5138_5602_chapter 02 - the derivatives market in india

7/28/2019 5138_5602_Chapter 02 - The Derivatives Market in India

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The Derivatives Market in India

Chapter 2


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Dorling Kindersley India Pvt. Ltd. 2011

Objectives

Which of the exchanges in India trade in derivative

products?

What are the various types of orders used in

derivatives exchanges? What is the trading mechanism in derivatives

exchanges?

What is an OTC derivatives market? How are

derivatives traded on it? What contracts are available in Indian exchanges?


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Development of Derivative Markets

Internationally, earlier derivative contracts were over-

the-counter

Over-the-counter markets suffer from counterparty

risk, lack of transparency, and are mostly unregulated

Derivative exchanges were created to solve theseissues


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The International Derivatives Market

1710 Dojima Rice Exchange, Japan

1848 Chicago Board of Trade (CBOT), USA

1874 Chicago Produce Exchange, USA

1919 Chicago Mercantile Exchange (CME), USA

1972, International Money Market (IMM) under the

CME, USA

1973 Chicago Board of Options Exchange (CBOE),

USA


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Derivatives Contracts Traded

Commodity derivatives on agricultural commodities,cattle, metal and energy products like oil andelectricity

Equity derivatives on single-stock and stock indices

Interest rate derivatives on short-term and long-terminterest rates

Currency derivatives

Credit derivatives

Traded on exchanges and over-the-counter markets


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Derivatives in India Financial derivatives in NSE and BSE in 2000 Commodity derivatives started in MCX, NMCE and

NCDEX in 2003

Index futures (2000) and index options (2001) as wellas stock futures and options (2001) are traded

Short- and long-term interest rate futures wereintroduced in 2003, but withdrawn in 2006; in 2009they were re-introduced

Currency futures introduced in 2008 and traded inNSE, BSE and MCX

Interest rate swaps, currency swaps, forward rateagreements and credit derivatives traded in the over-the-counter market


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The Operation of Derivative

Exchanges

Three major operations of an exchange are:

Trading

Clearing

Settlement


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The Trading System

Fully automated screen-based system

Based on order-driven market

Provides transparency

Orders are time-stamped as they arrive and stored inorder books if not marked

Storage based on price-time priority, according to bestprice and time


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Types of Orders

Market order

Limit order

Stop-loss order

Immediate or cancel order

Good-till day order

Good-till cancelled order

Good-till date order Spread order


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Order Matching Rules

The best buy order will be matched with the best sellorder

An order may match partially with another order,resulting in multiple trades

Orders will be entered by members, and will remain inthe system until matched

Any new order will be matched first with ordersremaining in the system


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Order Conditions

On the basis of time:

Day orders

Immediate or Cancel orders

On the basis of price:

Limit price/orders

Market price/orders Stop-loss price/orders

Sell orders


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Clearing System

Clearingmeans that a transaction is clearly recorded,

and provides for orderly settlement

Is done by the clearing corporation, a subsidiary of

the derivatives exchange

E.g. in the NSE, the National Securities Clearing

Corporation Limited (NSCCL) is the clearing agency


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Members of the Clearinghouse Clearing members are authorized to clear trades

undertaken by traders

Trading members are members who can trade onbehalf of clients, and match orders that membersreceive

A clearing member performs:

a. Clearance

b. Settlement

c. Risk management

The clearing corporation provides qualifications for atrader to be a clearing member


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Clearing Mechanisms

When a trading member matches an order received

from a client, the trading member will approach a

clearing member to clear the trade

The clearing member takes the position of

counterparty for every contract that they clear

The exchange will keep record of all trades cleared by

a clearing member


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Margins

The cleaning member will be required to post acertain amount of money, known as a margin, on alltrades cleared

This margin will be based on the value of the contractcleared

The margin account will be updated daily, usingmarking-to-marketprocedure

If the margin account balance falls below a certainlevel, a margin callwill be issued by the clearingcorporation and the member will have to put upadditional costs as margin


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Settlement Settlementmeans that parties will be settling their

obligations under the contract

Daily mark-to-market settlement of margins typicallyupdates margin accounts, and issues margin calls

when necessary

Final settlement occurs when contracts are closedout, or on maturity date

If the final settlement calls for delivery, the party thathas an open position to deliver will be called upon todo so

If the final settlement is for cash, the losing party willpay the winning party


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Trading Process The contract is brokered and an order will be place

The broker enters the order in the order book

When the order is matched, the broker will clear thetransaction through a clearing member

The broker will ask the client to post a margin

The margin account will be updated daily through thedaily settlement price, and a margin call will be issuedwhen necessary


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Trading Process (Continued) If the client wants to close the position, he or she will

inform the broker, who will match the order, close the

margin account, and pay the balance

If the contract is held until maturity, the marginaccount will be closed with the final settlement

amount and balance given to the client

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