Post on 28-Oct-2014
FINAL PROJECT REPORT ON
“DETAILED STUDY ON HEDGING, ARBITRAGE AND SPECULATION”
A report submitted to IIMT, Greater Noida as a partial fulfillment of full time Post Graduate Diploma in Management
Under the guidance of
Mr. Abhishek Kumar Verma
Submitted To: Submitted By:Dr.D.K.Garg, Anima MishraChairman, ENR. FMR-3007IIMT.Gr. Noida 15th Batch
Ishan Institute of Management &Technology
1A, Knowledge Park -1,Greater Noida, Dist.-G.B.Nagar (U.P.)
Website:www.ishanfamily.com
E-Mail: student@ishanfamily.com
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PREFACE
“Project Work” is a very essential component of learning in a management program.
It is the best way to practice what a student has learnt in the classrooms or through
books. It enables a student to apply his/her conceptual knowledge to live
organizational problem and issues. It helps the student to practice the art of
conducting a study in a systematic and scientific manner and then presenting their
finding and recommendations in a coherent report. It is an “Action Research” and
as a manager it will be constantly required to identify real problem and collect
related information for making sound decisions.
This work on “Project Work” has been written for easy comprehension of
management’s participants. It is aimed to provide basic insight into the subject on a
very simple and clear manner. It is hoped that it will generate due interest and
motivate to further learn the subject in greater detail and practice this in their
professional life.
The objective of my project was to know about the real working of mutual fund.
This is in fact, a partial fulfillment of the requirements for obtaining final PGDFM
diploma from “ISHAN INSTITUTE OF MANAGEMENT &TECHNOLOGY.”
This project work has been a first-hand experience of the real condition, which
provided an opportunity to utilize managerial knowledge and skill and to bring out
some solutions to the problems identified during project study.
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DECLARATION
The Final project on “DETAILED STUDY ON HEDGING, ARBITRAGE AND
SPECULATION” is the original work done by me.
This is the property of the Institute and use of this report without prior permission of
the Institute will be considered illegal and actionable.
DATE 2/08/2011 KUMARI ANIMA
(Finance) ENR- FMR 3007,
15thBATCH
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TABLE OF CONTENT
CHAPTERS PAGE NO
CHAPTER 1: INDIAN FINANCIAL MARKET 9-81
1.1 MONEY MARKET
Introduction
Instruments
1.2 CAPITAL MARKET
A. Primary Market
Meaning
Mode of issuing Securities
Public issue
Private Placement
Right issue
Activities in case of public issue and right issue
Intermediaries in raising the funds
IPO Grading
Grading Process and Methodology
B. Secondary Market
Meaning of stock exchange
History and organization of stock market in India
Functions of stock exchange
Market mechanism
Buying & selling Procedure including online trading system
Placing an order
Execution of order
Reporting and confirmation of transaction
Functional specialization of Brokers
Speculator
Hedger
Arbitrager
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CHAPTER 2: DERIVATIVE MARKET 82-98
2.1 Derivatives
Introduction
Product, Participant and Function
Types of derivatives
2.2 Introduction to future and Options
Forward contract
Limitations of forward contract
Introduction to futures
Distinction between futures and Forward contract
Futures terminology
Options Introduction
Options terminology
Index future
Feature of Index future
SWAP
CHAPTER 3: APPLICATION OF FUTURE & OPTION 99-118
3.1 Application of futures
Hedging :long security ,sell future
Speculation: Bullish security, buy futures
Speculation : Bearish security ,sell futures
Arbitrage :overpriced future: buy spot ,sell future
Arbitrage : Underpriced future: buy future, sell spot
3.2 Application of options
Hedging :Have underlying buy puts
Speculation: Bullish security, buy calls & sell puts
Speculation : Bearish security ,sell calls & buy puts
Bull spreads : Buy a call and sell another
Bear spreads : sell a call and buy another
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CHAPTER 4: TRADING OF FUTURES & OPTIONS 119-126
4.1 Futures and Options trading system
Entities in the trading system
Basis of trading
Corporate hierarchy
Client Broker relationship in derivative segment
4.2 Criteria for stocks and Index eligibility for trading
Eligibility Criteria of stocks
Eligibility Criteria of indices
Eligibility Criteria of stocks for derivative trading
4.3 charges
CHAPTER 5: CLEARANCE AND SETTLEMENT OF FUTURES & OPTIONS
5.1Clearing Entities 127-138
Clearing Members
Clearing banks
5.2 Clearing Mechanism
Settlement Mechanism
Settlement of future Contract
Settlement of options Contract
Adjustment for corporate actions
Risk management
CHAPTER 6: COMMODITY DERIVATIVES TRADING IN INDIA 138-160
6.1 Introduction
6.2 Using commodity Futures
Hedging
Basic Principles of hedging
Short Hedge
Long Hedge
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Advantage & Limitations of hedging
Speculation
Speculation: Bullish commodity, buy futures
Speculation : Bearish commodity ,sell futures
Arbitrage
Overpriced commodity futures: Buy spot ,sell futures
Underpriced commodity future : buy futures , sell spot
CHAPTER 7: TRADING OF COMMODITY 161-192
7.1 Futures Trading System
Entities in the trading system
Guidelines for allotment of client code
Contract specification
Order types and trading parameter
Permitted lot size
Pick size for contracts
Quantity freeze
Base Price
Price range of contracts
7.2 Margins for trading in futures
7.3 charges
CHAPTER 8: CLEARANCE AND SETTLEMENT OF COMMODITY FUTURES
8.1 Clearing 192-215
Clearing Mechanism
Clearing Banks
Depository Participants
8.2 Settlement
Settlement Mechanism
Settlement Methods
Entities involved in Physical Settlement
8.3 Margining at NCDEX
SPAN
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Initial Margin
Computation of Initial margins
CHAPTER 9: REGULATORY FRAMEWORK 215-293
9.1 Securities Contracts (Regulation) Act 1956
9.2 Securities and exchange Board of India Act 1992
9.3 Regulation for Derivative Trading
Forms of collateral’s acceptable at NSCCL
9.4 Regulations for commodity Derivative Exchanges
Rules governing Intermediaries
Trading
Clearance
Rules governing investor grievances, arbitration
CHAPTER 10:
LIMITATION 244
SUGGESTION 245
WORD OF THANKS 246
BIBLIOGRAPHY 247
CHAPTER1 INDIAN FINANCIAL MARKET
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INTRODUCTION
What is India Financial Market?
In economics, a financial market is a mechanism that allows people to buy and sell
(trade) financial securities (such as stocks and bonds), commodities (such as
precious metals or agricultural goods), and other fungible items of value at
low transaction costs and at prices that reflect the efficient-market hypothesis.
Both general markets (where many commodities are traded) and specialized markets
(where only one commodity is traded) exist. Markets work by placing many
interested buyers and sellers in one "place", thus making it easier for them to find
each other. An economy which relies primarily on interactions between buyers and
sellers to allocate resources is known as a market economy in contrast either to
a command economy or to a non-market economy such as a gift economy.
In finance, financial markets facilitate:
The raising of capital (in the capital markets)
The transfer of risk (in the derivatives markets)
The transfer of liquidity (in the money markets)
International trade (in the currency markets)
– and are used to match those who want capital to those who have it.
Typically a borrower issues a receipt to the lender promising to pay back the capital.
These receipts are securities which may be freely bought or sold. In return for
lending money to the borrower, the lender will expect some compensation in the
form of interest or dividends.
India Financial market comprise of the primary market, FDIs, alternative investment
options, banking and insurance and the pension sectors, asset management segment
as well. With all these elements in the India Financial market, it happens to be one
of the oldest across the globe and is definitely the fastest growing and best among all
the financial markets of the emerging economies. The history of Indian capital
markets spans back 200 years, around the end of the 18th century. It was at this time
that India was under the rule of the East India Company. The capital market of India
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initially developed around Mumbai; with around 200 to 250 securities brokers
participating in active trade during the second half of the 19th century.
Scope of Indian Financial Market
The financial market in India at present is more advanced than many other sectors as
it became organized as early as the 19th century with the securities exchanges in
Mumbai, Ahmedabad and Kolkata. In the early 1960s, the number of securities
exchanges in India became eight - including Mumbai, Ahmedabad and Kolkata.
Apart from these three exchanges, there was the Madras, Kanpur, Delhi, Bangalore
and Pune exchanges as well. Today there are 23 regional securities exchanges in
India.
The Indian stock markets till date have remained stagnant due to the rigid economic
controls. It was only in 1991, after the liberalization process that the India securities
market witnessed a flurry of IPOs serially. The market saw many new companies
spanning across different industry segments and business began to flourish.
The launch of the NSE (National Stock Exchange) and the OTCEI (Over the
Counter Exchange of India) in the mid 1990s helped in regulating a smooth and
transparent form of securities trading.
The regulatory body for the Indian capital markets was the SEBI (Securities and
Exchange Board of India). The capital markets in India experienced turbulence after
which the SEBI came into prominence. The market loopholes had to be bridged by
taking drastic measures.
Potential of the India Financial Market
India Financial Market helps in promoting the savings of the economy - helping to
adopt an effective channel to transmit various financial policies. The Indian financial
sector is well-developed, competitive, efficient and integrated to face all shocks. In
the India financial market there are various types of financial products whose prices
are determined by the numerous buyers and sellers in the market. The other
determinant factor of the prices of the financial products is the market forces of
demand and supply. The various other types of Indian markets help in the
functioning of the wide India financial sector. 10
Features of the Financial Market in India
India Financial Indices - BSE 30 Index, various sector indexes, stock quotes,
Sensex charts, bond prices, foreign exchange, Rupee & Dollar Chart
Indian Financial market news
Stock News - Bombay Stock Exchange, BSE Sensex 30 index, S&P CNX-
Nifty, company information, issues on market capitalization, corporate
earnings statements
Fixed Income - Corporate Bond Prices, Corporate Debt details, Debt trading
activities, Interest Rates, Money Market, Government Securities, Public
Sector Debt, External Debt Service
Foreign Investment - Foreign Debt Database composed by BIS, IMF,
OECD,& World Bank, Investments in India & Abroad
Global Equity Indexes - Dow Jones Global indexes, Morgan Stanley Equity
Indexes
Currency Indexes - FX & Gold Chart Plotter, J. P. Morgan Currency Indexes
National and Global Market Relations
Mutual Funds
Insurance
Loans
Forex and Bullion
If an investor has a clear understanding of the India financial market, then
formulating investing strategies and tips would be easier.
Types of Financial Market
The financial markets can be divided into different subtypes:
Capital markets which consist of:
Stock markets, which provide financing through the issuance of shares
or common stock, and enable the subsequent trading thereof.
Bond markets, which provide financing through the issuance of bonds, and
enable the subsequent trading thereof.
Commodity markets, which facilitate the trading of commodities.
Money markets, which provide short term debt financing and investment.
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Derivatives markets, which provide instruments for the management
of financial risk.
Futures markets, which provide standardized forward contracts for trading
products at some future date; see also forward market.
Insurance markets, which facilitate the redistribution of various risks.
Foreign exchange markets, which facilitate the trading of foreign exchange.
The capital markets consist of primary markets and secondary markets. Newly
formed (issued) securities are bought or sold in primary markets. Secondary markets
allow investors to sell securities that they hold or buy existing securities. The
transaction in primary market exist between investors and public while secondary
market its between investors
Raising the capital
To understand financial markets, let us look at what they are used for, i.e. what
where firms make the capital to invest Without financial markets, borrowers would
have difficulty finding lenders themselves. Intermediaries such as banks help in this
process. Banks take deposits from those who have money to save. They can then
lend money from this pool of deposited money to those who seek to borrow. Banks
popularly lend money in the form of loans and mortgages.
More complex transactions than a simple bank deposit require markets where
lenders and their agents can meet borrowers and their agents, and where existing
borrowing or lending commitments can be sold on to other parties. A good example
of a financial market is a stock exchange. A company can raise money by
selling shares to investors and its existing shares can be bought or sold.
The following table illustrates where financial markets fit in the relationship
between lenders and borrowers:
Relationship between lenders and borrowers
Lenders Financial Financial Borrowers
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Intermediaries Markets
Individuals
Companies
Banks
Insurance Companies
Pension Funds
Mutual Funds
Interbank
Stock Exchange
Money Market
Bond Market
Foreign Exchange
Individuals
Companies
Central Government
Municipalities
Public Corporations
Lenders
Who have enough money to Lend or to give someone money from own pocket at the
condition of getting back the principal amount or with some interest or charge, is the
Lender.
Individuals & Doubles
Many individuals are not aware that they are lenders, but almost everybody does
lend money in many ways. A person lends money when he or she:
puts money in a savings account at a bank;
contributes to a pension plan;
pays premiums to an insurance company;
invests in government bonds; or
Invests in company shares.
Companies
Companies tend to be borrowers of capital. When companies have surplus cash that
is not needed for a short period of time, they may seek to make money from their
cash surplus by lending it via short term markets called money markets.
There are a few companies that have very strong cash flows. These companies tend
to be lenders rather than borrowers. Such companies may decide to return cash to
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lenders (e.g. via a share buyback.) Alternatively, they may seek to make more
money on their cash by lending it (e.g. investing in bonds and stocks.
Borrowers
Individuals borrow money via bankers' loans for short term needs or longer term
mortgages to help finance a house purchase.
Companies borrow money to aid short term or long term cash flows. They also
borrow to fund modernization or future business expansion.
Governments often find their spending requirements exceed their tax revenues. To
make up this difference, they need to borrow. Governments also borrow on behalf of
nationalized industries, municipalities, local authorities and other public sector
bodies. In the UK, the total borrowing requirement is often referred to as the Public
sector net cash requirement (PSNCR).
Governments borrow by issuing bonds. In the UK, the government also borrows
from individuals by offering bank accounts and Premium Bonds. Government debt
seems to be permanent. Indeed the debt seemingly expands rather than being paid
off. One strategy used by governments to reduce the value of the debt is to
influence inflation.
Municipalities and local authorities may borrow in their own name as well as
receiving funding from national governments. In the UK, this would cover an
authority like Hampshire County Council.
Public Corporations typically include nationalized industries. These may include
the postal services, railway companies and utility companies.
Many borrowers have difficulty raising money locally. They need to borrow
internationally with the aid of Foreign exchange markets.
Borrower's having same need can form them into a group of borrowers. It can also
take an organizational form. just like Mutual Fund. They can provide mort gaze on
weight basis. The main advantage is that it lowers their cost of borrowings.
Derivative products
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During the 1980s and 1990s, a major growth sector in financial markets is the trade
in so called derivative products, or derivatives for short.
In the financial markets, stock prices, bond prices, currency rates, interest rates and
dividends go up and down, creating risk. Derivative products are financial products
which are used to control risk or paradoxically exploit risk. It is also called financial
economics.
Derivative products or instruments help the issuers to gain an unusual profit from
issuing the instruments. For using the help of these products a contract have to be
made. Derivative contracts are mainly 3 types: 1. Future Contracts 2. Forward
Contracts 3. Option Contracts.
Currency markets
Seemingly, the most obvious buyers and sellers of currency are importers and
exporters of goods. While this may have been true in the distant past, when
international trade created the demand for currency markets, importers and exporters
now represent only 1/32 of foreign exchange dealing, according to the Bank for
International Settlements.
The picture of foreign currency transactions today shows:
Banks/Institutions
Speculators
Government spending (for example, military bases abroad)
Importers/Exporters
Tourists
1.1MONEY MARKET
1.1(a) Introduction
The money market is a market for short-term funds, which deals in financial assets
whose period of maturity is upto one year. It helps in meeting the short-term and 15
very short-term requirements of banks, financial institutions, firms, companies and
also the Government. It should be noted that money market does not deal in cash or
money as such but simply provides a market for credit instruments such as bills of
exchange, promissory notes, commercial paper, treasury bills, etc. These financial
instruments are close substitute of money. These instruments help the business units,
other organizations and the Government to borrow the funds to meet their short-term
requirement.
Money market does not imply to any specific market place. Rather it refers to the
whole networks of financial institutions dealing in short-term funds, which provides
an outlet to lenders and a source of supply for such funds to borrowers. Most of the
money market transactions are taken place on telephone, fax or Internet. The Indian
money market consists of Reserve Bank of India, Commercial banks, Co-operative
banks, and other specialized financial institutions. The Reserve Bank of India is the
leader of the money market in India. Some Non-Banking Financial Companies
(NBFCs) and financial institutions like LIC, GIC, UTI, etc. also operate in the
Indian money market.
On the other hand, the surplus funds for short periods, with the individuals and other
savers, are immobilized through the market and made available to the aforesaid
entities for utilization by them. Thus, the money market provides a mechanism for
evening out short-term liquidity imbalances within an economy. The development of
the money market is, thus, a prerequisite for the growth and development of the
economy of a country.
1.1(b) PARTICIPANTS IN MONEY MARKET
The major participants who supply the funds and demand the same in the money
market are as follows:
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1. Reserve Bank of India: Reserve Bank of India is the regulator over the
money market in India. As the Central Bank, it injects liquidity in the
banking system, when it is deficient and contracts the same in opposite
situation.
2. Banks: Commercial Banks and the Co-operative Banks are the major
participants in the Indian money market. They mobilize the savings of the
people through acceptance of deposits and lend it to business houses for their
short term working capital requirements. While a portion of these deposits is
invested in medium and long-term Government securities and corporate
shares and bonds, they provide short-term funds to the Government by
investing in the Treasury Bills. They employ the short-term surpluses in
various money market instruments.
3. Discount and Finance House of India Ltd. (DFHI):
DFHI deals both ways in the money market instruments. Hence, it has helped
in the growth of secondary market, as well as those of the money market
instruments.
4. Financial and Investment Institutions:
These institutions (e.g. LIC, UTI, GIC, Development Banks, etc.) have been
allowed to participate in the call money market as lenders only.
5. Corporate:
Companies create demand for funds from the banking system. They raise
short-term funds directly from the money market by issuing commercial
paper. Moreover, they accept public deposits and also indulge in
intercorporate deposits and investments.
6. Mutual Funds: Mutual funds also invest their surplus funds in various
money market instruments for short periods. They are also permitted to
participate in the Call Money Market. Money Market Mutual Funds have
been set up specifically for the purpose of mobilization of short-term funds
for investment in money market instruments.
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1.1(b) INSTRUMENTS
1. TREASURY BILLS
A Treasury Bill is an instrument for short-term borrowing by the Government of
India. It is issued by the Reserve Bank of India on behalf of the Government of India
in the form of a promissory note.
The necessity for issuing treasury bills arises because of the periodic nature of
receipts of Government while the Government expenditure is on a continuing basis.
Taxes are payable to the Government after quarterly intervals or so, but Government
has to meet its expenditure on daily or monthly basis. Thus, to bridge this mis-match
between the timings of Government receipts and expenditure, Government borrows
money on short-term basis by issuing Treasury Bills.
The Treasury Bills are issued for different maturity periods. Till May 14, 2001, the
maturity periods were 14 days, 91 days, 182 days and 365 days. But with effect from
May 14, 2001 auctions of 14 days and 182 days Treasury Bills have been
discontinued. The Treasury Bills are sold through auctions. While auctions of 91
days Treasury Bills take place on a weekly basis, the auctions for 364, days Treasury
Bills are held on a fortnightly basis.
2. COMMERCIAL BILLS OF EXCHANGE
Commercial Bills of Exchange arise out of genuine trade transactions and are drawn
by the seller of the goods on the buyers (i.e. debtors), where goods are sold on
credit. They are called 'Demand Bills', when payable on demand or on presentment
before the buyer, who is called the 'drawee' of the bill. Alternatively, the bills may
be payable after a specified period of time, e.g. 30, 60 or 90 days. Such bills are
called 'Usance Bills and need acceptance by the drawee.
By accepting the bills, the drawee gives his consent to make payment of the bills on
the due date. Thus, payment of the bills is assured on the dates of maturity. These
bills are, therefore, called self-liquidating in nature. The drawee or the bill (i.e. the 18
seller of the goods) generally discounts the bill with a commercial bank. By
discounting is meant that the bill is endorsed in favour of the banker, who makes
payment of the amount of the bill less discount (interest on the amount for the period
of the bill) to the drawee. Thus, the drawee gets payment of the bill (discount)
immediately. The discounting banker, however, recovers the money from the
acceptor of the bill on the due date of the bill. The bill is thereafter extinguished.
Commercial bill of exchange is a negotiable instrument i.e.it may be negotiated (or
endorsed transferred) any number of times till its maturity. When the discounting
bank falls short of liquidity, it may negotiate the bill in favor of any other bank
financial institution or the Reserve Bank of India and may receive payment of the
bill less re-discounting charges (i.e. interest for the unexpired period of the bill).This
process is called re-discounting of Commercial Bills and may be undertaken several
times, till the date of maturity of the bill. The Reserve Bank of India introduced a
Bills Re-discounting Scheme in 1970. Under this scheme bills are re-discounted by
Reserve Bank of India or by any scheduled bank/financial institution/investment
institution/mutual fund. But important pre-conditions are that the bill should arise
out of a genuine trade transaction, must be accepted by the buyer's banker either
singly or jointly with him and the period of maturity should not exceed 90 days.
Commercial bill of exchange, thus, is an instrument through which the banks,
financial institutions/mutual funds may park their surplus funds for a shorter period
as they can afford. Thus liquidity imbalances in the financial system are removed or
minimized. Reserve Bank of India has taken several steps in the past, but the
practice of drawing bills has not become very popular in India. The obvious reason
is the strict discipline that it imposes on the acceptor of the bill to make payment of
the bill on the due date. Bills purchased and discounted by Scheduled Commercial
Banks in India as on March 31, 2001 constituted just 3.88% of their total assets (i.e.
Rs. 50224 crores). Rut the outstanding amount of commercial bills re-discounted by
them with various financial institutions was Rs. 1013 crores as on the same date.
This shows that bills re-discounting with other financial institutions is to a limited
extent only.
3. CERTIFICATES OF DEPOSITS
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A Certificate of Deposit is a receipt for a deposit of money with a bank or a financial
institution. It differs from a fixed Deposit Receipt in two respects. First, it is issued
for a big amount and second, it is freely negotiable. The Reserve Bank of India
announced the scheme of Certificates of Deposit in March 1989. The main features
of the scheme are as follows:
i) Certificate of Deposits can be issued by Scheduled Commercial Banks (excluding
Regional Rural Banks) and the specified All-India Financial Institutions like
Industrial Development Bank of India (IDBI), Industrial Finance Corporation of
lndia (IFCI), Industrial Credit and Investment Corporation of lndia (ICICI), Small
Industries Development Bank of India (SIDBI), Industrial Investment Bank of India
(IDBI), and the Export Import Bank of India (Exim Bank).
ii) Certificates of Deposits can be issued to Individuals, Associations, Companies
and Trust Funds.
iii) Certificates of Deposits are freely transferable by endorsement and delivery after
an initial lock-in period of 15 days after which they may be sold to any of the above
participants or to the Discount and Finance House of India (DFHI).
iv) The maturity period of Certificate of Deposits issued by Banks may range from 3
months to 12 months while those issued by specified Financial Institutions may
range from 1 to 3 years.
v) Certificate of Deposits are to be issued at a discount to the face value.
vi) Presently there is no limit on the amount which a Bank may raise through
Certificate of Deposits. Initially, though, there was a limit linked is the fortnightly
aggregate average deposits of the bank.
vii) The minimum amount for which they may be issued is now pegged at Rs. 5
Lacs. (Reduced from Rs. 25 Lacs).
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viii) The minimum size of issue of Certificate of Deposits to a single investor is Rs.
5 Lacs, thereafter they can be issued in multiples of Rs. 1 Lac, (with effect from
October1997).
ix) Banks and Financial Institutions are required to issue CDa only in dematerialized
form with effect from June 30, 2002. The existing CDs are to be converted into
demat forms by October 2002. Certificate of Deposits are a popular avenue for
companies to invest their short-term surpluses because Certificate of Deposits offer
n risk-free investment opportunity at rates of interest higher than Treasury bills and
term deposits, besides being fairly liquid. For the Issuing Banks, Certificate of
Deposits provides another source of mobilizing funds in bulk.
4. TRADE BILL:
Normally the traders buy goods from the wholesalers or manufactures on
credit. The sellers get payment after the end of the credit period. But if any seller
does not want to wait or in immediate need of money he/she can draw a bill of
exchange in favour of the buyer. When buyer accepts the bill it becomes a
negotiable instrument and is termed as bill of exchange or trade bill. This trade bill
can now be discounted with a bank before its maturity. On maturity the bank gets
the payment from the drawee i.e., the buyer of goods. When trade bills are accepted
by Commercial Banks it is known as Commercial Bills. So trade bill is an
instrument, which enables the drawer of the bill to get funds for short period to meet
the working capital needs.
6.2CAPITAL MARKET
Introduction
Capital Market may be defined as a market dealing in medium and long-term funds.
It is an institutional arrangement for borrowing medium and long-term funds and
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which provides facilities for marketing and trading of securities. So it constitutes all
long-term borrowings from banks and financial institutions, borrowings from
foreign markets and raising of capital by issue various securities such as shares
debentures, bonds, etc. The market where securities are traded known as Securities
market. It consists of two different segments namely primary and secondary market.
The primary market deals with new or fresh issue of securities and is, therefore, also
known as new issue market; whereas the secondary market provides a place for
purchase and sale of existing securities and is often termed as stock market or stock
exchange.
6.2(a) PRIMARY MARKET
I. New issue market
The primary market is an intermittent and discrete market where the initially
listed shares are traded first time, changing hands from the listed company to the
investors. It refers to the process through which the companies, the issuers of
stocks, acquire capital by offering their stocks to investors who supply the
capital. In other words primary market is that part of the capital markets that
deals with the issuance of new securities. Companies, governments or public
sector institutions can obtain funding through the sale of a new stock or bond
issue. This is typically done through a syndicate of securities dealers. The
process of selling new issues to investors is called underwriting. In the case of a
new stock issue, this sale is called an initial public offering (IPO). Dealers earn a
commission that is built into the price of the security offering, though it can be
found in the prospectus.
The Primary Market consists of arrangements, which facilitate the procurement
of long term funds by companies by making fresh issue of shares and
debentures. We know that companies make fresh issue of shares and/or
debentures at their formation stage and, if necessary, subsequently for the
expansion of business. It is usually done through private placement to friends,
relatives and financial institutions or by making public issue.
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In any case, the companies have to follow a well-established legal procedure and
involve a number of intermediaries such as underwriters, brokers, etc. who form
an integral part of the primary market. You must have learnt about many initial
public offers (IPOs) made recently by a number of public sector undertakings
such as ONGC, GAIL, NTPC and the private sector companies like Tata
Consultancy Services (TCS), Biocon, Jet-Airways and so on.
II. Mode of issuing securities
Most companies are usually started privately by their promoter(s). However, the
promoters' capital and the borrowings from banks and financial institutions may not
be sufficient for setting up or running the business over a long term. So companies
invite the public to contribute towards the equity and issue shares to individual
investors.
The way to invite share capital from the public is through a 'Public Issue'. Simply
stated, a public issue is an offer to the public to subscribe to the share capital of a
company. Once this is done, the company allots shares to the applicants as per the
prescribed rules and regulations laid down by SEBI.
Primarily, issues can be classified as a Public, Rights or Preferential issues (also
known as private placements). While public and rights issues involve a detailed
procedure, private placements or preferential issues are relatively simpler. The
classification of issues is illustrated below:
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a) Initial Public Offering (IPO) is when an unlisted company makes either a
fresh issue of securities or an offer for sale of its existing securities or both
for the first time to the public. This paves way for listing and trading of the
issuer's securities.
An initial public offering (IPO), referred to simply as an "offering" or
"flotation", is when a company (called the issuer) issues common
stock or shares to the public for the first time. They are often issued by
smaller, younger companies seeking capital to expand, but can also be done
by large privately owned companies looking to become publicly traded.
In an IPO the issuer obtains the assistance of an underwriting firm, which
helps determine what type of security to issue (common or preferred), best
offering price and time to bring it to market.
ADVANTAGES OF AN IPO
Bolstering and diversifying equity base
Enabling cheaper access to capital
Exposure, prestige and public image
Attracting and retaining better management and employees through liquid equity
participation
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Facilitating acquisitions
Creating multiple financing opportunities: equity, convertible debt, cheaper bank
loans, etc.
Increased liquidity for equity holder
Disadvantages of an IPO
There are several disadvantages to completing an initial public offering, namely:
Significant legal, accounting and marketing costs
Ongoing requirement to disclose financial and business information
Meaningful time, effort and attention required of senior management
Risk that required funding will not be raised
Public dissemination of information which may be useful to competitors,
suppliers and customers.
Procedure
IPOs generally involve one or more investment banks known as "underwriters". The
company offering its shares, called the "issuer", enters a contract with a lead
underwriter to sell its shares to the public. The underwriter then approaches
investors with offers to sell these shares.
The sale (allocation and pricing) of shares in an IPO may take several forms.
Common methods include: A large IPO is usually underwritten by a "syndicate" of
investment banks led by one or more major investment banks (lead underwriter).
Upon selling the shares, the underwriters keep a commission based on a percentage
of the value of the shares sold (called the gross spread). Usually, the lead
underwriters, i.e. the underwriters selling the largest proportions of the IPO, take the
highest commissions—up to 8% in some cases.
Multinational IPOs may have many syndicates to deal with differing legal
requirements in both the issuer's domestic market and other regions. For example, an
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issuer based in the E.U. may be represented by the main selling syndicate in its
domestic market, Europe, in addition to separate syndicates or selling groups for
US/Canada and for Asia. Usually, the lead underwriter in the main selling group is
also the lead bank in the other selling groups.
Because of the wide array of legal requirements and because it is an expensive
process, IPOs typically involve one or more law firms with major practices
in securities law, such as the Magic Circle firms of London and the white shoe
firms of New York City.
Public offerings are sold to both institutional investors and retail clients of
underwriters. A licensed securities salesperson ( Registered Representative in
the USA and Canada ) selling shares of a public offering to his clients is paid a
commission from their dealer rather than their client. In cases where the salesperson
is the client's advisor it is notable that the financial incentives of the advisor and
client are not aligned.
In the US sales can only be made through a final Prospectus cleared by the
Securities and Exchange Commission.
A follow on public offering (Further Issue) is when an already listed company
makes either a fresh issue of securities to the public or an offer for sale to the public,
through an offer document.
b) Rights Issue A rights issue is a way in which a company can sell new
shares in order to raise capital. Shares are offered to existing shareholders in
proportion to their current shareholding, respecting their pre-emption rights.
The price at which the shares are offered is usually at a discount to the
current share price, which gives investors an incentive to buy the new shares
— if they do not, the value of their holding is diluted.
A rights issue by a highly geared company intended to strengthen its balance
sheet is often a bad sign. Profits are already low (or negative) and future
profits are diluted. Unless the underlying business is improved, changing
its capital structure achieves little.
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A rights issue to fund expansion can usually be regarded somewhat more
optimistically, although, as with acquisitions, shareholders should be
suspicious because management may be empire-building at their expense
(the usual agency problem with expansion).
The rights are normally a trade able security themselves (a type of short
dated warrant). This allows shareholders who do not wish to purchase new
shares to sell the rights to someone who does. Whoever holds a right can
choose to buy a new share (exercise the right) by a certain date at a set price.
Some shareholders may choose to buy all the rights they are offered in the
rights issue. This maintains their proportionate ownership in the expanded
company, so that an x% stake before the rights issue remains an x% stake
after it. Others may choose to sell their rights, diluting their stake and
reducing the value of their holding.
If rights are not taken up the company may (and in practice, in many
markets, does) sell them on behalf of the rights holder.
Because the rights are usually worth enough to cover the price difference
between the market price of the shares and the exercise price of the rights
(because of the law of one price), shareholders do not lose if the rights are
issued at a steep discount. It is therefore usual for the discount to be large
(especially of the share price is volatile) to ensure that the rights are
exercised.
A rights issue is an issue of additional shares by a company to raise capital
under a seasoned equity offering. The rights issue is a special form of shelf
offering or shelf registration. With the issued rights, existing shareholders
have the privilege to buy a specified number of new shares from the firm at a
specified price within a specified time. A rights issue is in contrast to an
initial public offering, where shares are issued to the general public through
market exchanges. Closed-end companies cannot retain earnings, because
they distribute essentially all of their realized income, and capital gains each
year. They raise additional capital by rights offerings. Companies usually opt
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for a rights issue either when having problems raising capital through
traditional means or to avoid interest charges on loans.
A rights issue is directly offered to all shareholders of record or through
broker dealers of record and may be exercised in full or partially.
Subscription rights may either be transferable, allowing the subscription-
right shareholder to sell them privately, on the open market or not at all. A
right issuance to shareholders is generally issued as a tax-free dividend on a
ratio basis (e.g. a dividend of one subscription right for one share of
Common stock issued and outstanding). Because the company receives
shareholders' money in exchange for shares, a rights issue is a source
of capital in an organization.
Considerations
Issue rights the financial manager has to consider:
Engaging a Dealer-Manager or Broker Dealer to manage the Offering processes
Selling Group and broker dealer participation
Subscription price per new share
Number of new shares to be sold
The value of rights vs. trading price of the subscription rights
The effect of rights on the value of the current share
The effect of rights to shareholders of record and new shareholders and right
shareholders.
c) Preferential issue
It is an issue of shares or of convertible securities by listed companies to a
select group of persons under Section 81 of the Companies Act, 1956 which
is neither a rights issue nor a public issue. This is a faster way for a company
to raise equity capital. The issuer company has to comply with the
Companies Act and the requirements contained in the Chapter pertaining to
preferential allotment in SEBI guidelines which inter-alia include pricing,
disclosures in notice etc.
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d) Private Placement
The sale of securities to a relatively small number of select investors as a
way of raising capital. Investors involved in private placements are usually
large banks, mutual funds, insurance companies and pension funds. Private
placement is the opposite of a public issue, in which securities are made
available for sale on the open market.
Since a private placement is offered to a few, select individuals, the
placement does not have to be registered with the Securities and Exchange
Commission. In many cases, detailed financial information is not disclosed
and a need for a prospectus is waived. Finally, since the placements are
private rather than public, the average investor is only made aware of the
placement after it has occurred.
ACTIVITIES IN CASE OF PUBLIC ISSUE AND RIGHT ISSUES
I. Listing for Public issue
Listing means admission of securities of an issuer to trading privileges (dealings) on
a stock exchange through a formal agreement. The prime objective of admission to
dealings on the exchange is to provide liquidity and marketability to securities, as
also to provide a mechanism for effective control and supervision of trading.
When a company lists its securities on a public exchange, the money paid by
investors for the newly-issued shares goes directly to the company (in contrast to a
later trade of shares on the exchange, where the money passes between
investors). An IPO, therefore, allows a company to tap a wide pool of investors to
provide it with capital for future growth, repayment of debt or working capital. A
company selling common shares is never required to repay the capital to investors.
Once a company is listed, it is able to issue additional common shares via a
secondary offering, thereby again providing itself with capital for expansion
without incurring any debt. This ability to quickly raise large amounts of
capital from the market is a key reason many companies seek to go public.
II. Underwriting for right issues
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Rights issues may be underwritten. The role of the underwriter is to guarantee that
the funds sought by the company will be raised. The agreement between the
underwriter and the company is set out in a formal underwriting agreement.
Typical terms of an underwriting require the underwriter to subscribe for any
shares offered but not taken up by shareholders. The underwriting agreement will
normally enable the underwriter to terminate its obligations in defined
circumstances. A sub-underwriter in turn sub-underwrites some or all of the
obligations of the main underwriter; the underwriter passes its risk to the sub-
underwriter by requiring the sub-underwriter to subscribe for or purchase a
portion of the shares for which the underwriter is obliged to subscribe in the event
of a shortfall. Underwriters and sub-underwriters may be financial institutions,
stock-brokers, major shareholders of the company or other related or unrelated
parties.
Basic example
An investor:
Mr. A had 100 shares of company X at a total investment of $40,000, assuming that he
purchased the shares at $400 per share and that the stock price did not change between
the purchase date and the date at which the rights were issued.
Assuming a 1:1 subscription rights issue at an offer price of $200, Mr. A will be notified by a
broker dealer that he has the option to subscribe for an additional 100 shares of common
stock of the company at the offer price. Now, if he exercises his option, he would have to
pay an additional $20,000 in order to acquire the shares, thus effectively bringing his
average cost of acquisition for the 200 shares to $300 per share
((40,000+20,000)/200=300). Although the price on the stock markets should reflect a new
price of $300 (see below), the investor is actually not making any profit nor any loss. In
many cases, the stock purchase right (which acts as an option) can be traded at an
exchange. In this example, the price of the right would adjust itself to $100 (ideally).
The company:
Company X has 100 million outstanding shares. The share price currently quoted on the
stock exchanges is $400 thus the market capitalization of the stock would be $40 billion
(outstanding shares times share price).
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If all the shareholders of the company choose to exercise their stock option, the company's
outstanding shares would increase by 100 million. The market capitalization of the stock
would increase to $60 billion (previous market capitalization + cash received from owners
of rights converting their rights to shares), implying a share price of $300 ($60 billion / 200
million shares). If the company were to do nothing with the raised money, its Earnings per
share (EPS) would be reduced by half. However, if the equity raised by the company is
reinvested (e.g. to acquire another company), the EPS may be impacted depending upon
the outcome of the reinvestment.
6.2(c) Intermediaries for raising fund
Financial intermediaries as the name suggests are middlemen, i.e institutions that
stand between investors and companies raising capital/funds. They include banks,
insurance companies, investment dealers, mutual and pension funds. An institution
that acts as the middleman between investors and firms raising funds. Often referred
to as financial institutions.
6.2(d) IPO Grading
IPO grading is the grade assigned by a Credit Rating Agency registered with SEBI,
to the initial public offering (IPO) of equity shares or any other security which may
be converted into or exchanged with equity shares at a later date. The grade
represents a relative assessment of the fundamentals of that issue in relation to the
other listed equity securities inIndia. Such grading is generally assigned on a five-
point point scale with a higher score indicating stronger fundamentals and vice versa
as below
IPO grade 1: Poor fundamentals
IPO grade 2: Below-average fundamentals
IPO grade 3: Average fundamentals
IPO grade 4: Above-average fundamentals
IPO grade 5: Strong fundamentals
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IPO grading has been introduced as an endeavor to make additional information
available for the investors in order to facilitate their assessment of equity issues
offered through an IPO.
IPO grading can be done either before filing the draft offer documents with SEBI or
thereafter. However, the Prospectus/Red Herring Prospectus, as the case may be,
must contain the grade/s given to the IPO by all CRAs approached by the company
for grading such IPO.Further information regarding the grading process may be
obtained from the Credit Rating Agencies
Grading process and methodology
IPO Grading is designed to provide investors an independent, reliable and consistent
assessment of the fundamentals of IPO Issuer Companies. As IPO Grading is
decided much earlier than the issue price or issue dates are finalize (usually on the
IPO filing) and they only tells the fundamentals of the company, investors should
not consider them as 'Buy IPO' or 'Skip IPO' recommendations.
IPO Ratings, IPO Grading and IPO Ranking are among the few popular inputs
investor's uses before applying in an initial public offerings IPO.
IPO Ratings are provided by various financial institutions & independent brokers.
Few popular IPO Rating providers in India are Capital Market, Money Control, S P
Tulsian's IPO recommendations etc.
IPO Grading is provided by SEBI approved rating agencies including CRISIL, CARE
and ICRA. IPO Grading is designed to provide investors an independent, reliable
and consistent assessment of the fundamentals of IPO Issuer Companies. As IPO
Grading is decided much earlier than the issue price or issue dates are finalize
(usually on the IPO filing) and they just tell about the fundamentals of the
company, investors should not consider them as 'Buy IPO' or 'Skip IPO'
recommendations.
It is a rating assigned by the Securities and Exchange Board of India-
registered credit rating agencies to initial public offerings (IPOs) of various
firms. The grade indicates an assessment of business fundamentals and
market conditions in comparison to other listed equities at the time of the 32
issuance. These ratings are generally assigned on a five-point scale, with a
higher score indicating stronger companies. IPO grading can be done either
before filing the draft offer documents or thereafter. However, the red
herring prospectus must have the grades given by all the rating agencies.
A company which has filed the draft offer document for an IPO on or after
May 1, 2007, must be rated by at least one agency. Companies cannot reject
the grade. If dissatisfied, they can opt for another agency. But, all grades
obtained for the IPO must be disclosed to the regulator and the investors.
6.2(b) SECONDARY MARKET
The secondary market, also known as the aftermarket, is the financial market
where previously issued securities and financial instruments such as stock, bonds,
options, and futures are bought and sold. The term "secondary market" is also used
to refer to the market for any used goods or assets, or an alternative use for an
existing product or asset where the customer base is the second market (for example,
corn has been traditionally used primarily for food production and feedstock, but a
"second" or "third" market has developed for use in ethanol production). Another
commonly referred to usage of secondary market term is to refer to loans which are
sold by a mortgage bank to investors such as Fannie Mae and Freddie Mac.
In the secondary market, stocks and shares in publicly traded companies are bought
and sold through one of the major stock exchanges, which serve as managed
auctions for stock. A stock exchange, share market, or bourse is a company,
corporation, or mutual organization that provides facilities for stockbrokers and
traders to trade stocks and other securities. Stock exchanges also provide facilities
for the issue and redemption of securities, trading in other financial instruments, and
the payment of income and dividends.
With primary issuances of securities or financial instruments, or the primary market,
investors purchase these securities directly from issuers such as corporations issuing
shares in an IPO or private placement, or directly from the federal government in the
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case of treasuries. After the initial issuance, investors can purchase from other
investors in the secondary market.
Secondary market refers to a market where securities are traded after being initially
offered to the public in the primary market and/or listed on the Stock Exchange.
Majority of the trading is done in the secondary market. Secondary market
comprises of equity markets and the debt markets. The secondary market enables
participants who hold securities to adjust their holdings in response to changes in
their assessment of risk and return. They also sell securities for cash to meet their
liquidity needs. The secondary market has further two components, namely the over-
the-counter (OTC) market and the exchange-traded market.
OTC is different from the market place provided by the Over The Counter
Exchange of India Limited. OTC markets are essentially informal markets where
trades are negotiated. Most of the trades in government securities are in the OTC
market. All the spot trades where securities are traded for immediate delivery and
payment take place in the OTC market. The exchanges do not provide facility for
spot trades in a strict sense. Closest to spot market is the cash market where
settlement takes place after some time.
Trades taking place over a trading cycle, i.e. a day under rolling settlement, are
settled together after a certain time (currently 2 working days). Trades executed on
the leading exchange (National Stock Exchange of India Limited (NSE) are cleared
and settled by a clearing corporation which provides novation and settlement
guarantee.
Nearly 100% of the trades settled by delivery are settled in demat form. NSE also
provides a formal trading platform for trading of a wide range of debt securities
including government securities. A variant of secondary market is the forward
market, where securities are traded for future delivery and payment. Pure forward is
outside the formal market. The versions of forward in formal market are futures and
options. In futures market, standardized securities are traded for future delivery and
settlement. These futures can be on a basket of securities like an index or an
individual security.
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In case of options, securities are traded for conditional future delivery. There are
two types of options–a put option permits the owner to sell a security to the writer of
options at a predetermined price while a call option permits the owner to purchase a
security from the writer of the option at a predetermined price. These options can
also be on individual stocks or basket of stocks like index.
Two exchanges, namely NSE and the Bombay Stock Exchange, (BSE) provide
trading of derivatives of securities. The past few years in many ways have been
remarkable for securities market in India. It has grown exponentially as measured in
terms of amount raised from the market, number of stock exchanges and other
intermediaries, the number of listed stocks, market capitalization, trading volumes
and turnover on stock exchanges, and investor population.
Along with this growth, the profiles of the investors, issuers and intermediaries have
changed significantly. The market has witnessed fundamental institutional changes
resulting in drastic reduction in transaction costs and significant improvements in
efficiency, transparency and safety.
