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    DERIVATIVES CONCEPTS A-Z

    This article presents a glossary of derivatives-related terminology that willmake the other articles in the Financial Pipeline's Derivatives section easier

    to understand, hopefully. It is not an exhaustive list. It will be updated fromtime to time. One of the characteristics of new financial products is theproliferation of different terms used to describe the same instrument, as eachfinancial institution tries to brand its product name onto the financialcommunity's awareness.

    A

    Actuals (see also Cash; Physicals; Underlying)

    Financial instruments that exist in one of the four main asset classes: interest rates, foreign

    exchange, equities or commodities. Typically, derivatives are used to hedge actual exposure or

    to take positions in actual markets.

    All or Nothings (see also Binary; Digital)

    An option whose payout is fixed at the inception of the option contract and for which the

    payout is only made if the strike price is in-the-money at expiry. If the strike price is out-of-the-

    money at expiry, there is no payout made to the option holder.

    American Style Option

    An option that can be exercised at any time from inception as

    opposed to a European Style option which can only be exercised at

    expiry. Early exercise of American options may be warranted by

    arbitrage. European Style option contracts can be closed out early,

    mimicking the early exercise property of American style options in

    most cases.

    Accreting Swap (see also Interest Rate Swap)

    An exchange of interest rate payments at regular intervals based

    upon pre-set indices and notional amounts in which the notional

    amounts decrease over time.

    Arbitrage (see also Correlation)

    The act of taking advantage of differences in price between markets. For example, if a stock is

    quoted on two different equity markets, there is the possibility of arbitrage if the quoted price

    (adjusted for institutional idiosyncrasies) in one market differs from the quoted price in the

    other. The term has been extended to refer to speculators who take positions on the correlation

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    between two different types of instrument, assuming stability to the correlation patterns. Many

    funds have discovered that correlation is not as stable as it is assumed to be.

    Asset-Liability Management

    Closing out exposure to fluctuations in interest rates by matching the timing of cash flowsassociated with assets and liabilities. This is a technique commonly used by financial

    institutions and large corporations.

    At-the-Market (see also Market Order)

    A type of financial transaction in which the order to buy or

    sell is executed at the current prevailing market price.

    At-the-Money Spot

    An option whose strike price is equal to the current, prevailing

    price in the underlying cash spot market.

    At-the-Money Forward

    An option whose strike price is equal to the current, prevailing

    price in the underlying forward market.

    Average Rate Options

    An option whose payout at expiry is determined by thedifference between its strike and a calculated average market

    rate where the period, frequency and source of observation for

    the calculation of the average market rate are specified at the

    inception of the contract. These options are cash settled,

    typically.

    Average Strike Options

    An option whose payout at expiry is determined by the difference between the prevailing cash

    spot rate at expiry and its strike, deemed to be equal to a calculated average market rate wherethe period, frequency and source of observation for the calculation of the average market rate

    are specified at the inception of the contract. These options are cash settled, typically.

    B

    Backwardation (see also Contango)

    A term often used in commodities or futures markets to refer to markets where shorter-dated

    contracts trade at a higher price than longer-dated contracts. Plotting the prices of contracts

    against time, with time on the x-axis, shows the commodity price curve as sloping downwardsas time increases.

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    Barrier Options (see also Knock-In Options, Knock-Out Options)

    An option contract for which the maturity, strike price and underlying are specified at inception

    in addition to a trigger price. The trigger price determines whether or not the option actually

    exists. In the case of a knock-in option, the barrier option does not exist until the trigger is

    touched. For a knock-out option, the option exists until the trigger is touched.

    Basis (see also Index)

    The difference in price or yield between two different indices.

    Benchmarking

    A benchmark is a reference point. Benchmarking in financial risk management refers to the

    practice of comparing the performance of an individual instrument, a portfolio or an approach

    to risk management to a pre-determined alternative approach.

    Black-Scholes

    A closed-form solution (i.e. an equation) for valuing

    plain vanilla options developed by Fischer Black

    and Myron Scholes in 1973 for which they shared

    the Nobel Prize in Economics.

