Bid, Ask & Spread
A market maker quotes bid at $99.50 and ask at $100.50. A client wants to sell. At which price does the trade execute.
$99.50, the bid price
Why are OTC trades usaually larger and require a credit relationship with the bank.
OTC is a wholesale market, counterparty risk is real and dealers need to trust the client can settle
A limit sell order sits in the order book at $50.00. A market buy order arrives. At what price does the trade execute.
$50.00 — the limit order sets the price, the market order takes it
Why futures contracts being standardized in assets, amounts, and maturities is both a strength and a limitation.
Strengths: standardization allows exchange trading and deep liquidity.
Limitation: cannot tailor to specific client needs unlike OTC
Why is a market with high depth considered more liquid than one with a tight spread but low depth.
High depth means large trades can execute without moving prices.
A tight spread only helps if there is volume behind it.
Why does Ask > Bid in virtually all market conditions.
Dealers need compensation for providing liquidity and bearing inventory risk.
A dealer's inventory position rises sharply after a wave of client sell orders. This exposes the dealer to what specific risk?
Inventory risk, the value of their position changes as market prices move.
Why is the bid-ask spread on an exchange constantly change.
New limit and market orders arrive continuously, shifting the best available bid and ask at any moment
What does the clearinghouse eliminate that makes futures safer than bilateral OTC contracts.
Counterparty risk, you no longer depend on the other trader honoring the contract
Why are futures trading done through brokers rather than directly between counterparties.
Brokers interface with the clearinghouse, handle margin accounts, and ensure daily settlement. And the infrastructure requires an intermediary
A narrowing bid-ask spread could signal what about market conditions.
Liquidity is increasing and competition among dealers or limit order providers is intensifying.
Why are OTC derivatives like swaps and forwards cannot easily be standardized and moved to an exchange.
They are tailored to each client's specific needs in terms of size, maturity, and structure.
A trader places a limit buy order below the current market price. This order does not execute immediately. What is this trader providing to the market and why?
Liquidity, by posting a standing order others can trade against, they make it easier for future sellers to transact quickly
A futures trader's account falls below maintenance margin. Describe exactly what happens next.
The broker issues a margin call, so the trader must deposit additional funds to bring the account back to initial margin or the position is liquidated.
What is the difference between funding liquidity risk and market liquidity risk, and explain how one can trigger the other.
Funding liquidity risk is inability to roll over liabilities.
Market liquidity risk is inability to sell assets without a large loss.
So if a bank must sell assets to fund outflows, fire-sale prices can cause losses that worsen funding stress
Why would the bid-ask spread widen sharply during a financial crisis even for normally liquid assets.
Inventory risk spikes, dealers pull back from market-making, depth collapses, and uncertainty makes pricing impossible
What is the difference between how bid-ask spread is determined in an OTC market versus an exchange.
OTC spread is set by an individual dealer. Exchange spread is determined by the entire market competing through limit orders.
trader needs to buy a stock immediately at whatever price is available. Another trader is willing to buy but only at a specific price and will wait. Explain the fundamental difference between the two.
The first trader is using a market order which guarantes the execution but not at a specific price, they accept whatever the best available ask is. The second is using a limit order, where they control the price but risk never executing if the market never reaches their specified price.
Why is daily settlement with the clearinghouse prevent the accumulation of large losses that could cause a counterparty to default.
Gains and losses are realized every day rather than at contract expiration. Therefore, no one can build up a catastrophic unpaid obligation over time.
Why are rogue traders classified as operational risk rather than market risk even though their losses come from market movements.
The source of the loss is internal failure, the unauthorized action by an employee and not a legitimate market position.
A security's ask price is $101.25 and bid price is $100.75. A dealer has just taken on a large inventory position after a wave of client sell orders, and market prices are now falling. Using only the concepts of bid-ask spread, inventory risk, and liquidity, explain what the dealer must do and what happens to liquidity in the market as a result.
The dealer must widen the bid-ask spread to compensate for the increasing inventory risk as their position loses value. This widening spread makes it more expensive for clients to trade, reducing the volume of trades and directly decreasing market liquidity. And therefore shows that inventory risk and liquidity are directly linked through the spread.
A client wants to execute a $500 million interest rate swap. Explain why this goes through OTC and not an exchange, and refer to at least three characteristics of OTC markets.
OTC: handles large wholesale trades, is tailored to client needs, requires a credit relationship, and deals in assets like derivatives that exchanges don't standardize. - Any three
Explain why a sudden wave of market sell orders with no limit buy orders in the book produces a crash in prices, referencing depth and liquidity.
Market orders consume available limit buy orders, if depth is shallow, each order clears a price level and the next trade executes lower. With no new limit orders arriving, prices collapse as liquidity vanishes.
A bank trader takes a large unauthorized position in futures contracts that moves against them. Walk through how the margin system, daily settlement, and clearinghouse interact to determine when and how the loss is discovered.
Daily settlement means losses hit the account every day. Margin calls alert the broker when the account falls below maintenance margin. The clearinghouse ensures losses are covered daily, so the unauthorized position cannot hide and escalates into a margin call that surfaces the rogue trade.
A rogue trader at a bank has been hiding losses for months using falsified records. Explain using futures market mechanics exactly why this is harder to sustain in a futures position than in an OTC position.
Futures require daily settlement with the clearinghouse and margin calls when accounts fall short. Losses will surface every single day and cannot be hidden.
OTC positions can be marked to model rather than market, settlements are at contract expiration, and there is no clearinghouse forcing daily loss recognition.