Introduction to Commodities Market

What is a Commodity?

A commodity is essentially a produce of a primary sector, in a relatively raw

or unprocessed form and mostly refers to any good that possesses a physical
attribute that finds use in the production of various goods and services. It is
a thing of value with uniform quality, produced in large quantities by many
different producers but not differentiated based on quality or producer.
Therefore, a commodity is largely a fungible item, which is used as an input
in the production of other goods and services.

A commodity is mostly traded in its natural form, without any processing or

value addition done to it. But there are several traded commodities that
have been minimally processed to make them useful as inputs, or to make
them easier to store and transport. For example, sugar, though processed
from sugarcane, is still traded as a commodity. It is traded in the market
without any differentiation. On the other hand, cement, which is processed
from limestone is not traded as commodity, as cement has been
differentiated on the basis of quality, as well as through branding. Anything
which is supplied across markets without any product differentiation and
for which there demand exists, is a commodity. Copper is a commodity and
has one price around the world, which is determined daily based on global
supply and demand and then adjusted for small differences in quality.

Commodities are uniform so that one part serves the same purpose as any
other. For example, a kilogram of gold is as good as another. It makes little
difference to those buying it as to which kilogram they receive, and whether
it has been mined in Canada or in South Africa or any other part of the
world. It is normally traded with a quality standard of 999 or 995 parts per
thousand. It is worth mentioning here that since commodities are given by
nature, there will be some quality variations in the commodity, and this will
be adjusted through adding a premium or reducing a discount in the price
of same commodity, depending on quality variation. There will also be
difference in prices due to shipping costs, differences in composition,
exchange rates of currencies and so forth, thus gold will sell at different
prices at different times and places.

Thus a commodity can be defined as a good that has following properties:

1. Given by nature and traded close to its natural/unprocessed form.

2. Usually produced and/or sold by many different producers.

3. Uniform in quality between producers that produce and sell it.

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4. Traded at a price resulting from its demand and supply.

Commodities are normally talked about as Hard or Soft. Hard

commodities are those that are mined or extracted out of the earth like
copper, gold or crude oil. Soft commodities, on the other hand, are those
that are grown like coffee, wheat, sugar.

Commodity markets:

Commodities, as discussed so far, are raw or partly refined goods whose

value mainly reflects the costs of finding, gathering, harvesting, or mining
them. They are traded for further processing or incorporation into final
goods. For the purpose of being traded, every commodity that is produced
(whether mined or grown) must eventually come to the market place
where it can be bought and sold. Commodity markets have existed for
centuries around the world because producers or buyers of food products
and other items have always needed a common place to trade. They are
the two core participants in commodity markets. Commodities can be
traded through bilateral negotiations between sellers and buyers, or
through network of brokers. Mostly, the commodity market provides a
meeting place for sellers and buyers, which can be either a physical
market place or an electronic or online one. The sellers represent the
supply side and buyers represent the demand side of this market.
Besides providing the meeting place, the market functions as a price
discovery mechanism, where the prices are determined through the
supply of and demand for the commodity. The auction mechanism forms
the basis of price discovery in commodity markets. In the auction
process, each seller will have an “ask” or an “offer” price, which is the
price at which the seller is willing to sell a commodity. Each buyer will
have a “bid” price, which is the price the buyer is willing to pay to buy
the commodity.

A market in which goods are sold for cash and delivered immediately is
called physical market. Deals in such markets are immediately effective.
The physical market is also known as the spot market or cash market, as
these are delivery-verses-payment markets where transactions are settled
on the spot and paid for in cash, as opposed to forward prices. In the
physical markets, the participation is restricted to people who are
involved with that commodity like the farmer, processor, wholesaler etc.
Since transactions take place directly between principals, there is a high
degree of flexibility in the transactions.

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 Markets for Agricultural Commodities

The Indian economy is identified as one of the largest agrarian economies

of the world. Agricultural growth is recognised as an enabler of the
overall economic growth of India, and hence has remained at the focus of
government regulations and policies. The agricultural sector occupies
centre stage in any effort to promote inclusive growth, enhance rural
incomes and sustain food security. Therefore, it is important to
understand the regulation for marketing of agricultural commodities and
the working of physical markets for such commodities in India.

Agriculture market provide for movement of Agricultural produce from

the farm where it is produced to the end-consumers or
processors/manufacturers. This covers physical handling and transport,
initial processing and packing to simplify handling and reduce wastage,
grading and quality control to streamline sales transaction and meet
different customer requirements and holding over time to match
concentrated harvest season with the year round demand of consumers.

The vital function of the Marketing System is to offer farmers with a suitable
outlet for their produce at a remunerative price and to provide this produce
to consumers and processors through an assured and steady supply at
reasonable price. It was this objective that in 1928, the very first legislation
to create common standard to measure the quality of produce and curb
rampant malpractices by private market operators was enacted by Royal
Commission on agriculture. Post-independence the regulatory efforts
continued with the rationale of ensuring a reasonable income for the
farmers and access to food commodities for consumers at affordable
prices. These regulations derived from Essential Commodities Act, 1955 and
impose control on private storage, transport, processing, export, import,
credit access and market infrastructure development.

Under the Constitution of India, Agriculture Marketing is a state subject.

The regulation of wholesale agriculture market is governed by various state
specific agricultural produce marketing committee acts, which date back to
the 1916 and allowed the state government to control procurement, storage
and movement of Agricultural commodities. The primary objective of the act
remained the same i.e. regulation of trading practices, increased market
efficiency through reduction in market charges, elimination of super floors
intermediaries and protecting the interest of producers and sellers. The
APMC Act empowers state governments to conduct trading in notified
agricultural commodities through designated market areas properly called
mandis.

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Physical markets and need for derivative markets

Physical spot markets, irrespective of the method of marketing

adopted, localised for specific commodities and can operate wherever the
infrastructure exist to conduct delivery based trading. Physical trading
normally involves visual inspection of the commodity or a sample of the
commodity and is carried out in markets, such as the wholesale markets.
Also, prices that prevail in the physical market are quite volatile depending
essentially on demand and supply.

Unpredictability of prices in the physical markets leave the commodity

buyers and sellers at a risk. A likely fall in prices of commodity will leave the
producer/seller of that commodity exposed to the risk of loss at the time of
sale of produce in the spot market. Growing wheat, for instance, take several
months from planting to harvest to sale. For example, farmer planted wheat
in November and the wheat is harvested and ready for sale, discovers in
March that the price of wheat for delivery in April Has fallen over the past
month. Likewise, the buyer of a given commodity will be at risk of an
increase in prices at the time of buying in the spot market. A wheat miller,
who has agreed to sell wheat flour to a bread maker in August at a price
decided in April based on wheat prices prevailing then, find that the prices
have risen sharply by the time he is ready to purchase wheat to make flour
from it.

Since commodity prices are almost always volatile, producers and

consumers will be exposed to the risk that arises out of such price volatility
and will seek ways of managing the same. As you would have realised by
now, physical market and spot contract do not have a mechanism to
manage price risk. In the physical markets, there is no way for a producer to
lock-in a selling price for his produce at the time that he begins his
production, just as there is no way a buyer can lock-in a future buying price
for a commodity he may use as an input for production.
Therefore, producers and consumers need some kind of protection against
unpredictable price movements in order to reduce the volatility of cash
flows, as to protect their profit margins in production. This will in turn help
them in more reliable forecasting of cash flows, lower capital requirements
and higher capital productivity.

Derivatives make future risk tradable, which gives rise to two main uses
from them - Future price discovery and price risk management and
investment. Producers and consumers, for example, use derivatives to
access future price directions and to protect themselves against changes in
raw material prices, exchange rates, interest rates etc. The second use of
derivative is an investment. They are an alternative to investing directly in
assets without buying and holding the asset itself. The derivatives market
has grown rapidly in recent years, as the benefit of using derivatives, such
as effective risk mitigation and risk transfer, have become increasingly
important.

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Therefore, all established physical commodities that have price volatility not
only have active physical market but also active derivatives market. Such
markets exist around the world for almost all the commodities known to us.
Physical commodity markets trade in basic resources, such as crude oil,
copper, aluminium, gold and silver and Agricultural Products such as sugar,
coffee beans, soya beans, rice and wheat. Derivative markets for these
commodities trade contracts such as forwards, futures, options and swaps.
It is through the use of such contracts that the producer can lock-in a price
for his produce when he is ready to sell and the buyer can fix a price at
which he would buy in the future. Derivative markets trade contracts that
determine the current price for a commodity transaction is it designated to
take place at a later date.

Evolution of commodity derivatives

The prices of a commodity is subject to supply and demand, producers as

well as consumers and intermediaries face a price risk. For example, a
farmer faces the risk of a decline in selling price of his produce, which he
will harvest a couple of months after sowing, as the price of his produce can
change between sowing time and harvest and sell time. It is not surprising
then that modern commodity markets have their roots in the trading of
Agricultural Products. In fact, derivatives trading, as we know it today, took
birth in agricultural commodity markets.

While commodity markets are almost as old as human history and spot
transactions had been the most common form of transacting initially,
forward agreement (used to deliver and pay for something in the future at a
price agreed upon in the present) have also been an integral part of
commodity markets.

The first recorded account of derivative contract can be traced back to the
philosopher Thales of Miletus in ancient Greece. In 600 bc. Olive oil was
used for making soaps, provide ng fuel for lamps, for cooking and was used
as a skin softener. For several seasons, the olive trees had not been
producing olives, but Thales Used his knowledge of astronomy to predict a
bumper olive crop in the coming season. Based on this expectation, Thales
made a tour of The Olive growing country side convinced discouraged olive
growers to sell their out of use olive presses to him. But when the big crop of
olives came the following year, there were no presses, to borrow or to buy.
Thales had got them all and had thus cornered the oil market and made a
fortune.

Evidence also suggest that forward agreements relating to the rice markets
were traded in the 17th century Japan. in Japan, traders who bought rice
from farmers at lower prices during harvest, stored it in warehouses for
future sale. To raise cash, warehouse owners sold receipts known as rice
ticket against the stored rice. Eventually, rice tickets become accepted as a
kind of general commodity currency and formed to standardise the trading

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in rice tickets. Over time, futures trading also began to take place with rice
tickets as the underlying asset.

In the 1840s, two simultaneous development had a significant impact on

commodity derivatives trading. Railroad expansion towards the east in the
United States as well as the development of Telegraph lines turned Chicago
into an important Trade Centre. Coinciding with this, the invention of
McCormick reaper lead to a multi fold increase in the production of wheat.
Farmers would come to Chicago to sell their wheat to merchants, who would
buy the wheat, store it and distribute it throughout the country. Since,
wheat, like most agricultural commodities, is harvested only once in a year,
the market for wheat was extremely unstable. Prices were high in the winter
and low in the summer, resulting in poor economic conditions for the
farmers. In the absence of storage options and due to set regulations to
control the quality and the price of the grain, farmers had no certainty of
income from the sale of their wheat. This led to the emergence of “to-arrive”
Contract, which was simple agreements between farmers and merchants for
the purchase of designated goods which they arrived into Chicago, and they
were used for centuries when shipping was the primary mode of
international trade. These “to-arrive” contracts were the immediate
predecessors of modern day future contracts. Trading that took place in
Chicago became efficient and organised when a group of Chicago-based
merchants took the initiative and formed Chicago Board of Trade (CBOT) in
1848.

Chicago Board of Trade (CBOT) The world's first and the oldest commodity
exchange, was a member owned organisation that offered a centralised
location for cash trading of variety of Agricultural goods as well as trading of
Forward contracts. Members served as Brokers who facilitated trading in
return for Commission. As trading of Forward contracts increased, Chicago
Board of Trade (CBOT) decided that standardizing those contracts would
streamline the trading and delivery processes. Instead of individualised “to-
arrive” contracts, which took a great deal of time to negotiate and fulfill,
people interested in the foreign trading of corn at Chicago Board of Trade
(CBOT), for example, were asked to trade contracts that were identical In
terms of quantity, quality, delivery month and delivery location, all as
established by the exchange. The only thing left for traders to negotiate was
the price and number of contract.

This standardised forwards were essentially the first modern future

contract. They were unlike other forwards in that they could only be traded
at exchange that created them and only during certain designated trading
hours. They are also different from other forward in that the bids, offers and
negotiated prices of the trades were made public by the exchange. The
practice established futures exchanges as a venue for price discovery and
transparent trading in US markets.

In contrast to customised contracts like forwards, Standardized futures

contracts were easy to trade, since all trades was simply renegotiation off

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price, and they usually change hands many time before expiry of the
contract. People who wanted to make a profit based on a likely price change,
could off set a future contract before it expired, by engaging in an opposite
trade, buying a contract which they had previously sold or gone short, or
selling a contract which they had previously bought or gone long. Dealers
soon started to sell their contract to other dealers and farmers passed their
orders on to other agricultural producers. It was not long before speculators
also entered the commodity trading market, to make substantial profits from
buying low and selling high, or even by first selling high and then buying
low. The contract also served as collateral to borrow money from banks.

As the usefulness of futures trading gained acceptance, a number of other

futures exchanges were established throughout the U.S.A. and the world in
the decades that followed. Some of the prominent commodity exchanges of
the world today are are the New York Mercantile Exchange, The Commodity
Exchange (COMEX), The London Metal Exchange (LME), The Tokyo
Commodity Exchange (TOCOM) and The Multi Commodity Exchange (MCX).

Financial Futures

Throughout the first seven decades of the twentieth century, the futures
industry remained essentially as it had been focused on the trading of
futures on Agricultural Products. The development of financial futures
market resulted from the changing world economy that followed World War
II. There was greater financial interdependence among nations sharp
increase in the amount of government debt. The fixed exchange rate between
US and West European currency, established after World War II, began to
unravel in the early 1970. Floating currencies contributed to the volatility of
not only money, but other financial assets. This along with the explosion of
US government issued debt moved the world economy away from a relatively
stable interest rate environment to a much volatile one.

Post 1970, the popularity of financial derivatives grew with the rise in
uncertainty when the US announced an end to the Bretton Woods System of
fixed exchange rates. In 1971, futures based on financial products were
introduced. The introduction of currency derivatives was followed by interest
rate futures on instruments such as United States treasury bonds and
treasury bills. In the 1980s, futures on stock market index is like S & P 500
were launched.

Evolution of Commodity Derivatives in India

The Indian experience in commodity derivatives market may date back to

thousands of years, with reference to such markets in India also appearing
in Kautilya’s Arthashastra. However, an organised trading in commodity
derivatives began in India with the setting up of Bombay cotton trade
Association Limited in 1875. Following this Gujarati Vyapari Mandali Was
set up in 1900 to carry out derivatives trading in groundnut, castor seeds
and cotton.

