ab15 12,13 futures
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Future Trading
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Derivatives
A derivative is an instrument whose value isderived from the value of one or more ofunderlying assets in a contractual manner.
The underlying asset could be equity, forex,metals, agri commodities.
Types of Derivative
Futures
Swaps
OptionsForwardsThe value of the derivative
instrument is DERIVED from the underlying security/Commodity
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Transactions have three components
i) Trading (buyer and seller negotiating and arriving at a Price)
ii) Clearing ( Finding out the net outstanding i.ehow much money the two should exchange)
iii) Settlement (the actual process of exchanging goods and money)
In Spot market all these happen simultaneously
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In a forward market
Trading takes place one day
Clearing and Settlement takes place at a future dateat a specified period
It is an agreement between the two entities to buy or sell the asset at a future date at today’s pre agreed price
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A bilateral agreement in which the buyer andseller agree upon the delivery of a specifiedquantity and quality of an asset at aspecified date and agreed price
Price of contract is called a delivery price:usually is equal to spot price plus cost ofcarry
Contracts are custom designedActual delivery has to take placeNo exchange guarantee
Futures
A futures contract is a binding agreement between aseller and a buyer to make (seller) and to take (buyer)delivery of underlying commodity (or financial instrument)at a specified future date with agreed upon paymentterms.
Futures contract are normally traded on an exchange. Tomake trading possible the exchange specifies certainstandardized features of the contract.
As the two parties do not necessarily know each otherthe exchange also provides a mechanism that givesthe two parties a guarantee that the contract will behonoured.
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A major difference between forwards and futuresis that futures contracts have standardizedcontract terms.
Futures contracts specify the quality andquantity of goods that can be delivered, thedelivery time, and the manner of delivery.
Standardization tells traders exactly what isbeing traded and the conditions of thetransaction.
it enables the traders to focus on one variable namely price
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The purchaser of a futures contract issaid to have gone long or taken a longposition.
The seller of a futures contact is said tohave gone short or taken a shortposition
•Short selling is the selling of asecurity/commodity that the seller doesnot own.
•Short sellers assume the risk that they will be able to buy at a more favorable price than the price at which they sold short.
•Holding a Long Position Investors arelegally owning a security/commodity.
Clearing House
Derivatives contracts are “cleared” by aClearinghouse - the foundation of allderivatives markets
A CH is a central counterparty to all transactions
CH assumes the role of buyer to the seller and seller to the buyer
Each futures exchange has a clearinghouse.
The clearing house guarantees that traders in thefutures market will honor their obligations.
Clearinghouse guarantees financial integrity ofderivatives markets
The clearing house splits each trade and acts asthe opposite side of each position.
CH assigns deliveries of commodities from sellerto buyer
Either side of the trade can reverse positions at afuture date without having to contact the otherside of the initial trade.
DetailsMCX NCDEXTrading cumclearingmember(deposit based)
InstitutionClearingMember
Trading cumclearingmember
ProfessionalClearingMembership
Admission Fee 5,00,000 10,00,000 15,00,000 25,00,000Interest Free SecurityDeposit
50,00,000 50,00,000 15,00,000 25,00,000
Processing Fee 10,000 10,000 5,00,000Annual Subscription 50,000 50,000 -- 1,00,000Annual insurance fee 5,600 5,600 -- --VSAT cost 1,65,000 1,65,000 -- --Advance maintenancecharges
-- -- 50,000 1,00,000
Net worthrequirement
-- -- 5,00,00,000 5,00,00,000
Membership Fee in the Two Major Commodity Exchanges (Amount in Rupess)
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Settlement
Settlement in the future market is done in three ways:
-- Physical Delivery – on Expiration-- Closing out open positions-- Cash Settlement – on Expiration
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Financial derivates vs Commodity Derivatives
Varying quality of asset
– Not there in financial derivatives-- In commodities the quality of the asset vary
Bulky in nature-- Physical settlement in financial derivatives
do not need storage facility-- Commodities need warehousing facility
ProducersCommoditiesEcosystem
MCX
Clearing House
QualityAssayers
Clearing Bank
Warehouses
Registrar and TransferAgents
Traders(Speculators)Arbitrageurs/
Client)
Hedger(Exporters/
Millers/Industry)
Global Commodities Market
Spot Market
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Exchange Bilateral tradingCommon platform for all traders Restricted access
Price transparency Traded prices unknown to other players
Low transaction costs High cost and time consuming negotiations
Absence of counter party credit risk
Counter party credit risk
Market prices available to wider world
Difficulty in price dissemination
Standardized contract size Customized contracts
Exchange - a common meeting ground for all industry participants
Institution Share Domain Expertise
NABARD 15 % Apex bank for agricultural lending
NSE 15 % Largest stock exchange in India. Highest volume in single stock futures in world.