    C

    Call Option

    A call option is a financial contract giving the owner the right but not the obligation to buy a

    pre-set amount of the underlying financial instrument at a pre-set price with a pre-set maturity

    date.

    Cap

    A cap is a financial contract giving the owner the right but not the obligation to

    borrow a pre-set amount of money at a pre-set interest rate with a pre-setmaturity date.

    Cash Settlement

    Some derivatives contracts are settled at maturity (or before maturity at closeout) by an

    exchange of cash from the party who is out-of-the-money to the party who is in-the-money.

    Chooser Option

    An option that gives the buyer the right at the choice date (before the option's expiry) to choose

    if the option is to be a call or a put.

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    Collar (see also Range Forward; Risk Reversal)

    A combination of options in which the holder of the contract has bought one out-of-the

    money option call (or put) and sold one (or more) out-of-the-money puts (or calls).

    Doing this locks in the minimum and maximum rates that the collar owner will use to

    transact in the underlying at expiry.

    Commodity Swap

    A contract in which counterparties agree to exchange payments related to indices, at least one

    of which (and possibly both of which) is a commodity index.

    Contango (see also Backwardation)

    A term often used in commodities or futures markets to refer to markets where shorter-dated

    contracts trade at a lower price than longer-dated contracts. Plotting the prices of contractsagainst time, with time on the x-axis, shows the commodity price curve as sloping upwards as

    time increases.

    Convexity

    A financial instrument is said to be convex (or to possess convexity) if the financial

    instrument's price increases (decreases) faster (slower) than corresponding changes in the

    underlying price.

    Correlation (see also Arbitrage)

    Correlation is a statistical measure describing the extent to which prices on different

    instruments move together over time. Correlation can be positive or negative. Instruments that

    move together in the same direction to the same extent have highly positive correlations.

    Instruments that move together in opposite direction to the same extent have highly negative

    correlations. Correlation between instruments is not stable.

    Covered Call Option Writing

    A technique used by investors to help fund their underlying positions, typically used in the

    equity markets. An individual who sells a call is said to "write" the call. If this individual sells a

    call on a notional amount of the underlying that he has in his inventory, then the written call is

    said to be "covered" (by his inventory of the underlying). If the investor does not have the

    underlying in inventory, the investor has sold the call "naked".

    Credit Risk

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    Credit risk is the risk of loss from a counterparty in default or from a pejorative change in the

    credit status of a counterparty that causes the value of their obligations to decrease.

    Currency Swap (see also Interest Rate Swap)

    An exchange of interest rate payments in different currencies on a pre-set notional amount andin reference to pre-determined interest rate indices in which the notional amounts are

    exchanged at inception of the contract and then re-exchanged at the termination of the contract

    at pre-set exchange rates.

    D

    Delta

    The sensitivity of the change in the financial instrument's price to changes in the price of theunderlying cash index.

    Documentation Risk

    The risk of loss due to an inadequacy or other unforeseen aspect of the legal documentation

    behind the financial contract.

    Duration

    A weighted average of the cash flows for a fixed income instrument, expressed in terms of

    time.

    E

    Embedded Derivatives (see also Structured Notes)

    Derivative contracts that exist as part of securities.

    Equity Swap (see also Interest Rate Swap)

    A contract in which counterparties agree to exchange payments related to indices, at least one

    of which (and possibly both of which) is an equity index.

    European Style Option

    An option that can be exercised only at expiry as opposed to anAmerican Style option that can be exercised at any time from

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    inception of the contract. European Style option contracts can be closed out early, mimicking

    the early exercise property of American style options in most cases.

    Exchange Traded Contracts

    Financial instruments listed on exchanges such as the Chicago Board of Trade.

    Exercise Price (see also Strike Price)

    The exercise price is the price at which a call's (put's) buyer can buy (or sell) the underlying

    instrument.

    Exotic Derivatives

    Any derivative contract that is not a plain vanilla contract. Examples include barrier options,

    average rate and average strike options, lookback options, chooser options, etc.

    F

    Floor (see also Cap; Collar)

    A floor is a financial contract giving the owner the right but not the obligation to lend a pre-set

    amount of money at a pre-set interest rate with a pre-set maturity date.