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Forward trading in raw jute and jute goods began in Kolkata with the
establishment of Culcutta Hessain Exchange Ltd. in 1919. In 1927, the East
Indian Jute Association Limited was also set up for derivatives trading in
Raw jute. These two associations merged in 1945 to form East India
jute and Hessian Exchange Ltd. Derivative markets for wheat were in
existence at several wheat trading centres of Punjab and UP with the most
notable being the Chamber of Commerce at Hapur, established in 1913.
Derivative market in Bullion began in Mumbai in 1920 and later, similar
markets came up at Rajkot, Laipur, Jamnagar, Kanpur, Delhi and Culcutta.

Between the years 1920 and 1940, organised derivatives trading on

exchanges had commenced in a number of commodities such as cotton,
groundnut, groundnut oil, raw jute, jute goods, castor seeds, wheat, rice,
sugar and precious metals like gold and silver. However, the Indian
experience with derivatives market has been inconsistent. During the World
War II, futures trading was prohibited under Defence of India rules. But
after independence in 1947, The subject of derivatives trading was placed in
the union list and forward contract Regulation Act 1952 was enacted.
Derivatives trading in commodities, particularly cotton, oil seeds and bullion
was at its peak during this period. forward contract regulation rules notified
by the central government in July 1954. In September 2015, FCRA 1952
was repealed commodity derivatives market were brought under the purview
of Security Contract Regulation Act, 1956.

The Essential Commodity Act, an act passed in India in 1955 to provide in

the interest of general public, for the control of production, supply, and
distribution of, and trade and commerce in certain commodities gives
control to the central government for securing equitable distribution of
essential commodity and their availability and their prices. Using the power
under the ECA, 1955, various Ministries of the central government issued
control orders for regulating production and distribution pertaining to the
commodities which are essential and administered by them.

The 1960s was a tough decade for India, and following the scarcity in
various commodities, derivatives trading in most commodities was
prohibited in mid-60s. in the 1970, most of the registered associations in
the commodity derivatives ecosystem become inactive, as futures as well as
forward trading in commodities for which they were registered came to be
either suspended or prohibited altogether. there was a time when derivatives
trading was permitted only into minor commodities pepper and turmeric.

The Khusro Committee (June 1980) recommended the reintroduction of

derivative trading in most of the major commodities. the government,
accordingly initiated derivatives trading and potatoes during the latter half
of 1980 in quite a few markets in Punjab and Uttar Pradesh. after the
introduction of economic reforms since June 1991, the Government of India
appointed committee on Forward Market under the chairmanship of
Professor K.N. Kabra. the committee submitted its report in September
1994. the growing realisation of eminent globalisation under the WTO

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regime and non sustainability of the Government support to commodity
sector prompted the government to explore the alternative of market based
mechanism, viz, Derivative market to protect the commodity sector from
price volatility.
It was April 1999 that the government removed the 30 year ban on
commodity derivatives trading in India. Food grains, pulses and Bullion
were all opened for trading as derivatives and the Government of India
issued notification on 1st April 2003 permitting futures trading in
commodities. as a result of this, three National level commodity exchanges
came up in 2003 - National Multi Commodity Exchange (NMCE), National
Commodities and Derivatives Exchange (NCDEX) and Multi Commodity
Exchange (MCX). Trading in commodity options however was permitted only
in 2017.

List of Commodities traded on Exchanges

Exchange traded commodities are;

METAL: Aluminium, Copper, Lead, Nickel, Sponge Iron, Steel Long

(Bhavnagar), Steel Long (Govindgarh), Steel Flat, Tin, Zinc

BULLION: Gold, Gold HNI, Gold M, i-gold, Silver, Silver HNI, Silver M

FIBER: Cotton L Staple, Cotton M Staple, Cotton S Staple, Cotton Yarn,

Kapas

ENERGY: Brent Crude Oil, Crude Oil, Furnace Oil, Natural Gas, M. E. Sour
Crude Oil

SPICES: Cardamom, Jeera, Pepper, Red Chilli, Turmeric

PLANTATIONS: Arecanut, Cashew Kernel, Coffee (Robusta), Rubber

PULSES: Chana, Masur, Yellow Peas

PETROCHEMICALS: HDPE, Polypropylene(PP), PVC

OIL & OIL SEEDS: Castor Oil, Castor Seeds, Coconut Cake, Coconut Oil,
Cotton Seed, Crude Palm Oil, Groundnut Oil, KapasiaKhalli, Mustard Oil,
Mustard Seed (Jaipur), Mustard Seed (Sirsa), RBD Palmolein, Refined Soy
Oil, Refined Sunflower Oil, Rice Bran DOC, Rice Bran Refined Oil, Sesame
Seed, Soymeal, Soy Bean, Soy Seeds

CEREALS: Maize Guargum, Guar Seed, Gurchaku, Mentha Oil, Potato

(Agra), Potato (Tarkeshwar), Sugar M-30, Sugar S-30

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Benefits of commodity futures market;

1. Price Discovery:

Based on inputs regarding specific market information, buyers and sellers

conduct trading at futures exchanges. This results into continuous price
discovery mechanism.

2. Hedging:

It is strategy of managing price risk that is inherent in spot market by taking

an equal but opposite position in the futures market to protect their
business from adverse price change.

3. Import- Export competitiveness:

The exporters can hedge their price risk and improve their competitiveness
by making use of futures market. A majority of traders which are involved in
physical trade internationally intend to buy forwards. The existence of
futures market allows the exporters to hedge their proposed purchase by
temporarily substituting for actual purchase till the time is ripe to buy in
physical market.

4. Portfolio Diversification

Commodity offers at another investment options which is largely negatively

correlated with equity and currency and thus could offer great portfolio
diversification.

Commodity spot markets versus commodity futures market

Spot commodity markets are where the physical commodities are bought
and sold. This is typically an over the counter (OTC) market and the
commodities are bought and sold based on the credit worthiness of the
buyers and the sellers. Future market (as distinct from forwards) is a
regulated market where delivery is at a future date as against a spot market
which is marked for immediately delivery.

Commodity spot transactions are marked for immediate delivery as against

commodity futures that are marked for delivery at a future date (which
could be anything between 1 month and 6 months) in the Indian context.
The following are some of the key differences between the spot commodity
markets and the commodity futures market.

The first difference between commodity spot market and futures market is in
the nature of pricing in the two markets. Futures prices are different from

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spot market prices because of carrying costs and carrying return. This
includes the interest cost of locking in funds as well as the cost of storage,
taxes and damage if any. Although futures prices are marked to market on a
daily basis, the price of the futures contracts differ from the underlying spot
or cash market. Traders incur these costs during the respective month they
are trading and hence the futures price factors in these costs on a
proportionate basis. The difference between spot and futures is called the
cost of carry.

The second difference is on the subject of managing counterparty risk. What

exactly is counterparty risk? It is the risk that one of the parties (buyer or
seller) may default on its commitments to the contract. In case of spot,
counterparty risk could become a big deal as the MTM margining is not
done. Also, the margin in the spot market is an upfront fee with the broker
and is not related to counter party risk. Therefore, counterparty risk is
largely dependent on the creditworthiness of the institution and its
supporting casts of banks and broker dealers. In case of commodity futures
traded through a recognized exchange, the counterparty risk is eliminated
as the clearing corporation of the exchange becomes the counterparty and
guarantees the performance of both legs of the transaction. Risk is also
managed better in the futures market by the exchange through a
combination of SPAN margins, ELM margins, MTM margins, delivery
margins, special margins and through real-time surveillance.

The next big difference between spot markets and commodity futures
markets pertains to the trade settlement period. For some spot markets, the
allowable settlement time period is two working days, which is basically
meant for the transfer of cash from the buyer to the seller. However, in most
cases, spot market prices settle near real-time. In the case of futures
commodity market, the underlying asset has a specific settlement date in
the future. If you are long or short on a futures contract, you agree to buy or
sell that contract on a specific date in the future. In case you choose not to
deliver the contracts on the specified date, you will need to roll over the
contracts to the next month expiry. Futures contracts can also be reversed
and closed out during the month.

Fourthly, the relationship between spot markets and futures market is more
symbiotic rather than competitive. For example, the commodity futures
market can be used for hedging against risk of adverse price movements in
the commodity spot markets. If you are long on spot commodities, the same
can be hedged either by selling equivalent futures of the same underlying or
by purchasing put options which are slightly out of the money. Most traders
use the futures and the options market as a hedge against spot market price
fluctuations. It is like an insurance against price risk.

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Last, but not the least, commodity futures give you the ability to leverage
your margins, but this facility is not available in the spot market. What do
we understand by commodity futures leverage? In commodity futures, every
contract represents a specified amount of units of the underlying commodity
or asset. This applies to all commodities irrespective of whether they pertain
to base metals, precious metals, energy products or agricultural products.
Paying a margin of 5% on the notional value of the contract is tantamount to
getting 20 times leverage. Leverage on commodity futures is much higher
than in stock futures due to the lower volatility risk.

Regulation of commodity spot and commodity futures market

At present, in India there are three tiers of regulation of forward/futures

trading system, consisting of Government of India at the top, followed by
Securities and Exchange Board of India (SEBI) and then the commodity
exchanges. The Commodity Derivatives Market Regulation Department
(CDMRD) is responsible for supervising the functioning and operations of
commodity derivative exchanges. Since, the constitution of India adopted by
the Parliament on 26 January 1950 placed the subject of stock exchanges
and futures markets in the Union list, the responsibility for regulation of
forward contract devolved to the Government of India. The regulation of
derivatives trading in commodities is provided for under the Securities
Contract Regulation Act, 1956.

SEBI tookover the regulation of commodity derivative market 28 September

2015 as a result of merger of Forward Market Commission (FMC) with
SEBI. Till then, FMC was the regulator for futures/forward trade in
commodities. FMC was set up under forward contract Regulation Act, 1952
which was repealed as a result of the Merger and the responsibility for
regulation of commodity derivatives market passed on to SEBI.

SEBI Reports to the Government of India, which has the power to approve
memorandum and articles of association and bylaws of exchanges, to direct
to make or to make article rules, to suspend governing body of recognised
association and to suspend business of recognised association. Most of
these powers are delegated to SEBI, which is a regulatory body for futures
and forwards trades in India.

Following are the functions performed by SEBI:

1. To advise the central government in respect of grant of recognition for
withdrawal of recognition of any Association.
2. To keep forward markets under observation and take such action in
relation to them as it may consider necessary, in exercise of powers
assigned to it.
3. To collect and publish information related to trading conditions in
respect of goods including information relating to demand, supply and
prices and submit the same to the government through periodical

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 reports on the operation of the act and working of Forward Market in
commodities.
4. To make recommendations for improving the organisation and
working of forward markets
5. To undertake inspection of books of accounts and other documents of
recognised/registered associations.

The regulatory measures prescribed to commodity exchange by SEBI are:

1. Setting up of limits on net open position and on the close of the
trading hours.
2. Use of circuit filters for price limits to allow cooling of market in the
event of unwarranted price volatility
3. Application of margins on outstanding purchase or sales in
accordance with position profits or losses
4. Fixing of circuit breakers or minimum/maximum prices
5. Skipping trading in certain derivatives contracts, closing the market
for a specified period and even closing out the contract in emergency
situations.

However, it needs to be remembered that the regulation of spot and futures

markets in commodities are two different lines altogether. This is unlike the
equity markets where the spot and futures market in equities are regulated
by SEBI.

Commodity market regulation typically is broken up into the OTC spot

market regulation and SEBI. While all exchange traded futures and options
contracts come under the purview of SEBI regulation, all spot transactions
are regulated either by the Department of Consumer Affairs (DCA) or in
some cases by the respective state governments.

Structure of Commodities Contract

Description Characteristics
Name and Symbol Gold Futures (Gold)
Contract Listing Available as per the contract launch
calendar
Trading Unit 1 KG
Quotation 10 grams
Max Order Size 10 KG
Minimum Tick Rs.1 per 10 grams
Initial Margin Minimum 4% or SPAN; whichever is
higher
Extreme Loss Margin 1% (ELM)

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 Max Open Position Individual clients (5MT for all gold
contracts or 5% of MWPL) Member
Level (50MT or 20% of MWPL)

Delivery Unit 1 KG
Delivery period margin Higher of (3% + 5-day 99%VAR Spot)
and (25%)
Delivery Centre Designated clearing house facility at
Ahmadabad

Base metals include a number of lower value metals with substantial

industrial uses. These include aluminium, copper, zinc, nickel and each of
the versions also a major contract and a mini contract. These are more
synced with industrial demand cycles.

Description Characteristics
Name and Symbol Aluminium Futures (ALUMINIUM)
Contract Listing Available as per the contract launch
calendar
Trading Unit 5 MT
Quotation 1 KG
Max Order Size 150 MT
Minimum Tick Rs.0.05 per KG
Initial Margin Minimum 4% or SPAN; whichever is
higher
Extreme Loss Margin 1% (ELM)
Max Open Position Individual clients (25,000 MT for all
contracts or 5% of MWPL) Member
Level (250,000 MT or 20% of MWPL)
Delivery Unit 5 MT
Delivery period margin Higher of (3% + 5-day 99% VAR
Spot) and (25%)
Delivery Centre Ex-warehouse, Thane District,
Maharashtra

Participants in Commodities Market:

Hedger: A hedge is a position taken in order to offset the risk associated

with some other position. A hedger is someone who faces risk associated
with price movement of an asset and who uses derivatives as a means of
reducing that risk. A hedger is a trader who enters the futures market to
reduce a pre-existing risk.
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 Speculator: While hedgers are interested in reducing or eliminating risk,
speculators buy and sell derivatives to make profit and not to reduce risk.
Speculators willingly take increased risks. Speculators wish to take a
position in the market by betting on the future price movements of an asset.
Futures and options contracts can increase both the potential gains and
losses in a speculative venture. Speculators are important to derivatives
markets as they facilitate hedging, provide liquidity, ensure accurate pricing,
and help to maintain price stability. It is the speculators who keep the
market going because they bear risks which no one else is willing to bear.

Arbitrageur: An arbitrageur is a person who simultaneously enters into

transactions in two or more markets to take advantage of the discrepancy
between prices in these markets. For example, if the futures price of an
asset is very high relative to the cash price, an arbitrageur will make profit
by buying the asset and simultaneously selling futures. Hence, arbitrage
involves making profits from relative mispricing. Arbitrageurs also help to
make markets liquid, ensure accurate and uniform pricing, and enhance
price stability.

Connectivity, platforms and online commodity trading system

Electronic trading or e-trading is a screen based method of trading

electronically, as contrasted to the floor-based open outcry method. It uses
information technology to bring together buyers and sellers through
electronic media to create a visual market place. NCDEX and MCX in India
are examples of electronic market places, with no provision for open outcry
trading to take place. E-trading is widely believed to be more reliable than
older methods of trade processing, but glitches and cancelled trades do
occur.

