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«Forwards and futures A forward may be distinguished from a future as follows:  Liquidation versus no liquidation With futures, you can liquidate ...»

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Clearing and Bookkeeping Processing for Forwards

Updated September 18, 2013

Introduction

CME Clearing and CME Clearing Europe currently offer clearing of privately-negotiated deals, submitted

via CME ClearPort, in several types of forwards, including contracts on metals, delivered gas, wet freight

rates, and FX. In the future, we expect to begin offering clearing for other types of forwards. Exactly as

with futures, forwards may be cash-settled or physically-delivered.

This section outlines the basics of processing for forwards – what they are, how they work, how they differ from futures, etc.

Forwards and futures

A forward may be distinguished from a future as follows:

 Liquidation versus no liquidation With futures, you can liquidate your position simply by clearing an offsetting transaction, and with any counterparty. Sell the contract to party A, buy it back from party B, and you are out of the market. (Another commonly used term for this is multi-lateral position netting – you can net your positions together regardless of counterparty.) With forwards, however, normally there is never any liquidation. All trades are held open, at original trade price, until contract maturity. (The exception is that you can do a tearup – more on this below.)  Cash mark-to-market versus either cash or collateralized mark-to-market With futures, daily mark to market amounts are always banked in cash. This is called settlement variation. (Sometimes you’ll see this referred to as variation margin.) Every new trade you clear is marked from trade price to that day’s end-of-day settlement price. Similarly, your startof-day position is marked from the previous day’s end-of-day settlement price to today’s end-ofday settlement price. The net of all of these amounts is banked in cash.

With forwards, however, daily mark-to-market amounts may either be collateralized or banked in cash. In either case, every day, for every open trade, we calculate the mark-to-market amount from original trade price to the current day’s end-of-day settlement price, and discount the result to present value.

For forwards with a collateralized mark-to-market, today’s value for discounted mark-to-market, simply becomes an increment or decrement to your performance bond (“initial margin”) requirement. So if you’ve lost money on your mark-to-market amounts, you’ll have to post more collateral, of any acceptable collateral type. If you’ve made money, your collateral requirement will be decreased, and you may be able to withdraw excess collateral.

©2012-2013 CME Group For forwards with a cash mark-to-market, the net change in discounted mark-to-market from the previous clearing processing day, is simply banked in cash.

 Delivery at final settlement price versus delivery at original trade price If you hold your position in a cash-settled futures contract to maturity, the position is simply marked to market one final time, the resulting settlement variation is banked, and the position is removed. For a physically-delivered futures contract, if you hold the position to maturity, it delivers at the final settlement price of the future.

For a physically-delivered forward contract, however, at maturity the position delivers at original trade price. Depending on the contract, this may be a gross delivery – each original trade delivers at its own original trade price. Or it may be a net delivery, where the delivery obligations for the open trades are netted together to yield a single net delivery obligation, at the net of original trade price.

For a cash-settled forward contract, final cash-settlement amounts on all open trades are calculated, by marking each trade from original trade price to final settlement price. These amounts are netted together and then banked in cash.

Forwards are also more likely than futures to have position quantities quoted in notional terms. For example, for gold forwards, trade and position quantities are quoted in troy ounces, down to 0.0001 of an ounce. For most FX forwards – for example, a forward on the exchange rate between the US Dollar and the Chinese Yuan – quantities are quoted in currency units, down to the penny. This is not an absolute rule, however, and it is possible for futures to have quantities specified in notional amounts as well.

Clearing and Bookkeeping Processing for Forwards September 18, 2013 -- Page 2 Calculating mark-to-market amounts for open forward trades Regardless of whether the forward has a cash or collateralized mark-to-market, the calculation of markto-market is the same. There are two methods, however – the normal method, and the inverse method, which may be used for certain FX contracts.

The normal method: The mark-to-market amount for an open trade in a forward contract is calculated

as the product of four values:

 The price difference: Current End-of-Day Settlement Price less Original Trade Price  The trade quantity, expressed as positive number for a buy or a negative number for a sell  The contract value factor – the multiplier for this contract that converts quoted prices to money amounts, and  The discount factor – the appropriate value to discount the mark to market amount from the contract’s maturity date back to present value.





In other words:

–  –  –

The result is rounded normally to the precision of the currency in which the contract is denominated.

(For example, for USD, GBP and EUR, to the nearest penny, and for JPY to the nearest yen.) Discounting the mark-to-market amount back to present value is done because the final delivery or cash settlement won’t be realized until contract maturity.

For example, for gold forwards: Suppose you sold 4,379 contracts at a price of 865.67 USD per troy ounce, and at the end of the current clearing day the settlement price is 895.55 USD per troy ounce.

The contract value factor is 1 (because the contract is defined as being for 1 troy ounces), and suppose today’s discount factor is 0.98039. The discounted mark to market amount is calculated as the product

of:

 The price difference of 895.55 less 865.67)  The trade quantity of negative 4,379  The contract value factor of 1, and  The discount factor of 0.98039.

The result is -128,278.658693, which is rounded to -128,278.66 USD.

Clearing and Bookkeeping Processing for Forwards September 18, 2013 -- Page 3 The inverse method: this is used for non-deliverable FX forwards (NDF’s), where it is desirable to express the mark-to-market amount in the primary currency of the pair rather than the contract currency.

The process here is exactly analogous, except that it includes a final step, division by the daily

settlement price:

 Take the product of the price difference, the trade quantity, the contract value factor, and the discount factor.

 Divide this result by the end-of-day settlement price.

