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

40

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

46

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

69

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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