In fact, the Chicago Board of Trade (CBOT) and Chicago Merchantile

Exchange (CME) permit market participants to choose between floor and
screen-based trading systems for most futures contracts during regular
trading hours. The electronic trading system is also used by CBOT and CME
as a supplementary trading mechanism during the off-hours trading.
However, the CME and CBOT still execute a small portion of their
transactions (in dollar value) through the floor-based trading system.

Your interface with the commodity futures exchange begins with the Trader
work station (TWS). The TWS is the application through which members
access the trading platform, place orders and execute trades. The TWS offers
a multitude of user-friendly trading features which include commodity price
ticker, market watch screen displaying best buy, best sell, last traded price,

15
volume for the day, open interest etc., top gainer and loser contracts, net
position, on-line backup facility etc.
Trade Timings

Trading on MCX platform takes place on all days of the week (except on
Saturdays, Sundays and trading holidays declared by the Exchange) Market
timings are as under:

Monday to Friday: 9:00 am to 11:30 pm

Trading on NCDEX Platform happens from Monday to Friday. Market

timings segment-wise are as under:

Monday to Friday: 9:00 am to 9:00 pm

Types or Orders

The TWS (Trader Work Station) is the front-end for placing orders.
Time Related Conditions

DAY Order: A Day order is valid for the day on which it is entered. If the
order is not matched during the day, the order gets cancelled automatically
at the end of the trading day.
GTC Order: A Good Till Cancelled (GTC) order is an order that remains in
the system until the expiry of the respective contract in which it is entered
or until when the same is cancelled by the member.
GTD Order: A Good Till Date (GTD) order is valid till the date specified by
the member. After the specified date the unexecuted orders get
automatically cancelled by the system.
IOC Order: An Immediate or Cancel (IOC) order allows a member to execute
the orders as soon as the same is placed in the market, failing which the
order will get cancelled immediately.
Price Related Conditions

Limit Order: The order wherein the price is to be specified while placing the
same. The order will only be executed if the market gets a price that is at par
or better than the price condition. Buy orders will be at the Limit Price or
lower and Sell orders will be at the Limit price or higher. Limit orders work
best in volatile market conditions.
Market Order: The order at the best available price at the time of placing the
same. These orders will be execute at the best available price in the market
subjects to volumes being available. Market orders are useful when you are

16
buying in a falling market or if you are selling in a rising market. You can
get better prices through market orders.

Access to Commodity Exchanges

To participate in commodity derivatives trading on the commodity exchange

platform, a trader will need to go through the following procedure:
Step 1: Identify a SEBI recognised commodity brokerage house to open a
trading account.
Step 2: Fill a demat account opening form with the brokerage house (in
India, this mandates KYC process requiring PAN Card, Aadhar card, address
proof and passport size photos)
Step 3: Find out about: (1) rules and regulations of trading; 2) the service
deliverables from the broker; 3) the transaction costs; 4) other offers
available to the account holder (special training programs or choice of
brokerage plan)
Step 4: Deposit margin money into demat account so that the trading can
begin. For this purpose, the demat trading account will have to be linked
with the trader’s bank account.
For traders who intend to trade for actual delivery of the commodity, there is
also a need to open a Depository Participant Account and obtain a GST
Registration at the place where the delivery centre of the commodity traded
is located.

In an electronic trading system, the procedure for executing a trade will be

as follows:
1. Orders are initiated by clients and entered through trader terminals.
2. A credit-controlled module verifies credit worthiness based on clearing
member predetermined parameters.
3. Orders are matched on price and time priority.
4. Matched orders are confirmed at each originating terminal.
5. Meanwhile, all unmatched orders remain in the system until matched
or withdrawn.
6. The instant a trade is executed, all participating quote vendors receive
last sale price and quantity data, as well as updated information on
best bid and best offer prices, as well as size of each order.
7. As each trade is confirmed, it is routed to the exchange clearing
system for settlement.
8. Clearing member firms adjust buyers and sellers accounts for all open
positions and margins.

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 Clearing and Settlement

All commodity exchanges depend on the services of a clearing house to

handle the back-office work required to manage trades happening on the
exchange platform. The clearing house is responsible for keeping records of
all trades taking place between buyers and sellers by acting as a legal third
party on all buy and sell transactions. In other words, the clearing house
acts as a seller to all buyers and a buyer to all sellers. This role of the
clearing house is called as novation.
After each day of trading, all exchange members must report their buys and
sells to the clearing house. The clearing house then ensures that financial
settlement from all buyers and sellers is made. In addition, the clearing
house guarantees all contracts by requiring that the participants maintain
good-faith money or cash deposits called margins with the clearing house.
As soon as a contract is processed and cleared by the clearing house, the
buyer and the seller of the contract will have a contract with the clearing
house instead of the counterparty with which their original trade was made.
Clearing and settlement is the last step in the commodity trade process.
Clearing refers to determining the obligations of pay-in and pay-out based
on net positions of the clients, trading members and clearing members. This
hierarchy is maintained both ways. On the other hand, settlement is the
actually pay-in and pay-out to the CMs, which is then transmitted to the TM
and the actual trading clients.
In case of MCX, the MCX Clearing Corporation (MCXCCL) has entered into
an agreement with Multi Commodity Exchange of India Limited (MCX) to
provide clearing and settlement services to MCX whereby all trades executed
on MCX will be cleared and settled by MCXCCL.
MCXCCL also provides the counter guarantee to each trade by acting as the
counterparty. Effectively, the buyer and the seller on the commodity
exchange actually deal with the MCCXL as the counterparty, which actually
eliminates the default risk in totality. MCXCCL guarantees settlement of all
trades executed on MCX by assuming the counter party risk of the Clearing
Members for all the trades done on MCX. MCXCCL guarantees its Clearing
Members for:
 Funds pay-out till marking of delivery
 Financial compensation in case of default after marking of delivery
Clearing and Settlement Division of MCXCCL performs and monitors all
activities relating to delivery and fund settlement through a well-defined

18
settlement cycle. MCXCCL has empanelled with several Clearing Banks to
provide banking services to the Clearing Members. Once the clearing and
settlement is done, that completes the entire settlement process and the
trading loop is closed in the commodity exchange.
NCDEX set up a dedicated company to manage its clearing and settlement –
NCCL, only in 2018 as per SEBI stipulations. Till then, the clearing and
settlement was conducted by the exchange itself in association with the
clearing banks. The process of clearing and settlement in case of NCDEX is
broadly the same as MCX.
When the clearing house acts as a central counterparty to all trades on the
exchange, the counterparties for the clearing house are its CMs, which
generally are the subset of the exchange’s members.

THE SETTLEMENT PROCESS

The clearing house is the entity in charge of debiting the accounts of the
losers and redistributing this money to the accounts of the winners daily.
Settlement is the act of completing the contract and can be done in two
ways:

Physical Settlement: The specific amount of the underlying asset of the

contract is delivered by the seller of the contract to the exchange and by the
exchange to the buyers of the contract. Physical delivery is common with
commodities, through in practice, it occurs only on minority of contracts.
Most are cancelled out by purchasing an offsetting contract i.e. buying a
contract to cancel out an earlier sale (covering a short), or selling a contract
to square-off an earlier purchase (covering a long).

Cash Settlement: This is a method of settling future contracts whereby on

square-off of the contract, a position is simply debited or credited the
difference between the entry price for the contract and the final exit price.
Alternatively, a cash settlement takes place at the expiry of the contract and
involves a payment in cash for the value of commodity underlying the
contract. WTI Crude Oil and Natural Gas are popular cash settled contracts.
As the accounts of the parties in futures contracts are adjusted everyday,
most transactions in the futures market are settled in cash and the actual
physical commodity is bought and sold in the cash market. Prices in the
cash market and futures market tend to move in correlation with one
another, and when a futures contract expires, he spot and futures price
converge.

Broadly, a commodity futures contract may be settled by either cash or

delivery of commodity depending upon the specifications in the contract,

19
demand of the buyer and rules of exchange. Worldwide, in a futures
exchange environment, deliveries of the underlying commodity are only
about two percent of the volume of turnover. The remaining contracts are
settled at a settlement price arrived by the exchange between the buyers and
sellers. If the trade is expected to be settled by way of delivery of commodity,
the clearing house of the commodity exchange will receive warehouse
receipts (WRs) from the seller instead of actual commodities and pass such
WRs over to the buyer. It is common these days for WRs to be
dematerialised.

Warehouse Receipts:

Warehouse receipts (WR) are title documents issued by warehouses to

depositors against the commodities deposited in the warehouses. These
goods in the warehouse are valued by an assayer and verified and certified
by a statutory auditor. These documents are transferred by endorsement
and delivery. Either the original depositor or the holder in due course
(transferee) can claim the commodities from the warehouse.

While currency futures are necessarily settled in cash only, the commodity
futures market offers the facility to settle futures in cash or against actual
delivery. While the exchanges like the NCDEX or the MCX are not directly
involved in the delivery (as spot markets are outside its purview), they do get
involved in the process of facilitation of the entire warehousing ecosystem
including standardization, additional margins, certification etc. This makes
the entire process of delivery much simpler and transparent. Since
commodities are bulky and need to be moved in bulk quantities, the actual
transaction cannot wait till the physical movement since it is too
cumbersome. Hence, they use a proxy called warehouse receipts and these
warehouse receipts form the core of the commodity warehousing system.

The issue of warehousing is relevant only for hedgers who have an

underlying exposure. Warehousing and delivery is not relevant for traders
who are just playing on the price movements. How do hedgers operate for
delivery? For example, the copper manufacturer may use the commodity
futures market to sell futures in advance and they will give actual delivery
against the sell contract on the stipulated date. Similarly, an electrical goods
supplier uses copper as an important input and they can buy copper futures
in advance and lock in the price. On the date of delivery, they can just pay
and take delivery at the price fixed. This way they are immune to any
adverse price movements.

Commodity futures contracts can be settled either by cash or by delivery of

commodity depending upon the terms of trade, demand of the buyer and
rules of the exchange. If the trade is expected to be settled by way of delivery

20
of commodity, the clearing house of the commodity exchange will receive
warehouse receipts from the seller instead of actual commodities and pass
such warehouse receipts over to the buyer.

At that point the full payment for the actual delivery has to occur for the
trade to be considered to be good. Once the payment is made the buyer has
the right to remove the commodity from the warehouse. Quite often, the
buyer leaves the commodity at the storage location in exchange for
demurrage or storage fee.

From the beginning, India has adopted the system where the warehouse
receipts can be held in depository form with the NSDL, being the major DP
for commodity warehouse receipts. Only warehouses that have entered into
an agreement with NSDL and the commodity exchanges can issue
depository eligible warehouse receipts. Currently, NSDL has agreements
with the NCDEX and MCX and about 20 warehouses that hold 35 different
commodities in custody. An account holder who wants warehouse receipt
balances in its demat account, will have to quote the demat account number
specifically opened for this purpose. Warehouse will credit warehouse
receipts in the demat account using "corporate action" facility offered by
NSDL. The balances so created can be used for transfer or settlement of
commodity futures trade. This makes it transparent and less prone to
frauds.

VARIETY IN COMMODITY MARKETS

WEATHER DERIVATIVES

Weather Derivatives are financial instruments that seem like an insurance

policy but are more like options. They are unique in that there is no physical
underlying asset. The underlying asset is any measureable weather factor,
that is, temperature measured in degrees Celsius or Fahrenheit, rainfall
measured in centimeters, or snowfall measured in inches. On the Chicago
Mercantile Exchange, the values of these contracts are calculated based on
a weather index.

Weather Risk:

Companies involved in agriculture , energy, aviation, construction, mining,

event management, tourism etc. face risk due to adverse weather.

Hydroelectricity companies generate lower revenue if rainfall is low.

Mining companies halt mining operation when there is a heavy rainfall.

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Most temperature contracts in current practice are based on a Heating
Degree Day (HDD) for winter protection, or a Cooling Degree day (CDD) for
summer protection. Pay-off is based on a measurable index like HDD or
CDD, and it performs relative to the strike value (not the actual loss).

Heating Degree Day – A day can be categorized as Heating Degree Day if it is

cool enough for people to start their heating appliances

Cooling Degree Day – A day can be categorized as Cooling Degree Day if it is

hot enough for people to start their air conditioning

Base Temperature is provided by the exchange as a part of contract

specification.

Heating Degree Days (HDD) or Cooling Degree Days (CDD)

HDDi = Max(0, Base Temperature - Ti)

CDDi = Max(0,Ti - Base Temperature)

Ti = (Tmax + Tmin) / 2

HDD Futures contract at CME : Nov, Dec, Jan, Feb, Mar, Apr

CDD Futures contract at CME: May June July Aug Sep

Suppose we take base temp as 29 Degree Centigrade

Day 1 2 3 4 5 6 7

Actual 33 32 28 31 29 27 34
Average

22
 CDD 4 3 0 2 0 0 5

Weather Derivatives contracts are being used successfully by farmers,

theme parks, ski resorts, ice-cream manufacturers, energy and utilities
companies, etc., for over a decade now. Gas and power companies may use
HDD or CDD contracts to smooth earnings.

For example, a ski resort located in Auli may buy a put option by paying a
premium of Rs.1,00,000 to buy a right to receive Rs.20,000 for every inch of
snow below the strike amount of say, 50 inches, offsetting somewhat the
loss in revenues due to insufficient snowfall. The ski resort could also sell a
call option by receiving a premium of Rs.1.20,000 and paying Rs.30,000 for
every inch of snow over the strike of 50 inches, again assuming higher
revenue for the resort with heavy snowfall.

The index could also be based on rainfall. In 2005, NCDEX launched a rain
day index for Mumbai city for informational purposes only. Similarly, MCX
also has rainfall indices-RAINDEXMUM, RAINDEXIDR and RAINDEXJAI-
that record rainfall at Mumbai (Colaba), Indore and Jaipur, respectively, and
are designed to also consider normal rainfall in Mumbai, Indore and Jaipur.

