Future Trading

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Derivatives

A derivative is an instrument whose value isderived from the value of one or more ofunderlying assets in a contractual manner.

The underlying asset could be equity, forex,metals, agri commodities.

Types of Derivative

Futures

Swaps

OptionsForwardsThe value of the derivative

instrument is DERIVED from the underlying security/Commodity

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Transactions have three components

i) Trading (buyer and seller negotiating and arriving at a Price)

ii) Clearing ( Finding out the net outstanding i.ehow much money the two should exchange)

iii) Settlement (the actual process of exchanging goods and money)

In Spot market all these happen simultaneously

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In a forward market

Trading takes place one day

Clearing and Settlement takes place at a future dateat a specified period

It is an agreement between the two entities to buy or sell the asset at a future date at today’s pre agreed price

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A bilateral agreement in which the buyer andseller agree upon the delivery of a specifiedquantity and quality of an asset at aspecified date and agreed price

Price of contract is called a delivery price:usually is equal to spot price plus cost ofcarry

Contracts are custom designedActual delivery has to take placeNo exchange guarantee

Futures

A futures contract is a binding agreement between aseller and a buyer to make (seller) and to take (buyer)delivery of underlying commodity (or financial instrument)at a specified future date with agreed upon paymentterms.

Futures contract are normally traded on an exchange. Tomake trading possible the exchange specifies certainstandardized features of the contract.

As the two parties do not necessarily know each otherthe exchange also provides a mechanism that givesthe two parties a guarantee that the contract will behonoured.

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A major difference between forwards and futuresis that futures contracts have standardizedcontract terms.

Futures contracts specify the quality andquantity of goods that can be delivered, thedelivery time, and the manner of delivery.

Standardization tells traders exactly what isbeing traded and the conditions of thetransaction.

it enables the traders to focus on one variable namely price

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The purchaser of a futures contract issaid to have gone long or taken a longposition.

The seller of a futures contact is said tohave gone short or taken a shortposition

•Short selling is the selling of asecurity/commodity that the seller doesnot own.

•Short sellers assume the risk that they will be able to buy at a more favorable price than the price at which they sold short.

•Holding a Long Position Investors arelegally owning a security/commodity.

Clearing House

Derivatives contracts are “cleared” by aClearinghouse - the foundation of allderivatives markets

A CH is a central counterparty to all transactions

CH assumes the role of buyer to the seller and seller to the buyer

Each futures exchange has a clearinghouse.

The clearing house guarantees that traders in thefutures market will honor their obligations.

Clearinghouse guarantees financial integrity ofderivatives markets

The clearing house splits each trade and acts asthe opposite side of each position.

CH assigns deliveries of commodities from sellerto buyer

Either side of the trade can reverse positions at afuture date without having to contact the otherside of the initial trade.

DetailsMCX NCDEXTrading cumclearingmember(deposit based)

InstitutionClearingMember

Trading cumclearingmember

ProfessionalClearingMembership

Admission Fee 5,00,000 10,00,000 15,00,000 25,00,000Interest Free SecurityDeposit

50,00,000 50,00,000 15,00,000 25,00,000

Processing Fee 10,000 10,000 5,00,000Annual Subscription 50,000 50,000 -- 1,00,000Annual insurance fee 5,600 5,600 -- --VSAT cost 1,65,000 1,65,000 -- --Advance maintenancecharges

-- -- 50,000 1,00,000

Net worthrequirement

-- -- 5,00,00,000 5,00,00,000

Membership Fee in the Two Major Commodity Exchanges (Amount in Rupess)

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Settlement

Settlement in the future market is done in three ways:

-- Physical Delivery – on Expiration-- Closing out open positions-- Cash Settlement – on Expiration

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Financial derivates vs Commodity Derivatives

Varying quality of asset

– Not there in financial derivatives-- In commodities the quality of the asset vary

