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Introduction
Derivatives is useful for farmers to protect themselves against fluctuation in the price of their crop. A farmer who showed his crop in June facer uncertainty over the rice he would receive for his harvest in September. With the help of derivative he can sell his harvest.
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Derivatives Defined
A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. The Forwards contracts (Regulations) Act, 1952, regulates the forward/futures contracts in commodities all over India.
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Definitions of Derivative
A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. A contract which derives its value from the prices, or index of prices, of underlying securities.
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Derivatives Markets
Derivative markets can classified as commodity market and financial derivatives markets. Financial Market- trade in equity, interest rates and exchange rates as the underlying. Commodity Market- trade in agricultural commodity, Metal (gold, silver).
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Spot Transaction
In sport the trading, clearing and settlement happen immediately. Example-On 1st Jan. 09 Sunil want to buy some gold and goldsmith quotes Rs. 14000 per 10 grams. They agree upon this price and Sunil buy 10 grams. Gold.
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Forward Transaction
A contract by which two parties agree to settle a trade at a future date, for a stated price and quantity. The exchange of money and the underlying goods only happens at the future date as specified in the contract.
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Exchange Traded
OTC
Trade on an organized exchange Standardized contract terms Hence more liquid Requires margin payments Follow daily cash settlement
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Call Option- Give the right to buyer to buy the asset but not the obligation.
Put option- Give the right to buyer to sell the asset but not the obligation.
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Physical Settlement
It involves the physical delivery of the underlying commodities. The seller intending to make delivery would have to take the commodities to the designed warehouse. The buyer intending to take delivery would have to go to the designed warehouse and pick up the commodity.
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Assignment
The clearing house of the exchange identifies the buyer to whom this notice may be assigned. Any seller/buyer who has given intention to delivery/been assigned a delivery has an option to square off positions till market close of the day of delivery notice. The clearing house decides the daily delivery order rate at which delivery will be settled. The discount/ premium for quality and freight costs is published by the clearing house before introduction of the contract.
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Delivery
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After assignment process, clearing house/exchange issues a delivery order to the buyer. Exchange also inform respective warehouse about the identity of the buyer. Buyer is required to deposit a certain percentage of the contract amount with the clearing house as margin against the warehouse receipt. The period of physical delivery is decided by Exchange.
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Warehousing
In commodity derivatives there is a possibility of physical settlement. The seller handover the delivery to warehouse and buyer has to take delivery from warehouse. All international commodity exchanges used certified warehouses. All CWH are required to provide storage facilities for participants in the commodities markets and to certify the quantity and quality of the underlying commodity.
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Promoters
NCDEX is promoted by ICICI Bank Ltd., Life Insurance Corporation of India, National Bank for Agricultural and Rural Development (NABARD) and National Stock Exchange of India Limited.
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Governance
NCDEX is run by an independent Borard of Directors. Promoters do not participate in the day to ay activities of exchange. The board is responsible for managing and regulating all the operations of the exchange and commodities transaction. Board appoints an executive committee and other committees for the purpose of managing activities of the exchange.
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Exchange Membership
Membership of NCDEX is open to any person, association of persons, partnership, co-operative societies, companies etc. The members of NCDEX fall into two categories Trading Cum Clearing Members (TCM) Professional Clearing Members (PCM)
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Capital Requirements
NCDEX has specified capital requirements for it members. The member has to deposit Minimum Base Capital with the exchange Interest free cash security deposit Collateral security deposit ( Cash, Bank guarantee, Fixed Deposit receipts, Government of India Securities) NSCCL is the approved custodian for acceptance of government of India securities.
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Trading
The trading system on the NCDEX provides a fully automated screen-based trading for futures on commodities on a nationwide basis a well as an online monitoring and surveillance mechanism. The trade Timings of the NCDEX are 10 a.m. to 5 P.m. The NCDEX system supports an order driven market. Order matching is essentially on the basis of commodity, its price, time and quantity. The exchange specifies the unit of trading and the delivery unit for futures contracts on various commodities. The futures contracts are one month, two month and three month expiry cycles and expire on the 20th of every month.