Reforms in the securities market, particularly the establishment and empowerment
of SEBI, market determined allocation of resources, screen based nation-wide
trading, dematerialization and electronic transfer of securities, rolling settlement and
ban on deferral products, sophisticated risk management and derivatives trading,
have greatly improved the regulatory framework and efficiency of trading and
settlement. Indian market is now comparable to many developed markets in terms of
a number of qualitative parameters.
ADVANTAGES
Capital markets provide the lubricant between investors and those needing to
raise capital.
Capital markets create price transparency and liquidity. They provide a safe
platform for a wide range of investors —including commercial and
investment banks, insurance companies, pension funds, mutual funds, and
retail investors—to hedge and speculate.
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Holding different shares or bonds allows an investor to spread investment
risk.
The secondary market gives important pricing information that permits
efficient use of limited capital.
DISADVANTAGES
In capital markets, bond prices are influenced by economic data such as
employment, income growth/decline, consumer prices, and industrial prices.
Any information that implies rising inflation will weaken bond prices, as
inflation reduces the income from a bond.
Prices for shares in capital markets can be very volatile. Their value depends
on a number of external factors over which the investor has no control.
Different shares can have different levels of liquidity, i.e. demand from
buyers and sellers.
DISTINCTION BETWEEN PRIMARY MARKET AND SECONDARY
MARKET
The main points of distinction between the primary market and secondary market
are as follows:
1. Function: While the main function of primary market is to raise long-term funds
through fresh issue of securities, the main function of secondary market is to provide
continuous and ready market for the existing long-term securities.
2. Participants: While the major players in the primary market are financial
institutions, mutual funds, underwriters and individual investors, the major players
in secondary market are all of these and the stockbrokers who are members of the
stock exchange.
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3. Listing Requirement: While only those securities can be dealt within the
secondary market, which have been approved for the purpose (listed), there is no
such requirement in case of primary market.
4. Determination of prices: In case of primary market, the prices are determined by
the management with due compliance with SEBI requirement for new issue of
securities.
But in case of secondary market, the price of the securities is determined by
forces of demand and supply of the market and keeps on fluctuating.
MEANING OF STOCK EXCHANGE
Stock markets refer to a market place where investors can buy and sell
stocks. The price at which each buying and selling transaction takes is
determined by the market forces (i.e. demand and supply for a particular
stock).
Let us take an example for a better understanding of how market forces
determine stock prices. ABC Co. Ltd. enjoys high investor confidence and
there is an anticipation of an upward movement in its stock price. More and
more people would want to buy this stock (i.e. high demand) and very few
people will want to sell this stock at current market price (i.e. less supply).
Therefore, buyers will have to bid a higher price for this stock to match the
ask price from the seller which will increase the stock price of ABC Co. Ltd.
On the contrary, if there are more sellers than buyers (i.e. high supply and
low demand) for the stock of ABC Co. Ltd. in the market, its price will fall
down.
In earlier times, buyers and sellers used to assemble at stock exchanges to
make a transaction but now with the dawn of IT, most of the operations are
done electronically and the stock markets have become almost paperless.
Now investors don’t have to gather at the Exchanges, and can trade freely
from their home or office over the phone or through Internet.
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As indicated above, stock exchange is the term commonly used for a
secondary market,which provide a place where different types of existing
securities such as shares, debentures and bonds, government securities can be
bought and sold on a regular basis. A stock exchange is generally organised
as an association, a society or a company with a limited number of members.
It is open only to these members who act as brokers for the buyers and
sellers. The Securities Contract (Regulation) Act has defined stock exchange
as an “ association, organisation or body of individuals, whether incorporated
or not, established for the purpose of assisting, regulating and controlling
business of buying, selling and dealing in securities”.
THE MAIN CHARACTERISTICS OF A STOCK EXCHANGE ARE:
1. It is an organised market.
2. It provides a place where existing and approved securities can be bought and sold
easily.
3. In a stock exchange, transactions take place between its members or their
authorized agents.
4. All transactions are regulated by rules and by laws of the concerned stock
exchange.
5. It makes complete information available to public in regard to prices and volume
of transactions taking place every day.
It may be noted that all securities are not permitted to be traded on a recognized
stock exchange. It is allowed only in those securities (called listed securities) that
have been duly approved for the purpose by the stock exchange authorities.
The method of trading now-a-days, however, is quite simple on account of the
availability of on-line trading facility with the help of computers. It is also quite fast
as it takes just a few minutes to strike a deal through the brokers who may be
available close by. Similarly, on account of the system of scrip-less trading and
rolling settlement, the delivery of securities and the payment of amount involved
also take very little time, say, 2 days.
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HISTORY AND ORIGANIZATION OF STOCK MARKET IN
The Origin One of the oldest stock markets in Asia, the Indian Stock Markets
have a 200 years old history.
18th Century East India Company was the dominant institution and by end of the
century, busuness in its loan securities gained full momentum
1830's Business on corporate stocks and shares in Bank and Cotton presses
started in Bombay. Trading list by the end of 1839 got broader
1840's Recognition from banks and merchants to about half a dozen brokers
1850's Rapid development of commercial enterprise saw brokerage business
attracting more people into the business
1860's The number of brokers increased to 60
1860-61 The American Civil War broke out which caused a stoppage of cotton
supply from United States of America; marking the beginning of the
"Share Mania" in India
1862-63 The number of brokers increased to about 200 to 250
1865 A disastrous slump began at the end of the American Civil War (as an
example, Bank of Bombay Share which had touched Rs. 2850 could
only be sold at Rs. 87)
Pre-Independance Scenario - Establishment of Different Stock Exchanges
1874 With the rapidly developing share trading business, brokers used to gather
at a street (now well known as "Dalal Street") for the purpose of
transacting business.
The origin of the stock market in India goes back to the end of the eighteenth
century when long-term negotiable securities were first issued. However, for all
practical purposes, the real beginning occurred in the middle of the nineteenth
century after the enactment of the companies Act in 1850, which introduced the
features of limited liability and generated investor interest in corporate securities.
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The first organised stock exchange in India was started in Mumbai known as
Bombay Stock Exchange (BSE). It was followed by Ahmedabad Stock Exchange in
1894 and Kolkata Stock Exchange in 1908. The number of stock exchanges in India
went upto 7 by 1939 and it increased to 21 by 1945 on account of heavy speculation
activity during Second World War.
A number of unorganised stock exchanges also functioned in the country without
any formal set-up and were known as kerb market. The Security Contracts
(Regulation) Act was passed in 1956 for recognition and regulation of Stock
Exchanges in India.
At present we have 23 stock exchanges in the country. Of these, the most prominent
stock exchange that came up is National Stock Exchange (NSE). It is also based in
Mumbai and was promoted by the leading financial institutions in India. It was
incorporated in 1992 and commenced operations in 1994. This stock exchange has a
corporate structure, fully automated screen-based trading and nation-wide coverage.
Another stock exchange that needs special mention is Over The Counter Exchange
of India (OTCEI). It was also promoted by the financial institutions like UTI, ICICI,
IDBI,
An important early event in the development of the stock market in India was the
formation of the native share and stock brokers 'Association at Bombay in 1875,
the precursor of the present day Bombay Stock Exchange. This was followed by the
formation of associations/exchanges in Ahmedabad (1894), Calcutta (1908), and
Madras (1937). In addition, a large number of ephemeral exchanges emerged mainly
in buoyant periods to recede into oblivion during depressing times subsequently.
Stock exchanges are intricacy inter-woven in the fabric of a nation's economic life.
Without a stock exchange, the saving of the community- the sinews of economic
progress and productive efficiency- would remain underutilized. The task of
mobilization and allocation of savings could be attempted in the old days by a much
less specialized institution than the stock exchanges. But as business and industry
expanded and the economy assumed more complex nature, the need for 'permanent
finance' arose. Entrepreneurs needed money for long term whereas investors
demanded liquidity – the facility to convert their investment into cash at any given
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time. The answer was a ready market for investments and this was how the stock
exchange came into being.
Stock exchange means anybody of individuals, whether incorporated or not,
constituted for the purpose of regulating or controlling the business of buying,
selling or dealing in securities. These securities include:
a. Shares, scrip, stocks, bonds, debentures stock or other marketable securities
of a like nature in or of any incorporated company or other body corporate;
b. Government securities; and
c. Rights or interest in securities.
The Bombay Stock Exchange (BSE) and the National Stock Exchange of
India Ltd (NSE) are the two primary exchanges in India. In addition, there
are 22 Regional Stock Exchanges. However, the BSE and NSE have
established themselves as the two leading exchanges and account for about
80 per cent of the equity volume traded in India. The NSE and BSE are equal
in size in terms of daily traded volume. The average daily turnover at the
exchanges has increased from Rs 851 crore in 1997-98 to Rs 1,284 crore in
1998-99 and further to Rs 2,273 crore in 1999-2000 (April - August 1999).
NSE has around 1500 shares listed with a total market capitalization of
around Rs 9, 21,500 crore.
The BSE has over 6000 stocks listed and has a market capitalization of
around Rs 9, 68,000 crore. Most key stocks are traded on both the exchanges
and hence the investor could buy them on either exchange. Both exchanges
have a different settlement cycle, which allows investors to shift their
positions on the bourses. The primary index of BSE is BSE Sensex
comprising 30 stocks. NSE has the S&P NSE 50 Index (Nifty) which
consists of fifty stocks. The BSE Sensex is the older and more widely
followed index.
Both these indices are calculated on the basis of market capitalization and
contain the heavily traded shares from key sectors. The markets are closed
on Saturdays and Sundays. Both the exchanges have switched over from 41
the open outcry trading system to a fully automated computerized mode of
trading known as BOLT (BSE on Line Trading) and NEAT (National
Exchange Automated Trading) System.
It facilitates more efficient processing, automatic order matching, faster
execution of trades and transparency; the scrip's traded on the BSE have been
classified into 'A', 'B1', 'B2', 'C', 'F' and 'Z' groups. The 'A' group shares
represent those, which are in the carry forward system (Badla). The 'F' group
represents the debt market (fixed income securities) segment. The 'Z' group
scrip's are the blacklisted companies. The 'C' group covers the odd lot
securities in 'A', 'B1' & 'B2' groups and Rights renunciations. The key
regulator governing Stock Exchanges, Brokers, Depositories, Depository
participants, Mutual Funds, FIIs and other participants in Indian secondary
and primary market is the Securities and Exchange Board of India (SEBI)
Ltd.
IFCI, LIC etc. in September 1992 specially to cater to small and medium
sized companies with equity capital of more than Rs.30 lakh and less than
Rs.25 crore. It helps entrepreneurs in raising finances for their new projects
in a cost effective manner. It provides for nationwide online ringless trading
with 20 plus representative offices in all major cities of the country. On this
stock exchange, securities of those companies can be traded which are
exclusively listed on OTCEI only. In addition, certain shares and debentures
listed with other stock exchanges in India and the units of UTI and other
mutual funds are also allowed to be traded on OTCEI as permitted securities.
It has been noticed that, of late, the turnover at this stock exchange has
considerably reduced and steps have been afoot to revitalize it. In fact, as of
now, BSE and NSE are the two Stock Exchanges, which enjoy nation-wide
coverage and handle most of the business in securities in the country.
REGULATIONS OF STOCK EXCHANGES
As indicated earlier, the stock exchanges suffer from certain limitations and require
strict control over their activities in order to ensure safety in dealings thereon.
Hence, as early as 1956, the Securities Contracts (Regulation) Act was passed which
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provided for recognition of stock exchanges by the central Government. It has also
the provision of framing of proper bylaws by every stock exchange for regulation
and control of their functioning subject to the approval by the Government. All stock
exchanges are required submit information relating to its affairs as required by the
Government from time to time. The Government was given wide powers relating to
listing of securities, make or amend bylaws, withdraw recognition to, or supersede
the governing bodies of stock exchange in extraordinary/abnormal situations. Under
the Act, the Government promulgated the Securities Regulations (Rules) 1957,
which provided inter alia for the procedures to be followed for recognition of the
stock exchanges, submission of periodical returns and annual returns by recognised
stock exchanges, inquiry into the affairs of recognised stock exchanges and their
members, and requirements for listing of securities
FUNCTIONS OF A STOCK EXCHANGE
The functions of stock exchange can be enumerated as follows:
1. Provides ready and continuous market: By providing a place where listed
securities can be bought and sold regularly and conveniently, a stock exchange
ensures a ready and continuous market for various shares, debentures, bonds and
government securities This lends a high degree of liquidity to holdings in these
securities as the investor can encash their holdings as and when they want.
2. Provides information about prices and sales:
A stock exchange maintains complete record of all transactions taking place in
different securities every day and supplies regular information on their prices and
sales volumes to press and other media. In fact, now-a-days, you can get information
about minute to minute movement in prices of selected shares on TV channels like
CNBC, Zee News, NDTV and Headlines Today.
This enables the investors in taking quick decisions on purchase and sale of
securities in which they are interested. Not only that, such information helps them in
ascertaining the trend in prices and the worth of their holdings. This enables them to
seek bank loans, if required.
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3. Provides safety to dealings and investment:
Transactions on the stock exchange are conducted only amongst its members with
adequate transparency and in strict conformity to its rules and regulations which
include the procedure and timings of delivery and payment to be followed. This
provides a high degree of safety to dealings at the stock exchange. There is little risk
of loss on account of non-payment or nondelivery. Securities and Exchange Board
of India (SEBI) also regulates the business in stock exchanges in India and the
working of the stock brokers. Not only that, a stock exchange allows trading only in
securities that have been listed with it; and for listing any security, it satisfies itself
about the genuineness and soundness of the company and provides for disclosure of
certain information on regular basis. Though this may not guarantee the soundness
and profitability of the company, it does provide some assurance on their
genuineness and enables them to keep track of their progress.
5. Helps in mobilisation of savings and capital formation:
Efficient functioning of stock market creates a conducive climate for an active and
growing primary market. Good performance and outlook for shares in the stock
exchanges imparts buoyancy to the new issue market, which helps in mobilizing
savings for investment in industrial and commercial establishments. Not only that,
the stock exchanges provide liquidity and profitability to dealings and investments
in shares and debentures. It also educates people on where and how to invest their
savings to get a fair return. This encourages the habit of saving, investment and risk-
taking among the common people. Thus it helps mobilising surplus savings for
investment in corporate and government securities and contributes to capital
formation.
6. Barometer of economic and business conditions:
Stock exchanges reflect the changing conditions of economic health of a country, as
the shares prices are highly sensitive to changing economic, social and political
conditions. It is observed that during the periods of economic prosperity, the share
prices tend to rise. Conversely, prices tend to fall when there is economic stagnation
and the business activities slow down as a result of depressions. Thus, the intensity
of trading at stock exchanges and the corresponding rise on fall in the prices of
securities reflects the investors’ assessment of the economic and business conditions
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in a country, and acts as the barometer which indicates the general conditions of the
atmosphere of business.
7. Better Allocation of funds:
As a result of stock market transactions, funds flow from the less profitable to more
profitable enterprises and they avail of the greater potential for growth. Financial
resources of the economy are thus better allocated.
ADVANTAGES OF STOCK EXCHANGES
Having discussed the functions of stock exchanges, let us look at the advantages
which can be outlined from the point of view of (a) Companies, (b) Investors, and
(c) the Society as a whole.
(a) To the Companies
(i) The companies whose securities have been listed on a stock exchange enjoy a
better goodwill and credit-standing than other companies because they are supposed
to be financially sound.
(ii) The market for their securities is enlarged as the investors all over the world
become aware of such securities and have an opportunity to invest
(iii) As a result of enhanced goodwill and higher demand, the value of their
securities increases and their bargaining power in collective ventures, mergers, etc.
is enhanced.
(iv) The companies have the convenience to decide upon the size, price and timing
of the issue.
(b) To the Investors:
(i) The investors enjoy the ready availability of facility and convenience of buying
and selling the securities at will and at an opportune time. Because of the assured
safety in dealings at the stock exchange the investors are free from any anxiety about
the delivery and payment problems.
(iii) Availability of regular information on prices of securities traded at the stock
exchanges helps them in deciding on the timing of their purchase and sale.
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(iv) It becomes easier for them to raise loans from banks against their holdings in
securities traded at the stock exchange because banks prefer them as collateral on
account of their liquidity and convenient valuation.
(c) To the Society
(i) The availability of lucrative avenues of investment and the liquidity thereof
induces people to save and invest in long-term securities. This leads to increased
capital formation in the country.
(ii) The facility for convenient purchase and sale of securities at the stock exchange
provides support to new issue market. This helps in promotion and expansion of
industrial activity, which in turn contributes, to increase in the rate of industrial
growth.
(iii) The Stock exchanges facilitate realisation of financial resources to more
profitable and growing industrial units where investors can easily increase their
investment substantially.
(iv) The volume of activity at the stock exchanges and the movement of share prices
reflect the changing economic health.
(v) Since government securities are also traded at the stock exchanges, the
government borrowing is highly facilitated. The bonds issued by governments,
electricity boards, municipal corporations and public sector undertakings (PSUs) are
found to be on offer quite frequently and are generally successful.
LIMITATIONS OF STOCK EXCHANGES
Like any other institutions, the stock exchanges too have their limitations. One of
the common evils associated with stock exchange operations is the excessive
speculation. You know that speculation implies buying or selling securities to take
advantage of price differential at different times. The speculators generally do not
take or give delivery and pay or receive full payment. They settle their transactions
just by paying the difference in prices. Normally, speculation is considered a healthy
practice and is necessary for successful operation of stock exchange activity. But,
when it becomes excessive, it leads to wide fluctuations in prices and various
malpractices by the vested interests. In the process, genuine investors suffer and are
driven out of the market. Another shortcoming of stock exchange operations is that
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security prices may fluctuate due to unpredictable political, social and economic
factors as well as on account of rumors spread by interested parties. This makes it
difficult to assess the movement of prices in future and build appropriate strategies
for investment in securities. However, these days good amount of vigilance is
exercised by stock exchange authorities and SEBI to control activities at the stock
exchange and ensure their healthy functioning.
MARKET MECHANISM
BUYING AND SELLING PROCEDURE INCLUDING ONLINE TRADING
Placing an order
An order in a market such as a stock market, bond market, commodity
market or financial derivative market is an instruction from customers to brokers
to buy or sell on the exchange. These instructions can be simple or complicated.
There are some standard instructions for such orders. A market order is a buy
or sells order to be executed immediately at current market prices. As long as
there are willing sellers and buyers, market orders are filled. Market orders are
therefore used when certainty of execution is a priority over price of execution.
A market order is the simplest of the order types. This order type does not allow
any control over the price received. The order is filled at the best price available
at the relevant time. In fast-moving markets, the price paid or received may be
quite different from the last price quoted before the order was entered.[1] A
market order may be split across multiple participants on the other side of the
transaction, resulting in different prices for some of the shares.
Limit order
A limit order is an order to buy a security at not more, or sell at not less, than a
specific price. This gives the trader control over the price at which the trade is
executed; however, the order may never be executed ("filled").[2] Limit orders are
used when the trader wishes to control price rather than certainty of execution.
A buy limit order can only be executed at the limit price or lower. For example,
if an investor wants to buy a stock, but doesn't want to pay more than $20 for it,
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the investor can place a limit order to buy the stock at $20 "or better". By
entering a limit order rather than a market order, the investor will not buy the
stock at a higher price, but, may get fewer shares than he wants or not get the
stock at all. A sell limit order is analogous; it can only be executed at the limit
price or higher.
Both buy and sell orders can be additionally constrained. Two of the most
common additional constraints are Fill Or Kill (FOK) and All Or None (AON).
FOK orders are either filled completely on the first attempt or canceled outright,
while AON orders stipulate that the order must be filled with the entire number
of shares specified, or not filled at all. If it is not filled, it is still held on the order
book for later execution.
Time in force
A day order or good for day order (GFD) (the most common) is a market or
limit order that is in force from the time the order is submitted to the end of the
day's trading session. For equity markets, the closing time is defined by the
exchange. For the foreign exchange market, this is until 5pm EST/EDT for all
currencies except NZD.
A good-till-cancelled (GTC) order requires a specific cancelling order. It can
persist indefinitely (although brokers may set some limits, for example, 90 days).
An immediate-or-cancel order (IOC) will be immediately executed or cancelled
by the exchange. Unlike a fill-or-kill order, IOC orders allow for partial fills.
Fill-or-kill orders (FOK) are usually limit orders that must be executed or
cancelled immediately. Unlike IOC orders, FOK orders require the full quantity
to be executed. Most markets have single-price auctions at the beginning
("open") and the end ("close") of regular trading. An order may be specified on
the close or on the open, and then it is entered in an auction but has no effect
otherwise. There is often some deadline; for example, orders must be in 20
minutes before the auction. They are single-price because all orders, if they
transact at all, transact at the same price, the open price and the close price
respectively.
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Combined with price instructions, this gives market on close (MOC), market
on open (MOO), limit on close (LOC), and limit on open (LOO). For example,
a market-on-open order is guaranteed to get the open price, whatever that may
be. A buy limit-on-open order is filled if the open price is lower, not filled if the
open price is higher, and may or may not be filled if the open price is the same.
Regulation NMS (Reg NMS),which applies to U.S. stock exchanges, supports
two types of IOC orders, one which is Reg NMS compliant and will not be
routed during an exchange sweep, and one that can be routed to other
exchanges.Optimal order routing is a difficult problem that cannot be addressed
with the usual perfect market paradigm. Liquidity needs to be modeled in a
realistic way if we are to understand such issues as optimal order routing and
placement.
Conditional orders
A conditional order is any order other than a limit order which is executed only
when a specific condition is satisfied.
Stop orders
A stop order (also stop loss order) is an order to buy (or sell) a security once the
price of the security has climbed above (or dropped below) a specified stop price.
(Note that both bid and ask prices can trigger a stop order.) When the specified stop
price is reached, the stop order is entered as a market order (no limit).
This means the trade will definitely be executed, but not necessarily at or near the
stop price, particularly when the order is placed into a fast-moving market, or if
there is insufficient liquidity available relative to the size of the order.
The use of stop orders is much more frequent for stocks and futures that trade on an
exchange than those that trade in the over-the-counter (OTC) market.
Charles Schwab definition: Stop orders and stop-limit orders are very similar, the
primary difference being what happens once the stop price is triggered. A standard
sell-stop order is triggered when the bid price is equal to or less than the stop price
specified or when an execution occurs at the stop price.
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Key point is "bid/ask" which are cues and do not represent the stock’s value. The
broker above moves the stop order to the market queue based on a BID queue not on
a completed transaction. For instance, on a stock XYZ closing at $20 the day before
with a stop-loss order at $19 and which trades on low volume, the bid/ask at the
open can be skewed in that at the open all the market interest is not represented. The
bid queue shows $18.5, the market opens, being the highest bid the broker triggers
the stop-loss and moves the order to the market, for which there has not even been a
trade, an agreed value. The stock trades for $20.50, never even trading at or below
the stop-loss order. Brokers who use the BID queue as a trigger violate the stop-loss
definition as per the SEC who define it as a trade. The impetus for the broker
definition is commissions.
A sell stop order is an instruction to sell at the best available price after the price
goes below the stop price. A sell stop price is always below the current market price.
For example, if an investor holds a stock currently valued at $50 and is worried that
the value may drop, he/she can place a sell stop order at $40. If the share price drops
to $40, the broker sells the stock at the next available price. This can limit the
investor's losses (if the stop price is at or above the purchase price) or lock in some
of the investor's profits.
A buy stop order is typically used to limit a loss (or to protect an existing profit) on
a short sale.[12] A buy stop price is always above the current market price. For
example, if an investor sells a stockshort—hoping for the stock price to go down so
they can return the borrowed shares at a lower price (Covering)—the investor may
use a buy stop order to protect against losses if the price goes too high. It can also be
used to advantage in a declining market when you want to enter a long position
close to the bottom after turn-around.
A stop limit order combines the features of a stop order and a limit order. Once the
stop price is reached, the stop-limit order becomes a limit order to buy (or to sell) at
no more (or less) than another, pre-specified limit price.As with all limit orders, a
stop-limit order doesn't get filled if the security's price never reaches the specified
limit price.
A trailing stop order is entered with a stop parameter that creates a moving
or trailing activation price, hence the name. This parameter is entered as a
percentage change or actual specific amount of rise (or fall) in the security price.
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Trailing stop sell orders are used to maximize and protect profit as a stock's price
rises and limit losses when its price falls. Trailing stop buy orders are used to
maximize profit when a stock's price is falling and limit losses when it is rising.
For example, a trader has bought stock ABC at $10.00 and immediately places a
trailing stop sell order to sell ABC with a $1.00 trailing stop. This sets the stop price
to $9.00. After placing the order, ABC doesn't exceed $10.00 and falls to a low of
$9.01. The trailing stop order is not executed because ABC has not fallen $1.00
from $10.00. Later, the stock rises to a high of $15.00 which resets the stop price to
$14.00. It then falls to $14.00 ($1.00 from its high of $15.00) and the trailing stop
sell order is entered as a market order.
A trailing stop limit order is similar to a trailing stop order. Instead of selling at
market price when triggered, the order becomes a limit order. A trailing stop trailing
limit order is the most flexible possible order.
Market-if-touched order
A buy market-if-touched order is an order to buy at the best available price, if the
market price goes down to the "if touched" level. As soon as this trigger price is
touched the order becomes a market buy order.
A sell market-if-touched order is an order to sell at the best available price, if the
market price goes up to the "if touched" level. As soon as this trigger price is
touched the order becomes a market sell order.
One cancels other orders
One cancels other orders (OCO) are used when the trader wishes to capitalize on
only one of two or more possible trading possibilities. For instance, the trader may
wish to trade stock ABC at $10.00 or XYZ at $20.00. In this case, they would
execute an OCO order composed of two parts: A limit order for ABC at $10.00, and
a limit order for XYZ at $20.00. If ABC reaches $10.00, ABC's limit order would be
executed, and the XYZ limit order would be canceled.
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Tick sensitive orders
An uptick is when the last (non-zero) price change is positive, and a downtick is
when the last (non-zero) price change is negative. Any tick sensitive instruction can
be entered at the trader's option, for example buy on downtick, although these
orders are rare. In markets where short sales may only be executed on an uptick, a
short-sell order is inherently tick-sensitive.
Discretionary order
A discretionary order is an order that allows the broker to delay the execution at its
discretion to try to get a better price. These are sometimes called not held orders.
Bracket
Puts to the market a pair of two orders: For the same title, for the same direction, i.e.
both to sell:
One sell order is to realize the profit,
the second to lock the loss, not to get even deeper.
Quantity and display instructions
A broker may be instructed not to display the order to the market. For example an
"All-or-none" buy limit order is an order to buy at the specified price if another
trader is offering to sell the full amount of the order, but otherwise not display the
order. A so-called "iceberg order" requires the broker to display only a small part of
the order, leaving a large undisplayed quantity "below the surface".
Electronic markets
All of the above orders could be entered in an electronic market, but order priority
rules encourage simple market and limit orders. Market orders receive highest
priority, followed by limit orders. If a limit order has priority, it is the next trade
executed at the limit price. Simple limit orders generally get high priority, based on
a first-come-first-served rule. Conditional orders generally get priority based on the
time the condition is met. Iceberg orders and dark pool orders (which are not
displayed) are given lower priority.
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All About Stop Loss Order
The stop loss is the order placed to limit the losses when the stock price moves
against your trade.
1. Generally stop loss order are used during day trading/Intraday trading.
2. Stop loss can be used for buy order as well as for short sell order.
3. Stop loss order can be used for stocks, futures and options, currency (forex)
trading.
How to place the Stop loss for sell order?
For example – Suppose if you bought Cairn India Ltd at Rs 250 and if the stock
price starts moving down and if you want to limit your losses and plan to take risk of
Rs 10 then you can place the stop loss order at Rs 240.
How to place the stop loss order?
Trigger price – 241 Sell price – 240 If the share price of Cairn India Ltd moves
down and crosses Rs 241 then your order will be sent to exchange to sell your shares
at Rs 240. So instead of accepting big loss, only loss of Rs 10 per share has been
accepted.
How to place stop loss for Buy order?
Stop loss order for buy order is placed if you have short sell the trade.
What is the short sell?
Selling stocks at higher level and buying them at lower levels is called short selling
method. This method is only adopted during intraday/day trading.
For example – Suppose if the stock of Tata steel is at Rs 700 and expected to come
down then the trader can sell the stocks of Tata steel at Rs 700 and buy at lower
levels to take the profit. But if in case the stock price starts increasing at upper
direction then there is need to limit the losses. The trader can place the stop loss
order at Rs 730 taking into consideration the risk of Rs 30.
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Execution of Order
Often investors and traders alike do not fully understand what happens when you
click the "enter" button on your online trading account. If you think your order is
always filled immediately after you click the button in your account, you are
mistaken. In fact, you might be surprised at the variety of possible ways in which an
order can be filled and the associated time delays. How and where your order is
executed can affect the cost of your transaction and the price you pay for the stock.
A Broker's Options
A common misconception among investors is that an online account connects the
investor directly to the securities markets. This is not the case. When an investor
places a trade, whether online or over the phone, the order goes to a broker. The
broker then looks at the size and availability of the order to decide which path is the
best way for it to be executed. A broker can attempt to fill your order in a number of
ways:
Order to the Floor - For stocks trading on exchanges such as the New York Stock
Exchange(NYSE), the broker can direct your order to the floor of the stock
exchange, or to a regional exchange. In some instances regional exchanges will pay
a fee for the privilege to execute a broker's order, known as payment for order flow.
Because your order is going through human hands, it can take some time for
the floor broker to get to your order and fill it.
Order to Third Market Maker - For stocks trading on an exchange like the NYSE,
your brokerage can direct your order to what is called a third market maker. A third
market maker is likely to receive the order if: A) they entice the broker with an
incentive to direct the order to them or B) the broker is not a member firm of the
exchange in which the order would otherwise be directed.
Internalization - Internalization occurs when the broker decides to fill your order
from the inventory of stocks your brokerage firm owns. This can make for quick
execution. This type of execution is accompanied by your broker's firm making
additional money on the spread.
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Electronic Communications Network (ECN) - ECNs automatically match buy and
sell orders. These systems are used particularly for limit orders because the ECN can
match by price very quickly.
Order to Market Maker - For over-the-counter markets such as the Nasdaq, your
broker can direct your trade to the market maker in charge of the stock you wish to
purchase or sell. This is usually timely, and some brokers make additional money by
sending orders to certain market makers (payment for order flow). This means your
broker may not always be sending your order to the best possible market maker.
As you can see your broker has different motives for directing orders to specific
places. Obviously, they may be more inclined to internalize an order to profit on the
spread or send an order to a regional exchange or willing third market maker and
receive payment for order flow. The choice the broker makes can affect your bottom
line. However, as we explore below we will see some of the safeguards in place to
limit any unscrupulous broker activity when executing trades. (For more
information, check out The Basics Of Order Entry.)
Broker's Obligations
By law, brokers are obligated to give each of their investors the best possible order
execution. There is, however, debate over whether this happens, or if brokers are
routing the orders for other reasons, like the additional revenue streams we outlined
above.
Let's say, for example, you want to buy 1,000 shares of the TSJ Sports
Conglomerate, which is selling at the current price of $40. You place the market
order and it gets filled at $40.10. That means the order cost you an additional $100.
Some brokers state that they always "fight for an extra 1/16th", but in reality the
opportunity for price improvement is simply an opportunity and not a guarantee.
Also, when the broker tries for a better price (for a limit order), the speed and the
likelihood of execution also diminishes. However the market itself, and not the
broker, may be the culprit of an order not being executed at the quoted price,
especially in fast moving markets.
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It is somewhat of a high-wire act that brokers walk in trying to execute trades in the
best interest of their clients as well as their own. But as we will learn the Securities
and Exchange Commission (SEC) has put measures in place to tilt the scale towards
the client’s best interests.
The SEC Steps In
By invoking a rule made effective April 2001 (SEC Disclosure Rule), the SEC has
recently taken steps to ensure that investors get the best execution. This rule forces
brokers to report the quality of executions on a stock-by-stock basis, including how
market orders are executed and what the execution price is compared to the public
quote's effective spreads.
In addition, when a broker, while executing an order from an investor using a limit
order, provides the execution at a better price than the public quotes, that broker
must report the details of these better prices. With these rules in place it is much
easier to determine which brokers actually get the best prices and which ones use
them only as a marketing pitch. (To learn more, see What is the difference between
a stop and a limit order?)
Because the rule imposes significant fines and penalties on the brokers failing to
provide the best execution service, it is debatable whether this rule will be effective
in helping investors because should these fines start occurring, investors will
ultimately be the ones to absorb these costs in paying higher commissions. This is
something only time will tell.
Additionally, the SEC requires broker/dealers to notify their customers if their
orders are not routed for best execution. Typically, this disclosure is on the trade
confirmation slip you receive in the mail a week after placing your order.
Unfortunately, this disclaimer almost always goes unnoticed.
Is Order Execution Important?
The importance and impact order execution can have really depends on the
circumstances, in particular the type of order you submit. For example, if you are
placing a limit order, your only risk is the order might not fill. If you are placing a
market order, speed and price execution becomes increasingly important.
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When considering an investor with a long-term time horizon, an order for $2,000 of
stock the difference of 1/16th is less than $20 - a small extra when entering a stock
for the long haul. Contrast this to an active trader who attempts to profit from the
small ups and downs in day-to-day or intraday stock prices. The same $20 on a
$2,000 order eats into a jump of a few percentage points. Therefore, order execution
is much more important to active traders who scratch and claw for every percentage
they can get.
Conclusion
Remember, the best possible execution is no substitute for a sound investment plan.
Fast markets involve substantial risks and can cause execution of orders at prices
significantly different than expected. With a long-term horizon, however, these
differences are merely a bump on the road to successful investing.
FUNCTIONAL SPECIALIZATION OF BROKER
1. SPECULATOR
Before we get too deep, we have to make a distinction between a speculator
and your typical middleman. A middleman can be thought of as the means
by which products are dispersed. It would be a very different world if the
products we need and/or want were produced nearby. More often than not,
every product in your house has at least a component that has taken an
international voyage to get there.
The markup of the middleman usually matches the materials and overhead
costs used to ship, sort, bag and display those products in a store near you,
plus some profit to keep the middleman fulfilling this function. This gets
maple syrup to Hawaii, Korean laptops to New York and other products to
destinations where a higher profit can be realized.
In contrast, the speculator makes his/her money through contracts that allow
him/her to control commodities without ever directly handling them.
Generally speaking, speculators don't arrange shipment and storage for the
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commodities that they control. This hands-off approach has given
speculators the erroneous image of aloof financers jumping into markets they
care nothing about in order to make profits from the producers – the salt-of-
the-earth types that legislators are always claiming to defend
Avoiding Shortages
The most obvious function that people overlook when criticizing speculators
is their ability to head off shortages. Shortages are dangerous because they
lead to price spikes and/or rationing of resources. If a drought kills off half
the yield of hay in a given year, it's natural to expect the price of hay to
double in the fall.
On wider economies of scale, however, these shortages are not as easy to
spot. That's why commodities speculators help to keep an eye on overall
production, recognizing shortages and moving product to places of need (and
consequently higher profit) through intermediaries – the middlemen who use
futures contracts to control their costs. In this sense, speculators act as
financers to allow the middleman to keep supply flowing around the world.
More than merely financing middlemen, speculators influence prices of
commodities, currencies and other goods by using futures to encourage
stockpiling against shortages. Just because we want cheap oil or mangoes
doesn't mean we should blame speculators when prices rise. More often,
other factors, such as OPEC and tropical hurricanes, have raised the risk of a
more volatile price in the future, so speculators raise prices now to smooth
down the potentially larger future price.
A higher price dampens current demand, decreasing consumption and
prompting more resources – more people to take up mango growing or more
funds for oil exploration – to go into increasing stockpiles. This price
smoothing means that, while you might not appreciate paying $5 for gas or a
mango, you will always be able to find some.
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Preventing Manipulation
While people may recognize speculators' importance in preventing shortages
and smoothing prices, very few associate speculation with guarding against
manipulation. In markets with healthy speculation, that is many different
speculators participating, it is much harder to pull off a large-scale
manipulation and much more costly to attempt it (and even costlier upon
failing). Both Mr. Copper and Silver Thursday are examples of ongoing
manipulations that eventually collapsed as more market speculators entered
opposing trades. To avoid manipulation in markets we need more
speculation, not less. (For more, read The Copper King: An Empire Built On
Manipulation.)
In thinly traded markets, prices are necessarily more volatile, and the
chances for manipulation are increased because a few speculators can have a
much bigger impact. In markets with no speculators, the power to manipulate
prices swings yearly between producers and middlemen/buyers according to
the health of the crop or yield of a commodity. These mini-monopolies
and monopsonies result in more volatility being passed on to consumers in
the form of varying prices.
Consequences and Currency
Even when we leave the level of commodities and go into one of the largest
markets in the world, forex, we can see how speculators are essential for
preventing manipulation. Governments are some of the most blatant
manipulators. Governments want more money to fund programs while also
wanting a robust currency for international trade. These conflicting interests
encourage governments to peg their currencies while inflating away true
value to pay for domestic spending. It's currency speculators,
through shorting and other means, that keep governments honest by speeding
up the consequences of inflationary policies. (To learn more, check
out Forces Behind Exchange Rates.)
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Speculators can make a lot of money when they are right, and that can anger
producers and consumers alike. But these outsized profits are balanced
against the risks they protect those same consumers and producers from. For
every speculator making millions on a single contract, there is at least an
equal number losing millions on the trade - or a dollar on each of a million
smaller trades. In very volatile markets, like those after a natural disaster
or black swan event, speculators often lose money on the whole, keeping
prices stable by making up the difference out of their deep pockets.
Taken cumulatively, speculation helps us far more than it could ever hurt us
by moving risk to those who can financially handle it. Despite the
misunderstanding and negativity speculators have to face, the potential for
outsized profits will continue to attract people, as long as governments don't
regulate them into oblivion. With all the negativity aimed towards short-
sellers and speculators, it's easy for us to forget that their activities maintain
prices, prevent shortages and increase the amount of risk they undertake. I
don't want to become a speculator, but it's important that we preserve
speculative investing for the people who do – more than important, it's a
necessity for a healthy market and vibrant economy. You don't have to
become a speculator, or even hug the next one you see, just remember that
the next time you pay $5 a gallon for gas, it's so we'll still have some left
over for next week, year, decade and century. (For more, see Getting A Grip
On The Cost Of Gas.)
In finance, speculation is a financial action that does not promise safety of
the initial investment along with the return on the principal sum. Speculation
typically involves the lending of money for the purchase
of assets,equity or debt but in a manner that has not been given thorough
analysis or is deemed to have low margin of safety or a significant risk of the
loss of the principal investment. The term, "speculation," which is formally
defined as above in Graham and Dodd's 1934 text, Security Analysis,
contrasts with the term "investment," which is a financial operation that,
upon thorough analysis, promises safety of principal and a satisfactory
return.
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In a financial context, the terms "speculation" and "investment" are actually
quite specific. For instance, although the word "investment" is commonly
used to mean any act of placing money in a financial vehicle with the intent
of producing returns over a period of time, most ventured money—including
funds placed in the world's stock markets—is technically not investment, but
speculation. Speculators may rely on an asset appreciating in price due to any
of a number of fact rs that cannot be well enough understood by the speculator
to make an investment-quality decision. Some such factors are shifting
consumer tastes, fluctuating economic conditions, buyers' changing
perceptions of the worth of a stock security, economic factors associated
with market timing, the factors associated with solely chart-based analysis,
and the many influences over the short-term movement of securities. There
are also some financial vehicles that are, by definition, speculation. For
instance, trading commodity futures contracts, such as for oil and gold, is, by
definition, speculation. Short selling is also, by definition, speculative.
Financial speculation can involve the trade (buying, holding, selling)
and short-selling of stocks, bonds, commodities, currencies, collectibles, real
estate, derivatives, or any valuable financial instrument to attempt to profit
from fluctuations in its price irrespective of its underlying value. In
architecture, speculation is used to determine works that show a strong
conceptual and strategic focus
HEDGER
An investor who takes steps to reduce the risk of an investment by making
an offsetting investment. There are a large number of hedging strategies that a
hedger can use. Hedgers may reduce risk, but in doing so they also reduce their
profit potential.
Hedgers in the futures market try to offset potential price changes in the spot market
by buying or selling a futures contract.
In general, they are either producers or users of the commodity or financial product
underlying that contract. Their goal is to protect their profit or limit their expenses.
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For example, a cereal manufacturer may want to hedge against rising wheat prices
by buying a futures contract that promises delivery of September wheat at a
specified price.
If, in August, the crop is destroyed, and the spot price increases, the manufacturer
can take delivery of the wheat at the contract price, which will probably be lower
than the market price. Or the manufacturer can trade the contract for more than
Agricultural commodity price hedging
A typical hedger might be a commercial farmer. The market values of wheat and
other crops fluctuate constantly as supply and demand for them vary, with
occasional large moves in either direction. Based on current prices and forecast
levels at harvest time, the farmer might decide that planting wheat is a good idea one
season, but the forecast prices are only that — forecasts. Once the farmer plants
wheat, he is committed to it for an entire growing season. If the actual price of wheat
rises greatly between planting and harvest, the farmer stands to make a lot of
unexpected money, but if the actual price drops by harvest time, he could be ruined.
If the farmer sells a number of wheat futures contracts equivalent to his crop size at
planting time, he effectively locks in the price of wheat at that time: the contract is
an agreement to deliver a certain number of bushels of wheat to a specified place on
a certain date in the future for a certain fixed price. The farmer has hedged his
exposure to wheat prices; he no longer cares whether the current price rises or falls,
because he is guaranteed a price by the contract. He no longer needs to worry about
being ruined by a low wheat price at harvest time, but he also gives up the chance at
making extra money from a high wheat price at harvest times.
Hedging a stock price
A stock trader believes that the stock price of Company A will rise over the next
month, due to the company's new and efficient method of producing widgets. He
wants to buy Company A shares to profit from their expected price increase. But
Company A is part of the highly volatile widget industry. If the trader simply bought
the shares based on his belief that the Company A shares were underpriced, the trade
would be a speculation.
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Since the trader is interested in the company, rather than the industry, he wants
to hedge out the industry risk by short selling an equal value (number of shares ×
price) of the shares of Company A's direct competitor, Company B.
The first day the trader's portfolio is:
Long 1,000 shares of Company A at $1 each
Short 500 shares of Company B at $2 each
(Notice that the trader has sold short the same value of shares)
If the trader was able to short sell an asset whose price had a mathematically defined
relation with Company A's stock price (for example a put option on Company A
shares), the trade might be essentially riskless. In this case, the risk would be limited
to the put option's premium.
On the second day, a favorable news story about the widgets industry is published
and the value of all widgets stock goes up. Company A, however, because it is a
stronger company, increases by 10%, while Company B increases by just 5%:
Long 1,000 shares of Company A at $1.10 each: $100 gain
Short 500 shares of Company B at $2.10 each: $50 loss
(In a short position, the investor loses money when the price goes up.)
The trader might regret the hedge on day two, since it reduced the profits on the
Company A position. But on the third day, an unfavorable news story is published
about the health effects of widgets, and all widgets stocks crash: 50% is wiped off
the value of the widgets industry in the course of a few hours. Nevertheless, since
Company A is the better company, it suffers less than Company B:
Value of long position (Company A):
Day 1: $1,000
Day 2: $1,100
Day 3: $550 => ($1,000 − $550) = $450 loss
Value of short position (Company B):63
Day 1: −$1,000
Day 2: −$1,050
Day 3: −$525 => ($1,000 − $525) = $475 profit
Without the hedge, the trader would have lost $450 (or $900 if the trader took the
$1,000 he has used in short selling Company B's shares to buy Company A's shares
as well). But the hedge – the short sale of Company B – gives a profit of $475, for a
net profit of $25 during a dramatic market collapse.
Types of hedging
Hedging can be used in many different ways including forex trading.[3] The stock
example above is a "classic" sort of hedge, known in the industry as a pairs trade due
to the trading on a pair of related securities. As investors became more sophisticated,
along with the mathematical tools used to calculate values (known as models), the
types of hedges have increased greatly.