LIC 15 % Largest life insurance company in India
CRISIL 12% India’s first & largest credit rating agency. Now a Standard & Poor company
IFFCO 12% Largest farmer cooperative with affiliation of 36,000 cooperatives
PNB 8% Large public sector bank with strong rural reach specially in North India
Canara Bank 8% Large public sector bank with strong rural reach specially in South India
Goldman Sachs
7% Global Expertise in commodity markets
Intercontinental Exchange*
8% 6th largest commodity futures exchange in the world
*Acquired from ICICI Bank
- 46% held by public sector and balance by other institutions
- No private shareholding 18
Regulatory Structure - Spot & Futures
Spot Market
Futures Market/
Commodity Exchange
State Governments
Forward Markets
Commission (FMC) SEBI
Ministry of Consumer Affairs,
Food and Public Distribution
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There are 5 National Exchanges –NCDEX, MCX(both in Mumbai), NMCE and AhmedabadCommodity Exchange (ACE) (Ahmedabad)Indian Commodity Exchange Gurgaon
Besides 21 Regional Exchanges in different partsof the country
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NCDEXBarley, Cashew, Castor Seed, Chana, Chilli, coffee, cotton seed oilcake,crude palm oil, coriander, expeller mustard oil, groundnut, groundnutexpeller oil, guar gum, guar seeds, gur
Parboiled rice, basmati rice, cotton, Jeera, jute sacking, masur grain,menthe oil, raw silk, pepper, potato, raw silk, palmolein, refined soy oil,rubber, sesame seeds, soybean, sugar, tur, turmeric, urad, peas, maize,soy meal
MCXCastor oil, castor seeds, coconut cake, coconut oil, cotton seed, crudepalm oil, groundnut, cotton oil, mustard oil, mustard seed, palm oil,refined soy oil, sunflower oil, rice bran oil, sesame seed, soy meal,soybean, cardamom, coriander, jeera, pepper, red chilli, turmeric, chana,masur, Peas, maize, arecanut, cashew, rubber
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Types of ParticipantsHedgers, Speculators, Arbitrageurs
HedgersUse derivatives to reduce the risk they face frompotential future movements in a marketvariable. Hedgers want to avoid exposure toadverse movements in the price of an asset
SpeculatorsUse them to bet on the future direction of themarket variable.Take a position in the market either they arebetting that the price of the asset may go up ordown.
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ArbitrageursArbitrage involves locking in a
riskless profit by simultaneouslyentering into transactions in two ormore markets
The vast majority of futures contractsdo not lead to delivery. The reason isthat most traders choose to close outtheir positions prior to the deliveryperiod specified in the contract.
Closing out a position means enteringinto the opposite type of trade from theoriginal one.
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HedgingFuture contracts can be temporary substitutes foran intended transaction in the cash market that willoccur at a later date.
This is called hedging. Hedging is buying andselling futures contracts as a protection againstunfavourable price changes.
When an individual or a company decided to usethe future market to hedge a risk the objective is totake a position that neutralises the risk as much aspossible
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A short hedge is appropriate when the hedgeralready owns the assets or is likely to own theasset and expect it to sell sometime in thefuture. A long hedge is appropriate when acompany knows it will have to purchase acertain asset in the future and wants to lock in aprice now.