    Forward Contracts

    An over-the-counter obligation to buy or sell a financial instrument or to make a payment at

    some point in the future, the details of which were settled privately between the two

    counterparties. Forward contracts generally are arranged to have zero mark-to-market value at

    inception, although they may be off-market. Examples include forward foreign exchange

    contracts in which one party is obligated to buy foreign exchange from another party at a fixed

    rate for delivery on a pre-set date. Off-market forward contracts are used often in structured

    combinations, with the value on the forward contract offsetting the value of the other

    instrument(s).

    Forward or Delayed Start Swap (see also

    Interest Rate Swap)

    Any swap contract with a start that is later than the standard terms. This means that calculation

    of the cash flows does not begin straightaway but at some pre-determined start date.

    Forward Rate Agreements (FRAs) (see also Interest Rate Swap)

    A forward rate agreement is a cash-settled obligation on interest rates for a pre-set period on a

    pre-set interest rate index with a forward start date. A 3x6 FRA on US dollar LIBOR (the

    London Interbank Offered Rate) is a contract between two parties obliging one to pay the other

    the difference between the FRA rate and the actual LIBOR rate observed for that period. An

    Interest Rate Swap is a strip of FRAs.

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    Futures Contracts

    An exchange-traded obligation to buy or sell a financial instrument or to make

    a payment at one of the exchange's fixed delivery dates, the details of which are

    transparent publicly on the trading floor and for which contract settlement takes

    place through the exchange's clearinghouse.

    G

    Gamma (see also Delta)

    Gamma (or convexity) is the degree of curvature in the financial contract's price curve with

    respect to its underlying price. It is the rate of change of the delta with respect to changes in the

    underlying price. Positive gamma is favourable. Negative gamma is damaging in a sufficiently

    volatile market. The price of having positive gamma (or owning gamma) is time decay. Only

    instruments with time value have gamma.

    H

    Hedge

    A transaction that offsets an exposure to fluctuations in financial

    prices of some other contract or business risk. It may consist of cash

    instruments or derivatives.

    Historical Volatility

    A measure of the actual volatility (a statistical measure of dispersion)

    observed in the marketplace.

    Hybrid Security

    Any security that includes more than one component. For example, a hybrid security might be a

    fixed income note that includes a foreign exchange option or a commodity price option.

    I

    Implied Volatility

    Option pricing models rely upon an assumption of future volatility as well as the spot price,

    interest rates, the expiry date, the delivery date, the strike, etc. If we are given simultaneously

    all of the parameters necessary for determining the option price except for volatility and the

    option price in the marketplace, we can back out mathematically the volatility corresponding to

    that price and those parameters. This is the implied volatility.

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    In-The-Money Spot (see also Intrinsic Value; At-The-Money; Out-of-The-

    Money)

    An option with positive intrinsic value with respect to the prevailing market spot rate. If the

    option were to mature immediately, the option holder would exercise it in order to capture its

    economic value. For a call price to have intrinsic value, the strike must be less than the spotprice. For a put price to have intrinsic value, the strike must be greater than the spot price.

    In-The-Money-Forward (see also Intrinsic Value; At-

    The-Money; Out-of-The-Money)

    An option with positive intrinsic value with respect to the

    prevailing market forward rate. If the option were to mature

    immediately, the option holder would exercise it in order to

    capture its economic value. For a call price to have intrinsic

    value, the strike must be less than the spot price. For a put priceto have intrinsic value, the strike must be greater than the spot

    price.

    Index-Amortizing Swaps (see also Interest Rate Swaps; Accreting Swaps)

    An interest rate swap in which the notional amount for the purposes of calculating cash flows

    decreases over the life of the contract in a pre-specified manner.

    Interest Rate Swap (see also Forward Rate Agreements; Index-Amortizing

    Swaps; Accreting Swaps)

    An exchange of cash flows based upon different interest rate indices denominated in the same

    currency on a pre-set notional amount with a pre-determined schedule of payments and

    calculations. Usually, one counterparty will received fixed flows in exchange for making

    floating payments.