Bulky in nature-- Physical settlement in financial derivatives

do not need storage facility-- Commodities need warehousing facility

ProducersCommoditiesEcosystem

MCX

Clearing House

QualityAssayers

Clearing Bank

Warehouses

Registrar and TransferAgents

Traders(Speculators)Arbitrageurs/

Client)

Hedger(Exporters/

Millers/Industry)

Global Commodities Market

Spot Market

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Exchange Bilateral tradingCommon platform for all traders Restricted access

Price transparency Traded prices unknown to other players

Low transaction costs High cost and time consuming negotiations

Absence of counter party credit risk

Counter party credit risk

Market prices available to wider world

Difficulty in price dissemination

Standardized contract size Customized contracts

Exchange - a common meeting ground for all industry participants

Institution Share Domain Expertise

NABARD 15 % Apex bank for agricultural lending

NSE 15 % Largest stock exchange in India. Highest volume in single stock futures in world.

LIC 15 % Largest life insurance company in India

CRISIL 12% India’s first & largest credit rating agency. Now a Standard & Poor company

IFFCO 12% Largest farmer cooperative with affiliation of 36,000 cooperatives

PNB 8% Large public sector bank with strong rural reach specially in North India

Canara Bank 8% Large public sector bank with strong rural reach specially in South India

Goldman Sachs

7% Global Expertise in commodity markets

Intercontinental Exchange*

8% 6th largest commodity futures exchange in the world

*Acquired from ICICI Bank

- 46% held by public sector and balance by other institutions

- No private shareholding 18

Regulatory Structure - Spot & Futures

Spot Market

Futures Market/

Commodity Exchange

State Governments

Forward Markets

Commission (FMC) SEBI

Ministry of Consumer Affairs,

Food and Public Distribution

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There are 5 National Exchanges –NCDEX, MCX(both in Mumbai), NMCE and AhmedabadCommodity Exchange (ACE) (Ahmedabad)Indian Commodity Exchange Gurgaon

Besides 21 Regional Exchanges in different partsof the country

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NCDEXBarley, Cashew, Castor Seed, Chana, Chilli, coffee, cotton seed oilcake,crude palm oil, coriander, expeller mustard oil, groundnut, groundnutexpeller oil, guar gum, guar seeds, gur

Parboiled rice, basmati rice, cotton, Jeera, jute sacking, masur grain,menthe oil, raw silk, pepper, potato, raw silk, palmolein, refined soy oil,rubber, sesame seeds, soybean, sugar, tur, turmeric, urad, peas, maize,soy meal

MCXCastor oil, castor seeds, coconut cake, coconut oil, cotton seed, crudepalm oil, groundnut, cotton oil, mustard oil, mustard seed, palm oil,refined soy oil, sunflower oil, rice bran oil, sesame seed, soy meal,soybean, cardamom, coriander, jeera, pepper, red chilli, turmeric, chana,masur, Peas, maize, arecanut, cashew, rubber

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Types of ParticipantsHedgers, Speculators, Arbitrageurs

HedgersUse derivatives to reduce the risk they face frompotential future movements in a marketvariable. Hedgers want to avoid exposure toadverse movements in the price of an asset

SpeculatorsUse them to bet on the future direction of themarket variable.Take a position in the market either they arebetting that the price of the asset may go up ordown.

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ArbitrageursArbitrage involves locking in a

riskless profit by simultaneouslyentering into transactions in two ormore markets

The vast majority of futures contractsdo not lead to delivery. The reason isthat most traders choose to close outtheir positions prior to the deliveryperiod specified in the contract.

Closing out a position means enteringinto the opposite type of trade from theoriginal one.

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HedgingFuture contracts can be temporary substitutes foran intended transaction in the cash market that willoccur at a later date.

This is called hedging. Hedging is buying andselling futures contracts as a protection againstunfavourable price changes.

When an individual or a company decided to usethe future market to hedge a risk the objective is totake a position that neutralises the risk as much aspossible

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A short hedge is appropriate when the hedgeralready owns the assets or is likely to own theasset and expect it to sell sometime in thefuture. A long hedge is appropriate when acompany knows it will have to purchase acertain asset in the future and wants to lock in aprice now.