Hedging strategies
Examples of hedging include:
Forward exchange contract for currencies
Currency future contracts
Money Market Operations for currencies
Forward Exchange Contract for interest
Money Market Operations for interest
Future contracts for interest
This is a list of hedging strategies, grouped by category.
Financial derivatives such as call and put options
Risk reversal: Simultaneously buying a call option and selling a put option.
This has the effect of simulating being long on a stock or commodity
position.
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Delta neutral: This is a market neutral position that allows a portfolio to
maintain a positive cash flow by dynamically re-hedging to maintain a
market neutral position. This is also a type of market neutral strategy.
Natural hedges
Many hedges do not involve exotic financial instruments or derivatives such as
the married put. A natural hedge is an investment that reduces the undesired risk by
matching cash flows (i.e. revenues and expenses). For example, an exporter to the
United States faces a risk of changes in the value of the U.S. dollar and chooses to
open a production facility in that market to match its expected sales revenue to its
cost structure. Another example is a company that opens a subsidiary in another
country and borrows in the foreign currency to finance its operations, even though
the foreign interest rate may be more expensive than in its home country: by
matching the debt payments to expected revenues in the foreign currency, the parent
company has reduced its foreign currency exposure. Similarly, an oil producer may
expect to receive its revenues in U.S. dollars, but faces costs in a different currency;
it would be applying a natural hedge if it agreed to, for example, pay bonuses to
employees in U.S. dollars.
One common means of hedging against risk is the purchase of insurance to protect
against financial loss due to accidental property damage or loss, personal injury, or
loss of life.
Categories of hedgeable risk
There are varying types of risk that can be protected against with a hedge. Those
types of risks include:
Commodity risk: the risk that arises from potential movements in the value
of commodity contracts, which include agricultural products, metals, and
energy products.[4]
Credit risk: the risk that money owing will not be paid by an obligor. Since
credit risk is the natural business of banks, but an unwanted risk for
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commercial traders, an early market developed between banks and traders
that involved selling obligations at a discounted rate.
Currency risk (also known as Foreign Exchange Risk hedging) is used both
by financial investors to deflect the risks they encounter when investing
abroad and by non-financial actors in the global economy for whom multi-
currency activities are a necessary evil rather than a desired state of
exposure.
Interest rate risk: the risk that the relative value of an interest-bearing
liability, such as a loan or a bond, will worsen due to an interest
rate increase. Interest rate risks can be hedged using fixed-income
instruments orinterest rate swaps.
Equity risk: the risk that one's investments will depreciate because of stock
market dynamics causing one to lose money.
Volatility risk: is the threat that an exchange rate movement poses to an
investor's portfolio in a foreign currency.
Volumetric risk: the risk that a customer demands more or less of a product
than expected.
Hedging equity and equity futures
Equity in a portfolio can be hedged by taking an opposite position in futures. To
protect your stock picking against systematic market risk, futures are shorted when
equity is purchased, or long futures when stock is shorted.
One way to hedge is the market neutral approach. In this approach, an equivalent
dollar amount in the stock trade is taken in futures – for example, by buying 10,000
GBP worth of Vodafone and shorting 10,000 worth of FTSE futures.
Another way to hedge is the beta neutral. Beta is the historical correlation between a
stock and an index. If the beta of a Vodafone stock is 2, then for a 10,000 GBP long
position in Vodafone an investor would hedge with a 20,000 GBP equivalent short
position in the FTSE futures (the index in which Vodafone trades).
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Futures contracts and forward contracts are means of hedging against the risk of
adverse market movements. These originally developed out of commodity
markets in the 19th century, but over the last fifty years a large global market
developed in products to hedge financial market risk.
Futures hedging
Investors who primarily trade in futures may hedge their futures against synthetic
futures. A synthetic in this case is a synthetic future comprising a call and a put
position. Long synthetic futures means long call and short put at the same expiry
price. To hedge against a long futures trade a short position in synthetics can be
established, and vice versa.
Stack hedging is a strategy which involves buying various futures contracts that are
concentrated in nearby delivery months to increase the liquidity position. It is
generally used by investors to ensure the surety of their earnings for a longer period
of time.
Contract for difference
A contract for difference (CFD) is a two-way hedge or swap contract that allows the
seller and purchaser to fix the price of a volatile commodity. Consider a deal
between an electricity producer and an electricity retailer, both of whom trade
through an electricity market pool. If the producer and the retailer agree to a strike
price of $50 per MWh, for 1 MWh in a trading period, and if the actual pool price is
$70, then the producer gets $70 from the pool but has to rebate $20 (the "difference"
between the strike price and the pool price) to the retailer. Conversely, the retailer
pays the difference to the producer if the pool price is lower than the agreed upon
contractual strike price. In effect, the pool volatility is nullified and the parties pay
and receive $50 per MWh. However, the party who pays the difference is "out of the
money" because without the hedge they would have received the benefit of the pool
price
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ARBITRAGE
Arbitrage is the making of a gain through trading without committing any money
and without taking a risk of losing money. The term is also used more loosely to
cover a range of activities, such as statistical arbitrage, risk arbitrage, and uncovered
interest arbitrage, that are not true arbitrage (because they are risky).
Many of these strategies bear some similarities to true arbitrage, in that they
are market neutral attempts to identify and exploit (usually short lived) anomalies in
pricing. The terminology used usually adds a qualifier to make it clear that it is not
real arbitrage. The discussion below is of true arbitrage.
An arbitrage opportunity exists if it is possible to make a gain that is guaranteed to
be at least equal to the risk free rate of return, with a chance of making a greater
gain. This is equivalent to the definition of an arbitrage opportunity as the possibility
of a riskless gain with a zero cost portfolio, because a portfolio that is guaranteed to
make a profit can be bought with borrowed money.
Less rigorously, an arbitrage opportunity is a "free lunch", that allows investors to
make a gain for no risk. Being less rigorous means that it is not really possible to
distinguish between arbitrage and the closely related concepts of dominant trading
strategies and the law of one price.
Arbitrage should not be possible as, if an arbitrage opportunity exists, then market
forces should eliminate it. Taking a simple example, if it is possible to buy a security
in one market and sell it at a higher price in another market, then no-one would buy
it at the more expensive price, and no one would sell it at the cheaper price. The
prices in the two markets would converge.
Arbitrage between markets is the simplest type of arbitrage. More complex
strategies such as arbitraging the price of a security against a portfolio that replicates
its cash flows. These range from the relatively simple, such
as delta and gamma hedges, to extremely complex strategies based on quantitative
models.
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Much of financial theory (and therefore most methods for valuing securities) are
ultimately built on the assumption that securities will trade at prices that make
arbitrage impossible. In particular, if there is no arbitrage then a risk neutral pricing
measure exists and vice versa. Although this result is not something that is used by
most investors, it is of great importance in the theory of financial economics.
Although arbitrage opportunities do exist in real markets, they are usually very small
and quickly eliminated; therefore the no arbitrage assumption is a reasonable one to
build financial theory on.
When persistent arbitrage opportunities do exist it means that there is something
badly wrong with financial markets. For example, there is evidence that during the
dotcom boom the value of internet related tracker stocks and
listed subsidiaries was not consistent with the market value of parent companies: an
arbitrage opportunity existed and persisted.
Conditions for arbitrage
Arbitrage is possible when one of three conditions is met:
1. The same asset does not trade at the same price on all markets ("the law of
one price").
2. Two assets with identical cash flows do not trade at the same price.
3. An asset with a known price in the future does not today trade at its future
price discounted at the risk-free interest rate (or, the asset does not have
negligible costs of storage; as such, for example, this condition holds for
grain but not for securities).
Arbitrage is not simply the act of buying a product in one market and selling it in
another for a higher price at some later time.The transactions mus
toccur simultaneously to avoid exposure to market risk, or the risk that prices may
change on one market before both transactions are complete. In practical terms, this
is generally only possible with securities and financial products which can be traded
electronically, and even then, when each leg of the trade is executed the prices in the
market may have moved. Missing one of the legs of the trade (and subsequently
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having to trade it soon after at a worse price) is called 'execution risk' or more
specifically 'leg risk'.
In the simplest example, any good sold in one market should sell for the same price
in another. Traders may, for example, find that the price of wheat is lower in
agricultural regions than in cities, purchase the good, and transport it to another
region to sell at a higher price. This type of price arbitrage is the most common, but
this simple example ignores the cost of transport, storage, risk, and other factors.
"True" arbitrage requires that there be no market risk involved. Where securities are
traded on more than one exchange, arbitrage occurs by simultaneously buying in one
and selling on the other.
Examples
Suppose that the exchange rates (after taking out the fees for making the
exchange) in London are £5 = $10 = ¥1000 and the exchange rates in Tokyo
are ¥1000 = $12 = £6. Converting ¥1000 to $12 in Tokyo and converting that
$12 into ¥1200 in London, for a profit of ¥200, would be arbitrage. In reality,
this "triangle arbitrage" is so simple that it almost never occurs. But more
complicated foreign exchange arbitrages, such as the spot-forward arbitrage
(see interest rate parity) are much more common.
One example of arbitrage involves the New York Stock Exchange and the
Security Futures Exchange One Chicago (OCX). When the price of a stock
on the NYSE and its corresponding futures contract on OCX are out of sync,
one can buy the less expensive one and sell it to the more expensive market.
Because the differences between the prices are likely to be small (and not to
last very long), this can only be done profitably with computers examining a
large number of prices and automatically exercising a trade when the prices
are far enough out of balance. The activity of other arbitrageurs can make
this risky. Those with the fastest computers and the most expertise take
advantage of series of small differences that would not be profitable if taken
individually.
Economists use the term "global labor arbitrage" to refer to the tendency of
manufacturing jobs to flow towards whichever country has the lowest wages
per unit output at present and has reached the minimum requisite level of
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political and economic development to support industrialization. At present,
many such jobs appear to be flowing towards China, though some which
require command of English are going to India and the Philippines. In
popular terms, this is referred to as off shoring. (Note that "off shoring" is
not synonymous with "outsourcing", which means "to subcontract from an
outside supplier or source", such as when a business outsources its
bookkeeping to an accounting firm. Unlike off shoring, outsourcing always
involves subcontracting jobs to a different company, and that company can
be in the same country as the outsourcing company.)
Sports arbitrage – numerous internet bookmakers offer odds on the outcome
of the same event. Any given bookmaker will weight their odds so that no
one customer can cover all outcomes at a profit against their books.
However, in order to remain competitive their margins are usually quite low.
Different bookmakers may offer different odds on the same outcome of a
given event; by taking the best odds offered by each bookmaker, a customer
can under some circumstances cover all possible outcomes of the event and
lock a small risk-free profit, known as a Dutch book. This profit would
typically be between 1% and 5% but can be much higher. One problem with
sports arbitrage is that bookmakers sometimes make mistakes and this can
lead to an invocation of the 'palpable error' rule, which most bookmakers
invoke when they have made a mistake by offering or posting incorrect odds.
As bookmakers become more proficient, the odds of making an 'arb' usually
last for less than an hour and typically only a few minutes. Furthermore,
huge bets on one side of the market also alert the bookies to correct the
market.
Exchange-traded fund arbitrage – Exchange Traded Funds allow authorized
participants to exchange back and forth between shares in underlying
securities held by the fund and shares in the fund itself, rather than allowing
the buying and selling of shares in the ETF directly with the fund sponsor.
ETFs trade in the open market, with prices set by market demand. An ETF
may trade at a premium or discount to the value of the underlying assets.
When a significant enough premium appears, an arbitrageur will buy the
underlying securities, convert them to shares in the ETF, and sell them in the
open market. When a discount appears, an arbitrageur will do the reverse. In
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this way, the arbitrageur makes a low-risk profit, while fulfilling a useful
function in the ETF marketplace by keeping ETF prices in line with their
underlying value.
Some types of hedge funds make use of a modified form of arbitrage to
profit. Rather than exploiting price differences between identical assets, they
will purchase and sell securities, assets and derivatives with similar
characteristics, and hedge any significant differences between the two assets.
Any difference between the hedged positions represents any remaining risk
(such as basis risk) plus profit; the belief is that there remains some
difference which, even after hedging most risk, represents pure profit. For
example, a fund may see that there is a substantial difference between U.S.
dollar debt and local currency debt of a foreign country, and enter into a
series of matching trades (including currency swaps) to arbitrage the
difference, while simultaneously entering into credit default swaps to protect
against country risk and other types of specific risk..
Price convergence
Arbitrage has the effect of causing prices in different markets to converge. As a
result of arbitrage, the currency exchange rates, the price of commodities, and the
price of securities in different markets tend to converge to the same prices, in all
markets, in each category. The speed at which prices converge is a measure of
market efficiency. Arbitrage tends to reduce price discrimination by encouraging
people to buy an item where the price is low and resell it where the price is high, as
long as the buyers are not prohibited from reselling and the transaction costs of
buying, holding and reselling are small relative to the difference in prices in the
different markets.
Arbitrage moves different currencies toward purchasing power parity. As an
example, assume that a car purchased in the United States is cheaper than the same
car in Canada. Canadians would buy their cars across the border to exploit the
arbitrage condition. At the same time, Americans would buy US cars, transport them
across the border, and sell them in Canada. Canadians would have to buy American
Dollars to buy the cars, and Americans would have to sell the Canadian dollars they
received in exchange for the exported cars. Both actions would increase demand for
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US Dollars, and supply of Canadian Dollars, and as a result, there would be an
appreciation of the US Dollar. Eventually, if unchecked, this would make US cars
more expensive for all buyers, and Canadian cars cheaper, until there is no longer an
incentive to buy cars in the US and sell them in Canada. More generally,
international arbitrage opportunities in commodities
goods, securities and currencies, on a grand scale, tend to change exchange
rates until the purchasing power is equal.
In reality, of course, one must consider taxes and the costs of travelling back and
forth between the US and Canada. Also, the features built into the cars sold in the
US are not exactly the same as the features built into the cars for sale in Canada,
due, among other things, to the different emissions and other auto regulations in the
two countries. In addition, our example assumes that no duties have to be paid on
importing or exporting cars from the USA to Canada. Similarly, most assets exhibit
(small) differences between countries, transaction costs, taxes, and other costs
provide an impediment to this kind of arbitrage.
Similarly, arbitrage affects the difference in interest rates paid on government bonds,
issued by the various countries, given the expected depreciations in the currencies,
relative to each other (see interest rate parity).
Risks
Arbitrage transactions in modern securities markets involve fairly low day-to-day
risks, but can face extremely high risk in rare situations, particularly financial crises,
and can lead to bankruptcy. Formally, arbitrage transactions have negative skew –
prices can get a small amount closer (but often no closer than 0), while they can get
very far apart. The day-to-day risks are generally small because the transactions
involve small differences in price, so an execution failure will generally cause a
small loss (unless the trade is very big or the price moves rapidly). The rare case
risks are extremely high because these small price differences are converted to large
profits via leverage (borrowed money), and in the rare event of a large price move,
this may yield a large loss.
The main day-to-day risk is that part of the transaction fails – execution risk. The
main rare risks are counterparty risk and liquidity risk – that a counterparty to a 73
large transaction or many transactions fails to pay, or that one is required to
post margin and does not have the money to do so.
In the academic literature, the idea that seemingly very low risk arbitrage trades
might not be fully exploited because of these risk factors and other considerations is
often referred to as limits to arbitrage.[1][2][3]
Execution risk
Generally it is impossible to close two or three transactions at the same instant;
therefore, there is the possibility that when one part of the deal is closed, a quick
shift in prices makes it impossible to close the other at a profitable price. However,
this is not necessarily the case. Many exchanges and idbs allow multi legged trades
(e.g. basis block trades on LIFFE).
Competition in the marketplace can also create risks during arbitrage transactions.
As an example, if one was trying to profit from a price discrepancy between IBM on
the NYSE and IBM on the London Stock Exchange, they may purchase a large
number of shares on the NYSE and find that they cannot simultaneously sell on the
LSE. This leaves the arbitrageur in an unhedged risk position.
In the 1980s, risk arbitrage was common. In this form of speculation, one trades a
security that is clearly undervalued or overvalued, when it is seen that the wrong
valuation is about to be corrected by events. The standard example is the stock of a
company, undervalued in the stock market, which is about to be the object of a
takeover bid; the price of the takeover will more truly reflect the value of the
company, giving a large profit to those who bought at the current price—if the
merger goes through as predicted. Traditionally, arbitrage transactions in the
securities markets involve high speed, high volume and low risk. At some moment a
price difference exists, and the problem is to execute two or three balancing
transactions while the difference persists (that is, before the other arbitrageurs act).
When the transaction involves a delay of weeks or months, as above, it may entail
considerable risk if borrowed money is used to magnify the reward through
leverage. One way of reducing the risk is through the illegal use of inside
information, and in fact risk arbitrage with regard to leveraged buyouts was
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associated with some of the famous financial scandals of the 1980s such as those
involving Michael Milken and Ivan Boesky.
Mismatch
Another risk occurs if the items being bought and sold are not identical and the
arbitrage is conducted under the assumption that the prices of the items are
correlated or predictable; this is more narrowly referred to as aconvergence trade. In
the extreme case this is merger arbitrage, described below. In comparison to the
classical quick arbitrage transaction, such an operation can produce disastrous
losses.
Counterparty risk
As arbitrages generally involve future movements of cash, they are subject
to counterparty risk: if counterparty fails to fulfill their side of a transaction. This is
a serious problem if one has either a single trade or many related trades with a single
counterparty, whose failure thus poses a threat, or in the event of a financial crisis
when many counterparties fail. This hazard is serious because of the large quantities
one must trade in order to make a profit on small price differences.
For example, if one purchases many risky bonds, then hedges them with CDSes,
profiting from the difference between the bond spread and the CDS premium, in a
financial crisis the bonds may default and the CDS writer/seller may itself fail, due
to the stress of the crisis, causing the arbitrageur to face steep losses.
Liquidity risk
Arbitrage trades are necessarily synthetic, leveraged trades, as they involve a short
position. If the assets used are not identical (so a price divergence makes the trade
temporarily lose money), or the margin treatment is not identical, and the trader is
accordingly required to post margin (faces a margin call), the trader may run out of
capital (if they run out of cash and cannot borrow more) and go bankrupt even
though the trades may be expected to ultimately make money. In effect, arbitrage
traders synthesize a put option on their ability to finance themselves.[4]
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Prices may diverge during a financial crisis, often termed a "flight to quality"; these
are precisely the times when it is hardest for leveraged investors to raise capital (due
to overall capital constraints), and thus they will lack capital precisely when they
need it most.
Types of arbitrage
1. Merger arbitrage
Also called risk arbitrage, merger arbitrage generally consists of buying the stock of
a company that is the target of a takeover while shorting the stock of the acquiring
company.
Usually the market price of the target company is less than the price offered by the
acquiring company. The spread between these two prices depends mainly on the
probability and the timing of the takeover being completed as well as the prevailing
level of interest rates.
The bet in a merger arbitrage is that such a spread will eventually be zero, if and
when the takeover is completed. The risk is that the deal "breaks" and the spread
massively widens.
Municipal bond arbitrage
Also called municipal bond relative value arbitrage, municipal arbitrage, or
just muni arb, this hedge fund strategy involves one of two approaches.
Generally, managers seek relative value opportunities by being both long and short
municipal bonds with a duration-neutral book. The relative value trades may be
between different issuers, different bonds issued by the same entity, or capital
structure trades referencing the same asset (in the case of revenue bonds). Managers
aim to capture the inefficiencies arising from the heavy participation of non-
economic investors (i.e., high income "buy and hold" investors seeking tax-exempt
income) as well as the "crossover buying" arising from corporations' or individuals'
changing income tax situations (i.e., insurers switching their munis for corporates
after a large loss as they can capture a higher after-tax yield by offsetting the taxable
corporate income with underwriting losses). There are additional inefficiencies 76
arising from the highly fragmented nature of the municipal bond market which has
two million outstanding issues and 50,000 issuers in contrast to the Treasury market
which has 400 issues and a single issuer.
Second, managers construct leveraged portfolios of AAA- or AA-rated tax-exempt
municipal bonds with the duration risk hedged by shorting the appropriate ratio of
taxable corporate bonds. These corporate equivalents are typically interest rate
swaps referencing Libor or SIFMA The arbitrage manifests itself in the form of a
relatively cheap longer maturity municipal bond, which is a municipal bond that
yields significantly more than 65% of a corresponding taxable corporate bond. The
steeper slope of the municipal yield curve allows participants to collect more after-
tax income from the municipal bond portfolio than is spent on the interest rate swap;
the carry is greater than the hedge expense. Positive, tax-free carry from muni arb
can reach into the double digits. The bet in this municipal bond arbitrage is that,
over a longer period of time, two similar instruments—municipal bonds and interest
rate swaps—will correlate with each other; they are both very high quality credits,
have the same maturity and are denominated in U.S. dollars. Credit risk and duration
risk are largely eliminated in this strategy. However, basis risk arises from use of an
imperfect hedge, which results in significant, but range-bound principal volatility.
The end goal is to limit this principal volatility, eliminating its relevance over time
as the high, consistent, tax-free cash flow accumulates. Since the inefficiency is
related to government tax policy, and hence is structural in nature, it has not been
arbitraged away.
Note, however, that many municipal bonds are callable, and that this imposes
substantial additional risks to the strategy.
Convertible bond arbitrage
A convertible bond is a bond that an investor can return to the issuing company in
exchange for a predetermined number of shares in the company.
A convertible bond can be thought of as a corporate bond with a stock call
option attached to it.
The price of a convertible bond is sensitive to three major factors:
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Interest rate. When rates move higher, the bond part of a convertible bond
tends to move lower, but the call option part of a convertible bond moves
higher (and the aggregate tends to move lower).
Stock price. When the price of the stock the bond is convertible into moves
higher, the price of the bond tends to rise.
Credit spread. If the creditworthiness of the issuer deteriorates
(e.g. rating downgrade) and its credit spread widens, the bond price tends to
move lower, but, in many cases, the call option part of the convertible bond
moves higher (since credit spread correlates with volatility).
Given the complexity of the calculations involved and the convoluted structure that
a convertible bond can have, an arbitrageur often relies on sophisticated quantitative
models in order to identify bonds that are trading cheap versus their theoretical
value.
Convertible arbitrage consists of buying a convertible bond and hedging two of the
three factors in order to gain exposure to the third factor at a very attractive price.
For instance an arbitrageur would first buy a convertible bond, then sell fixed
income securities or interest rate futures (to hedge the interest rate exposure) and
buy some credit protection (to hedge the risk of credit deterioration). Eventually
what he'd be left with is something similar to a call option on the underlying stock,
acquired at a very low price. He could then make money either selling some of the
more expensive options that are openly traded in the market or delta hedging his
exposure to the underlying shares.
Depository receipts
A depository receipt is a security that is offered as a "tracking stock" on another
foreign market. For instance a Chinese company wishing to raise more money may
issue a depository receipt on the New York Stock Exchange, as the amount of
capital on the local exchanges is limited. These securities, known as ADRs
(American Depositary Receipt) or GDRs (Global Depositary Receipt) depending on
where they are issued, are typically considered "foreign" and therefore trade at a
lower value when first released. However, they are exchangeable into the original
security (known as fundibility) and actually have the same value. In this case there is 78
a spread between the perceived value and real value, which can be extracted. Since
the ADR is trading at a value lower than what it is worth, one can purchase the ADR
and expect to make money as its value converges on the original. However there is a
chance that the original stock will fall in value too, so by shorting it one can hedge
that risk.
Dual-listed companies
A dual-listed company (DLC) structure involves two companies incorporated in
different countries contractually agreeing to operate their businesses as if they were
a single enterprise, while retaining their separate legal identity and existing stock
exchange listings. In integrated and efficient financial markets, stock prices of the
twin pair should move in lockstep. In practice, DLC share prices exhibit large
deviations from theoretical parity. Arbitrage positions in DLCs can be set up by
obtaining a long position in the relatively underpriced part of the DLC and a short
position in the relatively overpriced part. Such arbitrage strategies start paying off as
soon as the relative prices of the two DLC stocks converge toward theoretical parity.
However, since there is no identifiable date at which DLC prices will converge,
arbitrage positions sometimes have to be kept open for considerable periods of time.
In the meantime, the price gap might widen. In these situations, arbitrageurs may
receive margin calls, after which they would most likely be forced to liquidate part
of the position at a highly unfavorable moment and suffer a loss. Arbitrage in DLCs
may be profitable, but is also very risky, Background material is available at
A good illustration of the risk of DLC arbitrage is the position in Royal Dutch Shell
—which had a DLC structure until 2005—by the hedge fund Long-Term Capital
Management (LTCM, see also the discussion below). Lowenstein (2000) describes
that LTCM established an arbitrage position in Royal Dutch Shell in the summer of
1997, when Royal Dutch traded at an 8 to 10 percent premium. In total $2.3 billion
was invested, half of which long in Shell and the other half short in Royal Dutch In
the autumn of 1998 large defaults on Russian debt created significant losses for the
hedge fund and LTCM had to unwind several positions. Lowenstein reports that the
premium of Royal Dutch had increased to about 22 percent and LTCM had to close
the position and incur a loss. According to Lowenstein (p. 234), LTCM lost $286
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million in equity pairs trading and more than half of this loss is accounted for by
the Royal Dutch Shell trade.
Private to public equities
The market prices for privately held companies are typically viewed from a return
on investment perspective (such as 25%), whilst publicly held and or exchange
listed companies trade on a Price to Earnings multiple (such as a P/E of 10, which
equates to a 10% ROI). Thus, if a publicly traded company specialises in the
acquisition of privately held companies, from a per-share perspective there is a gain
with every acquisition that falls within these guidelines. Exempli gratia, Berkshire-
Hathaway. A hedge fund that is an example of this type of arbitrage is Greenridge
Capital, which acts as an angel investor retaining equity in private companies which
are in the process of becoming publicly traded, buying in the private market and
later selling in the public market. Private to public equities arbitrage is a term which
can arguably be applied to investment banking in general. Private markets to public
markets differences may also help explain the overnight windfall gains enjoyed by
principals of companies that just did an initial public offering.
Regulatory arbitrage
Regulatory arbitrage is where a regulated institution takes advantage of the
difference between its real (or economic) risk and the regulatory position. For
example, if a bank, operating under the Basel I accord, has to hold 8% capital
against default risk, but the real risk of default is lower, it is profitable
to securities the loan, removing the low risk loan from its portfolio. On the other
hand, if the real risk is higher than the regulatory risk then it is profitable to make
that loan and hold on to it, provided it is priced appropriately.
This process can increase the overall riskiness of institutions under a risk insensitive
regulatory regime, as described by Alan Greenspan in his October 1998 speech
on The Role of Capital in Optimal Banking Supervision and Regulation.
In economics, regulatory arbitrage (sometimes, tax arbitrage) may be used to refer to
situations when a company can choose a nominal place of business with a
regulatory, legal or tax regime with lower costs. For example, an insurance company
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may choose to locate in Bermuda due to preferential tax rates and policies for
insurance companies. This can occur particularly where the business transaction has
no obvious physical location: in the case of many financial products, it may be
unclear "where" the transaction occurs.
Regulatory arbitrage can include restructuring a bank by outsourcing services such
as IT. The outsourcing company takes over the installations, buying out the bank's
assets and charges a periodic service fee back to the bank. This frees up cashflow
usable for new lending by the bank. The bank will have higher IT costs, but counts
on the multiplier effect of money creation and the interest rate spread to make it a
profitable exercise.
Example: Suppose the bank sells its IT installations for 40 million USD. With a
reserve ratio of 10%, the bank can create 400 million USD in additional loans (there
is a time lag, and the bank has to expect to recover the loaned money back into its
books). The bank can often lend (and securitize the loan) to the IT services company
to cover the acquisition cost of the IT installations. This can be at preferential rates,
as the sole client using the IT installation is the bank. If the bank can generate 5%
interest margin on the 400 million of new loans, the bank will increase interest
revenues by 20 million. The IT services company is free to leverage their balance
sheet as aggressively as they and their banker agree to. This is the reason behind the
trend towards outsourcing in the financial sector. Without this money creation
benefit, it is actually more expensive to outsource the IT operations as the
outsourcing adds a layer of management and increases overhead.
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CHAPTER 2 DERIVATIVE MARKET
2.1 DERIVATIVES
Introduction
Derivative is a product whose value is derived from the value of one or more basic
variables, called bases (underlying asset, index or reference rate), in a contractual
manner. The underlying asset can be equity, forex, commodity or any other asset.
For example, wheat farmers may wish to sell their harvest at a future date to
eliminate the risk of a change in prices by that date. Such a transaction is an example
of a derivative. The price of this derivative is driven by the spot price of wheat
which is the ‘underlying’.
The International Monetary Fund defines derivatives as "financial instruments that
are linked to a specific financial instrument or indicator or commodity and through
which specific financial risks can be traded in financial markets in their own right.
The value of a financial derivative derives from the price of an underlying item,
such as an asset or index. Unlike debt securities, no principal is advanced to be
repaid and no investment income accrues".
The emergence of the market for derivative products, most notably forwards, futures
and options, can be traced back to the willingness of risk-averse economic agents to
guard themselves against uncertainties arising out of fluctuations in asset prices. By
their very nature, the financial markets are marked by a very high degree of
volatility. Through the use of derivative products, it is possible to partially or fully
transfer price risks by locking–in asset prices.
As instruments of risk management, these generally do not influence the fluctuations
in the underlying asset prices. However, by locking in asset prices, derivative
products minimize the impact of fluctuations in asset prices on the profitability and
cash flow situation of risk-averse investors.
Derivative products initially emerged as hedging devices against fluctuations in
commodity prices and commodity-linked derivatives remained the sole form of such
products for almost three hundred years. The financial derivatives came into
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spotlight in post-1970 period due to growing instability in the financial markets.
However, since their emergence, these products have become very popular and by
1990s, they accounted for about two-thirds of total transactions in derivative
products.
In recent years, the market for financial derivatives has grown tremendously both in
terms of variety of instruments available, their complexity and also turnover.
The factors generally attributed as the major driving force behind growth of
financial derivatives are
(a) Increased volatility in asset prices in financial markets,
(b)187 increased integration of national financial markets with the international
markets,
(c) marked improvement in communication facilities and sharp decline in their costs,
(d) development of more sophisticated risk management tools, providing economic
agents a wider choice of risk management strategies, and
(e) Innovations in the derivatives markets, which optimally combine the risks and
returns over a large number of financial assets, leading to higher returns, reduced
risk as well as transaction costs as compared to individual financial assets. In the
class of equity derivatives, futures and options on stock indices have gained more
popularity than on individual stocks, especially among institutional investors, who
are major users of index-linked derivatives.
Even small investors find these useful due to high correlation of the popular indices
with various portfolios and ease of use. The lower costs associated with index
derivatives vis-à-vis derivative products based on individual securities is another
reason for their growing use.
Products, participants and functions
Derivative contracts have several variants. The most common variants are forwards,
futures, options and swaps. The following three broad categories of participants’
hedgers, speculators, and arbitrageurs trade in the derivatives market.
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a) Hedgers face risk associated with the price of an asset. They use futures or
options markets to reduce or eliminate this risk.
b) Speculators wish to bet on future movements in the price of an asset. Futures
and options contracts can give them an extra leverage; that is, they can
increase both the potential gains and potential losses in a speculative venture.
c) Arbitrageurs are in business to take advantage of a discrepancy between
prices in two different markets. If, for example, they see the futures price of
an asset getting out of line with the cash price, they will take offsetting
positions in the two markets to lock in a profit.
The derivatives market performs a number of economic functions. First, prices in an
organized derivatives market reflect the perception of market participants about the
future and lead the prices of underlying to the perceived future level. The prices of
derivatives converge with the prices of the underlying at the expiration of the
derivative contract. Thus, derivatives help in discovery of future as well as current
prices.
Second, the derivatives market helps to transfer risks from those who have them but
may not like them to those who have an appetite for them.
Third, derivatives, due to their inherent nature, are linked to the underlying cash
markets. With the introduction of derivatives, the underlying market witnesses
higher trading volumes because of participation by more players who would not
otherwise participate for lack of an arrangement to transfer risk.
Fourth, speculative trades shift to a more controlled environment of derivatives
market. In the absence of an organized derivatives market, speculators trade in the
underlying cash markets. Margining, monitoring and surveillance of the activities of
various participants become extremely difficult in these kinds of mixed markets.
Fifth, an important incidental benefit that flows from derivatives trading is that it
acts as a catalyst for new entrepreneurial activity. The derivatives have a history of
attracting many bright, creative, well educated people with an entrepreneurial
attitude. They often energies others to create new businesses, new products and new
employment opportunities, the benefit of which are immense.
Finally, derivatives markets help increase savings and investment in the long run.
Transfer of risk enables market participants to expand their volume of activity.
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Instruments Available For Trading
In recent years, derivatives have become increasingly popular due to their
applications for hedging, speculation and arbitrage. Before we study about the
applications of commodity derivatives, we will have a look at some basic derivative
products. While futures and options are now actively traded on many Exchanges,
forward contracts are popular on the OTC market. At present, only commodity
futures trade on the NCDEX.
TYPES OF DERIVATIVES
The most commonly used derivatives contracts are forwards, futures and options
which we shall discuss in detail later. Here we take a brief look at various
derivatives contracts that have come to be used.
Forwards:
A forward contract is a customized contract between two entities, where settlement
takes place on a specific date in the future at today’s pre-agreed price.
Futures:
A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Futures contracts are special types of
forward contracts in the sense that the former are standardized exchange-traded
contracts.
Options:
Options are of two types – calls and puts. Calls give the buyer the right but not the
obligation to buy a given quantity of the underlying asset, at a given price on or
before a given future date. Puts give the buyer the right, but not the obligation to sell
a given quantity of the underlying asset at a given price on or before a given date.
Warrants: Options generally have lives of upto one year, the majority of
options traded on options exchanges having maximum maturity of nine
months. Longer dated options are called warrants and are generally traded
over-the-counter.
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LEAPS:
The acronym LEAPS means Long Term Equity Anticipation Securities.
These are options having a maturity of up to three years.
Baskets:
Basket options are options on portfolios of underlying assets. The underlying asset
is usually a moving average or a basket of assets. Equity index options are a form of
basket options.
Swaps:
Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of
forward contracts. The two commonly used swaps are:
a) Interest rate swaps: These entail swapping only the interest related cash
flows between the parties in the same currency
b) Currency Swaps: These entail swapping both principal and interest between
the parties, with the cash flows in one direction being in a different currency
than those in the opposite direction.
Swaptions: Swaptions are options to buy or sell a swap that will become operative
at the expiry of the options. Thus, Swaptions is an option on a forward swap. Rather
than have calls and puts, the Swaptions market has receiver Swaptions and payer
Swaptions A receiver swaption is an option to receive fixed and pay floating. A
payer swaption is an option to pay fixed and receive floating.
2.2 INTRODUCTION TO FUTURES AND OPTIONS
In recent years, derivatives have become increasingly important in the field of
finance. While futures and options are now actively traded on many exchanges,
forward contracts are popular on the OTC market. In this chapter we shall study in
detail these three derivative contracts.
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2.2(a) FORWARD CONTRACTS
A forward contract is an agreement to buy or sell an asset on a specified date for a
specified price. One of the parties to the contract assumes a long position and agrees
to buy the underlying asset on a certain specified future date for a certain specified
price. The other party assumes a short position and agrees to sell the asset on the
same date for the same price.
Other contract details like delivery date, price and quantity are negotiated bilaterally
by the parties to the contract. The forward contracts are normally traded outside the
exchanges.
The salient features of forward contracts are:
• They are bilateral contracts and hence exposed to counter-party risk.
• Each contract is custom designed, and hence is unique in terms of contract size,
expiration date and the asset type and quality.
• The contract price is generally not available in public domain.
• On the expiration date, the contract has to be settled by delivery of the asset.
• If the party wishes to reverse the contract, it has to compulsorily go to the same
counter-party, which often results in high prices being charged.
However forward contracts in certain markets have become very standardized, as in
the case of foreign exchange, thereby reducing transaction costs and increasing
transactions volume. This process of standardization reaches its limit in the
organized futures market.
Forward contracts are very useful in hedging and speculation. The classic hedging
application would be that of an exporter who expects to receive payment in dollars
three months later. He is exposed to the risk of exchange rate fluctuations. By using
the currency forward market to sell dollars forward, he can lock on to a rate today
and reduce his uncertainty. Similarly an importer who is required to make a payment
in dollars two months hence can reduce his exposure to exchange rate fluctuations
by buying dollars forward.
If a speculator has information or analysis, which forecasts an upturn in a price, then
he can go long on the forward market instead of the cash market. The speculator
would go long on the forward, wait for the price to rise, and then take a reversing
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transaction to book profits. Speculators may well be required to deposit a margin
upfront. However, this is generally a relatively small proportion of the value of the
assets underlying the forward contract. The use of forward markets here supplies
leverage to the speculator.
2.2(b) LIMITATIONS OF FORWARD MARKETS
Forward markets world-wide are afflicted by several problems:
• Lack of centralization of trading,
• Illiquidity, and
• Counterparty risk
In the first two of these, the basic problem is that of too much flexibility and
generality. The forward market is like a real estate market in that any two consenting
adults can form contracts against each other. This often makes them design terms of
the deal which are very convenient in that specific situation, but makes the contracts
non-tradable. Counterparty risk arises from the possibility of default by any one
party to the transaction.
When one of the two sides to the transaction declares bankruptcy, the other suffers.
Even when forward markets trade standardized contracts, and hence avoid the
problem of illiquidity, still the counterparty risk remains a very serious issue.
2.2(c) INTRODUCTION TO FUTURES
Futures markets were designed to solve the problems that exist in forward markets.
A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. But unlike forward contracts, the futures
contracts are standardized and exchange traded.
To facilitate liquidity in the futures contracts, the exchange specifies certain standard
features of the contract. It is a standardized contract with standard underlying
instrument, a standard quantity and quality of the underlying instrument that can be
delivered, (or which can be used for reference purposes in settlement) and a standard
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timing of such settlement. A futures contract may be offset prior to maturity by
entering into an equal and opposite transaction. More than 99% of futures
transactions are offset this way.
The standardized items in a futures contract are:
i. Quantity of the underlying
ii. Quality of the underlying
iii. The date and the month of delivery
iv. The units of price quotation and minimum price change
v. Location of settlement
2.2(d) DISTINCTION BETWEEN FUTURES AND FORWARDS
CONTRACTS
Forward contracts are often confused with futures contracts. The confusion is
primarily because both serve essentially the same economic functions of allocating
risk in the presence of future price uncertainty. However futures are a significant
improvement over the forward contracts as they eliminate counterparty risk and
offer more liquidity.
Distinction between futures and forwards
Futures Forwards
Trade on an organized exchange OTC in nature
Standardized contract terms Customized contract terms
hence more liquid hence less liquid
Requires margin payments No margin payment
Follows daily settlement Settlement happens at end of period
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2.2(e) FUTURES TERMINOLOGY
i. Spot price:
The price at which an asset trades in the spot market.
ii. Futures price:
The price at which the futures contract trades in the futures market.
iii. Contract cycle:
The period over which a contract trades. The index futures contracts on the
NSE have one- month, two- months and three months expiry cycles which
expire on the last Thursday of the month.
Thus a January expiration contract expires on the last Thursday of January
and a February expiration contract ceases trading on the last Thursday of
February. On the Friday following the last Thursday, a new contract having a
three- month expiry is introduced for trading.
The commodity futures contracts on the NCDEX have one month, two
months, and three months etc (not more than a year) expiry cycles. Most of
the agri commodities futures contracts of NCDEX expire on the 20th day of
the delivery month.
Thus, a January expiration contract expires on the 20th of January and a
February expiration contract ceases to exist for trading after the 20th of
February. If 20th happens to be a holiday, the expiry date shall be the
immediately preceding trading day of the Exchange, other than a Saturday.
New contracts for agri commodities are introduced on the 10th of the month.
iv. Expiry date:
It is the date specified in the futures contract. This is the last day on which
the contract will be traded, at the end of which it will cease to exist.
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v. Contract size:
The amount of asset that has to be delivered under one contract. Also called
as lot size.
vi. Basis:
In the context of financial futures, basis can be defined as the futures price
minus the spot price. There will be a different basis for each delivery month
for each contract. In a normal market, basis will be positive. This reflects that
futures prices normally exceed spot prices.
vii. Cost of carry:
The relationship between futures prices and spot price can be summarized in
terms of what is known as the cost of carry.This measures the storage cost
plus the interest that is paid to finance the asset less the income earned on the
asset.
viii. Initial margin:
The amount that must be deposited in the margin account at the time a
futures contract is first entered into is known as initial margin.
ix. Marking-to-market:
In the futures market, at the end of each trading day, the margin account is
adjusted to reflect the investor's gain or loss depending upon the futures
closing price. This is called marking-to-market.
x. Maintenance margin:
This is somewhat lower than the initial 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 and is expected to top up the margin account to the initial margin
level before trading commences on the next day.
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2.2(f) INTRODUCTION TO OPTIONS
In this section, we look at the next derivative product to be traded on the NSE,
namely options. Options are fundamentally different from forward and futures
contracts. An option gives the holder of the option the right to do something. The
holder does not have to exercise this right. In contrast, in a forward or futures
contract, the two parties have committed themselves to doing something. Whereas it
costs nothing (except margin requirements) to enter into a futures contract, the
purchase of an option requires an up-front payment.
2.2(g) OPTION TERMINOLOGY
i. Index options:
These options have the index as the underlying. Some options are
European while others are American. Like index futures contracts,
index options contracts are also cash settled.
ii. Stock options:
Stock options are options on individual stocks. Options currently
trade on over 500 stocks in the United States. A contract gives the
holder the right to buy or sell shares at the specified price.
iii. Buyer of an option:
The buyer of an option is the one who by paying the option
premium buys the right but not the obligation to exercise his option
on the seller/writer.
iv. Writer of an option:
The writer of a call/put option is the one who receives the option
premium and is thereby obliged to sell/buy the asset if the buyer
exercises on him.
There are two basic types of options, call options and put options.
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Call option:
A call option gives the holder the right but not the obligation to buy an asset
by a certain date for a certain price.
Put option:
A put option gives the holder the right but not the obligation to sell an asset
by a certain date for a certain price.
Option price/premium:
Option price is the price which the option buyer pays to the option seller. It
is also referred to as the option premium.
Expiration date:
The date specified in the options contract is known as the expiration date,
the exercise date, the strike date or the maturity.
Strike price:
The price specified in the options contract is known as the strike price or
the exercise price.
American options:
American options are options that can be exercised at any time up to the
expiration date. Most exchange-traded options are American.
European options:
European options are options that can be exercise only on the expiration
date itself. European options are easier to analyze than American options,
and properties of an American option are frequently deduced from those of
its European counterpart.
In-the-money option:
An in-the-money (ITM) option is an option that would lead to a positive
cash flow to the holder if it were exercised immediately. A call option on
the index is said to be in-the-money when the current index stands at a level
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higher than the strike price (i.e. spot price > strike price). If the index is
much higher than the strike price, the call is said to be deep ITM. In the case
of a put, the put is ITM if the index is below the strike price.
At-the-money option:
An at-the-money (ATM) option is an option that would lead to zero cash
flow if it were exercised immediately. An option on the index is at-the-
money when the current index equals the strike price (i.e. spot price = strike
price).
Out-of-the-money option:
An out-of-the-money (OTM) option is an option that would lead to a
negative cash flow if it were exercised immediately. A call option on the
index is out-of-the-money when the current index stands at a level which is
less than the strike price (i.e. spot price < strike price). If the index is much
lower than the strike price, the call is said to be deep OTM. In the case of a
put, the put is OTM if the index is above the strike price.
Intrinsic value of an option:
The option premium can be broken down into two components - intrinsic
value and time value. The intrinsic value of a call is the amount the option is
ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it
another way, the intrinsic value of a call is Max[0, (St — K)] which means
the intrinsic value of a call is the greater of 0 or (St — K). Similarly, the
intrinsic value of a put is Max[0, K — St],i.e. the greater of 0 or (K — St). K
is the strike price and St is the spot price.