    International Swaps Dealers' Association (ISDA) Agreements (see also Legal

    Risk)

    In order to minimize the legal risks of transacting with one another, counterparties will

    establish master legal agreements and sidebar product schedules to govern formally allderivatives transactions into which they may enter with one another.

    Intrinsic Value

    The economic value of a financial contract, as distinct from the contract's time value.

    One way to think of the intrinsic value of the financial contract is to calculate its value

    if it were a forward contract with the same delivery date. If the contract is an option, its

    intrinsic value cannot be less than zero.

    K

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    Knock-in Option (see also Knock-Out Option; Trigger Price)

    An option the existence of which is conditional upon a pre-set trigger price trading before the

    option's designated maturity. If the trigger is not touched before maturity, then the option is

    deemed not to exist.

    Knock-out Option

    An option the existence of which is conditional upon a pre-set trigger price trading before

    the option's designated maturity. The option is deemed to exist unless the trigger price is

    touched before maturity.

    L

    Legal Risk (see also

    International Swap Dealers' Association Agreements)

    The general potential for loss due to the legal and regulatory interpretation of contracts relating

    to financial market transactions.

    LIBOR London Interbank Offer Rate

    The rate of interest paid on offshore funds in the Eurodollar markets.

    Liquidity Risk

    The risk that a financial market entity will not be able to find a price (or a price within areasonable tolerance in terms of the deviation from prevailing or expected prices) for one or

    more of its financial contracts in the secondary market. Consider the case of a counterparty

    who buys a complex option on European interest rates. He is exposed to liquidity risk because

    of the possibility that he cannot find anyone to make him a price in the secondary market and

    because of the possibility that the price he obtains is very much against him and the theoretical

    price for the product.

    Look-Back Options

    An option which gives the owner the right to buy (sell) at the lowest (highest)price that traded in the underlying from the inception of the contract to its

    maturity, i.e. the most favourable price that traded over the lifetime of the

    contract.

    M

    Margin

    A credit-enhancement provision to master agreements and individual transactions in which one

    counterparty agrees to post a deposit of cash or other liquid financial instruments with the

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    entity selling it a financial instrument that places some obligation on the entity posting the

    margin.

    Mark to Market Accounting

    A method of accounting most suited for financial instruments in which contracts are revalued atregular intervals using prevailing market prices. This is known as taking a "snapshot" of the

    market.

    Market Risk

    The exposure to potential loss from fluctuations in market prices (as

    opposed to changes in credit status).

    Market-Maker

    A participant in the financial markets who guarantees to make

    simultaneously a bid and an offer for a financial contract with a pre-set

    bid/offer spread (or a schedule of spreads corresponding to different

    market conditions) up to a pre-determined maximum contract amount..

    N

    Naked Option Writing

    The act of selling options without having any offsetting exposure in the underlying cashinstrument.

    Netting

    When there are cash flows in two directions between two counterparties, they can be

    consolidated into one net payment from one counterparty to the other thereby reducing the

    settlement risk involved.

    O

    OCC

    The Office of the Comptroller of the Currency (US).

    OSFI

    Office of the Superintendent of Financial

    Institutions (Canada).

    Open Interest

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    Exchanges are required to post the number of outstanding long and short positions in their

    listed contracts. This constitutes the open interest in each contract.

    Operational Risk

    The potential for loss attributable to procedural errors or failures in internal control.

    Option

    The right but not the obligation to buy (sell) some underlying cash instrument at a pre-

    determined rate on a pre-determined expiration date in a pre-set notional amount.

    Out-of-The-Money Spot (see also At-The-Money; In-The-Money)

    An option with no intrinsic value with respect to the prevailing market spot rate. If the option

    were to mature immediately, the option holder would let it expire. For a call price to haveintrinsic value, the strike must be less than the spot price. For a put price to have intrinsic value,

    the strike must be greater than the spot price.

    Out-of-The-Money-Forward (see also At-The-Money; In-

    The-Money)

    An option with no intrinsic value with respect to the prevailing market

    forward rate. If the option were to mature immediately, the option holder

    would let it expire. For a call price to have intrinsic value, the strike must

    be less than the spot price. For a put price to have intrinsic value, the

    strike must be greater than the spot price.