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A Simple Long Hedge in MCX Potato Futures
Activities in the Commodity Futures Transactions
On October, the wafermanufacturer calculates that hemay need 300 tonnes of potato inMarch. He feels that a price of 350per quintal would be favourable tohim
On October he buys 10 potato futures contracts in MCX for delivery at Rs 350 per quintal.
On March, he buys 300 tonnes ofpotato in the spot market at Rs400 per quintal.
On March, sells 10 potato futuresfor Rs 400 per quintal
Spot market “loss” of Rs 50 perquintal is equal to Rs 1,50,000
Futures market “gain” is Rs 50 perquintal or Rs 1,50,000
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Suppose the opposite happens that isthe spot market price of potato in Marchfell to Rs 300 per quintal. The wafermanufacturer would buy 300 tonnes fromthe spot market in March. He sells hisfutures contract at Rs 300 per quintal. Heincurs a loss of Rs 50 per quintal and itamounts to Rs 1,50,000. His effectiveprice of potato still is Rs 350 per quintal
Remember the objective is not to make profit but sure about the price
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Convergence of Futures Price to Spot Price
As the delivery period for a futures contract isapproached the futures price converges to thespot price of the underlying asset when thedelivery period is reached, the futures priceequals or is very close to the spot price.
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Time Time
(a) (b)
FuturesPrice
FuturesPrice
Spot Price
Spot Price
Only the members of the exchange are eligible toparticipate in trading. Persons who are not membersof the exchange can participate in trading only asapproved users or clients through a registeredmember of the exchange. There are two types ofmembers, Trading cum Clearing Member andProfessional Clearing member
A trading cum clearing member is entitled to trade onhis own account as well as on account of his clientsand clear and settle trades himself. The Professionalclearing membership entails the members to cleartrades executed through trading cum clearingmembers (TCMs) both for themselves and on behalfof their clients
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The trading system provides a fully automatedscreen based trading for futures oncommodities on a nationwide basis as well ason online monitoring and surveillancemechanism. For example, the system supportsan order driven market where orders matchautomatically. Order matching is essentially onthe basis of commodity, its price, time andquantity
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ClearingClearing of Trade that takes place on the exchangehappens through the exchange clearing house (e.gNational Securities Clearing Corporation of NSE interfaceswith National Securities Depository Ltd (NSDL).
The exchange through the clearing house guarantees thefaithful compliance of all trade
Members of the clearing house are mostly financialinstitutions
Main task
Keep track of all the transactions that take place during aday to calculate the net position of each of its members
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MarginInitial margin is the money that must bedeposited by the customer at the time ofentering into a contract
It is set for each type of underlying asset.
Initial margin per contract is relatively low andequals about one day’s maximum pricefluctuation on the total value of the contract’sunderlying asset.
Maintenance margin is the amount of marginthat must be maintained in a futures account.
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If the margin balance in the account fallsbelow the maintenance margin, additionalfunds must be deposited to bring themargin balance back up to the initialmargin requirements.
If account margin exceeds the initial marginrequirement, funds can be withdrawn orused as initial margin for additionalpositions
a certain minimum amount of funds foreach open position held. --- Good FaithDeposits
The Clearing House and ClearingMargins
The exchange clearing house is an adjunctof the exchange and acts as anintermediary in futures transactions. Itguarantees the performance of the partiesto each transaction. The clearing house hasa number of members who must post fundswith the exchange.