Time value of an option:
The time value of an option is the difference between its premium and its
intrinsic value. Both calls and puts have time value. An option that is OTM
or ATM has only time value. Usually, the maximum time value exists when
the option is ATM. The longer the time to expiration, the greater is an
option's time value, all else equal. At expiration, an option should have no
time value.
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HISTORY OF OPTIONS
Although options have existed for a long time, they were traded OTC, without much
knowledge of valuation. The first trading in options began in Europe and the US as
early as the seventeenth century. It was only in the early 1900s that a group of firms
set up what was known as the put and call Brokers and Dealers Association with the
aim of providing a mechanism for bringing buyers and sellers together. If someone
wanted to buy an option, he or she would contact one of the member firms. The firm
would then attempt to find a seller or writer of the option either from its own clients
or those of other member firms.
If no seller could be found, the firm would undertake to write the option itself in
return for a price. This market however suffered from two deficiencies. First, there
was no secondary market and second, there was no mechanism to guarantee that the
writer of the option would honor the contract. In 1973, Black, Merton and Scholes
invented the famed Black-Scholes formula.
In April 1973, CBOE was set up specifically for the purpose of trading options. The
market for options developed so rapidly that by early '80s, the number of shares
underlying the option contract sold each day exceeded the daily volume of shares
traded on the NYSE. Since then, there has been no looking back.
FUTURES AND OPTIONS
An interesting question to ask at this stage is - when would one use options instead
of futures? Options are different from futures in several interesting senses. At a
practical level, the option buyer faces an interesting situation. He pays for the option
in full at the time it is purchased. After this, he only has an upside. There is no
possibility of the options position generating any further losses to him (other than
the funds already paid for the option).
This is different from futures, which is free to enter into, but can generate very large
losses. This characteristic makes options attractive to many occasional market
participants, who cannot put in the time to closely monitor their futures positions.
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Buying put options is buying insurance. To buy a put option on Nifty is to buy
insurance which reimburses the full extent to which Nifty drops below the strike
price of the put option. This is attractive to many people, and to mutual funds
creating "guaranteed return products".
USE OF OPTIONS IN THE SEVENTEENTH-CENTURY
Options made their first major mark in financial history during the tulip bulb mania
in seventeenth-century Holland. It was one of the most spectacular get rich quick
binges in history. The first tulip was brought into Holland by a botany professor
from Vienna. Over a decade, the tulip became the most popular and expensive item
in Dutch gardens. The more popular they became, the more Tulip bulb prices began
rising. That was when options came into the picture.
They were initially used for hedging. By purchasing a call option on tulip bulbs, a
dealer who was committed to a sales contract could be assured of obtaining a fixed
number of bulbs for a set price. Similarly, tulip-bulb growers could assure
themselves of selling their bulbs at a set price by purchasing put options. Later,
however, options were increasingly used by speculators who found that call options
were an effective vehicle for obtaining maximum possible gains on investment.
As long as tulip prices continued to skyrocket, a call buyer would realize returns far
in excess of those that could be obtained by purchasing tulip bulbs themselves. The
writers of the put options also prospered as bulb prices spiraled since writers were
able to keep the premiums and the options were never exercised. The tulip-bulb
market collapsed in 1636 and a lot of speculators lost huge sums of money. Hardest
hit were put writers who were unable to meet their commitments to purchase Tulip
bulbs.
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Distinction between futures and options
Futures Options
Exchange traded, with novation Same as futures.
Exchange defines the product Same as futures.
Price is zero, strike price moves Strike price is fixed, price moves.
Price is zero Price is always positive.
Linear payoff Nonlinear payoff.
Both long and short at risk Only short at risk.
The Nifty index fund industry will find it very useful to make a bundle of a Nifty
index fund and a Nifty put option to create a new kind of a Nifty index fund, which
gives the investor protection against extreme drops in Nifty. Selling put options is
selling insurance, so anyone who feels like earning revenues by selling insurance
can set himself up to do so on the index options market. More generally, options
offer "nonlinear payoffs" whereas futures only have "linear payoffs". By combining
futures and options, a wide variety of innovative and useful payoff structures can be
created.
2.2(h) INDEX DERIVATIVES
Index derivatives are derivative contracts which derive their value from an
underlying index. The two most popular index derivatives are index futures and
index options. Index derivatives have become very popular worldwide. Index
derivatives offer various advantages and hence have become very popular.
Institutional and large equity-holders need portfolio-hedging facility. Index-
derivatives are more suited to them and more cost-effective than derivatives
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based on individual stocks. Pension funds in the US are known to use stock
index futures for risk hedging purposes.
Index derivatives offer ease of use for hedging any portfolio irrespective of
its composition.
Stock index is difficult to manipulate as compared to individual stock prices,
more so in India, and the possibility of cornering is reduced. This is partly
because an individual stock has a limited supply, which can be cornered.
Stock index, being an average, is much less volatile than individual stock
prices. This implies much lower capital adequacy and margin requirements.
Index derivatives are cash settled, and hence do not suffer from settlement
delays and problems related to bad delivery, forged/fake certificates.
2.2(I) SWAPS:
Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of
forward contracts. The two commonly used swaps are:
1. Interest rate swaps:
These entail swapping only the interest related cash flows between the parties in the
same currency.
2. Currency swaps:
These entail swapping both principal and interest between the parties, with the cash
flows in one direction being in a different currency than those in the opposite
direction.
Swaptions:
Swaptions are options to buy or sell a swap that will become operative at the expiry
of the options. Thus a swaption is an option on a forward swap. Rather than have
calls and puts, the swaptions market has receiver
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CHAPTER3 APPLICATIONS OF FUTURES AND
OPTIONS
The phenomenal growth of financial derivatives across the world is attributed the
fulfillment of needs of hedgers, speculators and arbitrageurs by these products. In
this chapter we first look at how trading futures differs from trading the underlying
spot. We then look at the payoff of these contracts, and finally at how these
contracts can be used by various entities in the economy. A payoff is the likely
profit/loss that would accrue to a market participant with change in the price of the
underlying asset. This is generally depicted in the form of payoff diagrams which
show the price of the underlying asset on the X-axis and the profits/losses on the Y-
axis
3.1 APPLICATION OF FUTURES
Understanding beta
The index model suggested by William Sharpe offers insights into portfolio
diversification. It expresses the excess return on a security or a portfolio as a
function of market factors and non market factors. Market factors are those factors
that affect all stocks and portfolios. These would include factors such as inflation,
interest rates, business cycles etc. Non-market factors would be those factors which
are specific to a company, and do not affect the entire market. For example, a fire
breakout in a factory, a new invention, the death of a key employee, a strike in the
factory, etc. The market factors affect all firms. The unexpected change in these
factors causes unexpected changes in the rates of returns on the entire stock market.
Each stock however responds to these factors to different extents. Beta of a stock
measures the sensitivity of the stocks responsiveness to these market factors.
Similarly, Beta of a portfolio, measures the portfolios responsiveness to these
market movements. Given stock beta’s, calculating portfolio beta is simple. It is
nothing but the weighted average of the stock betas. The index has a beta of 1.
Hence the movements of returns on a portfolio with a beta of one will be like the
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index. If the index moves up by ten percent, my portfolio value will increase by ten
percent. Similarly if the index drops by five percent, my portfolio value will drop by
five percent. A portfolio with a beta of two, responds more sharply to index
movements. If the index moves up by ten percent, the value of a portfolio with a
beta of two will move up by twenty percent. If the index drops by ten percent, the
value of a portfolio with a beta of two will fall by twenty percent. Similarly, if a
portfolio has a beta of 0.75, a ten percent movement in the index will cause a 7.5
percent movement in the value of the portfolio. In short, beta is a measure of the
systematic risk or market risk of a portfolio. Using index futures contracts, it is
possible to hedge the systematic risk. With this basic understanding, we look at
some applications of index futures. We look here at some applications of futures
contracts. We refer to single stock futures. However since the index is nothing but a
security whose price or level is a weighted average of securities constituting an
index, all strategies that can be implemented using stock futures can also be
implemented using index futures.
3.1(a) Hedging: Long security, sell futures
Futures can be used as an effective risk-management tool. Take the case of an
investor who holds the shares of a company and gets uncomfortable with market
movements in the short run. He sees the value of his security falling from Rs.450 to
Rs.390. In the absence of stock futures, he would either suffer the discomfort of a
price fall or sell the security in anticipation of a market upheaval. With security
futures he can minimize his price risk. All he need do is enter into an offsetting
stock futures position, in this case, take on a short futures position. Assume that the
spot price of the security he holds is Rs.390. Two-month futures cost him Rs.402.
For this he pays an initial margin. Now if the price of the security falls any further,
he will suffer losses on the security he holds. However, the losses he suffers on the
security will be offset by the profits he makes on his short futures position. Take for
instance that the price of his security falls to Rs.350. The fall in the price of the
security will result in a fall in the price of futures. Futures will now trade at a price
lower than the price at which he entered into a short futures position. Hence his short
futures position will start making profits. The loss of Rs.40 incurred on the security
he holds, will be made up by the profits made on his short futures position. Index
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futures in particular can be very effectively used to get rid of the market risk of a
portfolio. Every portfolio contains a hidden index exposure or a market exposure.
This statement is true for all portfolios, whether a portfolio is composed of index
securities or not. In the case of portfolios, most of the portfolio risk is accounted for
by index fluctuations (unlike individual securities, where only 30-60% of the
securities risk is accounted for by index fluctuations). Hence a position LONG
PORTFOLIO + SHORT NIFTY can often become one-tenth as risky as the LONG
PORTFOLIO position! Suppose we have a portfolio of Rs. 1 million which has a
beta of 1.25. Then a complete hedge is obtained by selling Rs.1.25 million of Nifty
futures.
Warning: Hedging does not always make money. The best that can be achieved
using hedging is the removal of unwanted exposure, i.e. unnecessary risk. The
hedged position will make less profit than the unhedged position, half the time. One
should not enter into a hedging strategy hoping to make excess profits for sure; all
that can come out of hedging is reduced risk.
3.1(b) Speculation: Bullish security, buy futures
Take the case of a speculator who has a view on the direction of the market. He
would like to trade based on this view. He believes that a particular security that
trades at Rs.1000 is undervalued and expects its price to go up in the next two-three
months. How can he trade based on this belief? In the absence of a deferral product,
he would have to buy the security and hold on to it. Assume he buys 100 shares
which cost him one lakh rupees. His hunch proves correct and two months later the
security closes at Rs.1010. He makes a profit of Rs.1000 on an investment of Rs.
1,00,000 for a period of two months. This works out to an annual return of 6 percent.
Today a speculator can take exactly the same position on the security by using
futures contracts. Let us see how this works. The security trades at Rs.1000 and the
two-month futures trades at 1006. Just for the sake of comparison, assume that the
minimum contract value is 1,00,000. He buys 100 security futures for which he pays
a margin of Rs.20,000. Two months later the security closes at 1010. On the day of
expiration, the futures price converges to the spot price and he makes a profit of
Rs.400 on an investment of Rs.20,000. This works out to an annual return of 12
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percent. Because of the leverage they provide, security futures form an attractive
option for speculators.
3.1(c) Speculation: Bearish security, sell futures
Stock futures can be used by a speculator who believes that a particular security is
over-valued and is likely to see a fall in price. How can he trade based on his
opinion? In the absence of a deferral product, there wasn't much he could do to
profit from his opinion. Today all he needs to do is sell stock futures. Let us
understand how this works. Simple arbitrage ensures that futures on an individual
securities move correspondingly with the underlying security, as long as there is
sufficient liquidity in the market for the security. If the security price rises, so will
the futures price. If the security price falls, so will the futures price. Now take the
case of the trader who expects to see a fall in the price of ABC Ltd. He sells one
two-month contract of futures on ABC at Rs.240 (each contact for 100 underlying
shares). He pays a small margin on the same. Two months later, when the futures
contract expires, ABC closes at 220. On the day of expiration, the spot and the
futures price converges. He has made a clean profit of Rs.20 per share. For the one
contract that he bought, this works out to be Rs.2000.
3.1(d) Arbitrage: Overpriced futures: buy spot, sell futures
As we discussed earlier, the cost-of-carry ensures that the futures price stay in tune
with the spot price. Whenever the futures price deviates substantially from its fair
value, arbitrage opportunities arise. If you notice that futures on a security that you
have been observing seem overpriced, how can you cash in on this opportunity to
earn riskless profits? Say for instance, ABC Ltd. trades at Rs.1000. One- month
ABC futures trade at Rs.1025 and seem overpriced. As an arbitrageur, you can make
riskless profit by entering into the following set of transactions.
1. On day one, borrow funds; buy the security on the cash/spot market at 1000.
2. Simultaneously, sell the futures on the security at 1025.
3. Take delivery of the security purchased and hold the security for a month.
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4. On the futures expiration date, the spot and the futures price converge. Now
unwind the position.
5. Say the security closes at Rs.1015. Sell the security.
6. Futures position expires with profit of Rs.10.
7. The result is a riskless profit of Rs.15 on the spot position and Rs.10 on the
futures position.
8. Return the borrowed funds.
When does it make sense to enter into this arbitrage? If your cost of borrowing funds
to buy the security is less than the arbitrage profit possible, it makes sense for you to
arbitrage. This is termed as cash-and-carry arbitrage. Remember however, that
exploiting an arbitrage opportunity involves trading on the spot and futures market.
In the real world, one has to build in the transactions costs into the arbitrage
strategy.
3.1(e) Arbitrage: Underpriced futures: buy futures, sell spot
Whenever the futures price deviates substantially from its fair value, arbitrage
opportunities arise. It could be the case that you notice the futures on a security you
hold seem underpriced. How can you cash in on this opportunity to earn riskless
profits? Say for instance, ABC Ltd. trades at Rs.1000. One month ABC futures trade
at Rs. 965 and seem underpriced. As an arbitrageur, you can make riskless profit by
entering into the following set of transactions.
1. On day one, sell the security in the cash/spot market at 1000.
2. Make delivery of the security.
3. Simultaneously, buy the futures on the security at 965.
4. On the futures expiration date, the spot and the futures price converge. Now
unwind the position.
5. Say the security closes at Rs.975. Buy back the security.
6. The futures position expires with a profit of Rs.10.
7. The result is a riskless profit of Rs.25 on the spot position and Rs.10 on the
futures position. 103
If the returns you get by investing in riskless instruments is more than the return
from the arbitrage trades, it makes sense for you to arbitrage. This is termed as
reverse-cash-and-carry arbitrage. It is this arbitrage activity that ensures that the spot
and futures prices stay in line with the cost-of-carry. As we can see, exploiting
arbitrage involves trading on the spot market. As more and more players in the
market develop the knowledge and skills to do cashand-carry and reverse cash-and-
carry, we will see increased volumes and lower spreads in both the cash as well as
the derivatives market.
3.2 APPLICATION OF OPTIONS
We look here at some applications of options contracts. We refer to single stock
options here. However since the index is nothing but a security whose price or level
is a weighted average of securities constituting the index, all strategies that can be
implemented using stock futures can also be implemented using index options.
3.2(a) Hedging: Have underlying buy puts
Owners of stocks or equity portfolios often experience discomfort about the overall
stock market movement. As an owner of stocks or an equity portfolio, sometimes
you may have a view that stock prices will fall in the near future. At other times you
may see that the market is in for a few days or weeks of massive volatility, and you
do not have an appetite for this kind of volatility. The union budget is a common and
reliable source of such volatility: market volatility is always enhanced for one week
before and two weeks after a budget. Many investors simply do not want the
fluctuations of these three weeks. One way to protect your portfolio from potential
downside due to a market drop is to buy insurance using put options. Index and
stock options are a cheap and easily implementable way of seeking this insurance.
The idea is simple. To protect the value of your portfolio from falling below a
particular level, buy the right number of put options with the right strike price. If
you are only concerned about the value of a particular stock that you hold, buy put
options on that stock. If you are concerned about the overall portfolio, buy put
options on the index. When the stoc k price falls your stock will lose value and the
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put options bought by you will gain, effectively ensuring that the total value of your
stock plus put does not fall below a particular level. This level depends on the strike
price of the stock options chosen by you. Similarly when the index falls, your
portfolio will lose value and the put options bought by you will gain, effectively
ensuring that the value of your portfolio does not fall below a particular level. This
level depends on the strike price of the index options chosen by you. Portfolio
insurance using put options is of particular interest to mutual funds who already own
well-diversified portfolios. By buying puts, the fund can limit its downside in case
of a market fall.
3.2(b) Speculation: Bullish security, buy calls or sell puts
There are times when investors believe that security prices are going to rise. For
instance, after a good budget, or good corporate results, or the onset of a stable
government. How does one implement a trading strategy to benefit from an upward
movement in the underlying security? Using options there are two ways one can do
this:
1. Buy call options; or
2. Sell put options
We have already seen the payoff of a call option. The downside to the buyer of the
call option is limited to the option premium he pays for buying the option. His
upside however is potentially unlimited. Suppose you have a hunch that the price of
a particular security is going to rise in a month’s time. Your hunch proves correct
and the price does indeed rise, it is this upside that you cash in on. However, if your
hunch proves to be wrong and the security price plunges down, what you lose is
only the option premium. Having decided to buy a call, which one should you buy?
Table 4.1 gives the premia for one month calls and puts with different strikes. Given
that there are a number of one-month calls trading, each with a different strike price,
the obvious question is: which strike should you choose? Let us take a look at call
options with different strike prices. Assume that the current price level is 1250, risk-
free rate is12% per year and volatility of the underlying security is 30%. The
following options are available:
1. A one month call with a strike of 1200.
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2. A one month call with a strike of 1225.
3. A one month call with a strike of 1250.
4. A one month call with a strike of 1275.
5. A one month call with a strike of 1300.
Which of these options you choose largely depends on how strongly you feel about
the likelihood of the upward movement in the price, and how much you are willing
to lose should this upward movement not come about. There are five one-month
calls and five one-month puts trading in the market. The call with a strike of 1200 is
deep in-the-money and hence trades at a higher premium. The call with a strike of
1275 is out-of-the-money and trades at a low premium. The call with a strike of
1300 is deep-out-of-money. Its execution depends on the unlikely event that the
underlying will rise by more than 50 points on the expiration date. Hence buying
this call is basically like buying a lottery. There is a small probability that it may be
in-the-money by expiration, in which case the buyer will make profits. In the more
likely event of the call expiring out-of-the-money, the buyer simply loses the small
premium amount of Rs.27.50.
As a person who wants to speculate on the hunch that prices may rise, you can also
do so by selling or writing puts. As the writer of puts, you face a limited upside and
an unlimited downside. If prices do rise, the buyer of the put will let the option
expire and you will earn the premium. If however your hunch about an upward
movement proves to be wrong and prices actually fall, then your losses directly
increase with the falling price level. If for instance the price of the underlying falls
to 1230 and you've sold a put with an exercise of 1300, the buyer of the put will
exercise the option and you'll end up losing Rs.70. Taking into account the premium
earned by you when you sold the put, the net loss on the trade is Rs.5.20.
Having decided to write a put, which one should you write? Given that there are a
number of one-month puts trading, each with a different strike price, the obvious
question is: which strike should you choose? This largely depends on how strongly
you feel about the likelihood of the upward movement in the prices of the
underlying. If you write an at-the-money put, the option premium earned by you will
be higher than if you write an out-of-the-money put. However the chances of an at-
the-money put being exercised on you are higher as well.
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Table 3.1 One month calls and puts trading at different strikes
The spot price is 1250. There are five one-month calls and five one-month puts
trading in the market. The call with a strike of 1200 is deep in-the-money and hence
trades at a higher premium. The call with a strike of 1275 is out-of-the-money and
trades at a low premium. The call with a strike of 1300 is deep-out-of-money. Its
execution depends on the unlikely event that the price of underlying will rise by
more than 50 points on the expiration date. Hence buying this call is basically like
buying a lottery. There is a small probability that it may be in-the-money by
expiration in which case the buyer will profit. In the more likely event of the call
expiring out-of-the-money, the buyer simply loses the small premium amount of Rs.
27.50. Figure 4.10 shows the payoffs from buying calls at different strikes.
Similarly, the put with a strike of 1300 is deep in-the-money and trades at a higher
premium than the at-the-money put at a strike of 1250. The put with a strike of 1200
is deep out-of-the-money and will only be exercised in the unlikely event that
underlying falls by 50 points on the expiration date. Following figure shows the
payoffs from writing puts at different strikes.
Underlying Strike price of
option
Call Premium(Rs.) Put Premium(Rs.)
1250 1200 80.10 18.15
1250 1225 63.65 26.50
1250 1250 49.45 37.00
1250 1275 37.50 49.80
1250 1300 27.50 64.80
In the example in above Figure at a price level of 1250, one opt ion is in-the-money
and one is out-of-the-money. As expected, the in-the-money option fetches the
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highest premium of Rs.64.80 whereas the out-of-the-money option has the lowest
premium of Rs. 18.15.
3.2(c) Speculation: Bearish security, sell calls or buy puts
Do you sometimes think that the market is going to drop? That you could make a
profit by adopting a position on the market? Due to poor corporate results, or the
instability of the government, many people feel that the stocks prices would go
down. How does one implement a trading strategy to benefit from a downward
movement in the market? Today, using options, you have two choices:
1. Sell call options; or
2. Buy put options
We have already seen the payoff of a call option. The upside to the writer of the call
option is limited to the option premium he receives upright for writing the option.
His downside however is potentially unlimited. Suppose you have a hunch that the
price of a particular security is going to fall in a months’ time. Your hunch proves
correct and it does indeed fall, it is this downside that you cash in on. When the
price falls, the buyer of the call lets the call expire and you get to keep the premium.
However, if your hunch proves to be wrong and the market soars up instead, what
you lose is directly proportional to the rise in the price of the security.
Figure 3.1 Payoff for buyer of call options at various strikes
The figure shows the profits/losses for a buyer of calls at various strikes. The in-the
money option with a strike of 1200 has the highest premium of Rs.80.10 whereas the
out-of-the-money option with a strike of 1300 has the lowest premium of Rs.27.50.
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Figure 3.2 Payoff for writer of put options at various strikes
The figure shows the profits/losses for a writer of puts at various strikes. The in the-
money option with a strike of 1300 fetches the highest premium of Rs.64.80
whereas the out-of-the-money option with a strike of 1200 has the lowest premium
of Rs. 18.15.
Having decided to write a call, which one should you write? Table 4.2 gives the
premiums for one month calls and puts with different strikes. Given that there are a
number of one-month calls trading, each with a different strike price, the obvious
question is: which strike should you choose? Let us take a look at call options with
different strike prices. Assume that the current stock price is 1250, risk-free rate is
12% per year and stock volatility is 30%. You could write the following options:
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1. A one month call with a strike of 1200.
2. A one month call with a strike of 1225.
3. A one month call with a strike of 1250.
4. A one month call with a strike of 1275.
5. A one month call with a strike of 1300.
Which of this option you write largely depends on how strongly you feel about the
likelihood of the downward movement of prices and how much you are willing to
lose should this downward movement not come about. There are five one-month
calls and five one-month puts trading in the market. The call with a strike of 1200 is
deep in-the-money and hence trades at a higher premium. The call with a strike of
1275 is out-of-the-money and trades at a low premium. The call with a strike of
1300 is deep-out-of-money. Its execution depends on the unlikely event that the
stock will rise by more than 50 points on the expiration date. Hence writing this call
is a fairly safe bet. There is a small probability that it may be in-the-money by
expiration in which case the buyer exercises and the writer suffers losses to the
extent that the price is above 1300. In the more likely event of the call expiring out
of- the-money, the writer earns the premium amount ofRs.27.50. As a person who
wants to speculate on the hunch that the market may fall, you can also buy puts. As
the buyer of puts you face an unlimited upside but a limited downside. If the price
does fall, you profit to the extent the price falls below the strike of the put purchased
by you. If however your hunch about a downward movement in the market proves to
be wrong and the price actually rises, all you lose is the option premium. If for
instance the security price rises to 1300 and you've bought a put with an exercise of
1250, you simply let the put expire. If however the price does fall to say 1225 on
expiration date, you make a neat profit of Rs.25.
Having decided to buy a put, which one should you buy? Given that there are a
number of one-month puts trading, each with a different strike price, the obvious
question is: which strike should you choose? This largely depends on how strongly
you feel about the likelihood of the downward movement in the market. If you buy
an at-the-money put, the option premium paid by you will by higher than if you buy
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an out-of-the-money put. However the chances of an at-the-money put expiring in-
the-money are higher as well.
Table 3.2 One month calls and puts trading at different strikes
The spot price is 1250. There are five one-month calls and five one-month puts
trading in the market. The call with a strike of 1200 is deep in-the-money and hence
trades at a higher premium. The call with a strike of 1275 is out-of-the-money and
trades at a low premium. The call with a strike of 1300 is deep-out of- money. Its
execution depends on the unlikely event that the price will rise by more than 50
points on the expiration date. Hence writing this call is a fairly safe bet. There is a
small probability that it may be in-the-money by expiration in which case the buyer
exercises and the writer suffers losses to the extent that the price is above 1300. In
the more likely event of the call expiring out-of-the-money, the writer earns the
premium amount of Rs.27.50. Figure 4.12 shows the payoffs from writing calls at
different strikes. Similarly, the put with a strike of 1300 is deep in-the-money and
trades at a higher premium than the at-the-money put at a strike of 1250. The put
with a strike of 1200 is deep out-of-the-money and will only be exercised in the
unlikely event that the price falls by 50 points on the expiration date. The choice of
which put to buy depends upon how much the speculator expects the market to fall.
Figure 3.3 shows the payoffs from buying puts at different strikes.
Price Strike price of
option
Call
Premium(Rs.)
Put Premium(Rs.)
1250 1200 80.10 18.15
1250 1225 63.65 26.50
1250 1250 49.45 37.00
1250 1275 37.50 49.80
1250 1300 27.50 64.80
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Figure 3.4 Payoff for seller of call option at various strikes
The figure shows the profits/losses for a seller of calls at various strike prices. The
in-the-money option has the highest premium of Rs.80.10 whereas the out-of-the-
money option has the lowest premium of Rs. 27.50.
Figure 3.5 Payoff for buyer of put options at various strikes
The figure shows the profits/losses for a buyer of puts at various strike prices. The
in-the-money option has the highest premium of Rs.64.80 whereas the out-of-the-
money option has the lowest premium of Rs. 18.50.
3.2(e) Bull spreads - Buy a call and sell another
There are times when you think the market is going to rise over the next two
months; however in the event that the market does not rise, you would like to limit
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your downside. One way you could do this is by entering into a spread. A spread
trading strategy involves taking a position in two or more options of the same type,
that is, two or more calls or two or more puts. A spread that is designed to profit if
the price goes up is called a bull spread.
How does one go about doing this? This is basically done utilizing two call options
having the same expiration date, but different exercise prices. The buyer of a bull
spread buys a call with an exercise price below the current index level and sells a
call option with an exercise price above the current index level. The spread is a bull
spread because the trader hopes to profit from a rise in the index. The trade is a
spread because it involves buying one option and selling a related option. What is
the advantage of entering into a bull spread? Compared to buying the underlying
asset itself, the bull spread with call options limits the trader's risk, but the bull
spread also limits the profit potential.
Figure 3.6 Payoff for a bull spread created using call options
The figure shows the profits/losses for a bull spread. As can be seen, the payoff
obtained is the sum of the payoffs of the two calls, one sold at Rs.40 and the other
bought at Rs.80. The cost of setting up the spread is Rs.40 which is the difference
between the call premium paid and the call premium received. The downside on the
position is limited to this amount. As the index moves above 3800, the position
starts making profits (cutting losses) until the index reaches 4200. Beyond 4200, the
profits made on the long call position get offset by the losses made on the short call
position and hence the maximum profit on this spread is made if the index on the
expiration day closes at 4200. Hence the payoff on this spread lies between -40 to
360. Who would buy this spread? Somebody who thinks the index is going to rise,
but not above 4200. Hence he does not want to buy a call at 3800 and pay a
premium of 80 for an upside he believes will not happen.
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In short, it limits both the upside potential as well as the downside risk. The cost of
the bull spread is the cost of the option that is purchased, less the cost of the option
that is sold. Table 4.3 gives the profit/loss incurred on a spread position as the index
changes. Figure 4.14 shows the payoff from the bull spread.
Broadly, we can have three types of bull spreads:
1. Both calls initially out-of-the-money.
2. One call initially in-the-money and one call initially out-of-the-money, and
3. Both calls initially in-the-money.
The decision about which of the three spreads to undertake depends upon how much
risk the investor is willing to take. The most aggressive bull spreads are of type 1.
They cost very little to set up, but have a very small probability of giving a high
payoff.
Table 3.3 Expiration day cash flows for a Bull spread using two-month calls
The table shows possible expiration day profit for a bull spread created by buying
calls at a strike of 3800 and selling calls at a strike of 4200. The cost of setting up
the spread is the call premium paid (Rs.80) minus the call premium received
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(Rs.40), which is Rs.40. This is the maximum loss that the position will make. On
the other hand, the maximum profit on the spread is limited to Rs.360. Beyond an
index level of 4200, any profits made on the long call position will be cancelled by
losses made on the short call position, effectively limiting the profit on the
combination.
Nifty Buy Jan 3800
Call
Sell Jan 4200
Call
Cash Flow Profit & Loss
(Rs.)
3700 0 0 0 -40
3750 0 0 0 -40
3800 0 0 0 -40
3850 +50 0 50 +10
3900 +100 0 100 +60
3950 +150 0 150 +110
4000 +200 0 200 +160
4050 +250 0 250 +210
4100 +300 0 300 +260
4150 +350 0 350 +310
4200 +400 0 400 +360
4250 +450 -50 400 +360
4300 +500 -100 400 +360
3.2(e) Bear spreads - sell a call and buy another
There are times when you think the market is going to fall over the next two months.
However in the event that the market does not fall, you would like to limit your
downside. One way you could do this is by entering into a spread. A spread trading
strategy involves taking a position in two or more options of the same type, that is,
two or more calls or two or more puts. A spread that is designed to profit if the price
goes down is called a bear spread. How does one go about doing this? This is
basically done utilizing two call options having the same expiration date, but 115
different exercise prices. How a bull is spread different from a bear spread? In a bear
spread, the strike price of the option purchased is greater than the strike price of the
option sold. The buyer of a bear spread buys a call with an exercise price above the
current index level and sells a call option with an exercise price below the current
index level. The spread is a bear spread because the trader hopes to profit from a fall
in the index. The trade is a spread because it involves buying one option and selling
a related option. What is the advantage of entering into a bear spread? Compared to
buying the index itself, the bear spread with call options limits the trader's risk, but it
also limits the profit potential. In short, it limits both the upside potential as well as
the downside risk. A bear spread created using calls involves initial cash inflow
since the price of the call sold is greater than the price of the call purchased. Table
4.4 gives the profit/loss incurred on a spread position as the index changes.
Figure 3.7 shows the payoff from the bear spread.
Broadly we can have three types of bear spreads:
1. Both calls initially out-of-the-money.
2. One call initially in-the-money and one call initially out-of-the-money, and
3. Both calls initially in-the-money.
The decision about which of the three spreads to undertake depends upon how much
risk the investor is willing to take. The most aggressive bear spreads are of type 1.
They cost very little to set up, but have a very small probability of giving a high
payoff. As we move from type 1 to type 2 and from type 2 to type 3, the spreads
become more conservative and cost higher to set up. Bear spreads can also be
created by buying a put with a high strike price and selling a put with a low strike
price.
Figure 3.8 Payoff for a bear spread created using call options
The figure shows the profits/losses for a bear spread. As can be seen, the payoff
obtained is the sum of the payoffs of the two calls, one sold at Rs. 150 and the other
bought at Rs.50. The maximum gain from setting up the spread is Rs. 100 which is
the difference between the call premium received and the call premium paid. The
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upside on the position is limited to this amount. As the index moves above 3800, the
position starts making losses (cutting profits) until the spot reaches 4200. Beyond
4200, the profits made on the long call position get offset by the losses made on the
short call position. The maximum loss on this spread is made if the index on the
expiration day closes at 2350. At this point the loss made on the two call position
together is Rs.400 i.e. (4200-3800). However the initial inflow on the spread being
Rs.100, the net loss on the spread turns out to be 300. The downside on this spread
position is limited to this amount. Hence the payoff on this spread lies between +100
to -300.
Table 3.4 Expiration day cash flows for a Bear spread using two-month calls
The table shows possible expiration day profit for a bear spread created by selling
one market lot of calls at a strike of 3800 and buying a market lot of calls at a strike
of 4200. The maximum profit obtained from setting up the spread is the difference
between the premium received for the call sold (Rs. 150) and the premium paid for
the call bought (Rs.50) which is Rs. 100. In this case the maximum loss obtained is
limited to Rs.300. Beyond an index level of 4200, any profits made on the long call
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position will be canceled by losses made on the short call position, effectively
limiting the profit on the combination
Nifty Buy Jan 4200
Call
Sell Jan 3800
Call
Cash Flow Profit&Loss
(Rs.)
3700 0 0 0 +100
3750 0 0 0 +100
3800 0 0 0 +100
3850 0 -50 -50 +50
3900 0 -100 -100 0
3950 0 -150 -150 -50
4000 0 -200 -200 -100
4050 0 -250 -250 -150
4100 0 -300 -300 -200
4150 0 -350 -350 -250
4200 0 -400 -400 -300
4250 +50 -450 -400 -300
4300 +100 -500 -400 -300
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CHAPTER4 TRADING OF FUTURES AND OPTIONS
In this chapter we shall take a brief look at the trading system for NSE's futures and
options market. However, the best way to get a feel of the trading system is to
actually watch the screen and observe trading.
4.1 FUTURES AND OPTIONS TRADING SYSTEM
The futures & options trading system of NSE, called NEAT-F&O trading system,
provides a fully automated screen-based trading for Index futures & options and
Stock futures & options on a nationwide basis as well as an online monitoring and
surveillance mechanism. It supports an order driven market and provides complete
transparency of trading operations. It is similar to that of trading of equities in the
cash market segment. The software for the F&O market has been developed to
facilitate efficient and transparent trading in futures and options instruments.
Keeping in view the familiarity of trading members with the current capital market
trading system, modifications have been performed in the existing capital market
trading system so as to make it suitable for trading futures and options.
4.1(A) ENTITIES IN THE TRADING SYSTEM
There are four entities in the trading system. Trading members, clearing members,
professional clearing members and participants.
1. Trading members:
Trading members are members of NSE. They can trade either on their own
account or on behalf of their clients including participants. The exchange
assigns a trading member ID to each trading member. Each trading member
can have more than one user. The number of users allowed for each trading
member is notified by the exchange from time to time. Each user of a trading
member must be registered with the exchange and is assigned a unique user
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ID. The unique trading member ID functions as a reference for all
orders/trades of different users. This ID is common for all users of a
particular trading member. It is the responsibility of the trading member to
maintain adequate control over persons having access to the firm’s User IDs.
2. Clearing members:
Clearing members are members of NSCCL. They carry out risk management
activities and confirmation/inquiry of trades through the trading system.
3. Professional clearing members:
A professional clearing members is a clearing member who is not a trading
member. Typically, banks and custodians become professional clearing
members and clear and settle for their trading members.
4. Participants:
A participant is a client of trading members like financial institutions. These
clients may trade through multiple trading members but settle through a
single clearing member.
4.1(B) BASIS OF TRADING
The NEAT F&O system supports an order driven market, wherein orders match
automatically. Order matching is essentially on the basis of security, its price, time
and quantity. All quantity fields are in units and price in rupees. The exchange
notifies the regular lot size and tick size for each of the contracts traded on this
segment from time to time. When any order enters the trading system, it is an active
order. It tries to find a match on the other side of the book. If it finds a match, a trade
is generated. If it does not find a match, the order becomes passive and goes and sits
in the respective outstanding order book in the system.
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4.1(C) CORPORATE HIERARCHY
In the F&O trading software, a trading member has the facility of defining a
hierarchy amongst users of the system. This hierarchy comprises corporate manager,
branch manager and dealer.
a. Corporate manager:
The term 'Corporate manager' is assigned to a user placed at the highest level
in a trading firm. Such a user can perform all the functions such as order and
trade related activities, receiving reports for all branches of the trading
member firm and also all dealers of the firm. Additionally, a corporate
manager can define exposure limits for the branches of the firm. This facility
is available only to the corporate manager.
b. Branch manager:
The branch manager is a term assigned to a user who is placed under the
corporate manager. Such a user can perform and view order and trade related
activities for all dealers under that branch.
c. Dealer:
Dealers are users at the lower most level of the hierarchy. A Dealer can
perform view order and trade related activities only for oneself and does not
have access to information on other dealers under either the same branch or
other branches.
Below given cases explain activities possible for specific user categories:
1) Clearing member corporate manager:
He can view outstanding orders, previous trades and net position of
his client trading members by putting the TM ID (Trading member
identification) and leaving the Branch ID and Dealer ID blank.
2) Clearing member and trading member corporate manager:
He can view:
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a. Outstanding orders, previous trades and net position of his
client trading members by putting the TM ID and leaving the
Branch ID and the Dealer ID blank.
b. Outstanding orders, previous trades and net positions entered
for himself by entering his own TM ID, Branch ID and User
ID.This is his default screen.
c. Outstanding orders, previous trades and net position entered
for his branch by entering his TM ID and Branch ID fields.
d. Outstanding orders, previous trades, and net positions entered
for any of his users/dealers by entering his TM ID, Branch I
and user ID fields.
3) Clearing member and trading member dealer:
He can only view requests entered by him.
4) Trading member corporate manager:
He can view:
a. Outstanding requests and activity log for requests entered by
him by entering his own Branch and User IDs. This is his
default screen.
b. Outstanding requests entered by his dealers and/or branch
managers by either entering the Branch and/or User IDs or
leaving them blank.
5) Trading member branch manager:
He can view:
a. Outstanding requests and activity log for requests entered by
him by entering his own Branch and User IDs. This is his
default screen.
b. Outstanding requests entered by his users either by filling the
User ID field with a specific user or leaving the User ID field
blank.
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6) Trading member dealer:
He can only view requests entered by him.
4.1(D) CLIENT BROKER RELATIONSHIP IN DERIVATIVE SEGMENT
A trading member must ensure compliance particularly with relation to the
following while dealing with clients:
1. Filling of 'Know Your Client' form
2. Execution of Client Broker agreement
3. Bring risk factors to the knowledge of client by getting acknowledgement of
client on risk disclosure document
4. Timely execution of orders as per the instruction of clients in respective client
codes.
5. Collection of adequate margins from the client
6. Maintaining separate client bank account for the segregation of client money.
7. Timely issue of contract notes as per the prescribed format to the client
8. Ensuring timely pay-in and pay-out of funds to and from the clients
9. Resolving complaint of clients if any at the earliest.
10. Avoiding receipt and payment of cash and deal only through account payee
cheques
11. Sending the periodical statement of accounts to clients
12. Not charging excess brokerage
13. Maintaining unique client code as per the regulations.
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4.2 CRITERIA FOR STOCKS AND INDEX ELIGIBILITY FOR
TRADING
4.2(a) Eligibility criteria of stocks
The stock is chosen from amongst the top 500 stocks in terms of average
daily market capitalization and average daily traded value in the previous six
months on a rolling basis.
The stock's median quarter-sigma order size over the last six months should
be not less than Rs. 5 lakhs. For this purpose, a stock's quarter-sigma order
size should mean the order size (in value terms) required to cause a change in
the stock price equal to one-quarter of a standard deviation.
The market wide position limit in the stock should not be less than Rs.100
crores. The market wide position limit (number of shares) is valued taking
the closing prices of stocks in the underlying cash market on the date of
expiry of contract in the month. The market wide position limit of open
position (in terms of the number of underlying stock) on futures and option
contracts on a particular underlying stock shall be 20% of the number of
shares held by non promoters in the relevant underlying security i.e. free-
float holding.
For an existing F&O stock, the continued eligibility criteria is that market wide
position limit in the stock shall not be less than Rs. 60 crores and stock’s median
quarter-sigma order size over the last six months shall be not less than Rs. 2 lakh. If
an existing security fails to meet the eligibility criteria for three months
consecutively, then no fresh month contract will be issued on that security.
However, the existing unexpired contracts can be permitted to trade till expiry and
new strikes can also be introduced in the existing contract months. Further, once the
stock is excluded from the F&O list, it shall not be considered for re-inclusion for a
period of one year.
Futures & Options contracts may be introduced on (new) securities which meet the
above mentioned eligibility criteria, subject to approval by SEBI.
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4.2(b) Eligibility criteria of indices
The exchange may consider introducing derivative contracts on an index if the
stocks contributing to 80% weightage of the index are individually eligible for
derivative trading. However, no single ineligible stocks in the index should have a
weightage of more than 5% in the index. The above criteria is applied every month,
if the index fails to meet the eligibility criteria for three months consecutively, then
no fresh month contract would be issued on that index, However, the existing
unexpired contacts will be permitted to trade till expiry and new strikes can also be
introduced in the existing contracts.
4.2(c) Eligibility criteria of stocks for derivatives trading especially on account of
corporate restructuring
The eligibility criteria for stocks for derivatives trading on account of corporate
restructuring are as under:
a) All the following conditions shall be met in the case of shares of a
company undergoing restructuring through any means for eligibility to
reintroduce derivative contracts on that company from the first day of
listing of the post restructured company/(s) (as the case may be) stock
(herein referred to as post restructured company) in the underlying
market, the Futures and options contracts on the stock of the original (pre
restructure) company were traded on any exchange prior to its
restructuring;
b) the pre restructured company had a market capitalization of at least
Rs.1000 crores prior to its restructuring;
c) the post restructured company would be treated like a new stock and if it
is, in the opinion of the exchange, likely to be at least one-third the size
of the pre restructuring company in terms of revenues, or assets, or
(where appropriate) analyst valuations; and
d) In the opinion of the exchange, the scheme of restructuring does not
suggest that the post restructured company would have any characteristic
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(for example extremely low free float) that would render the company
ineligible for derivatives trading.
II. If the above conditions are satisfied, then the exchange takes the following
course of action in dealing with the existing derivative contracts on the pre-
restructured company and introduction of fresh contracts on the post restructured
company.
a) In the contract month in which the post restructured company begins to
trade, the Exchange introduce near month, middle month and far month
derivative contracts on the stock of the restructured company.
b) In subsequent contract months, the normal rules for entry and exit of stocks
in terms of eligibility requirements would apply. If these tests are not met,
the exchange shall not permit further derivative contracts on this stock and
future month series shall not be introduced.
4.3 CHARGES
The maximum brokerage chargeable by a trading member in relation to trades
effected in the contracts admitted to dealing on the F&O segment o NSE is fixed at
2.5% of the contract value in case of index futures and stock futures. In case of
index options and stock options it is 2.5% of notional value of the contract [(Strike
Price + Premium) * Quantity)], exclusive of statutory levies. The transaction charges
payable to the exchange by the trading member for the trades executed by him on
the F&O segment are fixed at the rate of Rs. 2 per lakh of turnover (0.002%) subject
to a minimum of Rs. 1,00,000 per year. However for the transactions in the options
sub-segment the transaction charges are levied on the premium value at the rate of
0.05% (each side) instead of on the strike price as levied earlier. Further to this,
trading members have been advised to charge brokerage from their clients on the
Premium price (traded price) rather than Strike price. The trading members
contribute to Investor Protection Fund of F&O segment at the rate of Re. 1/- per
Rs.100 crores of the traded value (each side).
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CHAPTER 5
CLEARANCE AND SETTLEMENT OF FUTURES &
MECHANISM
National Securities Clearing Corporation Limited (NSCCL) undertakes clearing and
settlement of all trades executed on the futures and options (F&O) segment of the
NSE. It also acts as legal counterparty to all trades on the F&O segment and
guarantees their financial settlement.