    Over-the-Counter

    Any transaction that takes place between two counterparties and does not involve an exchange

    is said to be an over-the-counter transaction.

    P

    Path-Dependent Options (see also Knock-In Options; Knock-Out Options;Average Rate Options; Average Strike Options; Lookback Options)

    Any option whose value depends on the path taken by the underlying cash instrument.

    Potential Exposure

    An assessment of the future positive intrinsic value in all of the contracts outstanding with an

    individual counterparty who may choose (or may be unable) to make their obligated payments.

    Premium

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    The cost associated with a derivative contract, referring to the

    combination of intrinsic value and time value. It usually applies to

    options contracts. However, it also applies to off-market forward

    contracts.

    Put Option (see also Call Option)

    A put option is a financial contract giving the owner the right but not the

    obligation to sell a pre-set amount of the underlying financial instrument

    at a pre-set price with a pre-set maturity date.

    Put-Call Parity Theorem

    A long position in a put combined with a long position in the underlying forward instrument,

    both of which have the same delivery date has the same behavioral properties as a long position

    in a call for the same delivery date. This can be varied for short positions, etc.

    Q

    Quanto Option

    An option the payout for which is denominated in an index other than the underlying cash

    instrument.

    RRegulatory Risk

    The potential for loss stemming from changes in the regulatory environment pertaining to

    derivatives and financial contracts, the utility of these instruments for different counterparties,

    etc.

    Rho

    The sensitivity of a financial contract's value to small changes in interest rates.

    RiskMetrics (see also Value-at-Risk)

    A parametric methodology for calculating Value-at-Risk using data conditioned

    by JP Morgan's spinoff company RiskMetrics that is most useful for assessing

    portfolios with linear risks.

    S

    Settlement Risk

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    The risk of non-payment of an obligation by a counterparty to a transaction, exacerbated by

    mismatches in payment timings.

    Speculation

    Taking positions in financial instruments without having an underlying exposure that offsetsthe positions taken.

    Spot

    The price in the cash market for delivery using the standard market convention. In the foreign

    exchange market, spot is delivered for value two days from the transaction date or for the next

    day in the case of the Canadian dollar exchanged against the US dollar.

    Spread

    The difference in price or yield between two assets that differ by type of

    financial instrument, maturity, strike or some other factor. A credit spread is the

    difference in yield between a corporate bond and the corresponding government

    bond. A yield curve spread is the spread between two government bonds of

    differing maturity.

    Standard Deviation (see also Volatility; Implied Volatility)

    In finance, a statistical measure of dispersion of a time series around its mean; the expected

    value of the difference between the time series and its mean; the square root of the variance of

    the time series.

    Stress Testing

    The act of simulating different financial market conditions for their potential effects on a

    portfolio of financial instruments.

    Strike Price

    The price at which the holder of a derivative contract exercises his right if it is economic to do

    so at the appropriate point in time as delineated in the financial product's contract.

    Structured Notes

    Fixed income instruments with embedded derivative products.

    Swap Spread (see also Plain Vanilla Interest Rate Swap)

    The difference between the swap yield curve and the government yield curve for a particular

    maturity, referring to the market prices for the fixed rate in a plain vanilla interest rate swap.

    Swaptions (see also Plain Vanilla Interest Rate Swap)

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    Options on swaps.

    T

    Theta

    The sensitivity of a derivative product's value to changes in the date, all other factors staying

    the same.

    Time Value (see also Intrinsic Value; Premium)

    For a derivative contract with a non-linear value structure, time value is the difference

    between the intrinsic value and the premium.

    VValue at Risk or VaR (see also RiskMetrics)

    The caculated value of the maximum expected loss for a given portfolio over a defined time

    horizon (typically one day) and for a pre-set statistical confidence interval, under normal

    market conditions

    Value of a Basis Point

    The change in the value of a financial instrument attributable to a change in the relevant interestrate by 1 basis point (i.e. 1/100 of 1%).

    Vega

    The sensitivity of a derivative product's value to changes in implied volatility, all other factors

    staying the same.