 Round normally to the normal precision of the currency in which the mark-to-market amount is denominated. (the primary currency for an FX forward)

In other words:

–  –  –

For example, suppose you bought 10M USD in a non-deliverable forward on the exchange rate between the US Dollar and the Chilean Peso, at a trade price of 5.1234 CLP per USD, which had an end-of-day settlement price of 5.4792 CLP per USD. The contract value factor is 1 (because the contract is for 1 USD), and suppose that day’s discount factor was 0.98039.

The discounted mark-to-market amount is calculated as follows:

–  –  –

For forwards with collateralized mark-to-market As indicated above: Take the mark-to-market amounts calculated for today’s clearing business day for the various forward positions, and net them down by currency.

The result becomes part of the equity component of the performance bond (initial margin) requirement, in exactly the same manner as net option value. If a net negative number, it increases the margin requirement, and if a net positive number, it decreases the margin requirement.

The result, if a net negative number, becomes an increment to the performance bond (initial margin) requirement.

For forwards with cash mark-to-market For each such forward position, take the discounted mark-to-market value calculated at end-of-day for the current clearing business date, and subtract from it the discounted mark-to-market value at end-ofday for the immediately previous clearing business date.

The result is the settlement variation (variation margin) for this position for the current date, and is included in the total cash to be banked.

Clearing and Bookkeeping Processing for Forwards September 18, 2013 -- Page 5 Price Alignment Interest for Forwards with Cash Mark to Market Forwards with cash mark-to-market will have price alignment interest (PAI). This works in a manner exactly analogous to that for CME’s cleared credit default swaps and interest-rate swaps. Note that PAI is not applicable to forward contracts using collateralized mark-to-market.

PAI can be thought of as compensating the holders of out-of-the-money positions for the interest they could have received on the cash posted as settlement variation. It is calculated on days which are banking business days for the currency in which that settlement variation is denominated, and covers the period from the current day to the next such banking business day. On days which are not banking business days for this currency, PAI is always set to zero.

The effective interest-rate used is the appropriate rate index for the currency in question, annualized on either an actual/360 or an actual/365 basis. The interest-rate index and the annualization convention are specific to the currency. For USD, the rate is the Fed Funds Effective Rate, and the convention is Actual/360.

The cash amount which is the input to the calculation, is the net discounted mark-to-market amount realized as of the morning of the current business day. In other words, it is discounted mark-to-market amount calculated as of end-of-day for the immediately previous clearing business day (regardless of whether that immediately previous day was a holiday in any currency.) At the request of clearing firms, price alignment interest for forwards is calculated trade by trade. The PAI amount for the position as a whole, then, is simply the sum of the PAI amounts on the trades.

To simplify processing, all the needed attributes needed to drive the calculation will be provided in the FIXML Product Reference File and Settlement Price File for the forwards in question.

The PAI amount is calculated as the product of the following factors:

 Discounted mark-to-market amount for the immediately previous clearing processing day  Interest rate expressed as a decimal value  Number of days from the current banking business day to the next banking business day, divided by either 360 or 365  -1 The result is then rounded normally to the normal precision of the currency in which it is denominated, and is included in the total cash amount to be banked for the position.

Clearing and Bookkeeping Processing for Forwards September 18, 2013 -- Page 6 Cash-Settled and Physically-Delivered Forwards at Contract Maturity At maturity, forwards with cash mark-to-market can be either cash-settled or physically-delivered, exactly as for forwards with collateralized mark-to-market.

In other words, there are four different possibilities:

 Cash-settled, cash mark-to-market  Cash-settled, collateralized mark-to-market  Physically-delivered, cash mark-to-market  Physically-delivered, collateralized mark-to-market Calculating Mark-to-Market at Contract Maturity Regardless of which of these four possibilities adhere, the mark-to-market amount for margin processing is always set to zero, beginning at end-of-day on the clearing settlement date. Further

processing then behaves exactly as on any other day. Hence:

 If the forward has a collateralized mark-to-market, then beginning at end-of-day on the clearing settlement date, mark-to-market will no longer affect the performance bond requirement.

 If the forward has a cash mark-to-market, then the settlement variation amount at end-of-day on the clearing settlement date, will be the negative of the mark-to-market amount from the previous clearing business day – ie, zero (today’s value), less yesterday’s value.

Calculating the Final Settlement Amount for Cash-Settled Forwards For a cash-settled forward, the final cash-settlement amount is determined on the clearing settlement

date, in exactly the same manner as on any normal date:

 If normal mark-to-market calculation: as the product of the final settlement price less the original trade price, the quantity, the contract value factor, and the discount factor, rounded normally to the normal precision of the currency.

 If inverse mark-to-market calculation: as the above product, divided by the final settlement price, rounded normally to the normal precision of the currency.

Clearing and Bookkeeping Processing for Forwards September 18, 2013 -- Page 7 Calculating the Invoice Amount for Physically-Delivered Forwards

For a physically-delivered forward, the invoice amount is calculated as the product of:

–  –  –

which is then rounded normally to the normal precision of the currency. The invoice amount is always included in the total cash amount to be banked, in the end-of-day clearing cycle on the contract’s clearing settlement date.

Note that for CME Europe delivered gas forwards, the invoice amount is increased by 20%, to cover

value-added tax (VAT). In other words, the value is determined by taking the product of:

–  –  –

Which is then rounded normally to the normal precision of the currency.

On the clearing reports for such gas forwards, we distinguish between the clean invoice amount (without the tax), the full invoice amount (with the tax), and the amount of the Value-Added Tax.

–  –  –

FX forwards – cash-settled with cash mark-to-market



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