The clearing house – clearing margin withthe exchange 38
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Buying (Long Position)
10 Contract 1 cont =30
Future Price
Settlement Price
7-Oct 350/qtl 1050000
7-Oct 340 1020000 -30000
8-Oct 340 335 1005000 -15000
9-Oct 335 345 1035000 30000
10-Oct 345 355 1065000 30000
11-Oct 355 360 1080000 15000Square off (sell)
30000
Marked to Market
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Selling (Short Position)
7-Oct 350 qtl 1050000
7-Oct 340 qtl 1020000 30000
8-Oct 340 335 1005000 15000 9-Oct 335 345 1035000 -30000
10-Oct 345 355 1065000 -30000
11-Oct 355 360 1080000 -15000 Square off (buy)
-30000
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Daily Settlement Final Settlement
Types of Settlement
Handles Daily Price fluctuation for alltrades (mark to market)Daily Process at end of day
On contract expiry day
Daily Settlement Price
Handles finalsettlement of all open positions
FinalSettlement Price
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Daily Settlement (MTM) Final Settlement
Done at the end of the each trading day
Done on the day of Contract Expiry
Based on the daily settlement Prices
Based on the final settlement price
All open positions are marked to market
Only trades not closed till contract expiry
Settlement
Settlement of futures contract can be done in threeways by physical delivery of the underlying asset,by clearing out open position and by cashsettlement.
All contracts materialising into deliveries are settledin a period of 2-7 days after expiry.
The exact settlement day for each commodity isspecified by the exchange.
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Physical Delivery of the Underlying Asset
Any buyer intending to take physicals has to put arequest to his depository participant.
The DP uploads such requests to the specifieddepository who in turn forwards the same to theregistrar and transfer agent (R and T agent)concerned.
After due verification of the authenticity the R and Tagent forwards delivery details to the warehousewhich in turn arranges to release the commoditiesafter due verification of the identity of recipient.
On a specified day the buyer would go to thewarehouse and pick up the physicals 45
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The National Securities Depository Ltd (NSDL)and Central Depository Services Ltd., (CDSL), thedepositories of the securities market, had beenfacilitating the electronic holding and transfer ofcommodity balances for the clients of thecommodity derivatives market. Under thearrangement, each of the clearing members wouldopen a member pool account with the depositoriesthrough depository participants to facilitate thesettlement of commodities. The depositories had adirect connectivity with the clearing house andeffected the transfer of electronic balance to themember pool account of clearing members as perinstructions from the clearing house.
Products selected on the basis of Economic parameters ◦ Price volatility◦ Share in GDP◦ Correlation with global markets◦ Share in external trade◦ Government intervention◦ Warehousing facilities◦ Traders distribution◦ Geographical spread◦ Number of varieties
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Commodities given priority where they are more relevant to India: where price discovery takes place domestically
Deliveries in terms of Value (Rs. In Lakhs)
Period Total ValueDisputed
Value% of disputed
to total
2005-06 178,287 407 0.23
2006-07 256,524 1346 0.52
Apr- Jun 2007 52,991 20 0.04
Grand Total 487,802 1773 0.36
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Globally less than 2% volumes result in deliveries
Globally, exchanges are not used as delivery platform
However, NCDEX has seen large deliveries
The total number of accredited delivery centers are around 660
NCDEX Quality emerging as benchmark in the market for cereals, pulses, spices, oilseeds, sugar & guar
Created warehousing capacity of 1 million tonnes
Period Deliveries (MT)
Q4' FY05 43214Q1 ‘FY06 109562Q2 FY06 83081Q3 FY06 77160Q4 FY06 134260Q1 FY07 103,444Q2 FY07 125,989Q3 FY07 94,128Q4 FY07 52,063Apr-Jul FY08 1,55,813
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Farmers and the Futures – Aggregation Model
Electronic Spot Exchanges
NSPOT – NCDEX
NSEL -- MCX and Future Technologies ?
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Options
There are two types of optionsa) Call option
b) Put option
Four types of Participantsa) Buyers of Call
b) Sellers of Call
c) Buyers of Put
d) Sellers of PutStrike Price / Exercise Price
Option Premium
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Calls and Puts
The two types of options are calls and puts:
A call gives the holder the right to buy an asset at a certainprice within a specific period of time.Call options give the buyer the right but not the obligation tobuy the asset
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A put gives the holder the right to sell an asset at a certainprice within a specific period of time.
Put options give the buyer the right but not the obligation tosell an underlying asset at the strike price
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Strike Price / Exercise Price
Option Premium