5.1 CLEARING ENTITIES
Clearing and settlement activities in the F&O segment are undertaken by NSCCL
with the help of the following entities:
5.1(a) clearing members
In the F&O segment, some members, called self clearing members, clear and settle
their trades executed by them only either on their own account or on account of their
clients. Some others called trading member-cum-clearing member, clear and settle
their own trades as well as trades of other trading members (TMs). Besides, there is
a special category of members; called professional clearing members (PCM) who
clear and settle trades executed b TMs. The members clearing their own trades and
trades of others, and the PCMs are required to bring in additional security deposits
in respect of every TM whose trades they undertake to clear and settle.
5.1(b) clearing banks
Funds settlement takes place through clearing banks. For the purpose of settlement
all clearing members are required to open a separate bank account with NSCCL
designated clearing bank for F&O segment. The Clearing and Settlement process
comprises of the following three main activities:
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1) Clearing
2) Settlement
3) Risk Management
Table 5.1 Proprietary position of trading member Madanbhai on Day 1
Trading member Madanbhai trades in the futures and options segment for himself
and two of his clients.The table shows his proprietary position. Note: A buy position
'200@ 1000"means 200 units bought atthe rate of Rs. 1000.
Trading member Madanbhai
Buy Sell
Proprietary position 200@1000 400@1010
Table 5.2 Client position of trading member Madanbhai on Day 1
Trading member Madanbhai trades in the futures and options segment for himself
and two of his clients.The table shows his client position.
Trading member Madanbhai
Client position Buy Open Sell Close Sell Open Buy Close
Client A400@1109 200@1000
Client B 600@1100 200@1099
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5.2 CLEARING MECHANISM
The clearing mechanism essentially involves working out open positions and
obligations of clearing (self-clearing/trading-cum-clearing/professional clearing)
members. This position is considered for exposure and daily margin purposes. The
open positions of CMs are arrived at by aggregating the open positions of all the
TMs and all custodial participants clearing through him, in contracts in which they
have traded. A TM's open position is arrived at as the summation of his proprietary
open position and clients' open positions, in the contracts in which he has traded.
Whether proprietary (if they are their own trades) or client (if entered on behalf of
clients) through 'Pro/Cli' indicator provided in the order entry screen. Proprietary
positions are calculated on net basis (buy - sell) for each contract. Clients' positions
are arrived at by summing together net (buy - sell) positions of each individual
client. A TM's open position is the sum of proprietary open position, client open
long position and client open short position. Consider the following example given
from Table 6.1 to Table 6.4. The proprietary open position on day 1 is simply = Buy
- Sell = 200 - 400 = 200 short. The open position for client A = Buy (O) – Sell (C) =
400 - 200 = 200 long, i.e. he has a long position of 200 units. The open position for
Client B = Sell (O) – Buy (C) = 600 - 200 = 400 short, i.e. he has a short position of
400 units. Now the total open position of the trading member Madanbhai at end of
day 1 is 200(his proprietary open position on net basis) plus 600 (the Client open
positions on gross basis), i.e. 800. The proprietary open position at end of day 1 is
200 short. The end of day open position for proprietary trades undertaken on day 2 is
200 short. Hence the net open proprietary position at the end of day 2 is 400 short.
Similarly, Client A's open position at the end of day 1 is 200 long. The end of day
open position for trades done by Client A on day 2 is 200 long. Hence the net open
position for Client A at the end of day 2 is 400 long. Client B's open position at the
end of day 1 is 400 short. The end of day open position for trades done by Client B
on day 2 is 200 short. Hence the net open position for Client B at the end of day 2 is
600 short. The net open position for the trading member at the end of day 2 is sum
of the proprietary open position and client open positions. It works out to be 400 +
400 + 600, i.e. 1400. The following table illustrates determination of open position
of a CM, who clears for two TMs having two client
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Table 5.1 Proprietary position of trading member Madanbhai on Day 2
Assume that the position on Day 1 is carried forward to the next trading day and the
followingtrades are also executed.
Trading member Madanbhai
Buy Sell
Proprietary position 200@1000 400@1010
Table 5.2 Client position of trading member Madanbhai on Day 2
Trading member Madanbhai trades in the futures and options segment for himself
and two of his clients.
The table shows his client position on Day 2.Trading member Madanbhai
Client position Buy Open Sell Close Sell Open Buy Close
Client A400@1109 200@1000
Client B 600@1100 200@1099
5.3 SETTLEMENT MECHANISM
All futures and options contracts are cash settled, i.e. through exchange of cash. The
underlying for index futures/options of the Nifty index cannot be delivered. These
contracts, therefore, have to be settled in cash. Futures and options on individual
securities can be delivered as in the spot market. However, it has been currently
mandated that stock options and futures would also be cash settled. The settlement
amount for a CM is netted across all their TMs/clients, with respect to their
obligations on MTM, premium and exercise settlement.
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5.3(a) Settlement of futures contracts
Futures contracts have two types 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 day of the futures contract.
MTM settlement:
All futures contracts for each member are marked-to-market (MTM) to the daily
settlement price of the relevant futures contract at the end of each day. The
profits/losses are computed as the difference between:
The trade price and the day's settlement price for contracts executed during
the day but not squared up.
The previous day's settlement price and the current day's settlement price for
brought forward contracts.
The buy price and the sell price for contracts executed during the day and
squared up.
Table 5.3 Computation of MTM at the end of the day
The table gives the MTM charged on various positions. The margin charged on the
brought forward contract is the difference between the previous day's settlement
price of Rs.100 and today's settlement price of Rs.105. Hence on account of the
position brought forward, the MTM shows a profit of Rs.500.
For contracts executed during the day, the difference between the buy price and the
sell price determines the MTM. In this example, 200 units are bought @ Rs. 100 and
100 units sold @ Rs. 102 during the day. Hence the MTM for the position closed
during the day shows a profit of Rs.200.
Finally, the open position of contracts traded during the day, is margined at the day's
settlement price and the profit of Rs.500 credited to the MTM account. So the MTM
account shows a profit of Rs. 1200.
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Trade details Quantity
bought/sold
Settlement
price
MTM
Brought forward
from
previous day
100@100 105
500
Traded during day
Bought
Sold
200@100
100@102
102 200
Open position
(not squared up)
100@100 105 500
Total 1200
Final settlement for futures
On the expiry day of the futures contracts, after the close of trading hours, NSCCL
marks all positions of a CM to the final settlement price and the resulting profit/loss
is settled in cash. Final settlement loss/profit amount is debited/ credited to the
relevant CM's clearing bank account on the day following expiry day of the contract.
Settlement prices for futures
Daily settlement price on a trading day is the closing price of the respective futures
contracts on such day. The closing price for a futures contract is currently calculated
as the last half an hour weighted average price of the contract in the F&O Segment
of NSE. Final settlement price is the closing price of the relevant underlying
index/security in the capital market segment of NSE, on the last trading day of the
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contract. The closing price of the underlying Index/security is currently its last half
an hour weighted average value in the capital market segment of NSE.
5.3(B) SETTLEMENT OF OPTIONS CONTRACTS
Options contracts have three types of settlements, daily premium settlement,
exercise settlement, interim exercise settlement in the case of option contracts on
securities and final settlement.
Daily premium settlement
Buyer of an option is obligated to pay the premium towards the options purchased
by him. Similarly, the seller of an option is entitled to receive the premium for the
option sold by him. The premium payable amount and the premium receivable
amount are netted to compute the net premium payable or receivable amount for
each client for each option contract.
Exercise settlement
Although most option buyers and sellers close out their options positions by an
offsetting closing transaction, an understanding of exercise can help an option buyer
determine whether exercise might be more advantageous than an offsetting sale of
the option. There is always a possibility of the option seller being assigned an
exercise. Once an exercise of an option has been assigned to an option seller, the
option seller is bound to fulfill his obligation (meaning, pay the cash settlement
amount in the case of a cash-settled option) even though he may not yet have been
notified of the assignment.
Interim exercise settlement
Interim exercise settlement takes place only for option contracts on securities. An
investor can exercise his in-the-money options at any time during trading hours,
such options at the close of the trading hours, on the day of exercise. Valid exercised
option contracts are assigned to short positions in the option contract with the same
series (i.e. having the same underlying, same expiry date and same strike price), on a 133
random basis, at the client level. The CM who has exercised the option receives the
exercise settlement value per unit of the option from the CM who has been assigned
the option contract.
Final exercise settlement
Final exercise settlement is effected for all open long in-the-money strike price
options existing at the close of trading hours, on the expiration day of an option
contract. All such long positions are exercised and automatically assigned to short
positions in option contracts with the same series, on a random basis.The investor
who has long in-the-money options on the expiry date will receive the exercise
settlement value per unit of the option from the investor who has been assigned the
option contract.
Exercise process
The period during which an option is exercisable depends on the style of the option.
On NSE, index options are European style, i.e. options are only subject to automatic
exercise on the expiration day, if they are in-the-money. As compared to this,
options on securities are American style.
In such cases, the exercise is automatic on the expiration day, and voluntary prior to
the expiration day of the option contract, provided they are in-the-money. Automatic
exercise means that all in-the-money options would be exercised by NSCCL on the
expiration day of the contract. The buyer of such options need not give an exercise
notice in such cases. Voluntary exercise means that the buyer of an in-the-money
option can direct his TM/CM to give exercise instructions to NSCCL.
In order to ensure that an option is exercised on a particular day, the buyer must
direct his TM to exercise before the cut-off time for accepting exercise instructions
for that day. Usually, the exercise orders will be accepted by the system till the close
of trading hours. Different TMs may have different cut -off times for accepting
exercise instructions from customers, which may vary for different options. An
option, which expires unexercised, becomes worthless. Some TMs may accept
standing instructions to exercise, or have procedures for the exercise of every option,
which is in the- money at expiration. Once an exercise instruction is given by a CM
to NSCCL, it cannot ordinarily be revoked. Exercise notices given by a buyer at
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anytime on a day are processed by NSCCL after the close of trading hours on that
day. All exercise notices received by NSCCL from the NEAT F&O system are
processed to determine their validity.
Some basic validation checks are carried out to check the open buy position of the
exercising client/TM and if option contract is in-the-money. Once exercised
contracts are found valid, they are assigned.
Assignment process
The exercise notices are assigned in standardized market lots to short positions in
the option contract with the same series (i.e. same underlying, expiry date and strike
price) at the client level. Assignment to the short positions is done on a random
basis. NSCCL determines short positions, which are eligible to be assigned and then
allocates the exercised positions to any one or more short positions. Assignments are
made at the end of the trading day on which exercise instruction is received by
NSCCL and notified to the members on the same day. It is possible that an option
seller may not receive notification from its TM that an exercise has been assigned to
him until the next day following the date of the assignment to the CM by NSCCL.
Exercise settlement computation
In case of index option contracts, all open long positions at in-the-money strike
prices are automatically exercised on the expiration day and assigned to short
positions in option contracts with the same series on a random basis. For options on
securities, where exercise settlement may be interim or final, interim exercise for an
open long in-the-money option position can be effected on any day till the expiry of
the contract. Final exercise is automatically effected by NSCCL for all open long in-
the-money positions in the expiring month option contract, on the expiry day of the
option contract. The exercise settlement price is the closing price of the underlying
(index or security) on the exercise day (for interim exercise) or the expiry day of the
relevant option contract (final exercise). The exercise settlement value is the
difference between the strike price and the final settlement price of the relevant
option contract. For call options, the exercise settlement value receivable by a buyer
is the difference between the final settlement price and the strike price for each unit
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of the underlying conveyed by the option contract, while for put options it is
difference between the strike price and the final settlement price for each unit of the
underlying conveyed by the option contract. Settlement of exercises of options on
securities is currently by payment in cash and not by delivery of securities. It takes
place for in-the-money option contracts. The exercise settlement value for each unit
of the exercised contract is computed as follows:
Call options = Closing price of the security on the day of exercise — Strike price
Put options = Strike price — Closing price of the security on the day of exercise
For final exercise the closing price of the underlying security is taken on the
expiration day. The exercise settlement value is debited / credited to the relevant
CMs clearing bank account on T + 1 day (T = exercise date).
Special facility for settlement of institutional deals
NSCCL provides a special facility to Institutions/Foreign Institutional Investors
(FIIs)/Mutual Funds etc. to execute trades through any TM, which may be cleared
and settled by their own CM. Such entities are called custodial participants (CPs).To
avail of this facility; a CP is required to register with NSCCL through his CM. A
unique CP code is allotted to the CP by NSCCL. All trades executed by a CP
through any TM are required to have the CP code in the relevant field on the trading
system at the time of order entry. Such trades executed on behalf of a CP are
confirmed by their own CM (and not the CM of the TM through whom the order is
entered), within the time specified by NSE on the trade day though the on-line
confirmation facility. Till such time the trade is confirmed by CM of concerned CP,
the same is considered as a trade of the TM and the responsibility of settlement of
such trade vests with CM of the TM. Once confirmed by CM of concerned CP, such
CM is responsible for clearing and settlement of deals of such custodial clients. FIIs
have been permitted to trade in all the exchange traded derivative contracts subject
to compliance of the position limits prescribed for them and their subaccounts, and
compliance with the prescribed procedure for settlement and reporting. A FII/a sub-
account of the FII, as the case may be, intending to trade in the F&O segment of the
exchange, is required to obtain a unique Custodial Participant (CP) code allotted
from the NSCCL. FII/sub-accounts of FIIs which have been allotted a unique CP
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code by NSCCL are only permitted to trade on the F&O segment. The FD/sub-
account of FII ensures that all orders placed by them on the Exchange carry the
relevant CP code allotted by NSCCL.
5.4 ADJUSTMENTS FOR CORPORATE ACTIONS
The basis for any adjustment for corporate actions is such that the value of the
position of the market participants, on the cum and ex-dates for the corporate action,
continues to remain the same as far as possible. This facilitates in retaining the
relative status of positions, namely in-the-money, at-the-money and out-of-money.
This also addresses issues related to exercise and assignments. Corporate actions can
be broadly classified under stock benefits and cash benefits. The various stock
benefits declared by the issuer of capital are bonus, rights, merger/de- merger,
amalgamation, splits, consolidations, hiveoff, warrants and secured premium notes
(SPNs) among others. The cash benefit declared by the issuer of capital is cash
dividend. Any adjustment for corporate actions is carried out on the last day on
which a security is traded on a cum basis in the underlying equities market, after the
close of trading hours. Adjustments may entail modifications to positions and/or
contract specifications as listed below, such that the basic premise of adjustment laid
down above is satisfied:
1. Strike price
2. Position
3. Market lot/multiplier
The adjustments are carried out on any or all of the above, based on the nature of the
corporate action. The adjustments for corporate actions are carried out on all open,
exercised as well as assigned positions.
5.5 RISK MANAGEMENT
NSCCL has developed a comprehensive risk containment mechanism for theF&O
segment. The salient features of risk containment mechanism on theF&O segment
are:
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a) The financial soundness of the members is the key to risk management.
Therefore, the requirements for membership in terms of capital adequacy
(net worth, security deposits) are quite stringent.
b) NSCCL charges an upfront initial margin for all the open positions of a CM.
It specifies the initial margin requirements for each futures/options contract
on a daily basis. It also follows value-at-risk (VaR) based margining through
SPAN. The CM in turn collects the initial margin from the TMs and their
respective clients.
c) The open positions of the members are marked to market based on contract
settlement price for each contract. The difference is settled in cash on a T+1
basis.
d) NSCCL's on-line position monitoring system monitors a CM's open
positions on a real-time basis. Limits are set for each CM based on his
capital deposits. The on-line position monitoring system generates alerts
whenever a CM reaches a position limit set up by NSCCL. NSCCL monitors
the CMs for MTM value violation, while TMs are monitored for contract-
wise position limit violation.
e) CMs are provided a trading terminal for the purpose of monitoring the open
positions of all the TMs clearing and settling through him. A CM may set
exposure limits for a TM clearing and settling through him. NSCCL assists
the CM to monitor the intra-day exposure limits set up by a CM and
whenever a TM exceeds the limits, it stops that particular TM from further
trading.
f) A member is alerted of his position to enable him to adjust his exposure
orbring in additional capital. Position violations result in withdrawal of
trading facility for all TMs of a CM in case of a violation by the CM.
g) A separate settlement guarantee fund for this segment has been created out of
the capital of members. The most critical component of risk containment
mechanism for F&O segment is the margining system and on-line position
monitoring. The actual position monitoring and margining is carried out on-
line through Parallel Risk Management System (PRISM). PRISM uses
SPAN(r) (Standard Portfolio Analysis of Risk) system for the purpose of
computation of on-line margins, based on the parameters defined by SEBI.
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CHAPTER6 COMMODITY DERIVATIVES TRADING IN INDIA
6.1 INTRODUCTION
6.1(a) Derivatives Markets
Derivatives markets can broadly be classified as commodity derivatives market and
financial derivatives markets. As the name suggest, commodity derivatives markets
trade contracts are those for which the underlying asset is a commodity. It can be an
agricultural commodity like wheat, soybeans, rapeseed, cotton, etc or precious
metals like gold, silver, etc. or energy products like crude oil, natural gas, coal,
electricity etc. Financial derivatives markets trade contracts have a financial asset or
variable as the underlying. The more popular financial derivatives are those which
have equity, interest rates and exchange rates as the underlying. The most commonly
used derivatives contracts are forwards, futures and options which we shall discuss
in detail later.
Spot versus Forward Transaction
Every transaction has three components - trading, clearing and settlement. A buyer
and seller come together, negotiate and arrive at a price. This is trading. Clearing
involves finding out the net outstanding, that is exactly how much of goods and
money the two should exchange. For instance, A buys goods worth Rs.100 from B
and sells goods worth Rs. 50 to B. On a net basis, A has to pay Rs. 50 to B.
Settlement is the actual process of exchanging money and goods. Using the example
of a forward contract, let us try to understand the difference between a spot and
derivatives contract. In spot transaction 20 grams of gold that Aditya wants to buy
and Aditya leaves. A month later, he pays the goldsmith Rs. 34,200 and collects his
gold. This is a forward contract, a contract by which two parties irrevocably agree to
settle a trade at a future date, for a stated price and quantity. No money changes
hands when the contract is signed. The exchange of money and the underlying goods
only happens at the future date as specified in the contract. In a forward contract, the
process of trading, clearing and settlement does not happen instantaneously. The
trading happens today, but the clearing and settlement happens at the end of the
specified period.
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A forward contract is the most basic derivative contract. We call it a derivative
because it derives value from the price of the asset underlying the contract, in this
case- gold. If on the 1st of February, gold trades for Rs. 17,200 per 10 grams in the
spot market, the contract becomes more valuable to Aditya because it now enables
him to buy gold at Rs.17,100 per 10 grams. If however, the price of gold drops down
to Rs. 16,900 per 10 grams he is worse off because as per the terms of the contract,
he is bound to pay Rs. 17,100 per 10 grams for the same gold. The contract has now
lost value from Aditya's point of view. Note that the value of the forward contract to
the goldsmith varies exactly in an opposite manner to its value for Aditya.
Exchange Traded Versus OTC Derivatives
Derivatives have probably been around for as long as people have been trading with
one another. Forward contracting dates back at least to the 12th century and may
well have been around before then. These contracts were typically OTC kind of
contracts. Over the counter (OTC) derivatives are privately negotiated contracts.
Merchants entered into contracts with one another for future delivery of specified
amount of commodities at specified price. A primary motivation for prearranging a
buyer or seller for a stock of commodities in early forward contracts was to lessen
the possibility that large swings would inhibit marketing the commodity after a
harvest.
HISTORY OF COMMODITY DERIVATIVES MARKETS
Early forward contracts in the US addressed merchants' concerns about ensuring that
there were buyers and sellers for commodities. However, 'credit risk' remained a
serious problem. To deal with this problem, a group of Chicago businessmen formed
the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT
was to provide a centralized location known in advance for buyers and sellers to
negotiate forward contracts. In 1865, the CBOT went one step further and listed the
first 'exchange traded' derivatives contract in the US, these contracts were called
'futures contracts'. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was
reorganized to allow futures trading. Its name was changed to Chicago Mercantile
Exchange (CME). The CBOT and CME remain the two largest organized futures
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exchanges, indeed the two largest 'financial' exchanges of any kind in the world
today. The first stock index futures contract was traded at Kansas City Board of
Trade. Currently, the most popular stock index futures in the world are based on
S&P 500 index traded on Chicago Mercantile Exchange. During the mid eighties,
financial futures became the most active derivative instruments generating volumes
many times more than the commodity futures. Index futures, futures on T-bills and
Euro-Dollar futures are the three most popular futures contracts traded today. Other
popular international exchanges that trade derivatives are LIFFE in Europe, DTB in
Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc. Later
many of these contracts were standardized in terms of quantity and delivery dates
and began to trade on an exchange. The OTC derivatives markets have the following
features compared to exchange-traded derivatives:
1. The management of counter-party (credit) risk is decentralized and located within
individual institutions.
2. There are no formal centralized limits on individual positions, leverage, or
margining.
3. There are no formal rules for risk and burden-sharing.
4. There are no formal rules or mechanisms for ensuring market stability integrity,
and for safeguarding the collective interests of market participants.
5. The OTC contracts are generally not regulated by a regulatory authority and the
exchange's self-regulatory organization, although they are affected indirectly by
national legal systems, banking supervision and market surveillance.
The derivatives markets have witnessed rather sharp growth over the last few years,
which have accompanied the modernization of commercial and investment banking
and globalization of financial activities. The recent developments in information
technology have contributed to a great extent to these developments. While both
exchange-traded and OTC derivative contracts offer many benefits, the former have
rigid structures compared to the latter. The largest OTC derivative market is the
inter-bank foreign exchange market.Commodity derivatives, the world over are
typically exchange-traded and not OTC in nature.
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6.1 (B) DIFFERENCE BETWEEN COMMODITY AND FINANCIAL
DERIVATIVES
The basic concept of a derivative contract remains the same whether the underlying
happens to be a commodity or a financial asset. However, there are some features
which are very peculiar to commodity derivative markets. In the case of financial
derivatives, most of these contracts are cash settled. Since financial assets are not
bulky, they do not need special facility for storage even in case of physical
settlement. On the other hand, due to the bulky nature of the underlying assets,
physical settlement in commodity derivatives creates the need for warehousing.
Similarly, the concept of varying quality of asset does not really exist as far as
financial underlyings are concerned. However, in the case of commodities, the
quality of the asset underlying a contract can vary largely. This becomes an
important issue to be managed.
We have a brief look at these issues.
Physical Settlement
Physical settlement involves the physical delivery of the underlying commodity,
typically at an accredited warehouse. The seller intending to make delivery would
have to take the commodities to the designated warehouse and the buyer intending
to take delivery would have to go to the designated warehouse and pick up the
commodity. This may sound simple, but the physical settlement of commodities is a
complex process. The issues faced in physical settlement are enormous. There are
limits on storage facilities in different states. There are restrictions on interstate
movement of commodities. Besides state level octroi and duties have an impact on
the cost of movement of goods across locations.
The process of taking physical delivery in commodities is quite different from the
process of taking physical delivery in financial assets we take a general overview at
the process flow of physical settlement of commodities.
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Delivery notice period
Unlike in the case of equity futures, typically a seller of commodity futures has the
option to give notice of delivery. This option is given during a period identified as
`delivery notice period'.
Assignment
Whenever delivery notices are given by the seller, the clearing house of the
Exchange identifies the buyer to whom this notice may be assigned. Exchanges
follow different practices for the assignment process.
Delivery
The procedure for buyer and seller regarding the physical settlement for different
types of contracts is clearly specified by the Exchange. The period available for the
buyer to take physical delivery is stipulated by the Exchange. Buyer or his
authorized representative in the presence of seller or his representative takes the
physical stocks against the delivery order. Proof of physical delivery having been
effected is forwarded by the seller to the clearing house and the invoice amount is
credited to the seller's account. The clearing house decides on the delivery order rate
at which delivery will be settled. Delivery rate depends on the spot rate of the
underlying adjusted for discount/ premium for quality and freight costs. The
discount/ premium for quality and freight costs are published by the clearing house
before introduction of the contract. The most active spot market is normally taken as
the benchmark for deciding spot prices.
Warehousing
One of the main differences between financial and commodity derivative is the need
for warehousing. In case of most exchange-traded financial derivatives, all the
positions are cash settled. Cash settlement involves paying up the difference in
prices between the time the contract was entered into and the time the contract was
closed. For instance, if a trader buys futures on a stock at Rs.100 and on the day of
expiration, the futures on that stock close at Rs.120, he does not really have to buy
the underlying stock. All he does is take the difference of Rs.20 in cash. Similarly,
the person who sold this futures contract at Rs.100 does not have to deliver the
underlying stock. All he has to do is pay up the loss of Rs.20 in cash. In case of
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commodity derivatives however, there is a possibility of physical settlement. It
means that if the seller chooses to hand over the commodity instead of the difference
in cash, the buyer must take physical delivery of the underlying asset. This requires
the Exchange to make an arrangement with warehouses to handle the settlements.
The efficacy of the commodities settlements depends on the warehousing system
available. Such warehouses have to perform the following functions:
• Earmark separate storage areas as specified by the Exchange for storing
commodities;
• Ensure proper grading of commodities before they are stored;
• Store commodities according to their grade specifications and validity period; and
• Ensure that necessary steps and precautions are taken to ensure that the quantity
and grade of commodity, as certified in the warehouse receipt, are maintained during
the storage period. This receipt can also be used as collateral for financing.
In India, NCDEX has accredited over 775 delivery centers which meet the
requirements for the physical holding of goods that are to be delivered on the
platform. As future trading is delivery based, it is necessary to create the logistics
support for the same.
Quality of Underlying Assets
A derivatives contract is written on a given underlying. Variance in quality is not an
issue in case of financial derivatives as the physical attribute is missing. When the
underlying asset is a commodity, the quality of the underlying asset is of prime
importance. There may be quite some variation in the quality of what is available in
the marketplace. When the asset is specified, it is therefore important that the
Exchange stipulate the grade or grades of the commodity that are acceptable.
Commodity derivatives demand good standards and quality assurance/ certification
procedures. A good grading system allows commodities to be traded by
specification. Trading in commodity derivatives also requires quality assurance and
certifications from specialized agencies. In India, for example, the Bureau of Indian
Standards (BIS) under the Department of Consumer Affairs specifies standards for
processed agricultural commodities. AGMARK, another certifying body under the
Department of Agriculture and Cooperation, specifies standards for basic
agricultural commodities.
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6.1(c) Commodity Derivatives
Derivatives as a tool for managing risk first originated in the commodities markets.
They were then found useful as a hedging tool in financial markets as well. In India,
trading in commodity futures has been in existence from the nineteenth century with
organized trading in cotton through the establishment of Cotton Trade Association
in 1875. Over a period of time, other commodities were permitted to be traded in
futures exchanges. Regulatory constraints in 1960s resulted in virtual dismantling of
the commodity futures market. It is only in the last decade that commodity futures
exchanges have been actively encouraged. In the commodity futures market, the
quinquennium after the set up of national level exchanges witnessed exponential
growth in trading with the turnover increasing from 5.71 lakh crores in 2004-05 to
52.48 lakh crores in 2008-09. However, the markets have not grown to significant
levels as compared to developed countries. In this chapter, we take a brief look at
the global commodity markets and the commodity markets that exist in India.
Evolution of Commodity Exchanges
Most of the commodity exchanges, which exist today, have their origin in the late
19th and earlier 20th century. The first central exchange was established in 1848 in
Chicago under the name Chicago Board of Trade. The emergence of the derivatives
markets as the effective risk management tools in 1970s and 1980s has resulted in
the rapid creation of new commodity exchanges and expansion of the existing ones.
At present, there are major commodity exchanges all over the world dealing in
different types of commodities.
Commodity Exchange
Commodity exchanges are defined as centers where futures trade is organized in a
wider sense; it is taken to include any organized market place where trade is routed
through one mechanism, allowing effective competition among buyers and among
sellers. This would include auction-type exchanges, but not wholesale markets,
where trade is localized, but effectively takes place through many non-related
individual transactions between different permutations of buyers and sellers.
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Role of Commodity Exchanges
Commodity exchanges provide platforms to suit the varied requirements of
customers. Firstly, they help in price discovery as players get to set future prices
which are also made available to all participants. Hence, a farmer in the southern
part of India would be able to know the best price prevailing in the country which
would enable him to take informed decisions. For this to happen, the concept of
commodity exchanges must percolate down to the villages. Today the farmers base
their choice for next year's crop on current year's price. Ideally this decision ought to
be based on next year's expected price. Futures prices on the platforms of
commodity exchanges will hopefully move farmers of our country from the current
'cobweb' effect where additional acreage comes under cultivation in the year
subsequent to one when a commodity had good prices; consequently the next year
the commodity price actually falls due to oversupply.
Secondly, these exchanges enable actual users (farmers, agro processors, industry
where the predominant cost is commodity input/output cost) to hedge their price risk
given the uncertainty of the future - especially in agriculture where there is
uncertainty regarding the monsoon and hence prices. This holds good also for non-
agro products like metals or energy products as well where global forces could exert
considerable influence. Purchasers are also assured of a fixed price which is
determined in advance, thereby avoiding surprises to them. It must be borne in mind
that commodity prices in India have always been woven firmly into the international
fabric. Today, price fluctuations in all major commodities in the country mirror both
national and international factors and not merely national factors.
Thirdly, by involving the group of investors and speculators, commodity exchanges
provide liquidity and buoyancy to the system.
Lastly, the arbitrageurs play an important role in balancing the market as arbitrage
conditions, where they exist, are ironed out as arbitrageurs trade with opposite
positions on different platforms and hence generate opposing demand and supply
forces which ultimately narrows down the gaps in prices.
It must be pointed out that while the monsoon conditions affect the prices of agro-
based commodities, the phenomenon of globalization has made prices of other
products such as metals, energy products, etc., vulnerable to changes in global
politics, policies, growth paradigms, etc. This would be strengthened as the world
moves closer to the resolution of the WTO impasse, which would become a reality
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shortly. Commodity exchanges would provide a valuable hedge through the price
discovery process while catering to the different kind of players in the market.
6.1(d) Commodity Derivative Markets in India
Commodity futures markets have a long history in India. Cotton was the first
commodity to attract futures trading in the country leading to the setting up of the
Bombay Cotton Trade Association Ltd in 1875. The Bombay Cotton Exchange Ltd.
was established in 1893 following the widespread discontent amongst leading cotton
mill owners and merchants over the functioning of Bombay Cotton Trade
Association. Subsequently, many exchanges came up in different parts of the
country for futures trading in various commodities. Futures trading in oilseeds
started in 1900 with the establishment of the Gujarati Vyapari Mandali, which
carried on futures trade in groundnut, castor seed and cotton. Before the Second
World War broke out in 1939, several futures markets in oilseeds were functioning
in Gujarat and Punjab.
Futures trading in wheat existed at several places in Punjab and Uttar Pradesh, the
most notable of which was the Chamber of Commerce at Hapur, which began
futures trading in wheat in 1913 and served as the price setter in that commodity till
the outbreak of the Second World War in 1939.
Futures trading in bullion began in Mumbai in 1920 and subsequently markets came
up in other centres like Rajkot, Jaipur, Jamnagar, Kanpur, Delhi and Kolkata.
Calcutta Hessian Exchange Ltd. was established in 1919 for futures trading in raw
jute and jute goods. But organized futures trading in raw jute began only in 1927
with the establishment of East Indian Jute Association Ltd. These two associations
amalgamated in 1945 to form the East India Jute & Hessian Ltd. to conduct
organized trading in both raw jute and jute goods. In due course several other
exchanges were also created in the country to trade in such diverse commodities as
pepper, turmeric, potato, sugar and gur (jaggery).
After independence, with the subject of `Stock Exchanges and futures markets'
being brought under the Union list, responsibility for regulation of commodity
futures markets devolved on Govt. of India. A Bill on forward contracts was referred
to an expert committee headed by Prof. A. D. Shroff and select committees of two
successive Parliaments and finally in December 1952 Forward Contracts
(Regulation) Act, 1952, was enacted.
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The Act provided for 3-tier regulatory system:
(a) An association recognized by the Government of India on the recommendation
of Forward Markets Commission,
(b) The Forward Markets Commission (it was set up in September 1953) and
(c) The Central Government.
Forward Contracts (Regulation) Rules were notified by the Central Government in
July, 1954.
According to FC(R) Act, commodities are divided into 3 categories with reference
to extent of regulation, viz:
• Commodities in which futures trading can be organized under the auspices of
recognized association.
• Commodities in which futures trading is prohibited.
• Commodities which have neither been regulated nor prohibited for being traded
under the recognized association are referred as Free Commodities and the
association organized in such free commodities is required to obtain the Certificate
of Registration from the Forward Markets Commission. India was in an era of
physical controls since independence and the pursuance of a mixed economy set up
with socialist proclivities had ramifications on the operations of commodity markets
and commodity exchanges. Government intervention was in the form of buffer stock
operations, administered prices, regulation on trade and input prices, restrictions on
movement of goods, etc. Agricultural commodities were associated with the poor
and were governed by polices such as Minimum Price Support and Government
Procurement. Further, as production levels were low and had not stabilized, there
was the constant fear of misuse of these platforms which could be manipulated to fix
prices by creating artificial scarcities. This was also a period which was associated
with wars, natural calamities and disasters which invariably led to shortages and
price distortions. Hence, in an era of uncertainty with potential volatility, the
government banned futures trading in commodities in the 1960s.
The Khusro Committee which was constituted in June 1980 had recommended
reintroduction of futures trading in most of the major commodities, including cotton,
kapas, raw jute and jute goods and suggested that steps may be taken for introducing
futures trading in commodities, like potatoes, onions, etc. at appropriate time. The
government, accordingly initiated futures trading in Potato during the latter half of
1980 in quite a few markets in Punjab and Uttar Pradesh.
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With the gradual trade and industry liberalization of the Indian economy pursuant to
the adoption of the economic reform package in 1991, GOI constituted another
committee on Forward Markets under the chairmanship of Prof. K.N. Kabra. The
Committee which submitted its report in September 1994 recommended that futures
trading be introduced in the following commodities:
• Basmati Rice
• Cotton, Kapas, Raw Jute and Jute Goods
• Groundnut, rapeseed/mustard seed, cottonseed, sesame seed, sunflower seed,
safflower seed, copra and soybean and oils and oilcakes
• Rice bran oil
• Castor oil and its oilcake
• Linseed
• Silver
• Onions
The committee also recommended that some of the existing commodity exchanges
particularly the ones in pepper and castor seed, may be upgraded to the level of
international futures markets.
Futures Trading
The Government of India had appointed a committee under the chairmanship of
Prof. Abhijit Sen, Member, Planning Commission to study the impact of futures
trading, if any, on agricultural commodity prices. The Committee was appointed on
March 2, 2007 and submitted its report on April 29, 2008. The main findings and
recommendations of the committee are: negative sentiments have been created by
the decision to delist futures trades in some important agricultural commodities; the
period during which futures trading has been in operation is too short to discriminate
adequately between the effect of opening of futures markets, if any, and what might
simply be the normal cyclical adjustments in prices; Indian data analyzed does not
show any clear evidence of either reduced or increased volatility; the vibrant
agriculture markets including derivatives markets are the frontline institutions to
provide early signs of future prospects of the sector. The committee recommended
for upgradation of regulation by passing of the proposed amendment to FC(R) Act
1952 and removal of infirmities in the spot market (Economic Survey, 2009-10).
The "Study on Impact of Futures Trading in Wheat, Sugar, Pulses and Guar Seeds
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on Farmers" was commissioned by the Forward Markets Commission and
undertaken by the Indian Institute of Management, Bangalore. While the study was
primarily intended to find out how futures trading is helping major stakeholders in
the value chain of these commodities; it also dealt with the impact of futures trading
on the prices of these commodities. The study did not find any visible link between
futures trading and price movement and suggested that the main reason for price
changes seemed to be changes in the fundamentals (mainly on the Supply side) of
these commodities, Price changes were also attributed to changes in government
policies.
Indian Commodity Exchanges
There are more than 20 recognized commodity futures exchanges in India under the
purview of the Forward Markets Commission (FMC). The country's commodity
futures exchanges are divided majorly into two categories:
• National exchanges
• Regional exchanges
The four exchanges operating at the national level (as on 1st January 2010) are:
i) National Commodity and Derivatives Exchange of India Ltd. (NCDEX)
ii) National Multi Commodity Exchange of India Ltd. (NMCE)
iii) Multi Commodity Exchange of India Ltd. (MCX)
iv) Indian Commodity Exchange Ltd. (ICEX) which started trading operations on
November 27, 2009
The leading regional exchange is the National Board of Trade (NBOT) located at
Indore. There are more than 15 regional commodity exchanges in India.
6.2 USING COMMODITY FUTURES
For a market to succeed, it must have all three kinds of participants - hedgers,
speculators and arbitragers. The confluence of these participants ensures liquidity
and efficient price discovery in the market. Commodity markets give opportunity for
all three kinds of participants. In this chapter, we look at the use of commodity
derivatives for hedging, speculation and arbitrage.
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6.2(a) Hedging
Many participants in the commodity futures market are hedgers. They use the
futures market to reduce a particular risk that they face. This risk might relate to the
price of wheat or oil or any other commodity that the person deals in. The classic
hedging example is that of wheat farmer who wants to hedge the risk of fluctuations
in the price of wheat around the time that his crop is ready for harvesting. By selling
his crop forward, he obtains a hedge by locking in to a predetermined price. Hedging
does not necessarily improve the financial outcome; What it does however is, that it
makes the outcome more certain. Hedgers could be government institutions, private
corporations like financial institutions, trading companies and even other
participants in the value chain, for instance farmers, extractors, millers, processors
etc., who are influenced by the commodity prices.
Basic Principles of Hedging
When an individual or a company decides to use the futures markets to hedge a risk,
the objective is to take a position that neutralizes the risk as much as possible. Take
the case of a company that knows that it will gain Rs.1,00,000 for each 1 rupee
increase in the price of a commodity over the next three months and will lose
Rs.1,00,000 for each 1 rupee decrease in the price of a commodity over the same
period. To hedge, the company should take a short futures position that is designed
to offset this risk. The futures position should lead to a loss of Rs.1,00,000 for each
1 rupee increase in the price of the commodity over the next three months and a gain
of Rs.1,00,000 for each 1 rupee decrease in the price during this period. If the price
of the commodity goes down, the gain on the futures position offsets the loss on the
commodity. If the price of the commodity goes up, the loss on the futures position is
offset by the gain on the commodity. There are basically two kinds of hedges that
can be taken. A company that wants to sell an asset at a particular time in the future
can hedge by taking short futures position. This is called a short hedge. Similarly, a
company that knows that it is due to buy an asset in the future can hedge by taking
long futures position. This is known as long hedge. We will study these two hedges
in detail.
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SHORT HEDGE
A short hedge is a hedge that requires a short position in futures contracts. As we
said, a short hedge is appropriate when the hedger already owns the asset, or is
likely to own the asset and expects to sell it at some time in the future. For example,
a short hedge could be used by a cotton farmer who expects the cotton crop to be
ready for sale in the next two months. A short hedge can also be used when the asset
is not owned at the moment but is likely to be owned in the future.
For example, an exporter who knows that he or she will receive a dollar payment
three months later. He makes a gain if the dollar increases in value relative to the
rupee and smakes a loss if the dollar decreases in value relative to the rupee. A short
futures position will give him the hedge he desires.
Let us look at a more detailed example to illustrate a short hedge. We assume that
today is the 15th of January and that a refined soy oil producer has just negotiated a
contract to sell 10,000 Kgs of soy oil. It has been agreed that the price that will
apply in the contract is the market price on the 15th April. The oil producer is
therefore in a position where he will gain Rs.10000 for each 1 rupee increase in the
price of oil over the next three months and lose Rs.10000 for each one rupee
decrease in the price of oil during this period. Suppose the spot price for soy oil on
January 15 is Rs.450 per 10 Kgs and the April soy oil futures price on the NCDEX
is Rs.465 per 10 Kgs. The producer can hedge his exposure by selling 10,000 Kgs
worth of April futures contracts (1 unit).
If the oil producers closes his position on April 15, the effect of the strategy would
be to lock in a price close to Rs.465 per 10 Kgs. Figure 7.1 gives the payoff for a
short hedge. Let us look at how this works.
On April 15, the spot price can either be above Rs.465 or below Rs.465. Figure 6.1
Payoff for buyer of a short hedge. Irrespective of what the spot price of Soy Oil is
three months later, by going in for a short hedge he locks on to a price of Rs. 465 per
10 kgs.
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Table 6.1 Refined Soy Oil Futures Contract Specification
Trading system NCDEX trading system
Trading hours Monday- Friday :10:00 AM to 05:00 PM
Saturday : 10.00 AM to 2.00 PM
Unit of trading 10000 kgs (10 MT)
Delivery unit 10000 kgs (10 MT)
Quotation / base value Rs. per 10 kgs
Tick size 5 paise
Case 1: The spot price is Rs. 455 per 10 Kgs. The company realises Rs.4,55,000
under its sales contract. Because April is the delivery month for the futures contract,
the futures price on April 15 should be very close to the spot price of Rs. 455 on that
date. The company closes its short futures position at Rs. 455, making a gain of
Rs.465 - Rs.455 = Rs.10 per 10 Kgs, or Rs. 10,000 on its short futures position. The
total amount realized from both the futures position and the sales contract is
therefore about Rs. 465 per 10 Kgs, Rs.4,65,000 in total.
Case 2: The spot price is Rs.475 per 10 Kgs. The company realises Rs.4,75,000
under its sales contract. Because April is the delivery month for the futures contract,
the futures price on April 15 should be very close to the spot price of Rs.475 on that
date. The company closes its short futures position at Rs. 475, making a loss of
Rs.475 - Rs.465 = Rs.10 per 10 Kgs, or Rs. 10,000 on its short futures position. The
total amount realized from both the futures position and the sales contract is
therefore about Rs. 465 per 10 Kgs, Rs. 4,65,000 in total.
LONG HEDGE
Hedges that involve taking a long position in a futures contract are known as long
hedges. A long hedge is appropriate when a company knows it will have to purchase
a certain asset in the future and wants to lock in a price now.
Suppose that it is now January 15. A firm involved in industrial fabrication knows
that it will require 300 kgs of silver on April 15 to meet a certain contract. The spot
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price of silver is Rs.26800 per kg and the April silver futures price is Rs. 27300 per
kg.
Table 6.2 gives the contract specification for silver. A unit of trading is 30 kgs. The
fabricator can hedge his position by taking a long position in ten units of futures on
the NCDEX. If the fabricator closes his position on April 15, the effect of the
strategy would be to lock in a price close to Rs. 27300 per kg. Let us look at how
this works. On April 15, the spot price can either be above Rs. 27300 or below Rs.
27300 per kg.
Case 1: The spot price is Rs. 27800 per kg. The fabricator pays Rs. 83,40,000 to buy
the silver from the spot market. Because April is the delivery month for the futures
contract, the futures price on April 15 should be very close to the spot price of Rs.
27800 on that date. The company closes its long futures position at Rs. 27800,
making a gain of Rs.27800 - Rs.27300 = Rs.500 per kg, or Rs. 1,50,000 on its long
futures position. The effective cost of silver purchased works out to be about Rs.
27300 per Kg, or Rs.81,90,000 in total.
Case 2: The spot price is Rs. 26900 per Kg. The fabricator pays Rs.80,70,000 to buy
the silver from the spot market. Because April is the delivery month for the futures
contract, the futures price on April 15 should be very close to the spot price of Rs.
26900 on that date. The company closes its long futures position at Rs. 26900,
making a loss of Rs.27300 - Rs.26900 = Rs.400 per kg, or Rs.1,20,000 on its long
futures position. The effective cost of silver purchased works out to be about Rs.
27300 per Kg, or Rs.81,90,000 in total.
Table 6.2 Silver futures contract specification
Trading system NCDEX trading system
Trading hours Monday-Friday: 10:00 AM to 11:30 PM
Saturday : 10.00 AM to 2.00 PM
Unit of trading 30 kgs
Delivery unit 30 kgs
Quotation / base value Rs. per kg of Silver with 999 fineness
Tick size Re. 1/-
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Note that the purpose of hedging is not to make profits, but to lock on to a price to
be paid in the future upfront. In the industrial fabricator example, since prices of
silver rose in three months, on hind sight it would seem that the company would
have been better off buying the silver in January and holding it. But this would
involve incurring interest cost and warehousing costs. Besides, if the prices of silver
fell in April, the company would have not only incurred interest and storage costs,
but would also have ended up buying silver at a much higher price.