FREIGHT DERIVATIVES

Just as weather is a source of risk for farmers, organizations and

individuals, freight rates can also cause harm to the revenues of
organizations by impacting their shipping costs adversely. This is freight
market risk. Given the current volatility of the freight markets, managing
freight market risk is a significant issue for the shipping industry. Volatility
in freight rates drives the need for financial tools for risk management, and
attracts speculation on the future price movements of freight. The ability to
hedge the cost of freight permits traders to price their businesses with
greater degree of certainty and long-term stability. Freight Derivatives are
financial instruments used by organizations and individuals as part of their
risk management strategy to counter the negative economic effects of freight
rate alterations that harm the financial prospect of a company. Freight
derivatives are financial contracts between two parties to settle upon an
agreed future price for carrying commodities at sea. The freight derivatives
market began with the trading of voyage rates for certain ‘dry’ cargo routes
in the early 1990s, and was later expanded to include ‘wet’ tanker routes.
Dry cargo is of solid, dry material, rather than liquid or gas, and generally
does not require special temperature controls. Wet cargo consists of liquids

23
or gases that may also require special temperature conditions. Recently,
with commodities now standing at the forefront of international economics,
large financial trading houses, including banks and hedge funds, have
entered this market. Freight derivatives are primarily used by ship-owners
and operators, oil companies, trading companies and grain houses, as tools
for managing freight rate risk. Take the case of a trader who has agreed in
August 2012 to ship 3000 tonnes of sugar from Brazil to Japan in April,
2013. Assume that in August 2012, for this route, the freight rate per tonne
of sugar is $90 per tonne. The trader expects the rates to go up. He can
book a ship now, for April loading, but the ship owner may not want to
commit for so far into the future. The trader can, alternatively, purchase a
contract for settlement in April 2013, at $92 per tonne, and lock in this rate.
The settlement is against an index, like the Baltic Dry Index (BDI) which is a
daily average of prices paid by an end customer to have a shipping company
transport dry raw materials across 26 different routes throughout the world
averaged into one index. BDI is based on January 1985 as 1,000, and is
made up of an average of the Baltie Supramax, Panamax, and Capesize
indices. If in April 2013, the freight index is $95 per tonne, the trader makes
a profit of $3 per tonne, which is offset by the increased cost of shipping. If
the freight index has fallen to $88 per tonne, then the trader makes a loss of
$4 per tonne, which is offset by the now lower cost of shipping.

ELECTRICITY DERIVATES

Energy derivatives are derivative instruments with the underlying asset

being any energy product, including oil, natural gas and electricity, which
trade either on an exchange or over-the counter. Like other derivative
products, energy derivatives can be used as a form of insurance to protect
against the often volatile changes of energy prices. Electricity futures are
one type of energy derivatives. They can be options, futures or swap
agreements, among others. The value of a derivative will vary based on the
changes in the price of the underlying energy product. Electricity is a
commodity characterized by : – Seasonality of demand – High volatility of
prices – Non-elasticity of demand – Limited transportability – Non-storability
In fact, electricity derivatives were visualized as hedging instruments for
suppliers and users of electricity in the United States, where electricity
suppliers charge the consumers a variable tariff; the per unit rate depending
on weather, which determines the levels of electricity consumption. A need
was felt for derivatives because consumers preferred paying a fixed rate. To
meet the requirement of both the parties, an intermediary structured an
arrangement with the electricity supplier to collect a fixed amount from each
consumer based on an average energy consumption pattern in the past.

24
This is how the arrangement would work. Electricity sector reforms initiated
in the early nineties in India led to the commencement of power trading. The
Electricity Act, 2003, recognized power trading as a distinct licensed activity.
Open access regulations and inter State trading regulations made power
trading in India a reality. The Power Trading Corporation (PTC) played the
role of a trader by purchasing power from surplus units and selling it to
deficit state electricity boards (SEBs) at mutually agreed rates. The Central
Electricity Regulatory Commission (CERC), in 2007, granted in principle
approval to commence exchange trading, and also issued guidelines for
setting up and operation of the power exchange. Indian energy Exchange
(IEX), promoted by MCX became India’s first nation-wide automated online
electricity platform to trade spot electricity, to indentify the supply side, and
to act as an effective price discovery mechanism.

CATASTROPHE DERIVATIVES

Insurers are exposed to the risk of natural and man-made Catastrophes,

and need to effectively insure themselves by fixing their projected
catastrophic loss ratios irrespective of the magnitude and frequency of
Catastrophes. They have been able to protect themselves against such
losses by opting for reinsurance. Whenever a primary insurer has exposure
to excessive underwriting risk, it can pass on some of this risk to reinsurers.
Reinsurance agreements can be on a pro-rata agreement wherein the
primary insurer gives a portion of its premium income to a reinsurer, and
the reinsurer agrees to pay roughly the same portion of the former’s losses.
There can also be an excess-of-loss basis wherein the reinsurer agrees to
pay all losses incurred by the primary insurer in excess of a certain amount,
in exchange for a flat premium from the latter. Catastrophes represent a
major source of risk for property/casualty underwriters. This is a
Catastrophe risk. The Catastrophe Derivatives market was developed in
response to the need of insurance, reinsurance and other financial
companies to manage their bottom line exposure to major seasonal weather
events, such as hurricanes, that cause significant material damage.
Insurers, acting as hedgers, will buy CAT futures or CAT call options.
Speculators are attracted to CAT derivatives because they are perfect
diversification instrument, like zero-beta assets that have low correlation to
financial markets.

The value of the catastrophe futures contract is linked directly to

catastrophe losses. In the event of catastrophe, if losses are high, the value
of the contract goes up and the insurer, who has bought the contract,
makes a gain on selling it, so as to offset the losses incurred due to payouts
to the insured. If catastrophe losses are lower than expected, the value of
the contract decreases and the insurer (buyer) losses money.

25
How do catastrophe derivatives work?

Derivatives provide a market based tool for insurance and reinsurance

companies to quickly and efficiently spread risk by tapping a broad and
deep pool of liquidator. Companies can access CAT derivatives market either
through bilateral trade or through contracts based on exchanges. Exchanges
listing catastrophic derivative contract include:

The Chicago Mercantile Exchange

The Insurance Futures Exchange

The payoff of a cat derivative comes if a large amount of insurance claims

occur in a certain area, over a certain period. This happens in case of a
catastrophic event, such as hurricane, tornado, earthquake or terrorist
attack. catastrophe insurance futures or catastrophe futures are futures
contract that allow property/casualty underwriters to hedge against an
expected underwriting losses incurred as a result of major catastrophe.

The price of a contract is based upon an index prepared by Insurance

Service Office (ISO). The ISO index is based on the dollar loss on $25000 of
catastrophic premiums from a representative national pool of catastrophic
policies. If this pool include a loss ratio of 20% i.e. losses of $5,000 on
$25000 of premium income for a given quarter, the index value would be
$5000. Market users of this contract will form expectations regarding the
actual loss ratio on future quarters and trade accordingly.

Insurers, acting as hedgers, will buy CAT futures or CAT call options.
Sellers of CAT derivatives are normally construction companies, reinsurance
companies and speculators willing to take risk for profits are attracted to
CAT derivatives because they are perfect diversification instrument like zero
beta assets that have low correlation to financial markets. However in India,
insurers have not used much of this because of the following reasons:
1. Unfamiliarity with derivatives
2. Conservatism
3. Lack of focus on financial risk management.

CARBON DERIVATIVES

The international community met for the first time at the UN Conference on
Environment and Development, the Earth summit, to consider the global
environment and development needs, and the United Nations Framework
convention on Climate Change (UNFCCC) was adopted in 1992. Member
countries of UNFCCC began negotiations on the Kyoto protocol which was
adopted in 1997 and was signed by about 180 countries. The protocol,
which entered into force on 16 February 2005, developed three innovative
mechanism is known as:

26
 1. Joint Implementation (JI)
2. Clean Development Mechanism (CDM)
3. International Emission Trading (IET)

Joint Implementation permits a developed country with higher green house

gas reduction cost to setup a reduction project in another developed
country, but with a relatively lower costs. CDM proposes the setting up of a
green house gas reduction project by a developed country in a developing
country that has much lower reduction costs. Using IET, countries can
trade carbon credit in the international market. This so-called market-based
mechanism allows developed parties to earn emission credit through
projects implemented either in other developed countries or in developing
countries using JI or CDM, and trade them in the international market
using IET.

Carbon trading is an umbrella term that includes the trading of greenhouse

gas reduction credits that were defined in the 1997 Kyoto protocol of the
climate change convention. Carbon dioxide is the primary green house gas
considered responsible for global warming process and carbon account for
the bulk of emission trading. Carbon emission trading is emission trading
for Carbon dioxide. Carbon credits can be earned by companies that engage
in ecologically friendly practices and remove carbon dioxide emission from
the environment. This credit can be sold to other companies that continue to
produce carbon emissions. The carbon market trades emissions under cap
and trade schemes or with credits that pay for or offsets green house gas
reductions. Such programs set an overall emission limit referred to as cap,
then require participants, often energy intensive industries, to buy permits
in a form of Carbon credits to emit green house gases like carbon dioxide in
excess of their cap. The transfer of allowances is referred to as trade. The
first carbon trade was executed before any laws were enacted in March 2003
between Shell, the Global Oil Company and Nuon, six-year-old Dutch
multinationalPower supplier in which Nuon bought a significant volume of
allowances from Shell for 2005.

Businesses can buy credit directly from another party through a broker or
from an exchange. For example, a factory produces 20,000 tonnes of green
house emissions every year. The government sets a cap and ask the factory
to reduce this to 15000 tonnes. The factory either reduces its emission to
15000 tonnes or purchase Carbon credits to offset the excess. One carbon
credit is equal to one ton of carbon dioxide in the international market.
Similarly, if a business in India can prove that it is prevented the emission
of 5000 tonnes of carbon, it can sell this much worth of Carbon credits to
another business that has been emitting carbon. The incentive to trade is
based on the fact that for every tonne of carbon dioxide that goes over that
target, companies are liable to a fine.

Carbon derivatives are financial contracts with carbon dioxide emission as

the underlying. Carbon credits are earned by reduction in the carbon
dioxide emission. The carbon derivatives derive their value from this

27
reductions. Member firms that do not have enough allowances to cover their
emissions must either make reductions or buy another firm’s spare credits.
Members with extra allowances can choose to either sell them or stock them
for future use. This is what forms the basis for the functioning of carbon
derivatives market. Market forces drive the prices of credits.

Carbon exchange operates like a stock exchange for pollution. The Chicago
Climate Exchange (CME) was the world's first carbon exchange when it
started in 2003. China is a leading net seller of carbon credit in the world
and stands to benefit from the carbon Credit trade. In 2017, China launched
its national carbon market to bring in six of its largest carbon emitting
industrial sectors, though the first phase of the market only covers coal-fired
power generation.

In India, Multi Commodity Exchange (MCX) launched carbon derivatives

trading for the first time in January 2008 through a strategic alliance with
Chicago Climate Exchange (CME) with the contract size of 200 tonnes,
where each tonne is a carbon credit. NCDEX started carbon derivatives
trading in April 2008 for which the contract size is 500 tonnes. However, the
market for carbon derivatives failed to develop.

Introduction to Derivatives:

The word ‘derivative’ comes from the verb ‘to derive.’ It indicates that it has
no independent value. A derivative is a contract whose value is derived from
the value of another asset, known as the underlying, which could be a
share, a stock market index, an interest rate, a commodity, or a currency.
The underlying is the identification tag for a derivative contract. When the
price of this underlying changes, the value of the derivative also changes.
Without an underlying, derivatives do not have any meaning. For example,
the value of a gold futures contract derives from the value of the underlying
asset, i.e., gold.
To understand the meaning of derivatives, let us take the example of a
commodity such as cotton, which is the raw material for the textile industry.
It may so happen that the price of cotton rises before and after the harvest
but falls at the time of harvest. The farmer, who is exposed to such price
fluctuations, can eliminate this risk by selling his harvest at a future date by
entering into a forward, or futures, contract. This forward, or futures,
contract takes place in the ‘derivatives’ market. The prices in the derivatives
market are driven by the spot or cash market price of the underlying asset,
which is cotton in this example.

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 Derivatives are very similar to insurance. Insurance protects against
specific risks, such as fire, floods, and theft. Derivatives, on the other hand,
take care of market risks—volatility in interest rates, currency rates,
commodity prices, and share prices. Derivatives offer a sound mechanism
for insuring against various kinds of risks arising in the world of finance.
They offer a range of mechanisms to improve redistribution of risk, which
can be extended to every product existing, from coffee to cotton and live
cattle to debt instruments.
In this era of globalisation, the world is a riskier place and exposure to risk
is growing. Risk cannot be avoided or ignored. Man, however, is ‘risk-averse.’
This risk-averse characteristic of human beings has brought about growth
in derivatives. Derivatives help the risk averse individual by offering a
mechanism for hedging risks.
Derivative products, several centuries ago, emerged as hedging devices
against fluctuations in commodity prices. Commodity futures and options
have had a lively existence for several centuries. Financial derivatives came
into the limelight in the post-1970 period; today they account for 75 per
cent of the financial market activity in Europe, North America, and East
Asia.
The basic difference between commodity and financial derivatives lies in the
nature of the underlying instrument. In commodity derivatives, the
underlying is a commodity; it may be wheat, cotton, pepper, turmeric, corn,
oat, soyabeans, orange, rice, crude oil, natural gas, gold, silver, and so on.
In financial derivatives, the underlying includes treasuries, bonds, stocks,
stock index, foreign exchange, and currency.
The market for financial derivatives has grown tremendously both in terms
of variety of instruments and turnover. Derivatives can be futures, options,
swaps, forwards, puts, calls, swap options, and index-linked derivatives.
The explosive growth of derivatives in the developed centuries is fuelled by
the following:

 The increased volatility in global financial markets.

• The technological changes enabling cheaper communications and
computing power.
• Breakthrough in modern financial theory, providing economic agents a
wider choice of risk management strategies and instruments that optimally
combine the risk and returns over a large number of financial assets.
• Political developments, wherein the role of the government in the
economic arena has become more of a facilitator and less of a prime mover.
Thus, the move towards market-oriented policies and the deregulation in
29
financial markets has led to an increase in financial risk at the individual
participants’ level.
• Increased integration of domestic financial markets with international
markets

30
Economic Benefits of Derivatives:
Derivatives reduce risk and thereby increase the willingness to hold the
underlying asset. They enable hedging, which is the prime social rationale
for future trading. Hedging is also the equivalent of insurance facility
against risk from market price fluctuations.
Derivatives enhance the liquidity of the underlying asset market. A liquid
market is a market with enough trading activity to allow traders to readily
trade goods for a price that is close to its true value. The trading volume
increases in the underlying market as derivatives enable participation by a
large number of players.
Derivatives lower transaction costs. These costs associated with trading a
financial derivative are substantially lower than the cost of trading the
underlying instrument.
Derivatives enhance the price discovery process. Price discovery is the
revealing of information about future cash market prices through the
futures market. The prices in the derivatives market reflect the perception of
market participants about the future, and lead the prices of the underlying
to the perceived future level. The prices of derivatives converge with the
prices of the underlying at the expiration of a derivatives contract. Thus,
derivatives help in the discovery of future as well as current prices.
Derivatives can help the investors to adjust the risk and return
characteristics of their stock portfolio carefully. For instance, a risky stock
and a risky option may be combined to form a riskless portfolio. They also
provide a wide choice of hedging structures each with a unique risk/return
profile to meet the exact requirements of each market participant.
Derivatives provide information on the magnitude and the direction in which
various market indices are expected to move. The cash markets lookout to
the futures market for signals that could give market players information as
to where the markets are heading. The measures that are widely tracked by
the markets include Nifty discounts, which implies a lower value for Nifty
futures contract compared to the cash price; open interest outstanding
which is the total number of shares outstanding in the futures market; put–
call ratios, which is the ratio of put options outstanding for every call option;
and FII purchases and sales in the derivatives segment.