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Clearing
NSCCL undertakes clearing of trades executed on the NCDEX. The settlement guarantee fund is maintained and managed by NCDEX. After trading hours on the expiry date, based on the available information, the matching for deliveries taken place firstly, on the basis of location and then randomly, keeping in view the factors such as available capacity of the warehouse, commodities already deposited and dematerialized and offered for delivery.
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Settlement
Futures contracts have two type of settlements, The MTM settlement which happens on a continuous basis at the end of each day and The final settlement which happens on the last trading of the futures contracts. The final settlement price is the spot price on the expiry day. The seller intending to make delivery taken the commodities to the designed warehouse.
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Chapter 5
Forward Contracts Future contract Terminology Options
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Salient features: Bilateral contracts and hence exposed to counter-party risk Contract price not available in public domain On expiry, settlement is by delivery If the party wants to reverse the contract, it has to go to the same
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Buyer
Seller
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Limitations:
Lack of centralization Illiquidity Counter party risk.
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Futures
A future contract is an agreement between two parties to buy or sell an asset, at a certain time in the future at certain price. Future contracts are standardized and exchange traded.
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Future terminology
Spot price: The price at which an asset traded in spot market. Future price: The price at which the futures contract trades in the futures market.
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Future terminology
Contract cycle: The future contracts on the NCDEX have one-month, two-months ,and three-months expiry cycles, these expire on the 20th for specified month. Expiry date: It is the date specified in the future contract. This is last day on which the contract will be traded. Contract size: The amount of asset that has to be delivered under one contract. Famously known as lot size
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Future terminology
Basis: Basis can be defined as the future price minus the spot price. Cost of carry: It is the cost incurred over the storage, finance and interest paid for the asset. This is the relationship between the spot and future prices. Initial margin: The amount that must be deposited in the margin account at the time a future contract is first entered into. Marking-to-market: At the end of each trading day, the margin account is adjusted to reflect the investors gain or loss depending upon the future closing price.
Maintenance margin: This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call.
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Options
Options are derivative instruments where one party has a right to buy/sell the underlying while the other party has an obligation to buy/sell Types of options Based on the right: - Call option - Put option Based on the exercise: - American ( Individual Securities) - European (S&P CNX Nifty)
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Option Terminology
Index options: This option have the index as the underlying. Stock options: Stock Options are options on individual stocks. Buyer of an option: The Buyer of an option is the one who by paying the option premium buys the right.
Writer of an option: The writer is seller of the option who receives premium. Option price: Option price is the price which the option buyer pays to option seller. Famously known as premium.
Expiration date: The date specified in the option contract is known as maturity date. Strike price: The price specified in the option contract is known as strike price.
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Option Terminology
In-the-money option: An in-the-money option is an option that would lead to a positive cash flow to the holder if it is exercised immediately.
For a call : spot price > strike price. For a put: spot price < strike price.
At-the-money options: An at-the-money option is an option that would lead to zero cash flow if it were exercised immediately.
For both call and put: spot price = strike price.
Out-of-the-money options: An out-of-the-money option is an option that would lead to a negative cash flow if it were exercised immediately.
For a call: spot price < strike price For a put: spot price > strike price
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Option terminology
Intrinsic value of an options: The option premium can be broken down into two components Intrinsic value Time value.
For call intrinsic value is as follows: The intrinsic value of a call is the amount the option is In-the-money. If call is out-of the money then intrinsic value is zero. For put intrinsic value is as follows: The intrinsic value of a put is the amount the option is In-of- the-money. If put is out-of the money then intrinsic value is zero.
Time value of an option: The time value of money is the difference between its premium and its intrinsic value.