In the examples above, we assume that the futures position is closed out in the
delivery month. The hedge has the same basic effect if delivery is allowed to
happen. However, making or taking delivery can be a costly process. In most cases,
delivery is not made even when the hedger keeps the futures contract until the
delivery month. Hedgers with long positions usually avoid any possibility of having
to take delivery by closing out their positions before the delivery period.
ADVANTAGES OF HEDGING
Besides the basic advantage of risk management, hedging also has other advantages:
1. Hedging stretches the marketing period. For example, a livestock feeder does not
have to wait until his cattle are ready to market before he can sell them. The futures
market permits him to sell futures contracts to establish the approximate sale price at
any time between the time he buys his calves for feeding and the time the fed cattle
are ready to market, some four to six months later. He can take advantage of good
prices even though the cattle are not ready for market.
2. Hedging protects inventory values. For example, a merchandiser with a large,
unsold inventory can sell futures contracts that will protect the value of the
inventory, even if the price of the commodity drops.
3. Hedging permits forward pricing of products. For example, a jewellery
manufacturer can determine the cost for gold, silver or platinum by buying a futures
contract, translate that to a price for the finished products, and make forward sales to
stores at firm prices. Having made the forward sales, the manufacturer can use his
capital to acquire only as much gold, silver, or platinum as may be needed to make
the products that will fill its orders.
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LIMITATION OF HEDGING: BASIS RISK
In the examples we used above, the hedges considered were perfect. The hedger was
able to identify the precise date in the future when an asset would be bought or sold.
The hedger was then able to use the futures contract to remove almost all the risk
arising out of price of the asset on that date. In reality, hedging is not quite this
simple and straightforward. Hedging can only minimize the risk but cannot fully
eliminate it. The loss made during selling of an asset may not always be equal to the
profits made by taking a short futures position. This is because the value of the asset
sold in the spot market and the value of the asset underlying the future contract may
not be the same. This is called the basis risk. In our examples, the hedger was able to
identify the precise date in the future when an asset would be bought or sold. The
hedger was then able to use the perfect futures contract to remove almost all the risk
arising out of price of the asset on that date. In reality, this may not always be
possible for various reasons.
• The asset whose price is to be hedged may not be exactly the same as the asset
underlying the futures contract. For example, in India we have a large number of
varieties of cotton being cultivated. It is impractical for an Exchange to have futures
contracts with all these varieties of cotton as an underlying. The NCDEX has futures
contracts on medium staple cotton. If a hedger has an underlying asset that is exactly
the same as the one that underlies the futures contract, he would get a better hedge.
But in many cases, farmers producing small staple cotton could use the futures
contract on medium staple cotton for hedging. While this would still provide the
farmer with a hedge, since the price of the farmers cotton and the price of the cotton
underlying the futures contract would be related. However, the hedge would not be
perfect.
• The hedger may be uncertain as to the exact date when the asset will be bought or
sold. Often the hedge may require the futures contract to be closed out well before
its expiration date. This could result in an imperfect hedge.
• The expiration date of the hedge may be later than the delivery date of the futures
contract. When this happens, the hedger would be required to close out the futures
contracts entered into and take the same position in futures contracts with a later
delivery date. This is called a rollover. Hedges can be rolled forward many times.
However, multiple rollovers could lead to short-term cash flow problems.
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6.3 SPECULATION
An entity having an opinion on the price movements of a given commodity can
speculate using the commodity market. While the basics of speculation apply to any
market, speculating in commodities is not as simple as speculating on stocks in the
financial market. For a speculator who thinks the shares of a given company will
rise, it is easy to buy the shares and hold them for whatever duration he wants to.
However, commodities are bulky products and come with all the costs and
procedures of handling these products. The commodities futures markets provide
speculators with an easy mechanism to speculate on the price of underlying
commodities. To trade commodity futures on the NCDEX, a customer must open a
futures trading account with a commodity derivatives broker. Buying futures simply
involves putting in the margin money. This enables futures traders to take a position
in the underlying commodity without having to actually hold that commodity. With
the purchase of futures contract on a commodity, the holder essentially makes a
legally binding promise or obligation to buy the underlying security at some point in
the future (the expiration date of the contract). We look here at how the commodity
futures markets can be used for speculation.
6.3(a) Speculation: Bullish Commodity, Buy Futures
Take the case of a speculator who has a view on the direction of the price
movements of gold. Perhaps he knows that towards the end of the year due to
festivals and the upcoming wedding season, the prices of gold are likely to rise. He
would like to trade based on this view. Gold trades for Rs. 16000 per 10 gms in the
spot market and he expects its price to go up in the next two-three months. How can
he trade based on this belief? In the absence of a deferral product, he would have to
buy gold and hold on to it. Suppose he buys a 1 kg of gold which costs him Rs.
16,00,000. Suppose further that his hunch proves correct and three months later gold
trades at Rs. 17000 per 10 grams. He makes a profit of Rs. 1,00,000 on an
investment of Rs. 16,00,000 for a period of three months. This works out to an
annual return of about 25 percent. Today a speculator can take exactly the same
position on gold by using gold futures contracts.
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Let us see how this works. Gold trades at Rs. 16,000 per 10 gms and three-month
gold futures trades at Rs. 16,650 per 10 gms. Table 7.3 gives the contract
specifications for gold futures. The unit of trading is 1 kg and the delivery unit for
the gold futures contract on the NCDEX is 1 kg. He buys one kg of gold futures
which have a value of Rs. 16,65,000. Buying an asset in the futures market only
requires making margin payments. To take this position, suppose he pays a margin
of Rs. 1,66,500. Three months later gold trades at Rs. 17,000 per 10 gms. As we
know, on the day of expiration, the futures price converges to the spot price (else
there would be a risk-free arbitrage opportunity). He closes his long futures position
at Rs. 17,000 in the process making a profit of Rs. 35,000 on an initial margin
investment of Rs. 1,66,500. This works out to an annual return of 85 percent.
Because of the leverage they provide, commodity futures form an attractive tool for
speculators.
6.3(b) Speculation: Bearish Commodity, Sell Futures
Commodity futures can also be used by a speculator who believes that there is
likely to be excess supply of a particular commodity in the near future and hence the
prices are likely to see a fall. How can he trade based on this opinion? In the absence
of a deferral product, there wasn't much he could do to profit from his opinion.
Today all he needs to do is sell commodity futures.
Let us understand how this works. Simple arbitrage ensures that the price of a
futures contract on a commodity moves correspondingly with the price of the
underlying commodity. If the commodity price rises, so will the futures price. If the
commodity price falls, so will the futures price. Now take the case of the trader who
expects to see a fall in the price of pepper. Suppose price of pepper is Rs.14000 per
quintal and he sells two pepper futures contract which is for delivery of 2 MT of
pepper (1MT each). The value of the contract is Rs. 2,80,000. He pays a small
margin on the same. Three months later, if his hunch was correct the price of pepper
falls. So does the price of pepper futures. He close out his short futures position at
Rs.13000 per quintal i.e. Rs. 2,60,000 making a profit of Rs. 20,000.
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6.4 ARBITRAGE
A central idea in modern economics is the law of one price. This states that in a
competitive market, if two assets are equivalent from the point of view of risk and
return, they should sell at the same price. If the price of the same asset is different in
two markets, there will be operators who will buy in the market where the asset sells
cheap and sell in the market where it is costly. This activity termed as arbitrage,
involves the simultaneous purchase and sale of the same or essentially similar
security in two different markets for advantageously different prices. The buying
cheap and selling expensive continues till prices in the two markets reach
equilibrium. Hence, arbitrage helps to equalize prices and restore market efficiency.
6.4(a) Overpriced Commodity Futures: Buy Spot, Sell Futures
An arbitrager notices that gold futures seem overpriced. How can he cash in on this
opportunity to earn risk less profits? Say for instance, gold trades for Rs. 1600 per
gram in the spot market. Three month gold futures on the NCDEX trade at Rs.1685
per gram and seem overpriced. He could make risk less profit by entering into the
following set of transactions. On day one, borrow Rs. 1,60,05,100 at 6% per annum
to cover the cost of buying and holding gold. Buy 10 kgs of gold on the cash/ spot
market at Rs. 1,60,00,000. Pay Rs.5100 (approx) as warehouse costs.
Simultaneously, sell 10 gold futures contract at Rs. 1,68,50,000. Take delivery of the
gold purchased and hold it for three months. On the futures expiration date, the spot
and the futures price converge. Now unwind the position. Say gold closes at Rs.
1635 per gram in the spot market. Sell the gold for Rs. 1,63,50,000. Futures position
expires with profit of Rs. 5,00,000 From the Rs. 1,68,50,000 held in hand, return the
borrowed amount plus interest of Rs. 1,62,46,986. The result is a risk less profit of
Rs. 6,04,014.
When does it make sense to enter into this arbitrage? If the cost of borrowing funds
to buy the commodity is less than the arbitrage profit possible, it makes sense to
arbitrage. This is termed as cash-and-carry arbitrage. Remember however, that
exploiting an arbitrage opportunity involves trading on the spot and futures market.
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In the real world, one has to build in the transactions costs into the arbitrage
strategy.
6.4(b) Underpriced Commodity Futures: Buy Futures, Sell Spot
An arbitrager notices that gold futures seem underpriced. How can he cash in on this
opportunity to earn risk less profits? Say for instance, gold trades for Rs.1600 per
gram in the spot market. Three month gold futures on the NCDEX trade at Rs. 1620
per gram and seem underpriced. If he happens to hold gold, he could make risk less
profit by entering into the following set of transactions. On day one, sell 10 kgs of
gold in the spot market at Rs. 1,60,00,000. Invest the Rs. 1,60,00,000 plus the
Rs.5100 saved by way of warehouse costs for three months 6%. Simultaneously,
buy three-month gold futures on NCDEX at Rs.1,62,00,000. Suppose the price of
gold is Rs.1635 per gram. On the futures expiration date, the spot and the futures
price of gold converge. Now unwind the position. The gold sales proceeds grow to
Rs. 1,62,46,986 The futures position expires with a profit of Rs. 1,50,000 Buy back
gold at Rs.1,63,50,000 on the spot market. The result is a risk less profit of Rs.
46,986.When the futures price of a commodity appears underpriced in relation to its
spot price, an opportunity for reverse cash and carry arbitrage arises. It is this
arbitrage activity that ensures that the spot and futures prices stay in line with the
cost-of-carry. As we can see, exploiting arbitrage involves trading on the spot
market. As more and more players in the market develop the knowledge and skills to
do cash-and-carry and reverse cash-and-carry, we will see increased volumes and
lower spreads in both the cash as well as the derivatives market.
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CHAPTER7 TRADING OF COMMODITY
THE NCDEX PLATFORM
National Commodity & Derivatives Exchange Limited (NCDEX), a national level
online multicommodity exchange, commenced operations on December 15, 2003.
The Exchange has received a permanent recognition from the Ministry of Consumer
Affairs, Food and Public Distribution, Government of India as a national level
exchange. The Exchange, in just over two years of operations, posted an average
daily turnover (one-way volume) of around Rs 4500- 5000 crore a day (over USD 1
billion). The major share of the volumes come from agricultural commodities and
the balance from bullion, metals, energy and other products. Trading is facilitated
through over 850 Members located across around 700 centers (having ~20000
trading terminals) across the country. Most of these terminals are located in the
semi-urbanand rural regions of the country. Trading is facilitated through VSATs,
leased lines and the Internet.
Structure Of NCDEX
NCDEX has been formed with the following objectives:
• To create a world class commodity exchange platform for the market participants.
• To bring professionalism and transparency into commodity trading.
• To inculcate best international practices like de-materialised technology platforms,
low cost solutions and information dissemination into the trade.
• To provide nationwide reach and consistent offering.
• To bring together the entities that the market can trust.
Shareholders of NCDEX
NCDEX is promoted by a consortium of four institutions. These are National Stock
Exchange (NSE), ICICI Bank Limited, Life Insurance Corporation of India (LIC)
and National Board for Agriculture and Rural Development (NABARD). Later on
their shares were diluted and more institutions became shareholders of NCDEX.
These are Canara Bank, CRISIL Limited, Indian Farmers Fertilisers Cooperative
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Limited (IFFCO), Punjab National Bank (PNB), Goldman Sachs, Intercontinental
Exchange (ICE) and Shree Renuka Sugars Ltd. All the ten shareholders (now ICICI
is not a shareholder of NCDEX) bring along with them expertise in closely related
fields such as agriculture, rural banking, co-operative expertise, risk management,
intensive use of technology, derivative trading besides institution building expertise.
Governance
The governance of NCDEX vests with the Board of Directors. None of the Board of
Directors has any vested interest in commodity futures trading. The Board comprises
persons of eminence, each an authority in their own right in the areas very relevant
to the Exchange. Board appoints an executive committee and other committees for
the purpose of managing activities of the Exchange.
The executive committee consists of Managing Director of the Exchange who would
be acting as the Chief Executive of the Exchange, and also other members appointed
by the board. Apart from the executive committee the board has constituted
committees like Membership committee, Audit Committee, Risk Committee,
Nomination Committee, Compensation Committee and Business Strategy
Committee, which help the Board in policy formulation.
NCDEX Products
NCDEX currently offers an array of more than 50 different commodities for futures
trading. The commodity segments covered include both agri and non-agri
commodities [bullion, energy, metals (ferrous and non-ferrous metals) etc]. Before
identifying a commodity for trading, the Exchange conducts a thorough research
into the characteristics of the product, its market and potential for futures trading.
The commodity is recommended for approval of Forward Markets Commission, the
Regulator for commodity exchanges in the country after approval by the Product
Committee constituted for each of such product and Executive Committee of the
Exchange.
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Initiatives
• NCDEX pioneered constructing four indices: NCDEXAGRI - an agricultural spot
price index covering the agricultural spectrum, FUTEXAGRI - an agricultural
futures index, FREIGHTEX - a freight index and NCDEXRAIN - a rainfall index.
• NCDEX is the first commodity exchange in India to provide near real time spot
prices of commodities traded on the Exchange. These prices are polled from various
principal market places for the commodity two to three times a day.
• The spot prices that are collected and futures prices that are traded on the
Exchange are disseminated through its website, trader work stations, news agencies
such as Reuters, Bloomberg, newspapers and journals, rural kiosks (e-chaupals and
n-Logue), TV channels such as Doordarshan News, CNBC, etc.
• Price ticker boards have been widely installed by the Exchange to display both real
time futures and spot prices of commodities traded on its platform.
• NCDEX has also spearheaded several pilot projects for the purpose of encouraging
farmers to participate on the Exchange and hedge their price risk.
• NCDEX took the initiative of establishing a national level collateral management
company, National Collateral Management Services Limited (NCMSL) to take care
of the issues of warehousing, standards and grades, collateral management as well as
facilitate commodity finance by banks.
• Within a year of operations, NCDEX has accredited and networked around over
320 delivery centres (now over 775). Each warehouse has the services of reputed
and reliable assayers through accredited agencies.
• Very much like holding cash in savings bank accounts and securities in electronic
bank accounts, NCDEX has enabled holding of commodity balances in electronic
form and dematerialized the warehouse receipt (in partnership with National
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Securities Depository Limited (NSDL) and the Central Depository Services (India)
Limited (CDSL)) so as to enable smooth physical commodity settlements. The
Exchange was the first to facilitate holding of commodity balances in an electronic
form.
• Physical deliveries in an electronic form (demat mode) have taken place in many
commodities across the country.
• Physical deliveries of commodities take place through the Exchange platform
which presently range between 30,000-45,000 tonnes every month.
Spot Price Polling
Like any other derivative, a futures contract derives its value from the underlying
commodity. The spot and futures market are closely interlinked with price and
sentiment in one market affecting the price and sentiment in the other. Fair and
transparent spot price discovery attains importance when studied against the role it
plays in a futures market. The availability of spot price data of the basis centre has
the following benefits:
• Near real time spot price information helps the trading members to take a view on
the future market and vice versa.
• The data helps the Exchange to analyze the price data concurrently to make
meaningful analysis of price movement in the futures market and helps in the market
surveillance function.
• The Exchange has to track the convergence of spot and futures prices towards the
last few days prior to the expiry of a contract.
• The Exchange need to know the spot prices at around closing time of the contract
for the Final Settlement Price on the expiry day.
• The Exchange needs to know the spot price at the basis centre of the underlying
commodity of which the futures are being traded on the platform.
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• The near real-time spot price data when it is disseminated by the Exchange is of
great interest to the general public, especially researchers, governmental agencies,
international agencies, etc. In India, there is no effective mechanism or real time
spot price information of commodities.
The only government agency which collects spot prices is Agmarknet which
collects the posttrade mandi data, but even such information is not disseminated real
time. The Exchange needs the spot price information real time at several points in
time during the trading hours. Moreover, agricultural spot markets in India are
spread over 7,000 mandis across the country.
Prices for the same commodity differ from mandi to mandi. This is a direct
consequence of the lack of integration of markets and the lack of good transportation
facilities. The price differentials create a problem in the development of a unique
representative spot price for the commodity. Considering the importance of spot
price information to the trader and the unavailability of reliable source of real time
spot price data, NCDEX has put in place a mechanism to poll spot prices prevailing
at various mandis throughout the country.
This process is analogous to the interest rate polling conducted to find the LIBOR
rates. The Exchange collates spot prices for all commodities on which it offers
futures trading and disseminates the same to the market via the trading platform.
This collection and dissemination of spot prices is done by various reputed external
polling agencies which interact directly with market participants and collect
feedback on spot prices which are then disseminated to the market.
Polling and Bootstrapping
Polling is the process of eliciting information from a cross section of market players
about the prevailing price of the commodity in the market. A panel of polling
participants comprising various user class viz. growers, traders/brokers, processors
and users is chosen. Primarily, the days prior to the expiry of a contract.
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• The Exchange need to know the spot prices at around closing time of the contract
for the Final Settlement Price on the expiry day.
• The Exchange needs to know the spot price at the basis centre of the underlying
commodity of which the futures are being traded on the platform.
• The near real-time spot price data when it is disseminated by the Exchange is of
great interest to the general public, especially researchers, governmental agencies,
international agencies, etc. In India, there is no effective mechanism or real time
spot price information of commodities.
The only government agency which collects spot prices is Agmarknet which collects
the pos ttrade mandi data, but even such information is not disseminated real time.
The Exchange needs the spot price information real time at several points in time
during the trading hours.
Moreover, agricultural spot markets in India are spread over 7,000 mandis across the
country. Prices for the same commodity differ from mandi to mandi. This is a direct
consequence of the lack of integration of markets and the lack of good transportation
facilities. The price differentials create a problem in the development of a unique
representative spot price for the commodity.
Considering the importance of spot price information to the trader and the
unavailability of reliable source of real time spot price data, NCDEX has put in
place a mechanism to poll spot prices prevailing at various mandis throughout the
country. This process is analogous to the interest rate polling conducted to find the
LIBOR rates. The Exchange collates spot prices for all commodities on which it
offers futures trading and disseminates the same to the market via the trading
platform. This collection and dissemination of spot prices is done by various reputed
external polling agencies which interact directly with market participants and collect
feedback on spot prices which are then disseminated to the market.
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Polling and Bootstrapping
Polling is the process of eliciting information from a cross section of market players
about the prevailing price of the commodity in the market. A panel of polling
participants comprising various user class viz. growers, traders/brokers, processors
and users is chosen. Primarily, the data on spot prices is captured at the identified
delivery centres which are also termed as the primary centre of a commodity by
asking bid and ask quotes from the empanelled polling participants. Besides the
primary centre, spot price of a commodity from a couple of other major centers
(subject, sometimes, to adequate number of respondents) are also captured. These
centers are termed non-primary or non-priority centers. Multiple-location polling for
a commodity helps the Exchange
• in estimating the price at the primary centre when the market there is closed for
some reason.
• in validating the primary centre price when there are reasons to believe that polled
data is not reliable or justified considering the underlying factors.
• in providing a value addition to the users. Polling is carried out once, twice or
hrice a day depending upon the market timings, practices at the physical market.
When polling for the spot price of a commodity, the participant is asked 'what he
thinks is the ASK or BID price of the commodity conforming to grade and quality
specifications of the Exchange. The respondent may or may not have any buy or sell
position of the commodity in the physical market at that point in time. However
since the respondent is an active player in the spot trade of the commodity, he has a
clear understanding of the prevailing price at that point in time. Considering the vital
role the participants play in the process, the polling participants are carefully chosen
to ensure that they are active players in the market. For this reason no association,
group of persons or a trade body/association has been included as polling participant
as it is against the spirit of the polling process.
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Cleansing of data
The spot price polled from each mandi is transmitted electronically to a central
database for further process of bootstrapping to arrive at a clean benchmark average
price. To arrive at the bootstrapped price, all the BID & ASK quotes are sorted in
ascending order and through adaptive trimming procedure the extreme quotes are
trimmed from the total quotes. These values are sampled with replacement multiple
numbers of times, where software gives different mean with their respective
standard deviation. The mean with least standard deviation is the spot price that will
be uploaded by the polling agency through the polling application provided by
NCDEX. This price is broadcast through the Trader Work Station and also on the
NCDEX website without any human intervention.
Outsourcing of Polling
It is prohibitively expensive for the Exchange to post personnel at various mandis to
poll prices especially in the initial stages when there is no scope to recover any fee
from the sale of price data. Further it is advisable that the spot prices are polled by
an agency independently rather than by the Exchange itself for reasons of corporate
governance. Thirdly, the agencies chosen will have some expertise and experience
in this field which the Exchange can leverage upon.
For the above reasons, NCDEX has outsourced the processes of polling and
bootstrapping to external reputed entities. The Product Managers for the various
commodities are asked to identify through interactions at the mandis the participants
who would form a part of the polling community for a given commodity. They
would also explain in detail to the participants about the Exchange, futures trading,
need for polling, the reason why they have chosen the polling participant, the grade
and other quality specifications of the commodity and the name of the polling
agency. After obtaining the concurrence of the participant, the names and contact
numbers will be passed on to the polling agency.
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Validation & Checks on the Polling Processes
The Exchange routinely makes daily calls to the polling participants randomly in
various commodities and speak to them about the prices quoted to cross check the
raw quotes sent by the polling agency. Besides they also talk to them about the
demand and supply conditions, mandi arrivals, imports/exports activities, impact of
state procurement and agricultural policies, weather conditions impacting the crop,
etc. This gives them a feel of the spot market which is a valuable input in tracking
and analyzing futures price movements. Necessary precaution/checks are maintained
at the Exchange so that any spot price which deviates from the previous day's spot
price by +/- 4% is reviewed before uploading. In such case, the Exchange reviews
the raw prices as quoted by respondents available with the polling agency and tries
independently to ascertain the reason for deviation through interaction with the
participants. If the price rise/fall is justified with the feedback received from the
participants, the price is uploaded in the system after obtaining necessary approval.
If the price rise/fall is not justified with the feedback received from the participants,
the polling agency is asked to re-poll the prices and the new bootstrapped price is
allowed to be uploaded. Two days prior to the expiry of the contract, the above price
limit of 4% will be re-set to 2%. This is done as a precaution in view of the
impending expiry and the high risk of accepting what may be an incorrect spot price
as the FSP.
A check is conducted on the lines describe in the previous paragraph before the
prices are uploaded. It is very important that that the polling participants are
periodically reinforced about the grade and quality specifications set by the
Exchange for the commodity for which he is polled and it is the responsibility of the
polling agency to ensure that this is being adhered to.
Independence of the polling agency
To ensure impartiality and to remove any biases, the Exchange or its officials have
given themselves no right to alter a spot price provided by the agency.
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Dissemination of spot price data as a service
NCDEX disseminates the spot price data of underlying commodities traded at the
Exchange on its website www.ncdex.com. This is done at two or three times a day,
depending upon the availability of the price data at the spot market place. The
Exchange provides this data as a value added service. At present, the real time prices
are disseminated free to the members.
Exchange Membership
Membership of NCDEX is open to any person, association of persons, partnerships,
co-operative societies, companies etc. that fulfills the eligibility criteria set by the
Exchange. FIs, NRIs, Banks, MFs etc are not allowed to participate in commodity
exchanges at the moment. All the members of the Exchange have to register
themselves with the competent authority before commencing their operations.
NCDEX invites applications for Members from persons who fulfill the specified
eligibility criteria for trading commodities. The members of NCDEX fall into
following categories:
1. Trading cum Clearing Member (TCM) :
Members can carry out the transactions (Trading, clearing and
settlement) on their own account and also on their clients' accounts.
Applicants accepted for admission as TCM are required to pay the
requisite fees/ deposits and also maintain net worth as explained in
the following section.
2. Professional Clearing Members (PCM):
Members can carry out the settlement and clearing for their clients
who have traded through TCMs or traded as TMs. Applicants
accepted for admission as PCMs are required to pay the requisite fee/
deposits and also maintain net worth.
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3. Trading Member ( TM ):
Member who can only trade through their account or on account of their
clients and will however clear their trade through PCMs/STCMs.
4. Strategic Trading cum Clearing Member (STCM):
This is up gradation from the TCM to STCM. Such member can trade on
their own account, also on account of their clients. They can clear and settle
these trades and also clear and settle trades of other trading members who are
only allowed to trade and are not allowed to settle and clear.
Capital requirements
NCDEX has specified capital requirements for its members. On approval as a
member of NCDEX, the member has to deposit the following capital:
Base Minimum Capital (BMC)
Base Minimum Capital comprises of the following:
• Interest Free Cash Security Deposit
• Collateral Security Deposit
Interest Free Cash Security Deposit
An amount of Rs. 15 Lacs by Trading cum Clearing Members (TCM) and Rs. 25
Lacs by Professional Clearing Members (PCM) is to be provided in cash. The same
is to be provided by issuing a cheque / demand draft payable at Mumbai in favour of
National Commodity & Derivatives Exchange Limited.
Collateral Security Deposit
The minimum-security deposit requirement is Rs. 15 Lacs for TCM and Rs. 25 Lacs
for PCM. All Members have to comply with the security deposit requirement before
the activation of their trading terminal.
Members may opt to meet the security deposit requirement by way of the following:
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Cash
The same is to be provided by issuing a cheque / demand draft payable at Mumbai in
favour of 'National Commodity & Derivatives Exchange Limited'.
Bank Guarantee
Bank guarantee in favour of NCDEX as per the specified format. The minimum
term of the bank guarantee should be 12 months.
Fixed Deposit Receipt
Fixed Deposit Receipts (FDRs) issued by approved banks are accepted. The FDR
should be issued for a minimum period as specified by the Exchange from time to
time from any of the approved banks.
Government of India Securities
National Commodity Clearing Limited (NCCL) is the approved custodian for
acceptance of Government of India Securities.
The securities are valued on a daily basis and a haircut as prescribed the Exchange
is levied.
Additional Base Capital (ABC)
In case the members desire to increase their limit, additional capital may be
submitted to NCDEX in the following forms:
• Cash
• Cash Equivalents
- Bank Guarantee (BG)
- Fixed Deposit Receipt (FDR)
- Government of India Securities
- Bullion
- Shares (notified list)
The haircut for Government of India securities shall be 25% and 50% for the
notified shares.
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Risk Management
NCDEX ensures the financial integrity of trades put through on its platform by
adopting a comprehensive, unbiased and professional approach to risk management.
NCDEX does not have in its governing/management team, any person who has any
vested interest in commodity trading. The Value at risk (VaR) based margining and
limits on position levels are transparent and applied uniformly across market
participants.
In commodity futures markets, margins are collected from market participants to
cover adverse movements in futures prices. Prudent risk management requires that
margining system of the Exchange should respond to price volatility to ensure that
members are able to meet their counter party liability. In the long run, this ensures
financial discipline in the market and aids in the development of the market.
NCDEX provides position monitoring and margining. Position monitoring is carried
out on a real-time basis during the trading hours. Margins are calculated intraday to
capture the intraday volatility in the futures prices.
Other risk management tools like daily price limits and exposure margins have been
adopted in line with international best practices. Margins are netted at the level of
individual client and grossed across all clients, at the members level, without any
set-offs between clients. For orderly functioning of the market, stringent limits for
near month contracts are set.
Clearing And Settlement System
Clearing
National Commodity Clearing Limited (NCCL) undertakes clearing of trades
executed on the NCDEX. Only clearing members including professional clearing
members (PCMs) are entitled to clear and settle contracts through the clearing
house. At NCDEX, after the trading hours on the expiry date, based on the available
information, the matching for deliveries takes place firstly, on the basis of locations
and then randomly, keeping in view the factors such as available capacity of the
vault/warehouse, commodities already deposited and dematerialized and offered for
delivery etc. Matching done by this process is binding on the clearing members.
After completion of the matching process, clearing members are informed of the
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deliverable/ receivable positions and the unmatched positions. Unmatched positions
have to be settled in cash. The cash settlement is only for the incremental gain/ loss
as determined on the basis of final settlement price.
Settlement
Futures contracts have two types of settlements, the Mark-to-Market (MTM)
settlement which happens on a continuous basis at the end of the day, and the final
settlement which happens on the last trading day of the futures contract. On the
NCDEX, daily MTM settlement in respect of admitted deals in futures contracts are
cash settled by debiting/ crediting the clearing accounts of clearing members (CMs)
with the respective clearing bank. All positions of CM, brought forward, created
during the day or closed out during the day, are mark to market at the daily
settlement price or the final settlement price on the contract expiry. The
responsibility of settlement is on a trading cum clearing member for all trades done
on his own account and his client's trades.
A professional clearing member is responsible for settling all the participants trades
which he has confirmed to the Exchange. Few days before expiry date, as
announced by Exchange from time to time, members submit delivery information
through delivery request window on the trader workstation provided by NCDEX for
all open position for a commodity for all constituents individually. NCDEX on
receipt of such information matches the information and arrives at a delivery
position for a member for a commodity.
The seller intending to make delivery takes the commodities to the designated
warehouse. These commodities have to be assayed by the Exchange specified
assayer. The commodities have to meet the contract specifications with allowed
variances. If the commodities meet the specifications, the warehouse accepts them.
Warehouse then ensures that the receipts get updated in the depository system giving
a credit in the depositor's electronic account. The seller then gives the invoice to his
clearing member, who would courier the same to the buyer's clearing member. On
an appointed date, the buyer goes to the warehouse and takes physical possession of
the commodities.
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Clearing Days and Scheduled Time
Daily Mark to Market settlement where 'T' is the trading day
Mark to Market Pay-in (Payment): T+1 working day.
Mark to Market Pay-out (Receipt): T+1 working day.
Final settlement Final settlement for Futures Contracts
The settlement schedule for Final settlement for futures contracts is given by the
Exchange in detail for each commodity.
Timings for Funds settlement:
Pay-in: On Scheduled day as per settlement calendars.
Pay-out: On Scheduled day as per settlement calendars.
7.1 FUTURES TRADING SYSTEM
The trading system on the NCDEX, provides a fully automated screen-based trading
for futures on commodities on a nationwide basis as well as an online monitoring
and surveillance mechanism. It supports an order driven market and provides
complete transparency of trading operations.
The NCDEX system supports an order driven market, where orders match
automatically. Order matching is essentially on the basis of commodity, its price,
time and quantity. All quantity fields are in units and price in rupees. The Exchange
specifies the unit of trading and the delivery unit for futures contracts on various
commodities.
The Exchange notifies the regular lot size and tick size for each of the contracts
traded from time to time. When any order enters the trading system, it is an active
order. It tries to find a match on the other side of the book. If it finds a match, a trade
is generated. If it does not find a match, the order becomes passive and gets queued
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in the respective outstanding order book in the system. Time stamping is done for
each trade and provides the possibility for a complete audit trail if required.
7.2Entities in the Trading System
There are following entities in the trading system of NCDEX –
1. Trading cum Clearing Member (TCM) :
Trading cum Clearing Members can carry out the transactions (trading, clearing and
settling) on their own account and also on their clients' accounts. The Exchange
assigns an ID to each TCM. Each TCM can have more than one user. The number of
users allowed for each trading member is notified by the Exchange from time to
time. Each user of a TCM must be registered with the Exchange and is assigned an
unique user ID. The unique TCM ID functions as a reference for all orders/trades of
different users. It is the responsibility of the TCM to maintain adequate control over
persons having access to the firm's User IDs.
2. Professional Clearing Member (PCM) :
These members can carry out the settlement and clearing for their clients who have
traded through TCMs or traded as TMs.
3. Trading Member (TM):
Member who can only trade through their account or on account of their clients and
will however clear their trade through PCMs/STCMs.
4. Strategic Trading cum Clearing Member (STCM):
This is up gradation from the TCM to STCM. Such member can trade on their own
account, also on account of their clients. They can clear and settle these trades and
also clear and settle trades of other trading members who are only allowed to trade
and are not allowed to settle and clear.
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Structure
Box 7.1The open outcry system of trading
While most exchanges the world over are moving towards the electronic form of
trading, some still follow the open outcry method. Open outcry trading is a face-to-
face and highly activate form of trading used on the floors of the exchanges. In open
outcry system the futures contracts are traded in pits. A pit is a raised platform in
octagonal shape with descending steps on the inside that permit buyers and sellers to
see each other. Normally only one type of contract is traded in each pit like a
Eurodollar pit, Live Cattle pit etc.
Each side of the octagon forms a pie slice in the pit. All the traders dealing with a
certain delivery month trade in the same slice. The brokers, who work for
institutions or the general public stand on the edges of the pit so that they can easily
see other traders and have easy access to their runners who bring orders. The trading
process consists of an auction in which all bids and offers on each of the contracts
are made known to the public and everyone can see the market's best price.
To place an order under this method, the customer calls a broker, who time-stamps
the order and prepares an office order ticket. The broker then sends the order to a
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Exchange
Member
Client
booth on the exchange floor called broker's floor booth. There, a floor order ticket is
prepared, and a clerk hand delivers the order to the floor trader for execution.
In some cases, the floor clerk may use hand signals to convey the order to floor
traders. Large orders typically go directly from the customer to the broker's floor
booth. The floor trader, standing in a central location i.e. trading pit, negotiates a
price by shouting out the order to other floor traders, who bid on the order using
hand signals. Once filled, the order is recorded manually by both parties in the trade.
At the end of each day, the clearing house settles trades by ensuring that no
discrepancy exists in the matched-trade information.
7.2(A) GUIDELINES FOR ALLOTMENT OF CLIENT CODE
The trading members are recommended to follow guidelines outlined by the
Exchange for allotment and use of client codes at the time of order entry on the
futures trading system:
1. All clients trading through a member are to be registered clients at the member's
back office.
2. A unique client code is to be allotted for each client. The client code should be
alphanumeric and no special characters can be used.
3. The same client should not be allotted multiple codes.
7.3 CONTRACT SPECIFICATIONS
For derivatives with a commodity as the underlying, the Exchange specifies the
exact nature of the agreement between two parties who trade in the contract. In
particular, it specifies the underlying asset, unit of trading, price limits, position
limits, the contract size stating exactly how much of the asset will be delivered
under one contract, where and when the delivery will be made, etc.
Here, we look at the contract specifications of some of the commodities traded on
the Exchange. Contracts specifications of commodities are revised from time to time
in light of changing requirements and feedback of market participants in terms of
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product variety, quality, timings, delivery centers, etc. Most of the agri commodities
futures contract traded on NCDEX expire on the 20th of the expiry month.
Thus, a November expiration contract would expire on the 20th of November and a
December expiry contract would cease trading after the 20th of December. If 20 th
happens to be a holiday, the expiry date shall be the immediately preceding trading
day of the Exchange, other than a Saturday. Some of the contracts of metals, energy
etc expire on different dates.
7.3(A) COMMODITY FUTURES TRADING CYCLE
NCDEX trades commodity futures contracts having one-month, two-month, three-
month and more (not more than 12 months) expiry cycles. Most of the futures
contracts (mainly agri commodities contract) expire on the 20th of the expiry month.
Some contracts traded on the Exchange expire on the day other than 20th of the
month. New contracts for most of the commodities on NCDEX are introduced on
10th of every month.
7.4 Order Types and Trading Parameters
An electronic trading system allows the trading members to enter orders with
various conditions attached to them as per their requirements. These conditions are
broadly divided into the following categories:
• Time conditions
• Price conditions
• Other conditions
Several combinations of the above are possible thereby providing enormous
flexibility to users. The order types and conditions are summarized below. Of these,
the order types available on the NCDEX system are regular market order, limit
order, stop loss order, immediate or cancel order, good till day order, good till
cancelled order, good till date order and spread order.
Time conditions
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Good till day order:
A day order, as the name suggests is an order which is valid for the day on
which it is entered. If the order is not executed during the day, the system
cancels the order automatically at the end of the day. Example: A trader
wants to go long on February 1, 2010 in refined soy oil on the commodity
exchange. A day order is placed at Rs.660/ 10 kg. If the market does not
reach this price the order does not get filled even if the market touches
Rs.661 and closes. In other words, day order is for a specific price and if the
order does not get filled that day, one has to place the order again the next
day.
Good till cancelled (GTC):
A GTC order remains in the system until the user cancels it. Consequently, it
spans trading days, if not traded on the day the order is entered. The
maximum number of days an order can remain in the system is notified by
the Exchange from time to time after which the order is automatically
cancelled by the system. Each day counted is a calendar day inclusive of
holidays. The days counted are inclusive of the day on which the order is
placed and the order is cancelled from the system at the end of the day of the
expiry period. Example: A trader wants to go long on refined soy oil when
the market touches Rs.650/ 10kg. Theoretically, the order exists until it is
filled up, even if it takes months for it to happen. The GTC order on the
NCDEX is cancelled at the end of a period of seven calendar days from the
date of entering an order or when the contract expires, whichever is earlier.
Good till date (GTD):
A GTD order allows the user to specify the date till which the order should
remain in the system if not executed. The maximum days allowed by the
system are the same as in GTC order. At the end of this day/ date, the order
is cancelled from the system. Each day/ date counted are inclusive of the
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day/ date on which the order is placed and the order is cancelled from the
system at the end of the day/ date of the expiry period.
Immediate or Cancel (IOC)/ Fill or kill order:
An IOC order allows the user to buy or sell a contract as soon as the order is
released into the system, failing which the order is cancelled from the
system. Partial match is possible for the order, and the unmatched portion of
the order is cancelled immediately.
All or none order:
All or none order (AON) is a limit order, which is to be executed in its
entirety, or not at all.
Price condition
Limit order:
An order to buy or sell a stated amount of a commodity at a specified price,
or at a better price, if obtainable at the time of execution. The disadvantage is
that the order may not get filled at all if the price for that day does not reach
the specified price.
Stop-loss:
A stop-loss order is an order, placed with the broker, to buy or sell a
particular futures contract at the market price if and when the price reaches a
specified level. Futures traders often use stop orders in an effort to limit the
amount they might lose if the futures price moves against their position. Stop
orders are not executed until the price reaches the specified point. When the
price reaches that point the stop order becomes a market order. Most of the
time, stop orders are used to exit a trade. But, stop orders can be executed for
buying/ selling positions too. A buy stop order is initiated when one wants to
buy a contract or go long and a sell stop order when one wants to sell or go
short. The order gets filled at the suggested stop order price or at a better
price. Example: A trader has purchased crude oil futures at Rs.3750 per
barrel. He wishes to limit his loss to Rs. 50 a barrel. A stop order would then
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be placed to sell an offsetting contract if the price falls to Rs.3700 per barrel.
When the market touches this price, stop order gets executed and the trader
would exit the market.
Other condition
Market price: Market orders are orders for which no price is specified at the
time the order is entered (i.e. price is market price). For such orders, the
system determines the price. Only the position to be taken long/ short is
stated. When this kind of order is placed, it gets executed irrespective of the
current market price of that particular commodity.
Trigger price:
Price at which an order gets triggered from the stop-loss book.
Spread order:
A simple spread order involves two positions, one long and one short. They
are taken in the same commodity with different months (calendar spread) or
in closely related commodities. Prices of the two futures contract therefore
tend to go up and down together, and gains on one side of the spread are
offset by losses on the other. The spreaders goal is to profit from a change in
the difference between the two futures prices. The trader is virtually
unconcerned whether the entire price structure moves up or down, just so
long as the futures contract he bought goes up more (or down less) than the
futures contract he sold.
7.4(a) PERMITTED LOT SIZE
The permitted trading lot size for the futures contracts and delivery lot size on
individual commodities is stipulated by the Exchange from time to time. The lot size
currently applicable on select individual commodity contracts is given in Table 8.1
7.4. (b) TICK SIZE FOR CONTRACTS & TICKER SYMBOL
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The tick size is the smallest price change that can occur for the trades on the
Exchange for commodity futures contracts. The tick size in respect of futures
contracts admitted to dealings on the NCDEX varies for commodities. For example:
in case of refined soy oil, it is 5 paise, Wheat 20 paise and Jeera Re 1. A ticker
symbol is a system of letters that are used to identify a commodity. NCDEX
generally uses a system of alphabetic/alphanumeric to identify its commodities
uniquely. The symbol Indicate the commodity and it may indicate quality, quantity
and base centre of the commodity as well.
7.4(c) QUANTITY FREEZE
All orders placed by members have to be within the quantity specified by the
Exchange in this regard. Any order exceeding this specified quantity will not be
executed but will lie pending with the Exchange as a quantity freeze. Table 8.2 gives
the quantity freeze for some select commodity contracts. In respect of orders which
have come under quantity freeze, the order gets deleted from the system at the end
of the day's trading session.
Table 7.2 Commodity futures: Quantity freeze unit
Commodity Futures Quantity Freeze
Gold 51 KG
Soya bean 510 MT
Chana 510 MT
Silver 1530 KG
Guar Seed 510 MT
Chilli 255 MT
RM Seed 510 MT
Jeera 153 MT
7.4. (d) BASE PRICE
On introduction of new contracts, the base price is the previous days' closing price
of the underlying commodity in the prevailing spot markets. These spot prices are
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polled across multiple centers and a single spot price is determined by the
bootstrapping method. The base price of the contracts on all subsequent trading days
is the daily settlement price of the futures contracts on the previous trading day.
7.4. (e) PRICE RANGES OF CONTRACTS
To control wide swings in prices, an intra-day price limit is fixed for commodity
futures contract. The maximum price movement during the day can be +/- x% of the
previous day's settlement price for each commodity. If the price hits the first intra-
day price limit (at upper side or lower side), there will be a cooling period of 15
minutes. Then price band is revised further and in case the price reach that revised
level, no trade is permitted during the day beyond the revised limit.
Take an example of Guar Seed- Daily price fluctuation limit is (+/-) 4% (3% +1%).
If the trade hits the prescribed first daily price limit of 3 %, there will be a cooling
off period for 15 minutes. Trade will be allowed during this cooling off period
within the price band. Thereafter, the price band would be raised by (+/-) 1% and
trade will be resumed. If the price hits the revised price band (4%) during the day,
trade will only be allowed within the revised price band. No trade / order shall be
permitted during the day beyond the limit of (+/-) 4%. In order to prevent erroneous
order entry by trading members, operating price ranges on the NCDEX are pre-
decided for individual contracts from the base price. Presently, the price ranges for
agricultural commodities is (+/-) 4 % from the base price for the day, and upto (+/-)
9 % for non-agricultural commodities. Orders, exceeding the range specified for a
day's trade for the respective commodities are not executed.
7.5 MARGINS FOR TRADING IN FUTURES
Margin is the deposit money that needs to be paid to buy or sell each contract. The
margin required for a futures contract is better described as performance bond or
good faith money. The margin levels are set by the exchanges based on volatility
(market conditions) and can be changed at any time. The margin requirements for
most futures contracts range from 5% to 15% of the value of the contract, with a
minimum of 5%, except for Gold where the minimum margin is 4%. In the futures
market, there are different types of margins that a trader has to maintain. We will
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discuss them in more details when we talk about risk management in the next
chapter. At this stage we look at the types of margins as they apply on most futures
exchanges.