Derivatives defined Under the Securities Contracts (Regulation) Act,

1956
The Securities Contracts (Regulation) [Act SC(R)A], 1956, defines derivatives
in the following manner. Derivatives include the following.
31
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.

Types of Financial Derivatives:

IIn recent years, derivatives have become increasingly important in the field
of finance. Forwards, futures, options, swaps, warrants, and convertibles
are the major types of financial derivatives. A complex variety of composite
derivatives, such as swaptions, have emerged by combining some of the
major types of financial derivatives.
• Forwards: A forward contract is a contract between two parties obligating
each to exchange a particular good or instrument at a set price on a future
date. It is an over-the-counter agreement and has standardised market
features.
• Futures: Futures are standardised contracts between the buyers and
sellers, which fix the terms of the exchange that will take place between
them at some fixed future date. A futures contract is a legally binding
agreement. Futures are special types of forward contracts which are
exchange traded, that is, traded on an organised exchange. The major types
of futures are stock index futures, interest rate futures, and currency
futures.
• Options: Options are contracts between the option writers and buyers
which obligate the former and entitles (without obligation) the latter to
sell/buy stated assets as per the provisions of contracts. The major types of
options are stock options, bond options, currency options, stock index
options, futures options, and options on swaps. Options are of two types:
calls and puts. A call option gives a buyer/holder a right but not an
obligation to buy the underlying on or before a specified time at a specified
price (usually called strike/exercise price) and quantity. A put option gives a
holder of that option a right but not an obligation to sell the underlying on
or before a specified time at a specified price and quantity.
• Warrants: Warrants are long-term options with three to seven years of
expiration. In contrast, stock options have a maximum life of nine months.
Warrants are issued by companies as a means of raising finance with no
initial servicing costs, such as dividend or interest. They are like a call
option on the stock of the issuing firm. A warrant is a security with a market
price of its own that can be converted into a specific share at a

32
predetermined price and date. If warrants are exercised, the issuing firm has
to create a new share which leads to a dilution of ownership.
Swaps: Swaps are generally customised arrangements between
counterparts to exchange one set of financial obligations for another as per
the terms of agreement. The major types of swaps are currency swaps, and
interest-rate swaps, bond swaps, coupon swaps, debt–equity swaps.
• Swaptions: Swaptions are options on swaps. It is an option that entitles
the holder the right to enter into or cancel a swap at a future date.
Swaptions become operative at the expiry of the options. Instead of having
calls and puts, swaptions have receiver swaption (an option to receive fixed
and pay floating) and a payer swaption (an option to pay fixed and receive
floating).

33
Distinctive Features of the Derivatives Market

• The derivatives market is like any other market,

• It is a highly leveraged market in the sense that loss/profit can be

magnified compared to the initial margin. The investor pays only a fraction
of the investment amount to take an exposure. The investor can take large
positions even when he does not hold the underlying security.

• Derivatives contracts have a definite lifespan or a fixed expiration date.

They are primarily a tool to employ short-term expectations about a stock or
an index to hedge or trade.

• The derivatives market is the only market where an investor can go long
and short on the same asset at the same time.

• Derivatives carry risks that stocks do not. A stock loses its value in
extreme circumstances, while an option loses its entire value if it is not
exercised.

• Derivatives contracts are flexible as they allow investors to translate a

particular view into a variety of different trades, depending on their risk
appetite and availability of capital. Suppose an investor is bullish on Infosys,
then he can either buy Infosys futures or buy a call option or sell a put
option. Moreover, investors can capitalise on a bearish view as well as either
by selling futures or buying a put, or writing a call.

• Margin-based trading makes trading in derivative products attractive. The

margin requirement is about 12 per cent for futures and 8 per cent for
options. One can trade in derivatives by paying just a small fraction of the
total value. So, by depositing, sayRs. 25,000, it may be possible to trade in
Nifty futures worth Rs. 2 lakh.

34
Participants in Derivatives Market:

Hedger: A hedge is a position taken in order to offset the risk associated

with some other position. A hedger is someone who faces risk associated
with price movement of an asset and who uses derivatives as a means of
reducing that risk. A hedger is a trader who enters the futures market to
reduce a pre-existing risk.

Speculator: While hedgers are interested in reducing or eliminating risk,

speculators buy and sell derivatives to make profit and not to reduce risk.
Speculators willingly take increased risks. Speculators wish to take a
position in the market by betting on the future price movements of an asset.
Futures and options contracts can increase both the potential gains and
losses in a speculative venture. Speculators are important to derivatives
markets as they facilitate hedging, provide liquidity, ensure accurate pricing,
and help to maintain price stability. It is the speculators who keep the
market going because they bear risks which no one else is willing to bear.

Arbitrageur: An arbitrageur is a person who simultaneously enters into

transactions in two or more markets to take advantage of the discrepancy
between prices in these markets. For example, if the futures price of an
asset is very high relative to the cash price, an arbitrageur will make profit
by buying the asset and simultaneously selling futures. Hence, arbitrage
involves making profits from relative mispricing. Arbitrageurs also help to
make markets liquid, ensure accurate and uniform pricing, and enhance
price stability.

All three types of traders and investors are required for a healthy
functioning of the derivatives market. Hedgers and investors provide
economic substance to this market, and without them the markets would
become mere tools of gambling. Speculators provide liquidity and depth to
the market. Arbitrageurs help in bringing about price uniformity and price
discovery. The presence of hedgers, speculators, and arbitrageurs, not only
enables the smooth functioning of the derivatives market, but also helps in
increasing the liquidity of the market.

35
Forward Contracts

Forward contract is a customised contract between two parties where

settlement takes place on a specific date in the future at a price agreed
today. They are over-the-counter traded contracts. Forward contracts are
private agreements between two financial institutions or between a financial
institution and its corporate client.

In a forward contract, one party takes a long position by agreeing to buy the
asset at a certain specified date for a specified price and the other party
takes a short position by agreeing to sell the asset on the same date for the
same price.

The main features of forward contracts are as follows

• They are bilateral contracts wherein all the contract details, such as
delivery date, price, and quantity, are negotiated bilaterally by the parties to
the contract. Being bilateral in nature, they are exposed to counter-party
risk.

• Each contract is custom designed in the sense that the terms of a forward
contract are individually agreed between two counter-parties. Hence, each
contract is unique in terms of contract size, expiration date, and the asset
type and quality.

• As each contract is customised, the contract price is generally not

available in public domain.

• The contract has to be settled by delivery of the asset on the expiry date.

• In case, the party wishes to reverse the contract, it has to compulsorily

approach the same counterparty, which being in a monopoly situation can
command a high price. Forward markets for some goods are highly

36
developed and have standardised market features. Some forward contracts
do have liquid markets. In particular, the forward foreign exchange market
and the forward market for interest rates are highly liquid. Forward
contracts’ dominance is very high for the purposes of hedging foreign
exchange exposures, particularly in Europe.

Forward contracts help in hedging risks arising out of foreign exchange rate
fluctuations. For instance, an exporter who expects to receive payments in
dollars three months later can sell dollars forward and an importer who is
required to make payment in dollars can buy dollars forward, thereby
reducing their exposure to exchange-rate fluctuations. Forward markets are
not free from limitations. As these contracts are customised, they are non-
tradeable. Moreover, there is a possibility of default by any one party to the
transaction and this gives rise to counter-party risk which is a very serious
issue worldwide.

Example of a Forward Contract:

If you plan to grow 100 Tonnes of wheat next year, you could sell your
wheat for whatever the price is when you harvest it, or you could lock in a
price now by selling a forward contract that obligates you to sell 100 Tonnes
of wheat to, say, Kellogg after the harvest for a fixed price. By locking in the
price now, you eliminate the risk of falling wheat prices. On the other hand,
if prices rise later, you will get only what your contract entitles you to.

If you are Kellogg, you might want to purchase a forward contract to lock in
prices and control your costs. However, you might end up overpaying or
(hopefully) underpaying for the wheat depending on the market price when
you take delivery of the wheat.

The value of a forward contract usually changes when the value of the
underlying asset changes. So if the contract requires the buyer to pay
Rs.1,000 for 100 Tonnes of wheat but the market price drops to Rs.600 for
100 Tonnes of wheat, the contract is worth Rs.400 to the seller (because he
or she would get Rs.400 more than the market price for his or her wheat).

Forward contracts may be "cash settled," meaning that they settle with a
single payment for the value of the forward contract. For example, if the
price of 100 Tonnes of wheat is Rs.1,000 in the spot market (the current
market price) when the forward contract expires, but the forward contract
requires the buyer to pay only Rs.800, then the seller can just settle the
contract by paying the buyer Rs.200 instead of actually delivering 100
Tonnes of wheat and collecting a below-market price. The buyer might
appreciate this; after all, the only other way he would see his Rs.200 profit is

37
if he purchased the wheat for Rs.800 and then turned around and sold it at
the market price (Rs.1,000).

38
Futures Contract

Futures are exchange-traded contracts, or agreements, to buy or sell a

specified quantity of financial instrument/commodity in a designated future
month at a price agreed upon by the seller and buyer. Futures contracts
have certain standardised specifications, such as the following.

• Quantity of the underlying.

• Quality of the underlying (not required in financial futures).

• Date and month of delivery.

• Units of price quotation (not the price itself) and minimum change in price
(tick size). A tick is a change in the price of a contract be it up or down.

• Location of settlement.

Difference between Forwards and Futures:

Futures is a type of forward contract. The structure, pay-off profile, and

basic utility for both futures and forward are the same. However, futures
contracts differ from forward contracts in several ways.

• Futures are exchange-traded contracts, while forwards are OTC contracts,

not traded on a stock exchange.

• Futures contracts being traded on exchanges are standardised, that is,

have terms standardised by the exchange. Only the price is negotiated. In
contrast, all elements of forward contracts are negotiated and each contract
is customised, that is, all the terms of a forward contract are individually
agreed between two parties.

• Futures markets are transparent while the forward markets are not
transparent, as forwards are over the-counter instruments. The latter are
private bilateral agreements and as these agreements are not visible to other
parties, the forward market is not transparent. In futures market, everyone
can see the prices available as they are exchange traded.

• Futures contracts are usually more liquid than forward contracts,

because they are standardised and traded on futures exchanges. In
contrast, most forward contracts, due to their customised nature, are less
liquid.

• Futures contracts frequently involve a range of delivery dates whereas

there is generally a single delivery date in a forward contract.

39
• Futures contracts are marked-to-market daily whereas forward contracts
are not.

• Profits and losses on a futures contract are realised on a daily basis (via
the marking to market process). The profit or loss from a forward is realised
when the contract matures.

• Most futures contracts are closed prior to delivery whereas a forward

contract is not usually settled until the end of its life. Hence, futures allow
flexibility as to the date of closing out. Most forward contracts do lead to
delivery of the physical onset or a cash settlement as they are not typically
tradeable.

• A futures contract can be reversed with any member of the exchange

whereas a forward contract can be reversed only with the same counter-
party. To reverse a futures position simply means closing out the existing
contract and then taking an equal but opposite position, effectively reversing
the direction of your "bet". For instance, if you are long one futures contract
and you think the underlying asset is going to go down, you could simply
use the reverse order to turn the position around and become short one
contract of the same futures contract instantly.

• The futures trading system has effective safeguards against defaults.

Futures do not carry a credit risk, as there is a clearing house, which
guarantees both payment and delivery. Forward contracts, on the other
hand, are exposed to default risk by a counter-party as there is no such
clearing house involved.

• Futures markets are regulated by a financial regulator, while forward

contracts, in general, trade in an unregulated market.

Thus, forwards and futures are basically similar concepts. They differ only
in terms of the institutional setting in which they trade, the degree of
flexibility, and cost efficiency. Futures are recognised as the best and most
cost-efficient way of risk hedging.

Futures Terminology:

• Futures: A forward contract traded on an exchange.

• Long: A party is said to be long on an instrument when he or she owns

the instrument. An investor who purchases stock with his own capital is
said to be long stock. A long position indicates a net over bought position.

• Short: A party is said to be short if he or she has sold the contracts. An

investor who sells a stock that he does not currently own is short stock.
Short positions indicate an over-sold position.
40
• Spot price: The price at which an asset trades in the spot market.

• Futures price: The price at which the futures contract trades in the
futures market.

• Expiry date: The last day on which the contract will be traded, at the end
of which it will cease to exist. The expiry day is the last Thursday of the
expiry month or the previous trading day if the last Thursday is a trading
holiday.

• Contract size: The amount of asset that has to be delivered under one
contract. For instance, the contract size on the NSE’s futures market is 200
Nifties.

• Contract cycle: The period over which a contract trades. The index
futures contracts on the NSE have one (near) month, two (next) months and
three (far) months expiry cycles which expire on the last Thursday of the
month. On the Friday following the last Thursday, a new contract having a
three-month expiry would be introduced for trading.

• Marking-to-market: The practice of periodically adjusting a margin

account by adding or subtracting funds based on changes in market value
to reflect the investors’ gain or loss. This is to ensure there are no defaults.

• Margin: An amount of money deposited by both buyers and sellers of

futures contracts to ensure performance of the terms of the contract. The
aim of margin money is to minimise the risk of default by either counter-
party. The payment of margin ensures that the risk is limited to the previous
day’s price movement on each outstanding position. However, even this risk
is offset by the initial margin holdings. There are different types of margins
such as initial margin, variation margin, maintenance margin and additional
margin.

• Initial margin: The amount that must be deposited in the margin

account at the time a futures contract is first entered into. The purpose of
initial margin is to cover the largest potential loss in one day. Both buyer
and seller have to deposit margins. The technique of value-at-risk (VaR) is
used for calculating this margin. This margin is calculated on the basis of
variance observed in daily price of the underlying over a specified historical
period. The margin is kept in a way that it covers price movements more
than 99 per cent of the time. Usually three sigma (standard deviation) is
used for this measurement.

• Maintenance margin: The amount that is set aside to ensure that the
balance in the margin account never becomes negative is called
maintenance margin. It is usually lower than the initial margin. If the

41
balance in the margin account falls below the maintenance margin, the
investor receives a margin call.

• Variation or mark-to-market margin: The amount that is deposited as a

further collateral to meet daily losses. This margin is required by the close of
business, the following day. Any profits on the contract are credited to the
client’s variation margin account.

• Additional margin: The amount that may be called for by the exchange in
case of sudden higher than-expected volatility. This is a preemptive move by
the exchange to prevent breakdown.

• Closing out contracts: A long position in futures can be closed out by

selling futures while a short position in futures can be closed out by buying
futures on the exchange. The net difference is settled in cash without any
delivery of the underlying. Most contracts are not held till expiry, but closed
out before that. If held until expiry, some are settled for cash and others for
physical delivery.