    Volatility (see also Standard Deviation; Implied Volatility)

    In finance, a statistical measure of dispersion of a time series around its mean; the expectedvalue of the difference between the time series and its mean; the square root of the variance of

    the time series.

    Y

    Yield Curve

    For a particular series of fixed income instruments such as government bonds, the graph of the

    yields to maturity of the series plotted by maturity.

    Yield Curve Risk

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    The potential for loss due to shifts in the position or the shape of the yield curve.

    Z

    Zero Coupon Instruments

    Fixed income instruments that do not pay a coupon but only pay principal at maturity; trade at a

    discount to 100% of principal before maturity with the difference being the interest accrued.

    Zero Coupon Yield Curve

    For zero coupon bonds, the graph of the yields to maturity of the series plotted by maturity

    Trading in derivatives

    Why should I trade in derivatives?

    FUTURES trading will be of interest to those who wish to:

    1) Invest - take a view on the market and buy or sell accordingly.

    2) Price risk transfer - Hedging - Hedging is buying and selling futures contracts tooffset the risks of changing underlying market prices.

    Thus it helps in reducing the risk associated with exposures in the underlying marketby taking a counter-position in the futures market.

    For example, the hedgers who either have security or plan to have a security isconcerned about the movement in the price of the underlying before they buy or sellthe security.

    Typically he would take a short position in the futures markets, as the cash andfutures price tend to move in the same direction as they both react to the samesupply/demand factors.

    3) Arbitrage - Since the cash and futures price tend to move in the same direction asthey both react to the same supply/demand factors, the difference between theunderlying price and futures price called as basis.

    Basis is more stable and predictable than the movement of the prices of theunderlying or the futures price. Thus arbitrageur would predict the basis andaccordingly take positions in the cash and future markets.

    4) Leverage - Since the investor is required to pay a small fraction of the value of thetotal contract as margins, trading in futures is a leveraged activity since the investor isable to control the total value of the contract with a relatively small amount of margin.

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    Thus the leverage enables the traders to make a larger profit or loss with acomparatively small amount of capital.

    Options trading will be of interest to those who wish to:

    1) Participate in the market without trading or holding a large quantity of stock

    2) Protect their portfolio by paying a small premium amount.

    Benefits of trading in futures and options.

    1) Able to transfer the risk to the person who is willing to accept them.

    2) Incentive to make profits with minimal amount of risk capital.

    3) Lower transaction costs.

    4) Provides liquidity, enables price discovery in underlying market.

    5) Derivatives market are lead economic indicators.

    6) Arbitrage between underlying and derivative market.

    7) Eliminate security specific risk.

    What are the benefits of trading in index futures compared to any othersecurity?

    An investor can trade the `entire stock market' by buying index futures instead ofbuying individual securities with the efficiency of a mutual fund.

    The advantages of trading in index futures are:

    The contracts are highly liquid.Index futures provide higher leverage than any other stocks.It requires low initial capital requirement.It has lower risk than buying and holding stocks.It is just as easy to trade the short side as the long side.Only have to study one index instead of 100's of stocks.

    Settled in cash and therefore all problems related to bad delivery, forged, fake certificates, etc can be avoided.

    How do I start trading in the derivatives market?

    Futures/options contracts in both index as well as stocks can be bought and soldthrough the trading members of the National Stock Exchange.

    Some of the trading members also provide the Internet facility to trade in the futuresand options market.

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    You are required to open an account with one of the trading members and completethe related formalities, which include signing of member-constituent agreement,constituent registration form and risk disclosure document.

    The trading member will allot to you an unique client identification number. To begin

    trading, you must deposit cash and/or other collaterals with your trading member asmay be stipulated by him.

    Is there any margin payable?

    Yes. Margins are computed and collected on-line, real time on a portfolio basis at theclient level.

    Members are required to collect the margin upfront from the client and report thesame to the exchange.

    How are the contracts settled?

    All the futures and options contracts are settled in cash on a daily basis and at theexpiry or exercise of the respective contracts as the case may be.

    Clients/trading members are not required to hold any stock of the underlying fordealing in the futures/options market.

    All out of the money and at the money option contracts of the near month maturityexpire worthless on the expiration date.

    .