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Future
Option
Exchange traded Same as future Exchange defines the Same as future product Strike price is Prize is zero, strike fixed, price price moves moves Prize is zero Prize is always positive Linear payoff Both long and short at Nonlinear payoff risk Only short at risk
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Future
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Chapter 6
Pricing Commodity futures Investment Assets versus Consumption asset The cost of Carry Model Pricing Futures contracts on Investment Commodities Pricing Futures contracts on Consumption Commodities
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F= SerT
R= Interest Rate T= Time E = 2.71828
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(Practical Questions)
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F=
rT (S+U)e
(Practical Questions)
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Chapter 7
Hedging Speculation Arbitrage
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Hedging
Many participants in the commodity futures market are hedging. They use futures market to reduce a particular risk that they face. The risk might be related to price of wheat or oil or any other commodity that the person deals in. Type of hedgeShort Hedge Long Hedge
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Short Hedge
A short hedge that requires a short position in futures contracts. A shot hedge is appropriate when the hedger already owns the assets, or is likely to own the asset and expects to sell it at some time in the future.
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Long Hedge
Hedges that involve taking a long position in a futures contract are known as long hedgers. A long hedge is appropriate when company knows it will have to purchase a certain asset in the futures are wants to lock in a price now.
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Example
Suppose that it is now June 15, A firm involved in industrial fabrication that it will require 300 kgs. Of silver on July 15 to met a certain contract. The spot price of silver is Rs. 22000 per kg. and the July silver futures price is Rs. 23000. A unit of trading is 5 kgs. The fabricator can hedge his position by taking a long position in Sixty (300/5) units of futures on the NCDEX.
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Hedging Ratio
Hedge ratio is the ratio of the size of position taken in the futures contracts to the size of the exposure in the underlying asset.
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Qs/Qf H=p
s= Change in sport price f=Change in futures price Qs=Standard deviation of s Qf= Standard deviation of f P= Coefficient of correlation between s and f H= Hedge ratio (Practical Questions)
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Speculation
A Speculator who thinks the shares or the commodities price of a given company will rise, it is easy to buy the shares or commodities and hold them for whatever duration he wants to. Speculation can be two types Bullish commodity buy futures Bearish commodity sell futures
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Arbitrage
Arbitrager can buy and sell the same asset in different market when price variations is there. The arbitrager buying cheap and selling expensive continues till prices in the two markets reach equilibrium.
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Chapter 8
Trading
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Quantity Freeze
All orders placed by members have to be within the quantity specified by the exchange any order exceeding this specified quantity will not be executed by will lie pending with the exchange as a quantity freeze. The member is required to confirm to the exchange about quantity freeze order.
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Base Price
On introduction of new contracts the base price is the previous days closing price of the underlying commodity in the prevailing spot market.
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Types of Margin
Initial Margin Maintenance Margin Additional Margin Mark-to-Market Margin Just as a trader is required to maintain a margin account with a broker, clearing house member is required to maintain a margin account with the clearing house this is knows as clearing margin.
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Charges
The transaction charges are payable @ 6 Rs. Per one lakhs trade done. The due date is 7th day from the date of the bill every month in respect of the trade done in the previous month. NCDEX engaged BJPL ( Bill junction payments Limited) collect the transaction charges through Electronic Clearing System.
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Charges
In terms of the regulations, members are required to remit Rs. 50000 as advance transaction charges or registration. If the transaction charges are not paid or before the due date, a penal interest is levied as specified by the exchange.
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Chapter 9
Clearing and Settlement
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Clearing
The main task of the clearing house is to keep track of all the transactions that take place during a day so that the net position of each of its members can be calculated. Typically it is responsible for the following Effecting timely settlement Trade registration and follow up. Control of the evolution of open interest Financial clearing of the payment flow. Physical settlement of financial settlement of contract. Administration of financial guarantees demanded by the participants.