• Basis: The difference between spot price of an asset and its futures price.
Even through the spot and futures prices generally move in tandem with
each other, the basis is not constant. Changes in interest rates or expected
dividends cause unexpected changes in basis. Unexpected changes in basis
render hedges imperfect. Basis decreases with time and, on expiry, it is zero,
and futures price equals spot price.

• Contango: Under normal market conditions, futures contracts are priced

above the expected future spot price. This is known as contango.

• Backwardation: When futures price prevail below the expected future

spot price, it is known as backwardation. This situation may prevail when
the cost of carry is negative or when the underlying asset is in short supply
in the cash market but there is an expectation of increased supply in future.

• Maturity periods for futures contracts: In India, there are different

maturity periods for the futures contract—one, two, and three months with
the last Thursday of the month serving as expiry date. Suppose at the end of
July the one-month contract comes to an end, the August contract
automatically becomes a one-month contract, the September contract, a
two-month contract and the October contract, a three-month contract.

• Settlement basis: The settlement basis is mark-to-market and final

settlement is cash settled on T + 1 basis.

42
• Settlement price: Daily settlement price is the closing price of the futures
contracts for the trading day and the final settlement price is the closing
price of the underlying asset on the last trading day.

Value of a Futures Contract: The value of a futures contract is different from

the price of a futures contract, F0, which is the price at which two parties
agree to buy and sell the underlying asset on the maturity date. The value of
the futures contract is something different and can be defined as the profit
that can be made by the party out of the futures contract.. At the initiation
of a futures contract at F0, the value of the futures contract is zero. There is
no changing hands and there would be no arbitrage opportunity existing to
make profit. However, at maturity, St must be equal to Ft (due to
convergence property). If it is not, then there exists an arbitrage opportunity
to make profit. Say, on maturity, if St is more than Ft, then the profit that
can be made is St - Ft. This is the value of the contract.

Pricing of Futures

Futures price is the exercise price or the strike price that the two parties
have agreed to be paid by the buyer of the asset to the seller of the asset at
expiration in exchange for the underlying asset. It may also be called as
delivery price.

Cost of Carry Model

The cost of carry model determines futures prices in such a way that no
arbitrage opportunities arise.

 The price of the contract defined under this model is:

F = S + C

Futures price = Spot price + Carry costs

If an investor wants to acquire shares in a particular company, he can

acquire this shares today itself at the current price or he can take a long
position in futures. In either case, he will be having the asset. No doubt, the
market determined cost of acquiring the asset in either of these strategies
must be equal. So, there is some relationship between the current price of
the asset and cost of holding it in future and futures price today.

43
The relationship between the current spot price and the futures price is
known as spot-futures parity or cost of carry relationship. The expected
dividend (income) the asset gives during the futures period can also be
accommodated in the analysis.

The price of futures contract depends on the following:

1) The price of the underlying asset in the cash market

2) The rate of return expected from investment in the asset

3) Risk free rate of interest

Suppose, in cash market, the underlying asset is selling at Rs.100. The

expected return from the asset is 3% per quarter. The risk-free rate of
borrowing or lending is 8% per annum or 2% per quarter. The futures
contract period is also for 3 months. What should be the price of futures?

 Now Futures price = Spot price + Carry costs

F = S + S(r-y)

 Where, S = current spot price of the asset

F = futures price
r = % financing cost per futures period
y = percentage yield on investment per futures period

 Suppose, the investor borrows funds to purchase one unit of asset

“x” resulting in no initial cash outlay for his strategy. At the end of
three months period, Rs.3 will be received from holding the asset
“x” and would be required to pay interest (financing cost) of Rs.2.

In the example given above,

F = 100 + 100(0.02 - 0.03)
= Rs.99

So, the futures price should be Rs.99. This is called the theoretical price
of the futures.

What happens if the futures price is Rs.92 or Rs.107? The position can be
explained as follows:

In case, the futures contract is available at Rs.92 (less than the theoretical
price of Rs.99), the investor should buy one future contract for Rs.92 and
should sell one unit of asset “x” for Rs.100 and invest the money @ 8% per
annum for 3 months.

44
After 3 months, he will receive the proceeds of Rs.102 (Rs.100 +Rs.2). he will
spend Rs.92 to purchase an asset (out of futures contract) Besides, he will
not receive the yield of Rs.3 from the Asset. So his cost is Rs.95 (92 + 3). His
gain would be Rs.7 (102-95).

Similarly, if the futures contract price is Rs.107, he should sell futures

contract at Rs.107 and should borrow Rs.100 now to buy one unit of asset
x in the spot market.

After 3 months, proceeds would be Rs.110 (107+3) and payment would be

Rs.102 (100+2). He would be able to make a profit of Rs.8. So, if the futures
prices other than the theoretical price Rs.99, it could give rise to arbitrage
opportunities. In case of price of Rs.92 or Rs.107, investors can look for
riskless arbitrage profit of Rs.7 or Rs.8. The demand and supply forces
would react to this arbitrage opportunity and the futures price would settle
around the equilibrium level of Rs.99

The procedure for pricing futures can be standardised in 3 different

situations as follows:

 When the asset provides no income

F = S x ert

 When the asset provides known dividend (i.e. Dividend in Rs.)

F = (S x ert) – (I x ert)

 When the asset provides a known dividend yield (i.e. Dividend in

terms of %)

F = S x e(r-q)t

 Where, F = Futures Price

S = Spot Price of the underlying asset
e = 2.7183

r = Rate of interest on borrowing or lending

t = Time or duration of futures contract
I = Expected Dividend
q = Dividend yield.

45
Convergence of Futures and Spot Prices`

The spot price is the current market price at which an instrument or

commodity is bought or sold for immediate payment and delivery.
The futures price, on the other hand, is the price of an
instrument/commodity today for delivery at some point in the future, called
the maturity date. The difference between the two is called the basis.

The theoretical value of the futures contract is defined as the cash spot price
of the underlying plus the cost of carry. The cost of carry depends upon the
rate of interest and the time period till maturity of the futures. As the
transaction date of the futures approaches the maturity date, the time
period for which the coat of carry is calculated reduces and therefore, the
cost of carry approaches zero. So the spot price of the underlying and
futures value tends to converge to be equal by the maturity date. This is
called as convergence property.

Basis=spot price – futures price

As the maturity date nears, the basis converges toward zero, i.e., the spot
price tends towards the futures price. On the actual maturity date, the two
rates must be equal as long as no arbitrage opportunities exist. At maturity,
the futures price becomes the current market price, which is actually the
definition of the spot price.

46
Normal vs Inverted Futures Markets

A normal futures market, also known as a Contango market, means that

futures contracts are trading at a premium to the spot price. For example,
suppose the price of a barrel of crude oil today is $50per barrel, but the
price for delivery in three months is $53: the market would be in Contango.
On the other hand, if crude oil is trading at $50 per barrel for delivery right
now, and the three-month contract is trading at $45 per barrel, then that
market would be said to be inverted ( backwardation).

Hedge

A hedge is an action taken out specifically to reduce or cancel out the risk in
an investment. Futures can be used as hedging mechanism to reduce risk
associated with exposure in the underlying asset market by taking
appropriate counter position. Hedgers can use the futures trading to protect
themselves from the expected price movements. If an investor is holding an
asset, then he needs to take a position in futures market such that profit /
loss on asset price is offset by loss / profit in futures market.

Short Hedges vs. Long Hedges

A short hedge is a case when an owner of an asset expects the price to fall,
and in order to counter this risk, he sells the futures now. A short hedge is a
strategy to protect a future selling price of an existing asset. So, a long
position in asset is hedged by creating a short position in futures. If the
asset spot price declines by the expiry date, the owner will suffer a loss.
However, at the same time, the futures prices will also go down (due to
convergence property). The profit on futures will offset the loss on spot
position. On the other hand, as against the expectation, if the spot price
increases by the maturity date then the owner will earn gain on asset price
and incur loss on futures. Both will offset each other. So, an owner of an
asset can hedge his position by going short in futures. Short hedge can also
be created when a person holds the asset and expects a price decrease but
does not want to sell the asset, instead he can sell the futures.

A long hedge is a case where a prospective future buyer buys the futures
today and thereby locks the prices at which he would be acquiring the asset
in future., irrespective of what price would be prevailing in the market on
that day. For example, a wheat flour seller wants to maintain the price of the
flour over next one year period. In the market, the price of the wheat would
be fluctuating. So, either the profit would be affected adversely or the flour
price will not be maintained. What it can do is to buy the wheat futures
today and lock-in the price at which the wheat will be bought in future. So,
the long futures will help to maintain the flour prices.

47
Suppose RST Ltd. knows that it will be making a purchase in the future for
a particular item, it should take a long position in a futures contract to
hedge its position. It knows that in six months, it will have to buy 20 kgs of
silver to fulfill an order. Assume the spot price of the silver is Rs.60,000 per
kg. and the six month futures price is Rs.62,000 per kg. By buying the
futures contract, it can lock-in a price of Rs.62,000 per kg. This reduces the
company’s risk because it will be able to close its futures position and buy
20 kgs of silver for Rs.62,000 per kg in six months.

If a company knows that it will be selling a certain item, it should take a

short position in a futures contract to hedge its position. For example, RST
Ltd. Must fulfill a contract in six months that require it to sell 30 kgs of
silver utensils at the then prevailing price. Assume the spot price is
Rs.60,000 per kg and the futures price is Rs.63,000 per kg. It should short
futures contract on silver and close out the futures position in six months’
time. In this case, RST Ltd. Has reduced the risk by ensuring that it will
receive Rs.63,000 per kg of silver it sells.

Advantages and Disadvantages of Hedging

Advantages:

I. It helps asset holders to lock in a price for their assets. By taking

a short position, a corn farmer, for example, who is anticipating a
bumper harvest in a few months is able to lock in a predetermined
price for their corn. By so doing, they eliminate – or at least reduce the
risk of a price decrease.
II. It helps prospective buyers to lock in a price for the goods they
intend to purchase. Instead of a cereal company waiting to buy corn
at the prevailing post-harvest price, the company can lock in a
predetermined purchase price by getting into a long futures contract.
Even if prices rise dramatically between the signing of the contract
and the maturity date, the company will benefit from a fixed price.
III. Hedging makes earnings to be less volatile. Less volatile earnings
attract more investors.

Disadvantages:

I. Hedging might lock asset holders out of improving market

prices. Although hedging shields asset holders from price declines, it
locks them out of increases in value. Even if the asset’s price rises, the
short futures contract holder is obliged to honor all the terms of the
deal. They must sell the underlying at the contract price.
II. Hedging may subject a firm to losses. In cases where there is
negligible risk exposure, hedging might actually increase rather than
decrease losses.

48
This is a scenario where the futures trader closes out the contract even
before the expiry. If a trader has a long position, they will take an equivalent
short-term position in the same contract, and both positions will offset each
other. Similarly, if a trader has a short position, they will take an equivalent
long-term position in the same contract, and both positions will offset each
other.

Example: An investor has a portfolio of stocks which at current cash market

prices valued at Rs.1,00,00,000. The investor is in anticipation of
depreciation in stock prices, hedges the portfolio through sale of 3 month
Nifty Futures of equivalent value.

The current futures price is 5000 and contract size is 50.

The value of 1 Futures contract = 5000 x 50 = Rs.2,50,000

Number of contracts required for hedging

= Rs.1,00,00,000 / 2,50,000 = 40 Contracts

The futures contracts are reversed on expiry. Consider two contrasting

situations.
a) If market declines by 10%
b) If market appreciates by 5%.

Cashflows Rs. Cashflows Rs.

Particulars (Index falls by 10%) (Index rises by 5%)
Index Value 4,500 5,250
Futures Position
Sold 40 Contracts @ 5000 x 50 1,00,00,000 1,00,00,000
40 x 4500 x 50 = 40 x 5250 x 50 =
Bought 40 contracts 90,00,000 1,05,00,000
Profit or Loss on Futures 10,00,000 -5,00,000
Portfolio Position
Initial Value 1,00,00,000 1,00,00,000
Final Value 90,00,000 1,05,00,000
Profit or Loss on Portfolio -10,00,000 5,00,000
Net Position 0 0

In the above example, we assumed that rise or fall of prices in stock portfolio
and index would be in perfect proportion. In reality such direct relationship
does not exist. This means that number of index futures contracts to be
used for hedging needs to be adjusted for difference in variability. This is
known as Hedge ratio.

49
Different types of hedging positions can be designed depending upon the
present position and perception about the future. Some of the hedging
strategies are given below:

Present Position Perception about future Hedging Action

Holding Asset Price may fall Short Futures
Holding Asset Price may increase Do Nothing
About to buy asset Price may increase Long Futures
Short the asset Price may increase Long Futures
Short the asset Price may fall Do Nothing

Basis Risk and Its Causes

The convergence property states that the futures prices and spot prices are
equal on the maturity date. However, before maturity, the futures price may
differ substantially from the spot prices. Basis risk is the risk that the value
of a futures contract will not move in normal, steady correlation with the
price of the underlying asset. For example, if the current spot price
of gold is $1,500, and the six-month futures price of gold is $1,550, then the
basis, the differential, is $50. Basis risk, in this case, is the risk that
between now and maturity of the contract in six months, the price of gold
will fluctuate by more than $50.
A trader is exposed to basis risk if she/he closes out a futures contract
before its maturity. Basis is basically the difference between the spot price
and the futures price, and basis risk is the risk associated with basis at the
time of closing out a contract.

Basis = Spot Price−Futures Price

If the asset being hedged is different from the underlying asset in the futures
contract,

Then;

Basis=Spot Price of the hedged asset − Future price of the underlying

asset in the futures contract.

The fluctuation in the basis makes hedges less effective than they are meant
to be. Between contract initiation and liquidation, the price spread (the
difference between the cash price and futures price) may either narrow or
widen.

50
 Sources of basis risk:

 Imperfect matching between the cash asset and the hedge asset, e.g.,
hedging jet fuel with motor vehicle fuel.
 Changes in the components of the cost of carry, e.g., interest, storage and
safekeeping, and insurance.
 Maturity mismatch, e.g., hedging an exposure to physical prices in May with
a June futures contract.
 Location mismatch, e.g., hedging crude oil sold in New York with crude oil
futures traded on a Mumbai futures exchange.

To minimize basis risk, it’s imperative to choose the hedge tool that’s most
correlated with the underlying.

Cross Hedging

There are instances when it may be impossible to find futures contracts on a

particular underlying. In such scenarios, the hedger may turn to futures on
securities that exhibit positive correlation with the underlying. This is called
cross hedging. The hedger takes opposite positions in the two assets. Since
the assets are not entirely identical, there must be enough correlation for
the hedge to work.

51
Hedge ratio and Portfolio Insurance

If an investor has a diversified portfolio then the unsystematic (firm specific)

risk of that portfolio would have already been eliminated. The systematic
risk, however, can be hedged with the help of index futures. Such hedging is
based on the principle of positive correlation between spot prices and
futures prices. In order to hedge the risk of spot market (of the portfolio), a
negative correlation can be created by shorting the Index futures.

