of the gap between the 1% the fund pays and the 4% the market now charges.

❌ Value exists before default. The gap between the market premium and the fixed premium is value one side already owes the other, as a forward is worth something before delivery.

Show solution

A credit default swap is essentially a forward contract on the borrower's credit. The premium is fixed when the swap is struck; the market premium for the same protection then moves with credit quality.

Credit has worsened, so the market premium (4% a year) is far above the contract premium (1% a year).
The protection buyer, the pension fund, holds a contract worth more than it pays for; the protection seller, the dealer, owes that value over the swap's remaining life.
Without a clearing house and daily settlement, that value is not paid as it arises; it builds up, just as the soybean forward's loss did, and the dealer may owe a large sum just when it is least able to pay.

The futures remedy (standardized contracts, a clearing house in the middle, daily margin) caps what is unpaid at about one day's move. Central clearing for credit default swaps began in 2009, and by the mid-2020s more than half of all outstanding credit derivatives were centrally cleared.

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