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Clearing mechanism
PCM are entitled to clear and settle contracts through the clearing house. TCM open position is arrived at by the summation of his clients open position in the contracts in which they have traded. Client positions are netted at the level of individual client and grossed across all clients, at the member level without any set off between clients.
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Clearing Banks
ICICI Bank Limited Canara Bank UTI Bank Limited HDFC Bank Limited.
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Depository Participants
Every clearing member is required to maintain a CM Pool account exclusively for clearing operations (for effecting and receiving deliveries from NCDEX).
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Settlement
There are two type of settlements, MTM settlement which happens on a continuous basis at the end of each day and the final settlement which happens on the last trading day of the futures contracts both are cash settled by debiting/crediting the clearing accounts of CMs with the respective clearing banks.
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Final Settlement
On the date of expiry the final settlement price is the spot price on the expiry day. The responsibility of settlement is on a trading cum clearing member for all trades done on his own account and his clients trades. A professional clearing member is responsible for settling all the participants trades which he has confirmed to the exchange.
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Methods of Settlement
Closing out open positions Physical delivery Cash settlement NSCCL undertakes clearing of trades executed on the NCDEX.
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Cash Settlement
Contracts held till the last day of trading can be cash settled. When a contract is settled in cash it is marked to the marked to the market at the end of the last trading day and all positions are declared closed. The settlement price on the last trading day is set equal to the closing spot price of the underlying asset ensuring the convergence of future prices and the spot prices.
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Accredited warehouse
NCDEX specifies accredited warehouses through which delivery of a specific commodity can be effected and which will facilitate for storage of commodities Warehouses charge a fee that constitutes storage and other charges such as insurance, assaying and handling charges or any other incidental charges. Warehouses store commodities in line with their grade specifications and validity period and facilitate maintenance of identity.
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Approved Assayer
The exchange specifies approved assayers through whom grading of commodities can be availed by the constituents of clearing members. The functions are Inspect the warehouses identified by the exchange. Make available grading facilities. Grading certificate so issued by the assayer specifies the grade as well as the validity period up to which the commodities would retain the original grade, and time up to which the commodities are fit for trading.
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Risk Management
NCDEX had developed a comprehensive risk containment mechanism that is The requirements for membership in terms of capital adequacy. NCDEX charges an upfront initial margin for all the open positions of a member. The open position of the members are marked to market based on contract settlement price for each contract The difference is settled in cash on T+1 basis. A separate settlement guarantee fund for this has been created out of the capital of members.
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Margining At NCDEX
SPAN- is to identify overall risk in a portfolio of all futures contracts for each member on 99% VAR methodology.
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Regulatory Framework
Chapter 10
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Trading
NCDEX provides an automated trading facility in all the commodities admitted for dealings on the spot market and derivative market. Trading on the exchange is allowed only through approved workstation located at locations for the office of a trading member as approved by the exchange. Each trading member is required to have a unique identification number which is provided by the exchange.
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Trading Parameters
Every trading member is required to specify the buy or sell orders as either an open order or a close order for derivatives contracts. The exchange also prescribes different order books that shall be maintained on the trading system and also specifies various conditions on the order that will make it eligible to place it in those books.
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Trade Operations
They have to keep relevant records or documents concerning the order the trading system order number and copies of the order confirmation slip/modification slip must be made available to the constituents. When a trade cancellation is permitted and trading member wishes to cancel a trade, it can be done only with the approval of the exchange. The exchange also prescribes categories of securities that would be eligible for a margin deposit.
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Margin Requirements
The exchange prescribes from time to time the commodities/derivative contracts, the settlement periods and trade types for which margin would be attracted. Initial margin on derivatives contracts using the concepts of VAR concept. The margin has to be deposited with the exchange within the time notified by the exchange.
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Clearing
NSCCL undertakes clearing of trades executed on the NCDEX. All deals executed on the exchange are cleared and settled by the trading members on the settlement date by the trading members themselves as clearing members or through other professional clearing member in accordance with these regulations.
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