Hedge Ratio: Futures are one of the most common derivatives used to
hedge risk. The main reason for this is that futures provide the most
appropriate method to offset the risk exposure from fluctuations in prices of
the assets already held. In case the futures contract contains only one unit
of the underlying, then for each unit of the asset, a perfect hedge can be
created by selling one futures contract. However, this is not always the case.
A futures contract is always consisting of specific number of units of the
underlying asset, and that may not be equal to the number of units of the
underlying held by the hedger.

Hedge ratio is the number of futures contracts to be sold or purchased to

hedge the specific quantity of the underlying asset. The ratio if applied,
would give profit (loss) on futures contract, which is just equal to the loss
(profit) on the underlying in the spot market. The hedger has a nil payoff
position on maturity.

Suppose a person has 10,000 shares of SAIL with market price of Rs.85 per
share. Value of portfolio is Rs.8,50,000. Futures are being traded at
Rs.85.35 and one contract of futures has 1,980 shares. So, the value of the
contract is Rs.85.35 x 1,980 = Rs.1,68,993. Now, the number of contracts
required to hedge the portfolio value of Rs.8,50,000 is:

No. of contracts = Value of Portfolio / Value of 1 Futures Contract

= Rs.8,50,000 / Rs.1,68,993 = 5.03

So, the owner should sell 5.03 contracts. As only integer number of
contracts can be traded, the hedger will short 5 contracts and his position
will be slightly under-covered.

In the above case, it is assumed that in time to come, the spot prices and
futures prices will change in the same direction and in same proportion. If
spot prices are increasing 3%, then futures prices will also increase by 3%.

52
Such an assumption is valid if the asset being hedged and the underlying
asset of the futures are the same, as was the case of SAIL shares. But this is
not necessarily always the case.

Suppose, the hedger has a portfolio consisting of 20 shares and this

portfolio is being hedged by NIFTY Futures which is a portfolio of 50 shares.
In such a case, the change in portfolio value and change in NIFTY Futures
will not be the same. In order to frame a hedging strategy in this case, a
small adjustment is required in the calculation of hedge ratio, given above.
What is required is to find the β of the portfolio, and NIFTY Futures
represents the market. The number of contracts required to hedge the
portfolio can now be calculated as follows:

No. of Contracts = (Value of Portfolio / Value of 1 Futures Contract) x β of

the Portfolio

An investor has a portfolio of Rs.10,00,000 invested in several shares. He is

bearish about the market and expects decline of 20% in the NIFTY over next
3 months for which the NIFTY Futures are available at 3,700. The weighted
average beta for his portfolio is estimated at 1.12 (it means that his portfolio
is 12% more volatile than the market). One futures contract includes 100
units. How many contracts should be taken up by the investor? Show how
the investor’s position is hedged if there is a decline of 10% or increase by
15% in NIFTY during the futures period.

Solution:

The investor can hedge by selling appropriate number of futures contracts.

No. of contracts = (Value of Portfolio / NIFTY Futures x units) x β of the

Portfolio

= (Rs.10,00,000 / 3700 x 10) x 1.12

= 3.02 or 3 contracts.

So, the portfolio of Rs.10,00,000 having weighted average beta of 1.12 can
be hedged with 3 contracts.

Now suppose, the NIFTY goes down during the futures period by 10%. The
hedging will work as follows:

% Decline in value of portfolio = 1.12 x 10% = 0.112

Total Decline in the value (Rs.10,00,000 x 0.112) = Rs.1,12,000

% Decline in Nifty (3,700 x 0.90) = 3330

53
Purchase price on settlement (3330 x 3 x 100) = Rs.9.99.000

Sale price as per Futures (3700 x 3 x 100) = Rs.11,10,000

Profit on Futures = (Rs.11,10,000 – Rs.9,99,000) = Rs.1,11,000

So, the gain in Futures Rs.1,11,000 is almost equal to the loss in portfolio
Rs.1,12,000. The difference, if any, is due to approximation in number of
contracts.

In the same case, if NIFTY goes up by 15% instead of going down, then the
increase in value of the portfolio would be 1.12 x 0.15 = 0.168 or a gain of
Rs.1,68,000 and the loss on Futures would be:

NIFTY on settlement day (3,700 x 1.15) = 4,255

Value of Futures contract (4,255 x 100 x 3) = Rs.12,76,500

Sale price as per Futures (3700 x 3 x 100) = Rs.11,10,000

Loss on Futures (Rs.12,76,500 - Rs.11,10,000) = Rs.1,66,500

So, the loss in Futures Rs.1,66,500 is almost equal to the profit in portfolio
Rs.1,68,000. The difference, if any, is due to approximation in number of
contracts.

The Optimal Hedge Ratio

The optimal hedge ratio, also called the minimum variance ratio, is the
degree of correlation between the underlying asset and the futures contract
purchased to hedge financial risks. It’s the ratio of the futures position to
the spot position.

Hedge Ratio = ρSF x σS / σF

Where:

ρ SF =correlation between spot prices and the future prices

σS=standard deviation of the spot price
σF=standard deviation of the futures price

Note:

ρ SF = CovSF / σS x σF

And,

54
[CovSF / σS x σF] X σS / σF

= CovSF / σ2 F = βSF

The effectiveness of a hedge measures the amount of variance that’s reduced

by implementing the optimal hedge ratio.

The Optimal Number of Futures Contracts Needed to Hedge an

Exposure

The number of futures contracts required to completely hedge an equity

position is given by:

N=β portfolio x [Portfolio Value / Value of Futures Contract ]

=β portfolio x [Portfolio Value / (Futures Price x Contract Multiplier) ]

Example: Mr. Sachin, a mutual fund a portfolio manager in charge of

a Rs.20 Crores portfolio that has a beta of 1.5 relative to the NIFTY. The
NIFTY futures are trading at 10,800, and the multiplier is 75. Mr. Sachin
intends to hedge his exposure to market risk over the coming months.
Determine the type and number of NIFTY contracts required to implement
the hedge.

N=β portfolio x [Portfolio Value / (Futures Price x Contract Multiplier)]

= 1.5 x 20,00,00,000 /(10800 x 75)

= 1.5 x 20,00,00,000/ 810000

= 1.5 x 246.91

= 370.37 or 370 Contracts

55
Arbitrage using Futures Contracts

Arbitrage refers to taking two simultaneous actions to make risk-less profit

out of the price differential of the same asset at the same time in two
different markets. For example, at a particular point of time, share of Infosys
Ltd. Are trading at Rs.2380 at the NSE and Rs.2385 at BSE. A risk-less
profit can be earned by buying Infosys shares at NSE and simultaneously
selling these shares at BSE. However, if the two actions are not taken up
simultaneously, then profit opportunity may disappear. Moreover, if there is
a time gap between two actions, the prospective gain may turn into loss.

In other words, arbitrage has an objective of making risk-less profit out of

the market inefficiencies. A market is said to be inefficient one when the
market prices do not reflect and are not equal to the theoretical value of the
assets being traded in the market. Arbitrage is a mechanism by which the
derivatives market is linked with the cash market and derivative prices are
linked with the cash spot prices. If the arbitrage opportunity are not
identified and are not capitalized, then markets would remain far from
efficient. Inefficiency in the market, if any, should be spotted by the
arbitrageurs and a suitable strategy be framed to ensure a profit and to
drive the market prices back to their theoretical value.

It may be noted that arbitrage is not the same thing as speculation. The
latter is to expect profit by prediction of future prices and is definitely risky,
whereas the former is to make profit out of price differences and is therefore
riskless. Further that speculation can be undertaken any time but arbitrage
opportunities do not last for long. Due to actions of the arbitrageurs, the
market reaches equilibrium level again and the arbitrage opportunity
disappears.

Cash-and-Carry-Arbitrage

Cash-and-carry-arbitrage is a market neutral strategy combining the

purchase of a long position in an asset such as a stock or commodity, and
the sale (short) of a position in a futures contract on that same underlying
asset. It seeks to exploit pricing inefficiencies for the asset in the cash (or
spot) market and futures markets, in order to make riskless profits. The
futures contract must be theoretically expensive relative to the underlying
asset or the arbitrage will not be profitable.

Cash and carry Arbitrage strategy is implemented when futures is Over

Priced.

Following are the steps in Cash and Carry Arbitrage:

Step 1: Borrow amount equal to Spot price of an asset at risk-free rate.

56
Step 2: Purchase the asset in the spot market at the current spot price

Step 3: Sell the futures based in the asset.

Step 4: On maturity of the contract, deliver the share at futures price

Step 5: Repay the loan with interest.

Reverse cash-and-carry arbitrage

Reverse cash-and-carry arbitrage is a market neutral strategy combining a

short position in an asset and a long futures position in that same asset. Its
goal is to exploit pricing inefficiencies between that asset's cash, or spot,
price and the corresponding future's price to generate riskless profits.

Reverse Cash and carry Arbitrage strategy is implemented when futures

is Under Priced.

Following are the steps in Reverse Cash and Carry Arbitrage:

Step 1: Borrow share of the company under Stock Lending and Borrowing
Scheme.

Step 2: Sell the borrowed share at the current spot price in the stock
market.

Step 3: Lend money realized for the stock market at a risk free rate of
interest.

Step 4: Buy Futures contract on the share of the company.

Step 5: On maturity recover the loan with interest.

Step 6: Purchase the share on maturity of futures contract and return the
share to the broker.

57
Speculation and Futures Market

A speculator is a person who aims to earn profit out of movement of prices.

Futures can be used by speculators. If a speculator expects the prices to
increase, he goes long in futures and may earn profit or loss depending
upon the price movement. Similarly, if he expects a decline in prices, he can
go short. But the question is why he will like to go for futures and not for
the buy/sell of asset itself. Two reasons for this can be noted. First, in case
of futures, only the margins are payable during the futures period and
therefore, the speculator can take a larger position in futures than in assets.
So, futures trading provide a leverage to the speculator. Second, the
transaction cost of futures is definitely lower than the cost of buying the
asset.

At any point of time, a speculator may have a perception about the future
behavior of the market. He may perceive the market will move upward or
may perceive that the market is likely to go downward. Based on his
perception, one can build up a strategy as follows:

1. Perception of Downward Movement in the Market: If the speculator

feels that the current market prices are overvalued and in near future,
the prices are likely to decrease, the speculator has three alternatives:
a) If a particular share is found to be overvalued then one can go
short on that share of the futures of that share. If he wants to go
short on the shares, and he is not having the shares with him, he
should borrow the shares against collateral and sell the shares in
the market. The proceeds can be invested to earn some return. At
the end of the perception period, he should buy the shares from
the market out of the proceeds of investment and should return the
shares to the lenders. The speculator is also required to pay back
the dividend, if any, or effect of any corporate action such as issue
of bonus shares etc. Out of his speculative activity, he may gain or
lose depending on whether his perception was correct or wrong. It
may be noted that in this case, he may be exposed to both
systematic as well as unsystematic risk.
b) Alternatively, he can sell the futures of that shares on which some
margin (initial as well as mark to market) would be payable. At the
end of the futures period, or any time before that the shares
futures can be purchased back. The profit or loss on shares futures
will be his speculative gain or loss.
c) He can go short on the entire market by selling market index
futures. In this case, his risk is limited as the market is generally
less volatile than individual shares. Of course, margin would be
payable by him. He may gain or incur loss on his action.

2) Perception of Upward Movement in the Market: If a speculator feels

that the market prices are undervalued at present and in near future,
are likely to go up, he can built up a position to make prifit in future
as follows:

58
 a) He can go long on the individual shares which are found to be
undervalued. He is required to borrow money for this purpose. He will
also be entitled to get the benefit out of corporate actions if any. Gain
or loss on speculation will occur when he sells the shares in future. It
may be noted that he is subject to systematic as well as unsystematic
risk during the holding period of shares.

b) He can buy the shares futures on which the initial margin and
mark to market, both would be payable. Profit or loss of speculation
would occur when the position is squared off or at the end of the
futures period. The profits and losses would depend upon the
difference between the price at which the position is opened and the
price at which it is closed. Let an investor have a long position of one
Stock X futures @ Rs.450 the profit would be Rs.20 per share. In case,
the investor squares up his position by selling Stock X futures @
Rs.400, the loss would be Rs.30 per share.

c) He can also go long on the market index futures. He would be

exposed to risk. Margin money would be payable and profit or loss
would occur at the end of the futures period or when the position is
closed by squaring off.

Payoff of Futures

A payoff is the likely profit or loss that would accrue to a market participant
with change in the price of the underlying asset. Futures contracts have
linear payoffs. In simple words, it means that the losses as well as profits,
for the buyer and the seller of futures contracts, will change with the change
in the prices of underlying asset. The payoff for futures, that is, for buyers
(long futures) and sellers (short futures) is discussed below.

Payoff for Buyer of Futures: Long Futures

The payoffs for a person who buys a futures contract is similar to the pay off
for a person who holds an asset. He has a potentially unlimited upside as
well as downside. Take the case of a trader who buys a two month Nifty
index futures contract when the Nifty stands at 11200. The underlying asset
in this case is the Nifty portfolio. When the index moves up the long futures
position starts making profits and when the index moves down it starts
making losses.

Profit

Spot Price

11200
Loss

59
In the above figure, 11200 is the price at which the trader has taken a long
position in the futures contract. The figure shows that as the spot price
increases, the profit of the long trader also increases. The break even level is
one when spot price is equal to 11200.

For Long Position: Profit = Spot price at maturity – Futures price

Loss = Futures Price – Spot price at maturity

Payoff for Seller of Futures: Short Futures

The payoff for a person who sells a futures contract is similar to the payoff
for a person who shorts an asset. He has a potentially unlimited upside as
well as down side. Take a case of a trader who sells a two month Nifty index
futures contact when the Nifty stands at 11200. The underlying asset in this
case is the Nifty portfolio. When the index moves down the short futures
position starts making profits and when the index moves up, it start making
losses.

Profit

Spot Price

11200

Loss

The above figure shows that the maximum profit to the Short position holder
appears if the spot price is 0. Thus, profit decreases and loss increases as
the spot price increases. The break even level is one when spot price is equal
to 11200.

For Short position: Profit = Futures Price – Spot price at maturity

Loss = Spot price at maturity – Futures Price

60
Mark-to-Market Margin in Futures

Margin: An amount of money deposited by both buyers and sellers of

futures contracts to ensure performance of the terms of the contract. The
aim of margin money is to minimise the risk of default by either counter-
party.
There are different types of margins such as initial margin, variation margin,
maintenance margin and additional margin.