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A Simple Long Hedge in MCX Potato Futures

Activities in the Commodity Futures Transactions

On October, the wafermanufacturer calculates that hemay need 300 tonnes of potato inMarch. He feels that a price of 350per quintal would be favourable tohim

On October he buys 10 potato futures contracts in MCX for delivery at Rs 350 per quintal.

On March, he buys 300 tonnes ofpotato in the spot market at Rs400 per quintal.

On March, sells 10 potato futuresfor Rs 400 per quintal

Spot market “loss” of Rs 50 perquintal is equal to Rs 1,50,000

Futures market “gain” is Rs 50 perquintal or Rs 1,50,000

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Suppose the opposite happens that isthe spot market price of potato in Marchfell to Rs 300 per quintal. The wafermanufacturer would buy 300 tonnes fromthe spot market in March. He sells hisfutures contract at Rs 300 per quintal. Heincurs a loss of Rs 50 per quintal and itamounts to Rs 1,50,000. His effectiveprice of potato still is Rs 350 per quintal

Remember the objective is not to make profit but sure about the price

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Convergence of Futures Price to Spot Price

As the delivery period for a futures contract isapproached the futures price converges to thespot price of the underlying asset when thedelivery period is reached, the futures priceequals or is very close to the spot price.

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Time Time

(a) (b)

FuturesPrice

FuturesPrice

Spot Price

Spot Price

Only the members of the exchange are eligible toparticipate in trading. Persons who are not membersof the exchange can participate in trading only asapproved users or clients through a registeredmember of the exchange. There are two types ofmembers, Trading cum Clearing Member andProfessional Clearing member

A trading cum clearing member is entitled to trade onhis own account as well as on account of his clientsand clear and settle trades himself. The Professionalclearing membership entails the members to cleartrades executed through trading cum clearingmembers (TCMs) both for themselves and on behalfof their clients

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The trading system provides a fully automatedscreen based trading for futures oncommodities on a nationwide basis as well ason online monitoring and surveillancemechanism. For example, the system supportsan order driven market where orders matchautomatically. Order matching is essentially onthe basis of commodity, its price, time andquantity

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ClearingClearing of Trade that takes place on the exchangehappens through the exchange clearing house (e.gNational Securities Clearing Corporation of NSE interfaceswith National Securities Depository Ltd (NSDL).

The exchange through the clearing house guarantees thefaithful compliance of all trade

Members of the clearing house are mostly financialinstitutions

Main task

Keep track of all the transactions that take place during aday to calculate the net position of each of its members

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MarginInitial margin is the money that must bedeposited by the customer at the time ofentering into a contract

It is set for each type of underlying asset.

Initial margin per contract is relatively low andequals about one day’s maximum pricefluctuation on the total value of the contract’sunderlying asset.

Maintenance margin is the amount of marginthat must be maintained in a futures account.

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If the margin balance in the account fallsbelow the maintenance margin, additionalfunds must be deposited to bring themargin balance back up to the initialmargin requirements.

If account margin exceeds the initial marginrequirement, funds can be withdrawn orused as initial margin for additionalpositions

a certain minimum amount of funds foreach open position held. --- Good FaithDeposits

The Clearing House and ClearingMargins

The exchange clearing house is an adjunctof the exchange and acts as anintermediary in futures transactions. Itguarantees the performance of the partiesto each transaction. The clearing house hasa number of members who must post fundswith the exchange.