• Initial margin:
The amount that must be deposited by a customer at the time of entering into a
contract is called initial margin. This margin is meant to cover the potential loss in
one day. The margin is a mandatory requirement for parties who are entering into
the contract. The exchange levies initial margin on derivatives contracts using the
concept of Value at Risk (VaR) or any other concept as the Exchange may decide
periodically. The margin is charged so as to cover one-day loss that can be
encountered on the position on 99.95% confidence-interval VaR methodology.
• Exposure & Mark-to-Market Margin:
Exposure margin is charged taking into consideration the back testing results of the
VaR model. For all outstanding exposure in the market, the Exchange also collects
mark-to-market margin which are positions restated at the daily settlement prices
(DSP). At the end of each trading day, the margin account is adjusted to reflect the
trader's gain or loss. This is known as marking to market the account of each trader.
All futures contracts are settled daily reducing the credit exposure to one day's
movement. Based on the settlement price, the value of all positions is marked-to-
market each day after the official close. i.e. the accounts are either debited or
credited based on how well the positions fared in that day's trading session. If the
account falls below the required margin level the clearing member needs to
replenish the account by giving additional funds or closing positions either partially/
fully. On the other hand, if the position generates a gain, the funds can be withdrawn
(those funds above the required initial margin) or can be used to fund additional
trades.
• Additional margin:
In case of sudden higher than expected volatility, the Exchange calls for an
additional margin, which is a preemptive move to prevent potential default. This is
imposed when the Exchange/ regulator has view that that the markets have become
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too volatile and may result in some adverse situation to the integrity of the market/
Exchange.
• Pre-expiry margin:
This margin is charged as additional margin for most commodities expiring during
the current/near month contract. It is charged on a cumulative basis from typically 3
to 5 days prior to the expiry date (including the expiry date). This is done to ensure
that only interested parties remain in the market and speculators roll over their
positions to subsequent months and ensure better convergence of the futures and
spot market prices.
• Delivery Margin:
This margin is charged only in the case of positions materializing into delivery.
Members are informed about the delivery margin payable. Margins for delivery are
to be paid the day following expiry of contract.
• Special Margin:
This margin is levied when there is more than 20% uni-directional movement in the
price from a pre-determined base and is typically related to the underlying spot
price. The base could be the closing price on the day of launch of the contract or the
90 days prior settlement price. This is mentioned in the respective contract
specification. Some contracts also have an as-deemed-fit clause for levying of
Special margins. It can also be levied by market regulator if market exhibits excess
volatility. If required by the regulator, it has to be settled by cash. This is collected
as extra margin over and above normal margin requirement.
• Margin for Calendar Spread positions:
Calendar spread is defined as the purchase of one delivery month of a given futures
contract and simultaneous sale of another delivery month of the same commodity by
a client/ member. At NCDEX, for calendar spread positions, margins are imposed as
one half of the initial margin (inclusive of the exposure margin). Such benefit will
be given only of there is positive correlation in the prices of the months under
consideration and the far month contracts are sufficiently liquid. No benefit of
calendar spread is given in the case of additional and special margins.
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However, calendar spread positions in the far month contract are considered as
naked position three days before expiry of near month contract. Gradual reduction of
the spread position is done at the rate of 33.3% per day from 3 days prior to expiry.
Just as a trader is required to maintain a margin account with a broker, a clearing
house member is required to maintain collaterals/deposits with the clearing house
against which the positions are allowed to be taken.
7.6 CHARGES
Members are liable to pay transaction charges for the trade done through the
Exchange during the previous month. The important provisions are listed below.
The billing for the all trades done during the previous month will be raised in the
succeeding month.
1. Transaction charges:
The transaction charges are payable at the rate of Rs. 4 per Rs.100,000 worth of
trade done. This rate is charged for average daily turnover of Rs. 20 crores.
Reduced rate is charged for increase in daily turnover. This rate is subject to
change from time to time. The average daily turnover is calculated by taking the
total value traded by the member in a month and dividing it by number of
trading days in the month including Saturdays.
2. Due date:
The transaction charges are payable on the 10th day of every month in respect
of the trade done in the previous month.
3. Collection:
Members keep the Exchange Dues Account opened with the respective
Clearing Banks for meeting the commitment on account of transaction charges.
4. Adjustment against advances transaction charges:
In terms of the regulations, members are required to remit Rs.50,000 as advance
transaction charges on registration. The transaction charges due first will be
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adjusted against the advance transaction charges already paid as advance and
members need to pay transaction charges only after exhausting the balance lying
in advance transaction.
5. Penalty for delayed payments:
If the transaction charges are not paid on or before the due date, a penal interest
is levied as specified by the Exchange. Finally, the futures market is a zero sum
game i.e. the total number of long in any contract always equals the total
number of short in any contract.
The total number of outstanding contracts (long/ short) at any point in time is
called the 'Open interest'. This Open interest figure is a good indicator of the
liquidity in every contract. Based onstudies carried out in international
Exchanges, it is found that open interest is maximum in near month expiry
contracts.
7.6 HEDGE LIMITS
The Exchange permits higher client-level open interest (OI) limits (referred to as
"Hedge Limits") to Hedgers hedging the price risk of their current cash and expected
future commodity requirement subject to their satisfying certain conditions and
producing documents as specified by the Exchange.
The Exchange has introduced a Hedge Policy for the benefit of constituents and
Members trading in their proprietary account (hereinafter for referred to as
"Constituents") who have genuine hedging requirements by virtue of their being an
importer or an exporter or those having stocks of physical goods.
Registration:
• The Hedge Policy covers those Constituents who are processors, importers,
exporters and those who have physical stocks of the commodities.
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• The hedge limits against physical stocks are allowed only if the stocks are owned
by the Constituent or if they are pledged with any Government/ Scheduled or Co-
operative Banks. Warehouses where the physical stock may be kept include the
accredited warehouses, or any private warehouse including hedger's own
warehouse / factory premises.
• Such Constituents who have or expect to have one or more of the above
requirements for a commodity which exceeds the client-level open interest (OI) limit
set by the Exchange may apply for the status of a Hedger on the Exchange platform.
• A prospective Hedger is required to register with the Exchange as a Hedger by
forwarding his request for the Hedger status through a TCM along with the forms,
annexure and documents mentioned in the Appendix to the circular related to the
Hedge Policy of the Exchange.
• Hedge limits for a commodity are determined on the basis of applicant's hedging
requirement in the cash market and other factors which the Exchange deems
appropriate in the interest of market. This is subject to the applicant substantiating
his hedging requirement by documentary evidence in support of the stocks carried
by him or his export or import obligations.
• Under the terms and conditions, hedge limits are not allowed in the near month and
outstanding open position is required to be brought within normal client level
position levels in the near-month period.
• The hedge limits sanctioned to a Hedger can be utilized only by the hedger and not
by anyone else including any subsidiary/associate company.
• A Hedger registered with the Exchange is allotted a unique participant Code. The
Participant Code is used by the Hedger while trading on the Exchange in those
commodities in which he has been sanctioned hedge limits. This code should not be
used by the Hedger while trading in any other commodity where he has no hedge
limits approved to him.
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• The approved hedge limit is valid from the date of sanction for a period specified
in the sanction letter. Unless renewed, the hedge limit shall stands cancelled
automatically upon expiry of such period without any notice. The Hedger is required
to apply for any renewal of limits at least a month before the expiry of approval
along with relevant documents as prescribed by the Exchange from time to time.
• Clients whose applications for Hedge limits have been approved need to submit,
through the member through whom they are trading, a monthly statement in respect
of physical stock held by them. Members taking Hedge limits are similarly required
to submit such a statement of their physical holdings against which hedge limits
have been sanctioned in the prescribed format. Such monthly statement as of last
day of the calendar month, should reach the Exchange not later than 7th of
succeeding month.
• All applicants seeking Hedge limits are required to give a declaration in the
prescribed format for combining of positions taken through various trading
members.
Terms and Conditions for the Hedger & the Registering TCM
It is the intention of the Exchange to ensure that the sanction of hedge limits does
not result in market concentration or undue influence on the futures market prices.
The sanction of the hedge limits, therefore, is subject to certain terms and conditions
which include:
• The additional open position limit granted by way of hedge limit at no point of
time shall exceed a quantity equivalent to the prescribed client level open interest
position limit prescribed for that commodity. Where a different client level position
limit has been prescribed in a particular commodity/contract, to be applicable in the
near-month of the given contract, the hedge limit shall be in accordance with the
open position as applicable during such period. It would also be the responsibility of
the Registering TCM to ensure that the Hedger complies with the above
requirement.
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• A Hedger may be sanctioned hedge limits either for long positions or short
positions but not for both. Hence the applicant has to state clearly if the application
is for long or short position. A fresh application will be needed if the Hedger needs
an opposite position in lieu of the existing sanctioned position.
• The Hedger's sanctioned limit in a commodity will not be allowed to exceed at any
time and under any circumstances. If any violations (including intraday violations
for whatever reasons) are found, the Exchange may not permit taking of any further
position by the Hedger and may reduce his open interest position at market rate,
which shall be binding on the Hedger and the Registering TCM.
• The Registering TCM has a responsibility:
a) Not to put through any trade by a Hedger violating the limits or any of the terms
or conditions on which hedge limits are sanctioned to the Hedger by the Exchange.
b) To monitor the Hedger's position continuously to ensure that it does not exceed
the sanctioned limit or the terms and conditions of the sanction of the limits.
c) To ensure that the Hedger reduces the open interest positions in the spot month
contract within the normal limit for that contract before the last ten days prior to
expiry of the contract.
d) To immediately inform the Exchange of any violation of limit or terms and
conditions by a Hedger.
• Though the hedge positions can be liquidated based on sound commercial reasons
by the Hedgers, they shall not churn (frequent unwinding and reinitiating) the hedge
positions during a hedge period for whatever reasons.
For this purpose, the hedge period is defined as the time between initiation of hedge
position in a futures contract and the time of expiry of the contract. The Exchange
shall be the sole authority in determining whether frequent churning happens in a
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Hedger's position or not and the decision of the Exchange in this regard shall be
final and binding on all parties involved.
• The margins for any commodity prescribed by the Exchange for the other market
participants shall also be applicable to the hedgers.
• A Hedger shall furnish all information called for by the Exchange at any time and
allow officials of Exchange or any person/s authorized by the Exchange or officials
of regulatory authorities to inspect their records and account books as also
verification of physical stocks for the purpose of verification of information or
documents, with or without prior intimation.
• All parties to the limits sanctioned to a Hedger, i.e. the Hedger and the Registering
TCM are required to abide by the Rules, Bye-laws and Regulations of the Exchange
and directions of the Regulator, if any, may apart from the terms and conditions
under which the hedge limits are sanctioned.
Any violation may result in cancellation of hedger status and appropriate action
including penalties on the constituent and/or other parties concerned at the option of
the Exchange.
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CHAPTER8 CLEARANCE AND SETTLEMENT OF
COMMODITY FUTURES
Most futures contracts do not lead to the actual physical delivery of the underlying
asset. The settlement is done by closing out open positions, physical delivery or cash
settlement. All these settlement functions are taken care of by an entity called
clearing house or clearing corporation. National Commodity Clearing Limited
(NCCL) undertakes clearing of trades executed on the NCDEX.
8.1 CLEARING
Clearing of trades that take place on an Exchange happens through the Exchange
clearing house. A clearing house is a system by which Exchanges guarantee the
faithful compliance of all trade commitments undertaken on the trading floor or
electronically over the electronic trading systems.
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.
It guarantees the performance of the parties to each transaction. Typically it is
responsible for the following:
1. Effecting timely settlement.
2. Trade registration and follow up.
3. Control of the open interest.
4. Financial clearing of the payment flow.
5. Physical settlement (by delivery) or financial settlement (by price difference) of
contracts.
6. Administration of financial guarantees demanded by the participants.
The clearing house has a number of members, who are responsible for the clearing
and settlement of commodities traded on the Exchange. The margin accounts for the
clearing house members are adjusted for gains and losses at the end of each day (in
the same way as the individual traders keep margin accounts with the broker).
Everyday the account balance for each contract must be maintained at an amount
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equal to the original margin times the number of contracts outstanding. Thus
depending on a day's transactions and price movement, the members either need to
add funds or can withdraw funds from their margin accounts at the end of the day.
The brokers who are not the clearing members need to maintain a margin account
with the clearing house member through whom they trade.
8.1.1 Clearing mechanism
Only clearing members including professional clearing members (PCMs) are
entitled to clear and settle contracts through the clearing house. The clearing
mechanism essentially involves working out open positions and obligations of
clearing members. This position is considered for exposure and daily margin
purposes. The open positions of PCMs are arrived at by aggregating the open
positions of all the Trading Members clearing through him, in contracts in which
they have traded.
A Trading-cum-Clearing Member's (TCM) open position is arrived at by the
summation of his clients' open positions, 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-offs between clients. Proprietary
positions are netted at member level without any set-offs between client and
proprietary positions.
At NCDEX, after the trading hours on the expiry date, based on the available
information, the matching for deliveries takes place firstly, on the basis of locations
and then randomly, keeping in view the factors such as available capacity of the
vault/ warehouse, commodities already deposited and dematerialized and offered for
delivery etc. Matching done by this process is binding on the clearing members.
After completion of the matching process, clearing members are informed of the
deliverable/ receivable positions and the unmatched positions. Unmatched positions
have to be settled in cash. The cash settlement is only for the incremental gain/ loss
as determined on the basis of final settlement price.
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8.1.2 Clearing Banks
NCDEX has designated clearing banks through whom funds to be paid and/ or to be
received must be settled. Every clearing member is required to maintain and operate
a clearing account with any one of the designated clearing bank branches. The
clearing account is to be used exclusively for clearing operations i.e., for settling
funds and other obligations to NCDEX including payments of margins and penal
charges. A clearing member having funds obligation to pay is required to have clear
balance in his clearing account on or before the stipulated pay-in day and the
stipulated time. Clearing members must authorize their clearing bank to access their
clearing account for debiting and crediting their accounts as per the instructions of
NCDEX, reporting of balances and other operations as may be required by NCDEX
from time to time. The clearing bank will debit/ credit the clearing account of
clearing members as per instructions received from NCDEX.
• Bank of India
• Canara Bank
• HDFC Bank Ltd
• ICICI Bank Ltd
• Punjab National Bank
• Axis Bank Ltd
• IndusInd Bank Ltd
• Kotak Mahindra Bank Ltd
• Tamilnad Mercantile Bank Ltd
• Union Bank of India
• YES Bank Ltd
• Standard Chartered Bank Ltd
• State Bank of India
8.1.3 Depository participants
Every clearing member is required to maintain and operate two CM pool account
each at NSDL and CDSL through any one of the empanelled depository participants.
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The CM pool account is to be used exclusively for clearing operations i.e., for
effecting and receiving deliveries from NCDEX.
8.2 SETTLEMENT
Futures contracts have two types of settlements, the Mark-to-Market (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 contract. On the
NCDEX, daily MTM settlement and final MTM settlement in respect of admitted
deals in futures contracts are cash settled by debiting/ crediting the clearing accounts
of CMs with the respective clearing bank. All positions of a CM, either brought
forward, created during the day or closed out during the day, are marked to market
at the daily settlement price or the final settlement price at the close of trading hours
on a day.
• Daily settlement price: Daily settlement price is the consensus closing price as
arrived after closing session of the relevant futures contract for the trading day.
However, in the absence of trading for a contract during closing session, daily
settlement price is computed as per the methods prescribed by the Exchange from
time to time.
• Final settlement price: Final settlement price is the polled spot price of the
underlying commodity in the spot market on the last trading day of the futures
contract. All open positions in a futures contract cease to exist after its expiration
day. Settlement involves payments (Pay-Ins) and receipts (Pay-Outs) for all the
transactions done by the members. Trades are settled through the Exchange's
settlement system.
8.2.1 Settlement Mechanism
Settlement of commodity futures contracts is a little different from settlement of
financial futures which are mostly cash settled. The possibility of physical
settlement makes the process a little more complicated.
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Daily mark to market settlement
Daily mark to market settlement is done till the date of the contract expiry. This is
done to take care of daily price fluctuations for all trades. All the open positions of
the members are marked to market at the end of the day and the profit/ loss is
determined as below:
• On the day of entering into the contract, it is the difference between the entry value
and daily settlement price for that day.
• On any intervening days, when the member holds an open position, it is the
difference between the daily settlement price for that day and the previous day's
settlement price.
• On the expiry date if the member has an open position, it is the difference between
the final settlement price and the previous day's settlement price.
Table 8.1 Explains the MTM for a member who buys one unit of December
expiration Chilli contract at Rs.6435 per quintal on December 15. The unit of
trading is 5 MT and each contract is for delivery of 5 MT. The member closes the
position on December 19. The MTM profit/ loss per unit of trading show that he
makes a total loss of Rs.120 per quintal of trading. So upon closing his position, he
makes a total loss of Rs.6000, i.e (5 x 120 x 10) on the long position taken by him.
The MTM profit and loss is settled through pay in/ pays out on T+1 basis, T being
the trade day.
Table 8.1: MTM on a long position in Chilli Futures
Date Settlement Price MTM
December 15 6320 -115
December 16 6250 -70
December 17 6312 +62
December 18 6310 -2
December 19 6315 +5
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Table 8.2 explains the MTM for a member who sells December expiration Chilli
futures contract at Rs.6435 per quintal on December 15. The unit of trading is 5 MT
and each contract is for delivery of 5 MT. The member closes the position on
December 19. The MTM profit/ loss show that he makes a total profit of Rs.120 per
quintal. So upon closing his position, he makes a total profit of Rs.6000 on the short
position taken by him.
Table 8.2: MTM on a short position in Chilli Futures
Date Settlement Price MTM
December 15 6320 +115
December 16 6250 +70
December 17 6312 -62
December 18 6310 +2
December 19 6315 -5
Final settlement On the date of expiry, the final settlement price is the closing price
of the underlying commodity in the spot market on the date of expiry (last trading
day) of the futures contract. The spot prices are collected from polling participants
from base centre as well as other locations. The poll prices are bootstrapped and the
mid-point of the two boot strapped prices is the final settlement price. The
responsibility of settlement is on a trading cum clearing member for all trades done
on his own account and his client's trades.
A professional clearing member is responsible for settling all the participants' trades
which he has confirmed to the Exchange. Members are required to submit delivery
information through delivery request window on the trader workstations provided by
NCDEX for all open positions for a commodity for all constituents individually.
This information can be provided within the time notified by Exchange separately
for each contracts. NCDEX on receipt of such information matches the information
and arrives at a delivery position for a member for a commodity. A detailed report
containing all matched and unmatched requests is provided to members through the
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extranet. Pursuant to regulations relating to submission of delivery information,
failure to submit delivery information for open positions attracts penal charges as
stipulated by NCDEX from time to time.
NCDEX also adds all such open positions for a member, for which no delivery
information is submitted with final settlement obligations of the member concerned
and settled in cash as the case may be. Non-fulfillment of either the whole or part of
the settlement obligations is treated as a violation of the rules, bye-laws and
regulations of NCDEX and attracts penal charges as stipulated by NCDEX from
time to time. In addition, NCDEX can withdraw any or all of the membership rights
of clearing member including the withdrawal of trading facilities of all trading
members clearing through such clearing members, without any notice.
Further, the outstanding positions of such clearing member and/ or trading members
and/ or constituents, clearing and settling through such clearing member, may be
closed out forthwith or any time thereafter by the Exchange to the extent possible,
by placing at the Exchange, counter orders in respect of the outstanding position of
clearing member without any notice to the clearing member and/ or trading member
and/ or constituent. NCDEX can also initiate such other risk containment measures
as it deems appropriate with respect to the open positions of the clearing members. It
can also take additional measures like, imposing penalties, collecting appropriate
deposits, invoking bank guarantees or fixed deposit receipts, realizing money by
disposing off the securities and exercising such other risk containment measures as it
deems fit or take further disciplinary action.
8.2.2 Settlement Methods
Settlement of futures contracts on the NCDEX can be done in two ways - by
physical delivery of the underlying asset and by closing out open positions. We shall
look at each of these in some detail. All contracts materializing into deliveries are
settled in a period as notified by the Exchange separately for each contract. The
exact settlement day for each commodity is specified by the Exchange through
circulars known as 'Settlement Calendar'.
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a) Physical delivery of the underlying asset
If the buyer/seller is interested in physical delivery of the underlying asset, he must
complete the delivery marking for all the contracts within the time notified by the
Exchange. The following types of contracts are presently available for trading on the
NCDEX Platform.
1. Compulsory Delivery
• Staggered Delivery
• Early Delivery
2. Seller's Right
3. Intention Matching
1. Compulsory Delivery Contract
On expiry of a compulsory delivery contract, all the sellers with open position shall
give physical delivery of the commodity. That is, the sellers need to deliver the
commodity and buyers need to accept the delivery. To allocate deliveries in the
optimum location for clients, the members need to give delivery information for
preferred location. The information for delivery can be submitted during the trading
hours 3 trading days in advance of the expiry date and up to 6 p.m. on the last day of
marking delivery intention.
For example, for contracts expiring on the 20th of the month, delivery intentions
window will be open from the 18th and will close on the 20th.Clients can submit
delivery intentions up to the maximum of their open positions.
In case the delivery intention is not marked the seller would tender delivery from
the base location. Members will be allowed to submit one-time warehouse
preference (default location). They can give even multiple warehouse preferences.
The same will be sent by the members to the Exchange. This preference will be
applicable for all outstanding long and short client positions in that commodity. If
the member does not mark any specific location, the default preference will be
applied for all open positions. Members can change the default location preference
on any day except the last 5 days before the expiry of the contract. For those
members, who have not submitted the preference of the default location, delivery
will be marked on the base location specified for the commodity. After the trading
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hours on the expiry date, based on the available information, the delivery matching
is done. All corresponding buyers with open position as matched by the process put
in place by the Exchange shall be bound to settle his obligation by taking physical
delivery. The deliveries are matched on the basis of open positions and delivery
information received by the Exchange.
In the event of default by the seller, penalty as may be prescribed by the Exchange
from time to time would be levied. Penal Provisions for a compulsory delivery
contract.
Total amount of penalty imposed on a seller in case of a delivery default would be
• 3.0 % of the final settlement price
• The difference between the Final Settlement Price (FSP) and the average of three
highest of the last spot prices of 5 (five) succeeding days after the expiry of contract
(E+ 1 to E +5 days) If the average spot price so determined is higher than FSP then
this component will be zero
Bifurcation of penalty for a compulsory delivery contract
• 1.75 % shall be deposited in the Investor Protection Fund of the Exchange.
• 1 % shall be passed on to the corresponding buyer who was entitled to receive
delivery; and
• The rest 0.25 % shall be retained by the Exchange towards administrative
expenses.
The difference between the Final Settlement Price (FSP) and the average of three
highest of the last spot prices of 5 (five) succeeding days after the expiry of contract
(E+ 1 to E +5 days) would also be passed on to the corresponding buyers. It should
be noted that Buyers defaults are not permitted. The amount due from the buyers
shall be recovered from the buyer as Pay in shortage together with prescribed
charges. Exchange shall have right to sell the goods on account of such Buyer to
recover the dues and if the sale proceeds are insufficient, the Buyer would be liable
to pay the balance. The Sub Types of the compulsory delivery contracts are:
h) Staggered Delivery
In the case of certain commodities like gold and silver, delivery is staggered over
last 5 days of the contract. In such contracts, the marking of intention to deliver the
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commodity starts from 5 days prior to the expiry of the near month contract and the
physical settlement of the commodity will be the day after the intention is marked.
The process of staggered delivery at NCDEX is as follows:
• Tender period consists of trading hours during 5 trading days prior to and
including the expiry date of the contract
• If a seller marks a delivery intention during the tender period, the corresponding
buyer, who has open positions that are matched as per process defined by the
Exchange, is bound to settle by taking the delivery on T + 1 day (T is the date of
tender) from the delivery centre where the seller has delivered the same
• The contract will be settled in a staggered system of 5 Pay-ins and Pay-outs
starting from T +1. The 5th Pay-in and Pay-out will be the Final Settlement.
ii) Early Delivery System
In case of certain commodities such as Pepper, Mentha Oil, Rubber, Guar Seed, and
Soybean, the Exchange introduced early delivery system in 2009. The salient
features of this system for commodity futures contracts traded at NCDEX are listed
below:
a. An early delivery period is available during E-14 to E-1 days of the contract.
During the period from E-14 to E-8, normal client level position limits continue to
be in force. Hedgers, allowed higher limits by the Exchange, continue to avail of
such limits. If the intentions of the buyers/sellers match, then the respective
positions would be closed out by physical deliveries.
b. The near month limits is in force during the period from E-7 till expiry of the
contract. During this period also, if the intentions of the buyers / sellers match, then
the respective positions would be closed out by physical deliveries.
c. If there is no intention matching for delivery between sellers and buyers, then
such delivery intention will get automatically extinguished at the close of E-1 day.
The intentions can be withdrawn during the course of E-14 to E-1 day if they
remained unmatched. In case intention of delivery gets matched, then the process of
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pay-in and pay-out will be completed on T + 2 basis, where 'T' stands for the day on
which matching has been done.
d. In respect of delivery defaults after the matching of delivery intentions, penalty
provisions as applicable in the case of delivery defaults in compulsory delivery
contracts will be applied.
e. On the expiry of the contract, all outstanding positions would be settled by
physical delivery the penalty provisions for delivery default in case of Staggered
Delivery and Early delivery contracts shall be same as it is applicable in the
compulsory delivery contracts.
5. Sellers Right Contract
In Seller's Right contracts, delivery obligation is created for all valid sell requests
received by the Exchange. Simultaneously, the deliveries are allocated to the buyers
with open positions on a random basis, irrespective of whether a buy request has
been submitted or not. While allocating the deliveries, preference is given to those
buyers who have submitted buy requests. The information for delivery can be
submitted during the trading hours 3 trading days prior to 5 working days of expiry
of contracts. For example, for contracts expiring on the 20th of the month, delivery
intentions window will be open from the 13th and will close on the 15th.
Clients can submit delivery intentions up to the maximum of their open positions.
All open positions of those sellers who fail to provide delivery intention information
for physical delivery shall be settled in cash. In case of failure to give any delivery
intention the seller shall be charged @ of 0.5 % of the FSP as an Open interest
penalty. Ninety percent (90%) shall be paid to the corresponding buyers and ten
percent (10%) of the penalty amount shall be retained by the Exchange towards
administrative charges.
In settling contracts that are physically deliverable, the clearing house:
• Assigns longs to shorts (no relationship to original counterparties)
• Provides a delivery venue
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Successful matching of requests with respect to commodity and warehouse location
results in delivery on settlement day. After completion of the matching process,
clearing members are informed of the deliverable/ receivable positions.
6. Intention Matching Contract
The delivery position for intention matching contract would be arrived at by the
Exchange based on the information to give/take delivery furnished by the seller and
buyer as per the process put in place by the Exchange for effecting physical
delivery. If the intentions of the buyers and sellers match, the respective positions
would be settled by physical deliveries. The information for delivery can be
submitted during the trading hours 3 trading days prior to 5 working days of expiry
of contracts. For example, for contracts expiring on the 20th of the month, delivery
intentions window will be open from the 13th and will close on the 15th. Clients can
submit delivery intentions up to the maximum of their open positions. On the expiry
of the contract, all outstanding positions not resulting in physical delivery shall be
closed out at the Final Settlement Price as announced by the Exchange. Penal
Provisions for Intention matching and Seller's Right contract.
Total amount of penalty imposed on a seller in case of a delivery default would be
2.5 % of the final settlement price
• The difference between the Final Settlement Price (FSP) and the spot price on the
settlement day, if the said spot price is higher than FSP; else this component will be
zero.
Bifurcation of penalty for a Intention matching and Seller's right contract
• 2% shall be deposited in the Investor Protection Fund of the Exchange.
• 0.5% % shall be passed on to the corresponding buyer who was entitled to receive
delivery; and
• The difference between the Final Settlement Price (FSP) and the spot price on the
settlement day would also be passed on to the corresponding buyer, if the said spot
price is higher than FSP; else this component will be zero. Members giving delivery
requests for the Seller's right and Intention matching contract are not permitted to
square off their open positions. A penalty of 5% of final settlement price on the
position squared off will be levied on the Members violating the same. Buyer's
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defaults are not permitted in any of the above said contracts. The amount due from
the buyers shall be recovered from the buyer as Pay in shortage along with the
prescribed charges. Exchange shall have right to sell the goods on account of such
Buyer to recover the dues and if the sale proceeds are insufficient, the Buyer would
be liable to pay the balance. In case of international reference able commodity such
as Aluminum, Nickel, Zinc etc, the information for delivery can be submitted during
the trading hours 3 trading days prior to 3 working days of expiry of contracts. For
example, for contracts expiring on the 30th of the month, delivery intentions
window will be open from the 25th and will close on the 27th.Clients can submit
delivery intentions up to the maximum of their open positions. Any buyer intending
to take physicals has to put a request to his depository participant. The DP uploads
such requests to the specified depository who in turn forwards the same to the
registrar and transfer agent (R&T agent) concerned. After due verification of the
authenticity, the R&T agent forwards delivery details to the warehouse which in turn
arranges to release the commodities after due verification of the identity of recipient.
On a specified day, the buyer would go to the warehouse and pick up the physicals.
The seller intending to make delivery has to take the commodities to the designated
warehouse. These commodities have to be assayed by the Exchange specified
assayer. The commodities have to meet the contract specifications with allowed
variances. If the commodities meet the specifications, the warehouse accepts them.
Warehouses then ensure that the receipts get updated in the depository system giving
a credit in the depositor's electronic account. The seller then gives the invoice to his
clearing member, who would courier the same to the buyer's clearing member.
NCDEX contracts provide a standardized description for each commodity. The
description is provided in terms of quality parameters specific to the commodities.
At the same time, it is realized that with commodities, there could be some amount
of variances in quality/ weight etc., due to natural causes, which are beyond the
control of any person. Hence, NCDEX contracts also provide tolerance limits for
variances. A delivery is treated as good delivery and accepted if the delivery lies
within the tolerance limits. However, to allow for the difference, the concept of
premium and discount has been introduced. Goods that come to the authorized
warehouse for delivery are tested and graded as per the prescribed parameters. The
premium and discount rates apply depending on the level of variation. The price
payable by the party taking delivery is then adjusted as per the premium/ discount
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rates fixed by the Exchange. This ensures that some amount of leeway is provided
for delivery, but at the same time, the buyer taking delivery does not face windfall
loss/ gain due to the quantity/ quality variation at the time of taking delivery. This,
to some extent, mitigates the difficulty in delivering and receiving exact quality/
quantity of commodity.
c) Closing out by offsetting positions
Most of the contracts are settled by closing out open positions. In closing out, the
opposite transaction is effected to close out the original futures position. A buy
contract is closed out by a sale and a sale contract is closed out by a buy. For
example, an investor who took a long position in two gold futures contracts on the
January 30 at Rs.16090 per 10 grams can close his position by selling two gold
futures contracts on February 13, at Rs.15928. In this case, over the period of
holding the position, he has suffered a loss of Rs.162 per 10 grams. This loss would
have been debited from his account over the holding period by way of MTM at the
end of each day, and finally at the price that he closes his position, that is Rs.15928,
in this case.
d) Cash settlement
In the case of intention matching contracts, if the trader does not want to take/ give
physical delivery, all open positions held till the last day of trading are settled in
cash at the final settlement price and with penalty in case of Sellers Right contract.
Similarly any unmatched, rejected or excess intention is also settled in cash. When a
contract is settled in cash, it is marked to the market at the end of the last trading day
and all positions are declared closed. For example, Paul took a short position in five
Silver 5kg futures contracts of July expiry on June 15 at Rs.21500 per kg. At the end
of 20th July, the last trading day of the contract, he continued to hold the open
position, without announcing delivery intention. The closing spot price of silver on
that day was Rs.20500 per kg. This was the settlement price for his contract.
Though Paul was holding a short position on silver, he did not have to actually
deliver the underlying silver. The transaction was settled in cash and he earned profit
of Rs. 5000 per trading lot of silver. As mentioned earlier, unmatched positions of
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contracts, for which the intentions for delivery were submitted, are also settled in
cash. In case of NCDEX, all contracts being settled in cash are settled on the day
after the contract expiry date. If the cash settlement day happens to be a Saturday, a
Sunday or a holiday at the exchange, clearing banks or any of the service providers,
Pay-in and Pay-out would be effected on the next working day.
8.2.3 Entities involved in Physical Settlement
Physical settlement of commodities involves the following three entities - an
accredited warehouse, registrar & transfer agent and an assayer. We will briefly look
at the functions of each.
Accredited warehouse
NCDEX specifies accredited warehouses through which delivery of a specific
commodity can be affected and which will facilitate for storage of commodities. For
the services provided by them, warehouses charge a fee that constitutes storage and
other charges such as insurance, assaying and handling charges or any other
incidental charges. Following are the functions of an accredited warehouse:
3. Earmark separate storage area as specified by the Exchange for the
purpose of storing commodities to be delivered against deals made on
the Exchange. The warehouses are required to meet the specifications
prescribed by the Exchange for storage of commodities.
4. Ensure and co-ordinate the grading of the commodities received at
the warehouse before they are stored.
5. Store commodities in line with their grade specifications and validity
period and facilitate maintenance of identity. On expiry of such
validity period of the grade for such commodities, the warehouse has
to segregate such commodities and store them in a separate area so
that the same are not mixed with commodities which are within the
validity period as per the grade certificate issued by the approved
assayers.
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Approved Registrar and Transfer agents (R&T agents)
The Exchange specifies approved R&T agents through whom commodities can be
dematerialized and who facilitate for dematerialization/re-materialization of
commodities in the manner prescribed by the Exchange from time to time. The R&T
agent performs the following functions:
1. Establishes connectivity with approved warehouses and supports them with
physical infrastructure.
2. Verifies the information regarding the commodities accepted by the
accredited warehouse and assigns the identification number (ISIN) allotted
by the depository in line with the grade, validity period, warehouse location
and expiry.
3. Further processes the information, and ensures the credit of commodity
holding to the demat account of the constituent.
4. Ensures that the credit of commodities goes only to the demat account of the
constituents held with the Exchange empanelled DPs.
5. On receiving a request for re-materialization (physical delivery) through the
depository, arranges for issuance of authorization to the relevant warehouse
for the delivery of commodities. R&T agents also maintain proper records of
beneficiary position of constituents holding dematerialized commodities in
warehouses and in the depository for a period and also as on a particular
date. They are required to furnish the same to the Exchange as and when
demanded by the Exchange. R&T agents also do the job of co-ordinating
with DPs and warehouses for billing of charges for services rendered on
periodic intervals. They also reconcile dematerialized commodities in the
depository and physical commodities at the warehouses on periodic basis and
co-ordinate with all parties concerned for the same.
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Approved assayer
The Exchange specifies approved assayers through whom grading of commodities
(received at approved warehouses for delivery against deals made on the Exchange)
can be availed by the constituents of clearing members. Assayers perform the
following functions:
1. Make available grading facilities to the constituents in respect of the specific
commodities traded on the Exchange at specified warehouse. The assayer
ensures that the grading to be done (in a certificate format prescribed by the
Exchange) in respect of specific commodity is as per the norms specified by
the Exchange in the respective contract specifications.
2. 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 the time up to which the commodities are fit for trading subject to
environment changes at the warehouses.
8.3 Risk Management
NCDEX has developed a comprehensive risk containment mechanism for its
commodity futures market. The salient features of risk containment mechanism are:
1. The financial soundness of the members is the key to risk management.
Therefore, the requirements for membership in terms of capital adequacy (net worth,
security deposits) are quite stringent.
2. NCDEX charges an upfront initial margin for all the open positions of a member.
It specifies the initial margin requirements for each futures contract on a daily basis.
It also follows value-at-risk (VaR) based margining through SPAN. The PCMs and
TCMs in turn collect the initial margin from the TCMs and their clients respectively.
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3. The open positions of the members are marked to market based on contract
settlement price for each contract. The difference is settled in cash on a T+1 basis.
4. A member is alerted of his position to enable him to adjust his exposure or bring
in additional capital. Position violations result in withdrawal of trading facility and
reinstated only after violation(s) rectified.
5. To safeguard the interest of those trading on the Exchange platform, an Investor
Protection Fund is also maintained.
The most critical component of risk containment mechanism for futures market on
the NCDEX is the margining system and on-line position monitoring. The actual
position monitoring and margining is carried out on-line through the SPAN
(Standard Portfolio Analysis of Risk) system.
8.4 MARGINING AT NCDEX
In pursuance of the bye-laws, rules and regulations, the Exchange has defined norms
and procedures for margins and limits applicable to members and their clients. The
margining system for the commodity futures trading on the NCDEX is explained
below.
1. SPAN
SPAN (Standard Portfolio Analysis of Risk) is a registered trademark of the Chicago
Mercantile Exchange, used by NCDEX under license obtained from CME. The
objective of SPAN is to identify overall risk in a portfolio of all futures contracts for
each member. Its over-riding objective is to determine the largest loss that a
portfolio might reasonably be expected to suffer from one day to the next day based
on 99.95% confidence interval VaR methodology.
2. Initial Margins
This is the amount of money deposited by both buyers and sellers of futures
contracts to ensure performance of trades executed. Initial margin is payable on all
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open positions of trading cum clearing members, up to client level, at any point of
time, and is payable upfront by the members in accordance with the margin
computation mechanism and/ or system as may be adopted by the Exchange from
time to time. Initial margin includes SPAN margins and such other additional
margins that may be specified by the Exchange from time to time.
3. COMPUTATION OF INITIAL MARGIN
The Exchange has adopted SPAN (Standard Portfolio Analysis of Risk) system for
the purpose of real-time initial margin computation. Initial margin requirements are
based on 99.95% VaR (Value at Risk) over a one-day time horizon. Initial margin
requirements for a member for each contract are as under:
1. For client positions: These are netted at the level of individual client and
grossed across all clients, at the member level without any set-offs between
clients.
2. For proprietary positions: These are netted at member level without any set-
offs between client and proprietary positions. Consider the case of a trading
member who has proprietary and client-level positions in an April 2010 gold
futures contract. On his proprietary account, he bought 3000 trading units
and sold 1000 trading units within the day. On account of client A, he
bought 2000 trading units at the beginning of the day and sold 1500 units an
hour later. And on account of client B, he sold 1000 trading units. Table 9.3
gives the total outstanding position for which the TCM would be margined.
Table 8.3 Calculating outstanding position at TCM level
Account Number of units
bought
Number of units
sold
Outstanding
position
Proprietary 3000 1000 Long 2000
Client A 2000 1500 Long 500
Client B 1000 Short 1000
Net outstanding
Position
3500
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8.4.4 Implementation Aspects of Margining and Risk Management
We look here at some implementation aspects of the margining and risk
management system for trading on NCDEX.
1. Mode of payment of initial margin:
Margins can be paid by the members in cash, or in collateral security deposits in
the form of bank guarantees, fixed deposits receipts and approved Government
of India securities.
2. Payment of initial margin:
The initial margin is payable upfront by members.
3. Effect of failure to pay initial margins:
Non-fulfillment of either the whole or part of the initial margin obligations is
treated as a violation of the rules, bye-laws and regulations of the Exchange and
attracts penal charges as stipulated by NCDEX from time to time.
4. Exposure limits:
This is defined as the maximum open position that a member can take across all
contracts and is linked to the effective deposits of the member available with the
Exchange. The member is not allowed to trade once the exposure limits have
been exceeded on the Exchange. The trader workstation of the member is
disabled and trading permitted only on enhancement of exposure limits by
deposit of additional capital or reduction of existing positions.
a. Liquid net worth:
Typically Liquid net worth is defined as effective deposits less initial margin
payable at any point in time. The minimum cash maintained by the members at any
point in time as part of the base capital requirements cannot be less than Rs. 15 lakh
or such other amount, as may be specified by the Exchange from time to time.
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b. Effective deposits:
This includes all deposits made by the members in the form of cash, cash
equivalents and collaterals form the effective deposits. For the purpose of
computing effective deposits, cash equivalents mean bank guarantees, fixed
deposit receipts and Government of Indian securities.
c. Position limits:
Position limit is specified at a member and client level for a commodity and for
near month contracts. Typically member level limits are 3-5 times of the client
level limits or 15% of the market open interest, whichever is higher. The
position limits are prescribed by the FMC from time to time.
d. Calendar spread positions:
In case of calendar spread positions in futures contracts are treated as open
position of one third of the value of the far month futures contract. However the
spread positions is treated as a naked position in far month contract three trading
days prior to expiry of the near month contract.
5. Imposition of additional margins and close out of open positions:
As a risk containment measure, the Exchange may require the members to make
payment of additional margins as may be decided from time to time. This is in
addition to the initial margin, which is or may have been imposed. The
Exchange may also require the members to reduce/ close out open positions to
such levels and for such contracts as may be decided by it from time to time.
6. Failure to pay additional margins:
Non-fulfillment of either the whole or part of the additional margin obligations is
treated as a violation of the rules, bye-Laws and regulations of the Exchange and
attracts penal charges as stipulated by NCDEX.
7. Return of excess deposit:
Members can request the Exchange to release excess deposits held by it or by a
specified agent on behalf of the Exchange. Such requests may be considered by
the Exchange subject to the bye-laws, rules and regulations.
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8. Initial margin deposit or additional deposit or additional base capital:
Members who wish to make a margin deposit (additional base capital) with the
Exchange and/ or wish to retain deposits and/ or such amounts which are
receivable by them from the Exchange, at any point of time, over and above their
deposit requirement towards initial margin and/ or other obligations, must
inform the Exchange as per the procedure.
9. Position limits:
Position wise limits are the maximum open positions that a member or his
constituents can have in any commodity at any point of time. This is calculated
as the higher of a specified percentage of the total open interest in the
commodity or a specified value.
10. Intra-day price limit:
The maximum price movement allowed during a day is +/- x% of the previous
day's settlement price prescribed for each commodity.
(a) Daily settlement price:
The daily profit/losses of the members are settled using the daily
settlement price. The daily settlement price notified by the
Exchange is binding on all members and their constituents.
(b) Mark-to-market settlement:
All the open positions of the members are marked to market at the
end of the day and the profit/loss determined as below: (a) On the
day of entering into the contract, it is the difference between the
entry value and daily settlement price for that day. (b) On any
intervening days, when the member holds an open position, it is
the difference between the daily settlement value for that day and
the previous day's settlement price. (c) On the expiry date if the
member has an open position, it is the difference between the
final settlement price and the previous day's settlement price.
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11. Intra-day margin call:
The Exchange at its discretion can make intra day margin calls as risk
containment measure if, in its opinion, the market price changes sufficiently. For
example, it can make an intra-day margin call if the intra day price limit has
been reached, or any other situation has arisen, which in the opinion of the
Exchange could result in an enhanced risk. The Exchange at its discretion may
make selective margin calls, for example, only for those members whose
variation losses or initial margin deficits exceed a threshold value prescribed by
the Exchange.
12. Delivery margin:
In case of positions materialising into physical delivery, delivery margins are
calculated as N days VaR margins plus additional margins. N days refer to the
number of days for completing the physical delivery settlement. The number of
days are commodity specific, as described or as may be prescribed by the
Exchange from time to time. There is a mark up on the VaR based delivery
margin to cover for default.
8.4.5 Effect of violation
Whenever any of the margin or position limits are violated by members, the
Exchange can withdraw any or all of the membership rights of members including
the withdrawal of trading facilities of all members and/ or clearing facility of
custodial participants clearing through such trading cum members, without any
notice. In addition, the outstanding positions of such member and/ or constituents
clearing and settling through such member can be closed out at any time at the
discretion of the Exchange. This can be done without any notice to the member and/
or constituent. The Exchange can initiate further risk containment measures with
respect to the open positions of the member and/ or constituent. These could include
imposing penalties, collecting appropriate deposits, invoking bank guarantees/ fixed
deposit receipts, realizing money by disposing off the securities, and exercising such
other risk containment measures it considers necessary.