The clearing house – clearing margin withthe exchange 38

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Buying (Long Position)

10 Contract 1 cont =30

Future Price

Settlement Price

7-Oct 350/qtl 1050000

7-Oct 340 1020000 -30000

8-Oct 340 335 1005000 -15000

9-Oct 335 345 1035000 30000

10-Oct 345 355 1065000 30000

11-Oct 355 360 1080000 15000Square off (sell)

30000

Marked to Market

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Selling (Short Position)

7-Oct 350 qtl 1050000

7-Oct 340 qtl 1020000 30000

8-Oct 340 335 1005000 15000 9-Oct 335 345 1035000 -30000

10-Oct 345 355 1065000 -30000

11-Oct 355 360 1080000 -15000 Square off (buy)

-30000

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Daily Settlement Final Settlement

Types of Settlement

Handles Daily Price fluctuation for alltrades (mark to market)Daily Process at end of day

On contract expiry day

Daily Settlement Price

Handles finalsettlement of all open positions

FinalSettlement Price

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Daily Settlement (MTM) Final Settlement

Done at the end of the each trading day

Done on the day of Contract Expiry

Based on the daily settlement Prices

Based on the final settlement price

All open positions are marked to market

Only trades not closed till contract expiry

Settlement

Settlement of futures contract can be done in threeways by physical delivery of the underlying asset,by clearing out open position and by cashsettlement.

All contracts materialising into deliveries are settledin a period of 2-7 days after expiry.

The exact settlement day for each commodity isspecified by the exchange.

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Physical Delivery of the Underlying Asset

Any buyer intending to take physicals has to put arequest to his depository participant.

The DP uploads such requests to the specifieddepository who in turn forwards the same to theregistrar and transfer agent (R and T agent)concerned.

After due verification of the authenticity the R and Tagent forwards delivery details to the warehousewhich in turn arranges to release the commoditiesafter due verification of the identity of recipient.

On a specified day the buyer would go to thewarehouse and pick up the physicals 45

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The National Securities Depository Ltd (NSDL)and Central Depository Services Ltd., (CDSL), thedepositories of the securities market, had beenfacilitating the electronic holding and transfer ofcommodity balances for the clients of thecommodity derivatives market. Under thearrangement, each of the clearing members wouldopen a member pool account with the depositoriesthrough depository participants to facilitate thesettlement of commodities. The depositories had adirect connectivity with the clearing house andeffected the transfer of electronic balance to themember pool account of clearing members as perinstructions from the clearing house.

Products selected on the basis of Economic parameters ◦ Price volatility◦ Share in GDP◦ Correlation with global markets◦ Share in external trade◦ Government intervention◦ Warehousing facilities◦ Traders distribution◦ Geographical spread◦ Number of varieties

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Commodities given priority where they are more relevant to India: where price discovery takes place domestically

Deliveries in terms of Value (Rs. In Lakhs)

Period Total ValueDisputed

Value% of disputed

to total

2005-06 178,287 407 0.23

2006-07 256,524 1346 0.52

Apr- Jun 2007 52,991 20 0.04

Grand Total 487,802 1773 0.36

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Globally less than 2% volumes result in deliveries

Globally, exchanges are not used as delivery platform

However, NCDEX has seen large deliveries

The total number of accredited delivery centers are around 660

NCDEX Quality emerging as benchmark in the market for cereals, pulses, spices, oilseeds, sugar & guar

Created warehousing capacity of 1 million tonnes

Period Deliveries (MT)

Q4' FY05 43214Q1 ‘FY06 109562Q2 FY06 83081Q3 FY06 77160Q4 FY06 134260Q1 FY07 103,444Q2 FY07 125,989Q3 FY07 94,128Q4 FY07 52,063Apr-Jul FY08 1,55,813

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Farmers and the Futures – Aggregation Model

Electronic Spot Exchanges

NSPOT – NCDEX

NSEL -- MCX and Future Technologies ?

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Options

There are two types of optionsa) Call option

b) Put option

Four types of Participantsa) Buyers of Call

b) Sellers of Call

c) Buyers of Put

d) Sellers of PutStrike Price / Exercise Price

Option Premium

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Calls and Puts

The two types of options are calls and puts:

A call gives the holder the right to buy an asset at a certainprice within a specific period of time.Call options give the buyer the right but not the obligation tobuy the asset

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A put gives the holder the right to sell an asset at a certainprice within a specific period of time.

Put options give the buyer the right but not the obligation tosell an underlying asset at the strike price

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Strike Price / Exercise Price

Option Premium