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CHAPTER 9 REGULATORY FRAMEWORK
The trading of derivatives is governed by the provisions contained in the SC(R)A,
the SEBI Act, the rules and regulations framed thereunder and the rules and bye–
laws of stock exchanges.
9.1 SECURITIES CONTRACTS (REGULATION) ACT, 1956
SC(R)A aims at preventing undesirable transactions in securities by regulating the
business of dealing therein and by providing for certain other matters connected
therewith. This is the principal Act, which governs the trading of securities in India.
The term “securities” has been defined in the SC(R)A. As per Section 2(h), the
‘Securities’ include:
1. Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable
securities of a like nature in or of any incorporated company or other body
corporate.
2. Derivative
3. Units or any other instrument issued by any collective investment scheme to the
investors in such schemes.
4. Government securities
5. Such other instruments as may be declared by the Central Government to be
securities.
6. Rights or interests in securities.
“Derivative” is defined to include:
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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Section 18A provides that notwithstanding anything contained in any other law for
the time being in force, contracts in derivative shall be legal and valid if such
contracts are:
Traded on a recognized stock exchange
Settled on the clearing house of the recognized stock exchange, in
accordance with the rules and bye–laws of such stock exchanges.
9.2 SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992
SEBI Act, 1992 provides for establishment of Securities and Exchange Board of
India(SEBI) with statutory powers for (a) protecting the interests of investors in
securities (b) promoting the development of the securities market and (c) regulating
the securities market. Its regulatory jurisdiction extends over corporate in the
issuance of capital and transfer of securities, in addition to all intermediaries and
persons associated with securities market. SEBI has been obligated to perform the
aforesaid functions by such measures as it thinks fit. In particular, it has powers for:
Regulating the business in stock exchanges and any other securities markets.
Registering and regulating the working of stock brokers, sub–brokers etc.
Promoting and regulating self-regulatory organizations.
Prohibiting fraudulent and unfair trade practices.
Calling for information from, undertaking inspection, conducting inquiries
and audits of the stock exchanges, mutual funds and other persons associated
with the securities market and intermediaries and self–regulatory
organizations in the securities market.
Performing such functions and exercising according to Securities Contracts
(Regulation) Act, 1956, as may be delegated to it by the Central
Government.
9.3 REGULATION FOR DERIVATIVES TRADING
SEBI set up a 24- member committee under the Chairmanship of Dr. L. C. Gupta to
develop the appropriate regulatory framework for derivatives trading in India. On
May 11, 1998 SEBI accepted the recommendations of the committee and approved
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the phased introduction of derivatives trading in India beginning with stock index
futures.
The provisions in the SC(R)A and the regulatory framework developed there under
govern trading in securities. The amendment of the SC(R)A to include derivatives
within the ambit of ‘securities’ in the SC(R)A made trading in derivatives possible
within the framework of that Act.
1. Any Exchange fulfilling the eligibility criteria as prescribed in the L. C. Gupta
committee report can apply to SEBI for grant of recognition under Section 4 of the
SC(R)A, 1956 to start trading derivatives. The derivatives exchange/segment should
have a separate governing council and representation of trading/clearing members
shall be limited to maximum of 40% of the total members of the governing council.
The exchange would have to regulate the sales practices of its members and would
have to obtain prior approval of SEBI before start of trading in any derivative
contract.
2. The Exchange should have minimum 50 members.
3. The members of an existing segment of the exchange would not automatically
become the members of derivative segment. The members of the derivative segment
would need to fulfill the eligibility conditions as laid down by the L. C. Gupta
committee.
4. The clearing and settlement of derivatives trades would be through a SEBI
approved clearing corporation/house. Clearing corporations/houses complying with
the eligibility conditions as laid down by the committee have to apply to SEBI for
grant of approval.
5. Derivative brokers/dealers and clearing members are required to seek registration
from SEBI. This is in addition to their registration as brokers of existing stock
exchanges. The minimum net worth for clearing members of the derivatives clearing
corporation/house shall be Rs.300 Lakh. The net worth of the member shall be
computed as follows:
Capital + Free reserves
Less non-allowable assets viz.,
(a) Fixed assets
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(b) Pledged securities
(c) Member’s card
(d) Non-allowable securities (unlisted securities)
(e) Bad deliveries
(f) Doubtful debts and advances
(g) Prepaid expenses
(h) Intangible assets
(i) 30% marketable securities
6. The minimum contract value shall not be less than Rs.2 Lakh. Exchanges have to
submit details of the futures contract they propose to introduce.
7. The initial margin requirement, exposure limits linked to capital adequacy and
margin demands related to the risk of loss on the position will be prescribed by
SEBI/Exchange from time to time.
8. The L. C. Gupta committee report requires strict enforcement of “Know your
customer” rule and requires that every client shall be registered with the derivatives
broker. The members of the derivatives segment are also required to make their
clients aware of the risks involved in derivatives trading by issuing to the client the
Risk Disclosure Document and obtain a copy of the same duly signed by the client.
9. The trading members are required to have qualified approved user and sales
person who have passed a certification programme approved by SEBI.
Forms of collateral’s acceptable at NSCCL
Members and dealer authorized dealer have to fulfill certain requirements and
provide collateral deposits to become members of the F&O segment. All collateral
deposits are segregated into cash component and non-cash component. Cash
component means cash, bank guarantee, fixed deposit receipts, T-bills and dated
government securities. Non-cash component mean all other forms of collateral
deposits like deposit of approved demat securities.
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Requirements to become F&O segment member
The eligibility criteria for membership on the F&O segment is as given in Table
7.1. Table 7.2 gives the requirements for professional clearing membership.
Anybody interested in taking membership of F&O segment is required to take
membership of “CM and F&O segment” or “CM, WDM and F&O segment”. An
existing member of CM segment can also take membership of F&O segment. A
trading member can also be a clearing member by meeting additional requirements.
There can also be only clearing members.
7.3.3 Requirements to become authorized / approved user
Trading members and participants are entitled to appoint, with the approval of the
F&O segment of the exchange authorized persons and approved users to operate the
trading workstation(s). These authorized users can be individuals, registered
partnership firms or corporate bodies. Authorized persons cannot collect any
commission or any amount directly from the clients he introduces to the trading
member who appointed him. However he can receive a commission or any such
amount from the trading member who appointed him as provided under regulation.
Approved users on the F&O segment have to pass a certification program which has
been approved by SEBI. Each approved user is given a unique identification number
through which he will have access to the NEAT system. The approved user can
access the NEAT system through a password and can change such password from
time to time.
Position limits
Position limits have been specified by SEBI at trading member, client, market and
FII levels respectively.
Trading member position limits
Trading member position limits are specified as given below:
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1. Trading member position limits in equity index option contracts: The trading
member position limits in equity index option contracts is higher of Rs.500 crore or
15% of the total open interest in the market in equity index option contracts. This
limit is applicable on open positions in all option contracts on a particular
underlying index.
2. Trading member position limits in equity index futures contracts: The trading
member position limits in equity index futures contracts is higher of Rs.500 crore or
15% of the total open interest in the market in equity index futures contracts. This
limit is applicable on open positions in all futures contracts on a particular
underlying index.
3. Trading member position limits for combined futures and options position:
For stocks having applicable market-wise position limit(MWPL) of Rs.500
crores or more, the combined futures and options position limit is 20% of
applicable MWPL or Rs.300 crores, whichever is lower and within which
stock futures position cannot exceed 10% of applicable MWPL or Rs.150
crores, whichever is lower.
For stocks having applicable market-wise position limit (MWPL) less than
Rs.500 crores, the combined futures and options position limit is 20% of
applicable MWPL and futures position cannot exceed 20% of applicable
MWPL or Rs.50 crore which ever is lower. The Clearing Corporation shall
specify the trading member-wise position limits on the last trading day
month which shall be reckoned for the purpose during the next month.
Client level position limits
The gross open position for each client, across all the derivative contracts on an
underlying, should not exceed 1% of the free float market capitalization (in terms of
number of shares) or 5% of the open interest in all derivative contracts in the same
underlying stock (in terms of number of shares) whichever is higher.
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Market wide position limits
The market wide limit of open position (in terms of the number of underlying stock)
on futures and option contracts on a particular underlying stock is 20% of the
number of shares held by non-promoters in the relevant underlying security i.e. free–
float holding. This limit is applicable on all open positions in all futures and option
contracts on a particular underlying stock. The enforcement of the market wide
limits is done in the following manner:
At end of the day the exchange tests whether the market wide open interest
for any scrip exceeds 95% of the market wide position limit for that scrip. In
case it does so, the exchange takes note of open position of all client/TMs as
at end of that day for that scrip and from next day onwards they can trade
only to decrease their positions through offsetting positions.
At the end of each day during which the ban on fresh positions is in force for
any scrip, the exchange tests whether any member or client has increased his
existing positions or has created a new position in that scrip. If so, that client
is subject to a penalty equal to a specified percentage (or basis points) of the
increase in the position (in terms of notional value). The penalty is recovered
before trading begins next day. The exchange specifies the percentage or
basis points, which is set high enough to deter violations of the ban on
increasing positions.
The normal trading in the scrip is resumed after the open outstanding
position comes down to 80% or below of the market wide position limit.
Further, the exchange also checks on a monthly basis, whether a stock has
remained subject to the ban on new position for a significant part of the
month consistently for three months. If so, then the exchange phases out
derivative contracts on that underlying.
FII and sub–account position limits
FII and sub–account position limits are specified as given below:
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1. The FII position limit in all index options contracts on a particular underlying
index is Rs. 500 crore or 15% of the total open interest of the market in index
options, whichever is higher, per exchange. This limit is applicable on open
positions in all option contracts on a particular underlying index.
2. FII position limit in all index futures contracts on a particular underlying index is
the same as mentioned above for FII position limits in index option contracts. This
limit is applicable on open positions in all futures contracts on a particular
underlying index. In addition to the above, FIIs can take exposure in equity index
derivatives subject to the following limits:
1. Short positions in index derivatives (short futures, short calls and long puts) not
exceeding (in notional value) the FIIs holding of stocks.
2. Long positions in index derivatives (long futures, long calls and short puts) not
exceeding (in notional value) the FIIs holding of cash, government securities, T-bills
and similar instruments.
The FIIs should report to the clearing member (custodian) the extent of the FIIs
holding of stocks, cash, government securities, T-bills and similar instruments
before the end of the day. The clearing member (custodian) in turn should report the
same to the exchange. The exchange monitors the FII position limits. The position
limit for sub-account is same as that of client level position limits.
Position limits for mutual funds
Mutual Funds are allowed to participate in the derivatives market at par with
Foreign Institutional Investors (FII). Accordingly, mutual funds shall be treated at
par with a registered FII in respect of position limits in index futures, index options,
stock options and stock futures contracts. Mutual funds will be considered as trading
members like registered FIIs and the schemes of mutual funds will be treated as
clients like sub-accounts of FIIs. The position limits for Mutual Funds and its
schemes shall be as under:
1. Position limit for mutual funds in index options contracts:
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a) The mutual fund position limit in all index options contracts on a particular
underlying index shall be Rs.500 crore or 15% of the total open interest of the
market in index options, whichever is higher, per stock exchange.
b) This limit would be applicable on open positions in all options contracts on a
particular underlying index.
2. Position limit for mutual funds in index futures contracts:
a) The mutual fund position limit in all index futures contracts on a particular
underlying index shall be Rs.500 crore or 15% of the total open interest of the
market in index futures, whichever is higher, per stock exchange.
b) This limit would be applicable on open positions in all futures contracts on a
particular underlying index.
3. Additional position limit for hedging: In addition to the position limits above,
mutual funds may take exposure in equity index derivatives subject to the following
limits:
a) Short positions in index derivatives (short futures, short calls and long puts) shall
not exceed (in notional value) the mutual Fund’s holding of stocks.
b) Long positions in index derivatives (long futures, long calls and short puts) shall
not exceed (in notional value) the mutual Fund’s holding of cash, government
securities, T–Bills and similar instruments.
4. Foreign Institutional Investors and Mutual Fund Position limits on individual
securities:
a) For stoc ks having applicable market-wide position limit (MWPL) of Rs. 500
crores or more, the combined futures and options position limit shall be 20% of
applicable MWPL or Rs. 300crores, whichever is lower and within which stock
futures position cannot exceed 10% of applicable MWPL or Rs. 150 crores,
whichever is lower.
b) For stocks having applicable market-wide position limit (MWPL) less than Rs.
500 crores, the combined futures and options position limit shall be 20% of
applicable MWPL and stock futures position cannot exceed 20% of applicable
MWPL or Rs. 50 crores, whichever is lower.
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5. Position limit for each scheme of a mutual fund: The position limits for each
scheme of mutual fund and disclosure requirements shall be identical to that
prescribed for a sub–account of a FII. Therefore, the scheme–wise position
limit/disclosure requirements shall be as follows:
a) For stock option and stock futures contracts, the gross open position across all
derivative contracts on a particular underlying stock of a scheme of a mutual fund
shall not exceed the higher of 1% of the free float market capitalisation (number of
shares) or 5% of open interest (number of contracts) in derivative contracts on a
particular underlying stock.
b) This position limits shall be applicable on the combined position in all derivative
contracts on an underlying stock at a stock exchange.
c) For index based contracts, mutual funds shall disclose the total open interest held
by its scheme or all schemes put together in a particular underlying index, if such
open interest equals to or exceeds 15% of the open interest of all derivative contracts
on that underlying index.
Reporting of client margin
Clearing Members (CMs) and Trading Members (TMs) are required to collect
upfront initial margins from all their Trading Members/ Constituents. CMs are
required to compulsorily report, on a daily basis, details in respect of such margin
amount due and collected, from the TMs/ Constituents clearing and settling through
them, with respect to the trades executed/ open positions of the TMs/ Constituents,
which the CMs have paid to NSCCL, for the purpose of meeting margin
requirements. Similarly, TMs are required to report on a daily basis details in respect
of such margin amount due and collected from the constituents clearing and settling
through them, with respect to the trades executed/ open positions of the constituents,
which the trading members have paid to the CMs, and on which the CMs have
allowed initial margin limit to the TMs.
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REGULATORY FRAMEWORK OF COMMODITY FUTURES
At present, there are three tiers of regulations of forward/futures trading system in
India, namely, Government of India, Forward Markets Commission (FMC) and
Commodity Exchanges. The need for regulation arises on account of the fact that the
benefits of futures markets accrue in competitive conditions. Proper regulation is
needed to create competitive conditions. In the absence of regulation, unscrupulous
participants could use these leveraged contracts for manipulating prices. This could
also have undesirable influence on the spot prices, thereby affecting interests of
society at large. Regulation is also needed to ensure that the market has appropriate
risk management system. In the absence of such a system, a major default could
create a chain reaction. The resultant financial crisis in a futures market could create
systematic risk. Regulation is also needed to ensure fairness and transparency in
trading, clearing, settlement and management of the Exchange so as to protect and
promote the interest of various stakeholders, particularly non-member users of the
market.
RULES GOVERNING COMMODITY DERIVATIVES EXCHANGES
/PARTICIPANTS
The trading of commodity derivatives on the NCDEX is regulated by Forward
Markets Commission (FMC). In terms of Section 15 of the Forward Contracts
(Regulation) Act, 1952 (the Act), forward contracts in commodities notified under
section 15 of the Act can be entered into only by or through a member of a
recognized association, i.e, commodity exchange as popularly known. The
recognized associations/commodity exchanges are granted recognition under the Act
by the central government (Department of Consumer Affairs, Ministry of Consumer
Affairs, Food and Public Distribution). All the Exchanges, which permit forward
contracts for trading, are required to obtain certificate of registration from the
Central Government. The other legislations which have relevance to commodity
trading are the Companies Act, Stamp Act, Contracts Act, Essential Commodities
Act 1955, Prevention of Food Adulteration Act, 1954 and various other legislations,
which impinge on their working.
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Forward Markets Commission provides regulatory oversight in order to ensure
financial integrity (i.e. to prevent systematic risk of default by one major operator or
group of operators), market integrity (i.e. to ensure that futures prices are truly
aligned with the prospective demand and supply conditions) and to protect and
promote interest of customers/ non-members. Some of the regulatory measures by
Forward Markets Commission include:
1. Limit on net open position as on the close of the trading hours. Some times
limit is also imposed on intra-day net open position. The limits are imposed
member- wise and client wise.
2. Circuit-filters or limit on price fluctuations to allow cooling of market in the
event of abrupt upswing or downswing in prices.
3. Special margin deposit to be collected on outstanding purchases or sales
when price moves up or down sharply above or below the previous day
closing price. By making further purchases/sales relatively costly, the price
rise or fall is sobered down. This measure is imposed by the Exchange
(FMC may also issue directive).
4. Circuit breakers or minimum/maximum prices: These are prescribed to
prevent futures prices from falling below as rising above not warranted by
prospective supply and demand factors. This measure is also imposed on the
request of the exchanges (FMC may also issue directive).
5. Stopping trading in certain derivatives of the contract, closing the market for
a specified period and even closing out the contract. These extreme
measures are taken only in emergency situations.
Besides these regulatory measures, a client's position cannot be appropriated by the
member of the Exchange. No member of an Exchange can enter into a forward
contract on his own account with a non-member unless such member has secured
the consent of the non-member in writing to the effect that the sale or purchase is on
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his own account. The FMC is persuading increasing number of exchanges to switch
over to electronic trading, clearing and settlement,which is more safe and customer-
friendly. The FMC has also prescribed simultaneous reporting system for the
exchanges following open out-cry system. These steps facilitate audit trail and make
it difficult for the members to indulge in malpractices like trading ahead of clients,
etc.
The FMC has also mandated all the exchanges following open outcry system to
display at a prominent place in exchange premises, the name, address, telephone
number of the officer of the commission who can be contacted for any grievance.
The website of the commission also has a provision for the customers to make
complaint and send comments and suggestions to the FMC. Officers of the FMC
meet the members and clients on a random basis, visit exchanges, to ascertain the
situation on the ground to bring in development in any area of operation of the
market.
RULES GOVERNING TRADING ON EXCHANGE
The Forward Markets Commission (FMC) is the Regulatory Authority for futures
market under the Forward Contracts (Regulation) Act 1952. In addition to the
provisions of the Forward Contracts (Regulation) Act 1952 and rules framed
thereunder, the exchanges and participants of futures market are governed by the
Rules and Bye laws of the respective exchanges, which are published in the Official
Gazette and Regulations if any (all approved by the FMC). In this section, we shall
have a brief look at the important regulations that govern NCDEX (Exchange). For
the sake of convenience, these have been divided into two main divisions pertaining
to trading and clearing. The detailed Rules, Bye-laws and Regulations are available
on the NCDEX website home page.
Trading
The NCDEX provides an automated trading facility in all the commodities admitted
for dealings on the derivative market. Trading on the Exchange is allowed only
through approved workstation(s) located at locations for the office(s) of a trading
member as approved by the Exchange. The LAN or any other mode of connectivity
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to other workstations at any place connecting an approved workstation of a trading
member shall require an approval of the Exchange.
Each trading member is required to have a unique identification number which is
assigned by the Exchange and which will be used to log on (sign on) to the trading
system. Trading member has a non-exclusive permission to use the trading system
as provided by the Exchange in the ordinary course of business as trading member.
He does not have any title rights or interest whatsoever with respect to the trading
system, its facilities, software and the information provided by the trading system.
For the purpose of accessing the trading system, the member will install and use
equipment and software as specified by the Exchange at his own cost. The Exchange
has the right to inspect equipment and software used for the purposes of accessing
the trading system at any time. The cost of the equipment and software supplied by
the Exchange, installation and maintenance of the equipment is borne by the trading
member.
Trading members and users
Trading members are entitled to appoint, (subject to such terms and conditions, as
may be specified by the relevant authority of the Exchange) from time to time -
• Authorised persons
• Approved users
Trading members have to pass a certification program, which has been prescribed by
the Exchange. In case of trading members, other than individuals or sole
proprietorships, such certification program has to be passed by at least one of their
directors/ employees/ partners/ members of governing body.
Each trading member is permitted to appoint a certain number of approved users as
notified from time to time by the Exchange. The appointment of approved users is
subject to the terms and conditions prescribed by the Exchange. Each approved user
is given a unique identification number through which he will have access to the
trading system. An approved user can access the trading system through a password
and can change the password from time to time. The trading member or its approved
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users are required to maintain complete secrecy of its password. Any trade or
transaction done by use of password of any approved user of the trading member,
will be binding on such trading member. Approved user shall be required to change
his password at the end of the password expiry period.
Trading days
The Exchange operates on all days except Sunday and on holidays declared from
time to time. The types of order books, trade books, price limits, matching rules and
other parameters pertaining to each or all of these sessions are specified by the
Exchange to the members via its circulars or notices issued from time to time.
Members can place orders on the trading system during these sessions, as permitted
under the Bye-laws and Regulations prescribed by the Exchange.
Trading hours and trading cycle
The Exchange announces the normal trading hours/ open period in advance from
time to time. In case necessary, the Exchange can extend or reduce the trading hours
by notifying the members. Trading cycle for each commodity/ derivative contract
has a standard period, during which it will be available for trading.
Contract expiration
Derivatives contracts expire on a pre-determined date and time up to which the
contract is available for trading. This is notified by the Exchange in advance. The
contract expiration period will not exceed twelve months or as the Exchange may
specify from time to time.
Trading parameters
The Exchange from time to time specifies various trading parameters relating to the
trading system. 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
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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. The Exchange specifies the minimum quantity for orders that will be
allowed for each commodity/ derivatives contract. It also prescribes the number of
days after which `Good Till Cancelled' orders will be cancelled by the system. The
Exchange also specifies parameters like lot size in which orders can be placed, tick
size in which orders shall be entered on the trading system, position limits in respect
of each commodity etc.
Failure of trading member terminal
In the event of failure of trading member's workstation and/ or the loss of access to
the trading system, the Exchange can at its discretion undertake to carry out on
behalf of the trading member the necessary functions which the trading member is
eligible for. Only requests made in writing in a clear and precise manner by the
trading member would be considered. The trading member is accountable for the
functions executed by the Exchange on its behalf and has to indemnity the Exchange
against any losses or costs incurred by the Exchange.
Trade operations
Trading members have to ensure that appropriate confirmed order instructions are
obtained from the constituents before placement of an order on the system. They
have to keep relevant records or documents concerning the order and trading system
order number and copies of the order confirmation slip/modification slip must be
made available to the constituents. The trading member has to disclose to the
Exchange at the time of order entry whether the order is on his own account or on
behalf of constituents and also specify orders for buy or sell as open or close orders.
Trading members are solely responsible for the accuracy of details of orders entered
into the trading system including orders entered on behalf of their constituents.
Trades generated on the system are irrevocable and `locked in'. The Exchange
specifies from time to time the market types and the manner if any, in which trade
cancellation can be effected. Where a trade cancellation is permitted and trading
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member wishes to cancel a trade, it can be done only with the approval of the
Exchange.
Margin requirements
Every clearing member, has to deposit a margin with the Exchange in respect of the
trades to which he is party, in the manner prescribed by or under the provisions as
contained in the Exchange Bye-laws and Regulations as may be in force, . The
Exchange prescribes from time to time the commodities derivative contracts, the
settlement periods and trade types for which margin would be attracted. The
Exchange levies initial margin on derivatives contracts using the concept of Value at
Risk (VaR) or any other concept as the Exchange may decide from time to time. The
margin is charged so as to cover one-day loss that can be encountered on the
position. Additional margins may be levied for deliverable positions, on the basis of
VaR from the expiry of the contract till the actual settlement date plus a mark-up for
default. The margin has to be deposited with the Exchange within the time notified
by the Exchange. The Exchange also prescribes categories of securities that would
be eligible for a margin deposit, as well as the method of valuation and amount of
securities that would be required to be deposited against the margin amount. The
procedure for refund/ adjustment of margins is also specified by the Exchange from
time to time. The Exchange can impose upon any particular trading member or
category of trading member any special or other margin requirement. On failure to
deposit margin/s as required under this clause, the Exchange/clearing house can
withdraw the trading facility of the trading member. After the pay-out, the clearing
house releases all margins. Unfair trading practices No trading member shall buy,
sell, deal in derivatives contracts in a fraudulent manner, or indulge in any market
manipulation, unfair trade practices, including the following:
• Effect, take part either directly or indirectly in transactions, which are likely to
have effect of artificially, raising or depressing the prices of spot/ derivatives
contracts.
• Indulge in any act, which is calculated to create a false or misleading appearance of
trading, resulting in reflection of prices, which are not genuine.
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• Buy, sell commodities/ contracts on his own behalf or on behalf of a person
associated with him pending the execution of the order of his constituent or of his
company or director for the same contract.
• Delay the transfer of commodities in the name of the transferee.
• Indulge in falsification of his books, accounts and records for the purpose of
market manipulation.
• When acting as an agent, execute a transaction with a constituent at a price other
than the price at which it was executed on the Exchange.
• Either take opposite position to an order of a constituent or execute opposite orders
which he is holding in respect of two constituents except in the manner laid down by
the Exchange.
Clearing
National Commodity Clearing Limited (NCCL) as the clearing house, undertakes
clearing of trades executed on the NCDEX platform. 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 members in accordance with the Regulations, Bye laws and Rules of the
Exchange.
Last day of trading
Last trading day for a derivative contract in any commodity is the date as specified
in the respective commodity contract specifications. If the last trading day as
specified in the respective commodity contract is a holiday, the last trading day is
taken to be the previous working day of Exchange. For contracts with Sellers option
& Intention matching contract, the trading members/ clearing members have to give
delivery information as prescribed by the Exchange from time to time. If a trading
member/ clearing member fail to submit such information as permitted by the
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Exchange, the deals have to be settled in accordance with the settlement calendar
applicable for such deals, in cash together with penalty as stipulated by the
Exchange. For contracts having compulsory delivery, all the open positions at end of
trading hours on the expiry date of the contracts, will crystalise in to delivery
obligations and the members have to meet the obligation as per the settlement
calendar notified by the Exchange by giving or taking delivery as the case may be,
of the commodity.
Delivery
During the specified period as per settlement calender, the Exchange provides a
window on the trading system to submit delivery information for all open positions
for contracts having Sellers option & Intention matching contract. For contracts
having compulsory delivery, all the members having open positions at the end of
trading hours on the expiry date of the contracts, will have to give or take delivery as
the case may be. After the trading hours on the expiry date, based on the available
information, the matching for deliveries takes place. Matching done on the basis of
procedure of the Exchange is binding on the clearing members. After completion of
the matching process, clearing members are informed of the deliverable / receivable
positions and the unmatched positions. Unmatched positions have to be settled in
cash. The cash settlement is only for the incremental gain/ loss as determined on the
basis of the final settlement price. All matched and unmatched positions are settled
in accordance with the applicable settlement calendar.
The Exchange may allow an alternate mode of settlement between the constituents
directly provided that both the constituents through their respective clearing
members notify the Exchange before the closing of trading hours on the expiry date.
They have to mention their preferred identified counter-party and the deliverable
quantity, along with other details required by the Exchange. The Exchange however,
is not responsible or liable for such settlements or any consequence of such alternate
mode of settlements. If the information provided by the buyer/ seller clearing
members fails to match, then the open position would be treated in same way as
other open positions and are settled together with penalty (If any) as may be
stipulated by the Exchange. The clearing members are allowed to deliver their
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obligations post expiry of the contract, but before the pay in date as per applicable
settlement calendar, whereby the clearing house can reduce the margin requirement
to that extent. The Exchange specifies the parameters and methodology for
premium/ discount, as the case may be, from time to time for the quality/ quantity
differential, sales tax, taxes, government levies/ fees if any. Pay in/ Pay out for such
additional obligations are settled through supplemental settlement date as specified
in the settlement calendar.
Procedure for payment of sales tax/VAT
The Exchange prescribes the procedure for sales tax/VAT settlement applicable to
the deals culminating into sale with physical delivery of commodities. All members
have to ensure that their respective constituents, who intend to take or give delivery
of commodity, are registered with sales tax authorities of the State/s where the
delivery center for a particular commodity is situated and where delivery is
allocated. Members shall have themselves registered with the respective Sales
Tax/VAT authorities for giving or taking delivery on his own account and shall have
to maintain records/details of sales tax registration of each of its constituent giving
or taking delivery and shall furnish the same to the Exchange as and when required.
The seller is responsible for payment of sales tax/VAT, however the seller is entitled
to recover from the buyer, the sales tax and other taxes levied under the local state
sales tax law to the extent permitted by law. In no event shall the Exchange/ clearing
house be liable for payment of Sales Tax/ VAT or any other local tax, fees, levies
etc.
Penalties for defaults
In the event of a default by the seller in delivery of commodities, the Exchange
closes out the derivatives contracts and imposes penalties on the defaulting seller. In
case of default by a buying member penalty as prescribed by the Exchange is levied
on the member till such time that the buyer does not bring in the funds. However it
may be noted that buyers default are not permitted by Exchange and amount will be
recovered as pay-in shortages together with penalty. It can also use the margins
deposited by such clearing member to recover the loss.
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Process of dematerialization
Dematerialization refers to issue of an electronic credit, instead of a vault/
warehouse receipt, to the depositor against the deposit of commodity. Any person (a
constituent) seeking to dematerialize a commodity has to open a demat account with
an approved Depository Participant (DP).
The Exchange provides the list of approved DPs from time to time. In case of
commodities (other than precious metals), the constituent delivers the commodity to
the Exchange-approved warehouses. The commodity brought by the constituent is
checked for the quality by the Exchange-approved assayers before the deposit of the
same is accepted by the warehouse.
If the quality of the commodity is as per the norms defined and notified by the
Exchange from time to time, the warehouse accepts the commodity and sends
confirmation in the requisite format to the Registrar & Transfer (R&T) agent who
upon verification, confirms the deposit of such commodity to the depository for
giving credit to the demat account of the said constituent.
In case of precious metals, the commodity must be accompanied with the packing
list / shipping certificate. The vault accepts the precious metal, after verifying the
contents of the certificate with the precious metal being deposited. On acceptance,
the vault issues an acknowledgementto the constituent and sends confirmation in the
requisite format to the R&T agent who upon verification, confirms the deposit of
such precious metal to the depository for giving credit to the demat account of the
said constituent.
Validity date
In case of commodities having validity date assigned to it by the approved assayer,
the delivery of the commodity upon expiry of validity date is not considered as a
good delivery and such commodities are suspended from delivery. The clearing
member has to ensure that his concerned constituent revalidates the commodities for
all such commodities to make them deliverable on the Exchange.
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Final Expiry Date (FED)
All the commodities deposited in the warehouse are given an FED. The
commodities can not be revalidated after the FED. For the depository, commodities,
which have reached the FED, are moved out of the electronic deliverable quantity.
Such commodities are suspended from delivery. The constituent has to rematerialize
such quantity and remove the same from the warehouse. Failure to remove
commodities after FED from the warehouse may be levied a penalty as specified by
the relevant authority from time to time.
Process of rematerialisation
Re-materialization refers to issue of physical delivery against the credit in the demat
account of the constituent. The constituent seeking to rematerialize his commodity
holding has to make a request to his DP in the prescribed format and the DP then
routes his request through the depository system to the R&T agent, R&T issues the
authorisation addressed to the vault/ warehouse to release physical delivery to the
constituent. The vault/warehouse on receipt of such authorization releases the
commodity to the constituent or constituent's authorised person upon verifying the
identity.
Delivery through the depository clearing system
Delivery in respect of all deals for the clearing in commodities happens through the
depository clearing system. The delivery through the depository clearing system into
the account of the buyer with the DP is deemed to be delivery, notwithstanding that
the commodities are located in the warehouse along with the commodities of other
constituents.
Payment through the clearing bank
Payment in respect of all deals for the clearing has to be made through the clearing
bank(s); provided however that the deals of sales and purchase executed between
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different constituents of the same clearing member in the same settlement, shall be
offset by process of netting to arrive at net obligations.
Clearing and settlement process
The relevant authority from time to time fixes the various clearing days, the pay-in
and payout days and the scheduled time to be observed in connection with the
clearing and settlement operations of deals in commodities futures contracts.
1. Settlement obligations statements for TCMs:
The Exchange generates and provides to each trading clearing member,
settlement obligations statements showing the quantities of the different
kinds of commodities for which delivery/ deliveries is/ are to be given and/
or taken and the funds payable or receivable by him in his capacity as
clearing member and by professional clearing member for deals made by
him for which the clearing member has confirmed acceptance to settle. The
obligations statement isdeemed to be confirmed by the trading member for
which deliveries are to be given and/ or taken and funds to be debited and/ or
credited to his account as specified in the obligations statements and deemed
instructions to the clearing banks/ institutions for the same.
2. Settlement obligations statements for PCMs:
The Exchange/ clearing house generates and provides to each professional
clearing member, settlement obligations statements showing the quantities of
the different kinds of commodities for which delivery/ deliveries is/ are to be
given and/ or taken and the funds payable or receivable by him. The
settlement obligation statement is deemed to have been confirmed by the
said clearing member in respect of each and all obligations enlisted therein.
Delivery of commodities
Based on the settlement obligations statements, the Exchange generates delivery
statement and receipt statement for each clearing member. The delivery and receipt
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statement contains details of commodities to be delivered to and received from other
clearing members, the details of the corresponding buying/ selling constituent and
such other details. The delivery and receipt statements are deemed to be confirmed
by respective member to deliver and receive on account of his constituent,
commodities as specified in the delivery and receipt statements.
On respective pay-in day, clearing members effect depository delivery in the
depository clearing system as per delivery statement in respect of depository deals.
Delivery has to be made in terms of the delivery units notified by the Exchange.
Commodities, which are to be received by a clearing member, are delivered to him
in the depository clearing system in respect of depository deals on the respective
pay-out day as per instructions of the Exchange/ clearing house.
Delivery units The Exchange specifies from time to time the delivery units for all
commodities admitted to dealings on the Exchange. Electronic delivery is available
for trading before expiry of the validity date. The Exchange also specifies from time
to time the variations permissible in delivery units as per those stated in contract
specifications.
Depository clearing system
The Exchange specifies depository(ies) through which depository delivery can be
effected and which shall act as agents for settlement of depository deals, for the
collection of margins by way of securities for all deals entered into through the
Exchange, for any other commodities movement and transfer in a depository(ies)
between clearing members and the Exchange and between clearing member to
clearing member as may be directed by the relevant authority from time to time.
Every clearing member must have a clearing account with any of the Depository
Participants of specified depositories.
Clearing Members operate the clearing account only for the purpose of settlement of
depository deals entered through the Exchange, for the collection of margins by way
of commodities for deals entered into through the Exchange. The clearing member
cannot operate the clearing account for any other purpose. Clearing members are
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required to authorize the specified depositories and DP with whom they have a
clearing account to access their clearing account for debiting and crediting their
accounts as per instructions received from the Exchange and to report balances and
other credit information to the Exchange. TCM has to have pool accounts with both
the depositories (NSDL and CDSL).
Rules Governing Investor Grievances, Arbitration
The Exchange has put in place a dispute resolution mechanism by way of arbitration
for resolution of disputes between members or between a member and client arising
out of transactions on the Exchange. The arbitration mechanism and procedure for
reference of disputes to arbitration are detailed in the Exchange Bye-laws and
Regulations.
Definitions:
• Arbitrator means a sole arbitrator or a panel of arbitrators.
• Applicant/Claimant means the person who makes the application for initiating
arbitral proceedings.
• Respondent means the person against whom the applicant/claimant lodges an
arbitration application, whether or not there is a claim against such person.
The Exchange may provide for different seats of arbitration for different regions of
the country termed as Regional Arbitration Centres (RACs). The seat of arbitration
shall be Mumbai where no RAC has been notified.
JURISDICTION
In matters where the Exchange is a party to the dispute, the civil courts at Mumbai
shall have exclusive jurisdiction and in all other matters, proper courts within the
area covered under the respective RAC shall have jurisdiction in respect of the
arbitration proceedings falling/ conducted in that RAC.
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PERIOD FOR REFERENCE OF CLAIMS/DISPUTES
All claims shall have to be referred within six months from the date on which such
claim, dispute or difference arose. The time taken by the Exchange for
administratively resolving the dispute shall be excluded for the purpose of
determining the period of six months.
REFERENCE OF CLAIM
If the value of claim, difference or dispute is more than Rs.50 Lakh on the date of
application, then such claim, difference or dispute are to be referred to a panel of
three Arbitrators. If the value of the claim, difference or dispute is up to Rs.50 Lakh,
then they are to be referred to a sole Arbitrator. Where any claim, difference or
dispute arises between agent of the member and client of the agent of the member, in
such claim, difference or dispute, the member, to whom such agent is affiliated, is
impeded as a party. In case the warehouse refuses or fails to communicate to the
constituent the transfer of commodities, the date of dispute is deemed to have arisen
on
1. The date of receipt of communication of warehouse refusing to transfer the
commodities in favour of the constituent; or
2. The date of expiry of 5 days from the date of lodgment of dematerialized request
by the constituent for transfer with the seller; whichever is later.
Procedure for Arbitration
The applicant has to submit to the Exchange application for arbitration in the
specified form (Form No. I/IA) along with the following enclosures:
1. The statement of case (containing all the relevant facts about the dispute and relief
sought).
2. The statement of accounts.
3. Copies of member - constituent agreement.
4. Copies of the relevant contract notes, invoice and delivery challan or any other
relevant material in support of the claim.
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The Applicant has to also submit to the Exchange the following along with the
arbitration form:
a) A cheque/ pay order/ demand draft for the deposit payable at the seat of
arbitration in favour of National Commodity & Derivatives Exchange
Limited.
b) Form No. II/IIA containing list of names of the persons eligible to act as
Arbitrators. Upon receipt of Form No.I/IA, the Exchange forwards a copy of
the statement of case along with its enclosures to the respondent. The
respondent then has to submit Form II/IIA and also Form III/IIIA (reply) to
the Exchange within 7 days from the date of receipt. If the respondent fails to
submit the said Forms within the time period prescribed by the Exchange
unless the time is extended by the Exchange on request, then the Arbitrator is
appointed in the manner as specified Regulation 21 of the Regulations of the
Exchange.
c) The respondent has to submit the said Forms to the Exchange in three copies
in case of sole Arbitrator to be appointed and five copies in case of panel of
Arbitrators depending on the claim amount, along with the following
enclosures:
• The statement of reply (containing all available defences to the claim)
• The statement of accounts
• Copies of the member constituent agreement
• Copies of the relevant contract notes, invoice and delivery challan
• Statement of the set-off or counter claim along with statements of accounts and
copies of relevant contract notes and bills The respondent has to submit to the
Exchange a cheque/ pay order/ demand draft for the deposit payable at the seat of
arbitration in favour of National Commodity & Derivatives Exchange Limited along
with Form No.III/IIIA. If the respondent fails to submit Form III/IIIA within the
prescribed time, then the Arbitrator can proceed with the arbitral proceedings and
make the award ex-parte. Upon receiving the documents as above from the
respondent, the Exchange forwards a copy of the reply to the applicant/claimant.
The applicant should within seven days from the date of receipt of the same, submit
to the Exchange, his reply including reply to counterclaim, if any, which may have
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been raised by the respondent in its reply to the applicant/claimant. The Exchange
then forwards such reply to the respondent. The time period to file any pleading
referred to herein can be extended for such further periods as may be decided by the
Exchange in consultation with the Arbitrator depending on the circumstances of the
matter. The manner of selection of Arbitrator is detailed in the Regulations of the
Exchange.
Hearings and Arbitral Award
No hearing is required to be given to the parties to the dispute if the value of the
claim difference or dispute is Rs.75,000 or less. In such a case, the Arbitrator
proceeds to decide the matter on the basis of documents submitted by both the
parties provided. However, the Arbitrator for reasons to be recorded in writing may
hear both the parties to the dispute.
If the value of claim, difference or dispute is more than Rs.75,000, the Arbitrator
offers to hear the parties to the dispute unless both parties waive their right for such
hearing in writing. The Exchange in consultation with the Arbitrator determines the
date, time and place of the first hearing. Notice for the first hearing is given at least
ten days in advance, unless the parties, by their mutual consent, waive the notice.
The Arbitrator determines the date, time and place of subsequent hearings of which
the Exchange gives a notice to the parties concerned. If after the appointment of an
Arbitrator, the parties settle the dispute, then the Arbitrator records the settlement in
the form of an arbitral award on agreed terms.
All fees and charges relating to the appointment of the Arbitrator and conduct of
arbitration proceedings are to borne by the parties to the reference equally or in such
proportions as may be decided by the Arbitrator.
The costs, if any, are awarded to either of the party in addition to the fees and
charges, as decided by the Arbitrator. The Arbitrator may pronounce an interim
arbitral award or interim measures. The arbitral award shall be made within 3
months from the date of entering upon reference by the Arbitrator.
However the time limit may be extended by the Exchange for not exceeding 6
months.
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LIMITATION
In every Project there are some limitations and this project is no exception.
LIMITATIONS:
Topic of the project is based on lots of practical knowledge.
Due to lack of practical exposer to the topic assigned a bit difficulty was
faced during making of project.
LIMITATION OF TIME:
Time availability was one of the biggest limitations faced.
Due to shortage of time we had to limit the Work in its present form
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SUGGESTION
After going through this project I got detailed knowledge about arbitrage, hedging
and speculation. And after assessing and going through related books I felt that there
are various ways of making investment. It requires knowledge and experience to
invest in this mode. While making this project I went through many books,different
websites related to the topic in order to enhance the knowledge. I got some
information about the investment and want to give some suggestion regarding the
same. These are –
Arbitrage could be used for making investment as it is the making of a gain
through trading without committing any money and without taking a risk of
losing money.
Arbitrage transactions in modern securities markets involve fairly low day-
to-day risks, but can face extremely high risk in rare situations,
particularly financial crises, and can lead to bankruptcy.
In finance, speculation is a financial action that does not promise safety of
the initial investment along with the return on the principal sum. Speculation
typically involves the lending of money for the purchase of assets,
equity or debt but in a manner that has not been given thorough analysis or is
deemed to have low margin of safety or a significant risk of the loss of the
principal investment.
An investor who takes steps to reduce the risk of an investment by making
an offsetting investment. There are a large number of hedging strategies that
a hedger can use. Hedgers may reduce risk, but in doing so they also reduce
their profit potential.
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WORD OF THANKS
One of the most pleasant aspects of writing a project is the opportunity of thanks
those who have made it possible. Unfortunately, the list of expression of gratitude
no matter how expensive is always incomplete and inadequate. These
acknowledgements are of no exception. This project report is a result of endless
effort & immense degree of toil. I would like to thank all those people who
graciously helped me by sharing their valuable time, experience & knowledge. I
would like to express heartiest thanks to Dr. D. K. GARG (Chairman), Mr. M. K.
VERMA (Dean) and placement head Mr. T. K. GUHA for lending me their kind
support for completion of my project.
I thank all those who directly or indirectly supported me morally, financially and
through providing knowledge by which I could complete my project as well as
summer training. I thank to all those readers who will study this project in the
future. I am extremely thankful to all the faculty members for their valuable
guidance, untiring help and advice at every step. Their vast experience helped in
setting the direction of my project work. Then my intellectual debt is to those
academicians and practioners who have contributed significantly. During the course
of my project work I was in constant interaction with many company people who
were highly co-operative in laying down the strategy for the project.
I am thankful to the management of BMA Wealth Creation Ltd., New Delhi and
especially to my guide Abhishek Kumar Verma under whose Cooperation and
guidance was a milestone in completion of my project, who influenced me to work
positively at each step by giving his precious time to discuss and to provide relevant
information. Last but not the least, I express my parents and friends who financed
this project and have been a moral support to me during the project.
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ANNEXURE /BIBLIOGRAPHY
Necessary information for my project was obtained through following sources:
BOOKS
NCFM Modules
Derivative market dealers’ module
Commodity market dealers’ module
NSE Debt market basic module
Investment Management – Bhalla V.K
Capital Market- Dr.S.gurusami
Stock exchange , Investment and Derivative- V.Raghunatham
WEBSITES
www.bseindia.com
www.nseindia.com
www.sebi.gov.in.com
www.ncfm.com
www.google.com
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