Initial Margin: One of the basic concept of risk management that underlies
future position is the initial margin that is collected from the client to trade
in futures segment. The initial margin consists of Standardized Portfolio
Analysis of Risk (SPAN) margin and Exposure margin, the percentage of
which are defined by the exchange on a daily basis. This amount that gets
blocked upfront from your account. if you are long or short on the contract.
The SPAN margin is a basic margin that is calculated based on Value at
risk method. The Value at risk takes into account the maximum loss that a
stock can incur on a single trading day based on historical probabilities. The
collection of SPAN margin is mandatory as per SEBI and NSE rules and
regulation. The exposure margin is an additional margin which is optional,
but most brokers do collect the exposure margin to add buffer of safety.

Maintenance margin: The amount that is set aside to ensure that the
balance in the margin account never becomes negative is called
maintenance margin. It is usually lower than the initial margin. If the
balance in the margin account falls below the maintenance margin, the
investor receives a margin call.

Variation or mark-to-market margin: The amount that is deposited as a

further collateral to meet daily losses. This margin is required by the close of
business, the following day. Any profits on the contract are credited to the
client’s variation margin account.

Additional margin: The amount that may be called for by the exchange in
case of sudden higher than-expected volatility. This is a preemptive move by
the exchange to prevent breakdown.

Margin call: When the balance of margin account falls below a certain point
i.e. the span margin will be the point at which Margin Call will be made. At
this point, the broker will ask the client to replenish the account back to the
initial margin level. If client is not able to bring in additional margin, then
the broker has a choice to terminate the position and debit the losses to the
client's account.

Let us assume that you take a long position in Punjab National Bank
futures and the SPAN margin is 10.96% and Exposure margin is 6.23%
taking the total initial margin to 17.19%.

61
Positio Lot Pric Contract SPAN Exposure Total Margin
n Size e Value Margin Margin
1 Lot 4000 182 Rs.728,000 Rs.79,788.8 Rs.45,354.4 Rs.1,25,143.2
Long on
PNB
Futures

In the above case, the broker will collect a total initial margin of
Rs.1,25,143.2, if you initiate one lot long futures position in Punjab National
Bank.

The concept of initial margin is central to understanding the concept of

Mark to market margin. If the price of PNB share moves up or down, your
margin money value get adjusted to that extend. Margin helps us to
understand if we still have the protection or we need to bring in more
margin.

In the table, we are simulated have a margin balance of a trader will get
impacted when the price of Punjab National Bank moves on a daily basis. As
the trader is long on Punjab National Bank. rise in prices will mean positive
mark to market margin and fall in price will mean negative mark to market
margin. It is this impact that is captured in the margin balance column at
the end. In case of Punjab National Bank, we have clearly broken up the
total initial margin into the SPAN margin and the Exposure margin. Let us
also understand why this breakup is important from the point of view of
Margin Call and additional margining requested by the broker.

Note: At the end of Day 4 the margin balance will be Rs.29,143.2 (93,143.2
– 64,000). However, the SPAN margin required at the end of Day 4 is Rs.
69,267.2. This means that the amount in margin account is below the SPAN
62
Margin. Therefore, there will be a margin call and the trader has to replenish
the margin balance back to initial margin required i.e. Rs. 1,08,640.8.
Hence, Margin to be deposited at the end of Day 4 will be Rs. 79,497.6
(1,08,640.8 - 29,143.2).

For the first two days, the margin balance had depleted but has not fallen
below the span margin level. On the third day, there was a profit which
increased the balance in margin account. It is on the last day that a margin
balance falls to Rs.29,143.2, which is below the span margin requirement of
Rs.69,267.2. At this point the broker will make the margin call and ask the
client to replenish the account back to the initial margin level i.e. Rs.
1,08,640.8.
If the trader is not able to bring in additional margin, then the broker has a
choice to terminate the position and debit the losses to the client's account.

63
 Terminating a Futures Contract

Traders with short or long positions in futures contracts can terminate them
in one of four ways:

 Offset or Closeout or Square off: This is a scenario where the futures

trader closes out the contract even before the expiry. If a trader has a long
position, they will take an equivalent short position in the same contract,
and both positions will offset each other. Similarly, if a trader has a short
position, they will take an equivalent long position in the same contract, and
both positions will offset each other.

Offsetting or liquidating a position is the simplest and most common method

of exiting a trade. When offsetting a position, a trader is able to realize all
profits or losses associated with that position without taking physical or
cash delivery of the asset.

For example, a trader who is short two Crude Oil contracts expiring in
September will need to buy two Crude Oil contracts expiring on the same
date. The difference in price between his initial position and offset position
will represent the profit or loss on the trade.

Rollover
Rollover is when a trader moves his position from the front month contract
to a another contract further in the future. Traders will determine when they
need to move to the new contract by watching volume of both the expiring
contract and next month contract. A trader who is going to roll their
positions may choose to switch to the next month contract when volume has
reached a certain level in that contract.

When rolling forward, a trader will simultaneously offset his current position
and establish a new position in the next contract month. For example, a
trader who is long four Nifty futures contracts expiring in September will
simultaneously sell four Nifty Sept contracts and buy four Dec or further
away Nifty Futures contracts.

 Delivery: A short terminates the position by delivering the goods, and the
long pays the contract price. This is called delivery. In each exchange, there
are certain conditions that must be met before a delivery can be executed.

Cash settlement: In this scenario, a trader just leaves his position open,
and when the contract expires, his margin account will be marked-to-
market for P&L on the final day of the contract.

64
INTRODUCTION TO OPTIONS

Options are contracts that give the holder the option to buy/sell specified
quantity of the underlying assets at a particular (strike) price on or before a
specified time period. The word ‘option’ implies that the holder of the options
has the right but not the obligation to buy or sell underlying assets. The
underlying may be physical commodities such as
wheat/rice/cotton/oilseeds/gold, or financial instruments such as equity
shares, stock index, bonds and so on. In a forward or futures market, the
two parties commit to buy and sell, while the option gives the holder of the
option the right to buy or sell. However, the holder of the options has to pay
the price of the options, termed as the ‘premium.’ If the holder does not
exercise the option, he loses only the premium. Hence, options are
fundamentally different from forward or futures.

Options Terminology:

Underlying: The specific security/asset on which an option contract is

based. It is the asset whose price movement determines the value of the
option.

Option premium: The price paid by the buyer to the seller to acquire the
right to buy or sell.

Strike price: The pre-decided price at which the option may be exercised. It
is also known as the exercise price. The strike price is linked to the price of
the underlying asset in the cash market.

Call Option: A call option is a right to buy an underlying asset at a specified

price on or before a particular day by paying a premium.

Put Option: A put option is a right to sell an underlying asset at a specified

price on or before a particular day by paying a premium.

Expiration date: The date on which the option expires is known as the
expiration date. On the expiration date, either the option is exercised or it
expires worthless.

Exercise date: The date on which the option is actually exercised. In case of
European options, the exercise date is same as the expiry date while in case
of American options, the options contract may be exercised any day between
the purchase of the contract and its expiry date.

Option holder: One who buys an option which can either be a call or a put
option. He enjoys the right to buy or sell the underlying asset at a specified
price on or before specified time. His upside potential (profit) is unlimited

65
while losses are limited to the premium paid by him to the option writer.

Option seller/writer: One who is obligated to buy (in case of a put option) or
to sell (in case of a call option) the underlying asset in case the buyer of the
option decides to exercise his option. His profits are limited to the premium
received from the buyer while his downside is unlimited.

Moneyness: An option concept that refers to the potential profit or loss from
the exercise of an option. An option may be in the money, out of the money,
or at the money.
In-the-money (ITM) option: When the underlying asset price (S) is greater
than the strike price (X) of the call option, that is, S > X. An in-the-money
option would lead to a positive cash flow to the holder if it were exercised
immediately. For example, a NIFTY call option with strike of 11,500 is in the
money when the spot NIFTY is at 11,550 as S > X. The call holder has the
right to buy a NIFTY at 11,500 and sell it at 11,550 and make a profit. If the
index is much higher than the strike price, the call is said to be deep in the
money. In case of a put option, the put is in the money if the spot price is
below the strike price.
Out-of-the-money option: When the underlying asset price (S) is less than
the strike price (X of the call option), that is, S < X. An out-of-the-money
option would lead to a negative cash flow if exercised immediately. If, in the
above example, the NIFTY falls to 11,400, the call option no longer has
positive exercise value. The call holder will not exercise the option to buy
NIFTY at 11,500 when the current index is 11,400. If the index is much
lower than the strike price, the call is said to be a deep out-of-the-money
option. In the case of a put option, the put is out of the money if the index is
above the strike price.
At-the-money option: When the option’s underlying asset price is equal to
the option’s strike price, that is, S =X. It would lead to zero cash flow if
exercised immediately.

66
 Call Option Put Option
In-the- Spot Price of Underlying Asset Spot Price of Underlying Asset
money > Strike Price (S > X). < Strike Price (S < X)
At-the- Spot Price of Underlying Asset Spot Price of Underlying Asset
money = Strike Price. = Strike Price
Out-of-the- Spot Price of Underlying Asset Spot Price of Underlying Asset
money < Strike Price (S < X). > Strike Price (S > X).

Cash settled: When the investor is paid the difference between the strike
price and the market price on expiry it is referred to as ‘cash settled’. Index
options are always cash settled as physical settlement of the index itself is
impractical.

Delivery-based settlement: When a put buyer delivers the scrips on the day
of expiry and the seller is paid the expiry price, it is referred to as a ‘delivery-
based settlement.’ In case of calls, the buyer of a call gets the delivery of the
scrips and makes the payment. Delivery-based settlement is expected to be
introduced in India in the coming future.

LEAPS (Long-term Equity Anticipation Securities): In India, options

generally expire within three months or less. LEAPS are a variation of
standard option contracts in the sense that they are long dated with an
expiration date upto three years into the future. These long-term options
provide the holder the right to purchase (in case of a call), or sell (in case of
a put), a specified amount of the underlying stock at a predetermined price
for a specified period of time, which can be upto three years in the future.
LEAPS enable investors to trade for the long-term without making an
outright stock purchase.

Types of Options

Options are of two basic types—‘call’ option and ‘put’ option. A call option is
a right to buy an underlying asset at a specified price on or before a
particular day by paying a premium. A ‘put’ option is a right to sell an
underlying asset at a specified price on or before a particular day by paying
a premium.

There are two other important types of options: European-style options and
American-style options. European-style options can be exercised only on the
maturity date of the option, which is known as the expiry date. American-
style options can be exercised at any time before and on the expiry date. The

67
American option permits early exercise while a European option does not. In
India, options in stock indices such as NIFTY and Sensex es well as options
in equity shares are European.

Options can be over the counter and exchange traded. Over-the-counter

(OTC) options are private agreements between two parties and are tailor-
made to the requirements of the party buying the option. Exchange-traded
options are bought and sold on an organised exchange and are standardised
contracts.

Naked options and covered options: A call option is called a Covered option
if it is covered / written against assets owned by the option writer. In case of
exercise of the call option by the option holder, the option writer can deliver
the asset or the price differential. On the other hand, if the option is not
covered by the physical asset, it is known as the Naked option.

Stock, Interest and Index options: Option may also be classified with
reference to the underlying asset. Options on the individual shares are
known as stock options or equity options. In India, SEBI has allowed stock
options at NSE as well as BSE in selected shares. An Index option is an
option on the index of securities. In India, SEBI has allowed options on
NIFTY, SENSEX and other indices. Besides, there may be interest rate
options and currency options. It may be noted that the stock options, index
options and currency options are exchange traded options, whereas the
interest rate options are over the counter.

Comparing Futures and Options

Futures and options are significantly different from each other in the
following ways.

1) Futures are contracts to buy or sell specified quantity of underlying

assets at an agreed price on or before a specified time. Both the buyer
and seller are committed or obligated to buy/sell the underlying asset.
By contrast, in case of options, the buyer enjoys the right and not the
obligation to buy or sell the underlying asset. Thus, options are rights
for buyers and obligation for sellers.

2) Futures contracts have symmetric risk profile for both the buyer as
well as the seller, whereas options have an asymmetric risk profile. In
case of options, for a buyer or holder of the option, the downside is
limited to the premium he has paid while the profits may be
unlimited. For a seller or writer of an option, the downside is
unlimited while profits are limited to the premium received from the
buyer.

68
 3) Futures contracts prices are affected mainly by the prices of the
underlying assets. Option prices are influenced not only by the prices
of the underlying asset but also by the time remaining for expiry of the
contract and volatility of the underlying asset. Thus, options provide
exposure to a number of dimensions.

4) The parties are liable to deposit Initial margin while entering into a
futures contract whereas there is a cost of entering into an options
contract, termed as premium.
5) Regulatory complexities are greater with options as compared to
futures contract. Moreover, options trading strategies can be highly
complicated as compared to futures trading strategies.

Benefits of Options

1. Options are versatile derivative instruments. Options have helped to

revolutionise finance. Corporations use them in their financing
decisions to control risk.

2. Options are a means of insurance against adverse price movement. A

call option is a means of ensuring a maximum purchase price and a
put option provides a minimum selling price. A hedger uses options
when the price movement is uncertain. So, options supply the
insurance needed to overcome the uncertainty in prices.

3. Options provide high leverage as with a small investment in the form

of premium, one can take exposure in the underlying asset of much
greater value.

4. Options gives the investor the flexibility to trade for any potential
movement in an underlying security. As long as the investor has a
view regarding how the price of a security will move shortly, he can
use an options strategy. If an investor feels that the price of a security
is likely to rise, he can buy a call option and fix the price of the
security at a certain level. If the price of the underlying security goes
up, he can purchase the securities at the strike price and then sell it
at the market price to make profits. On the other hand, if an investor
feels that the price of a particular security is going to fall, he can buy
a put option for a certain strike price. Even if the price of the security
falls below the strike price, he can still sell the securities at the strike

69
 price and lock a specific price for selling the security. Options thus
work in all kinds of market conditions.

5. Institutional investors, such as mutual funds and pension funds, use

options to adjust the risk-and return characteristics of their portfolio.
Trading in options is cheaper than trading in stocks due to lower
transaction costs in options trading.

6. Options provide a means of taking a short-position on a stock by

buying puts or writing calls.

Option Premium:

The option premium can be broken down into two components—intrinsic

value of an option and time value of an option.

Intrinsic Value of Options: The intrinsic value of an option is the greater of

zero, or the amount that is in-the-money. Only in-the-money options have
intrinsic value. It is defined as the amount by which an option is in the
money, or the immediate exercise value of the option when the underlying
position is marked-to-market.

For a call option: Intrinsic value = Spot price − Strike price.

For a put option: Intrinsic value = Strike price − Spot price.

The intrinsic value of an option must be a positive number or zero. It cannot

be negative. For a call option, the strike price must be less than the price of
the underlying asset for the call to have an intrinsic value greater than zero.
In other words the intrinsic value of a call is max (S − X, O), which means
the intrinsic value of a call is the greater of S − X or O.
For a put option, the strike price must be greater than the underlying price
for it to have intrinsic value. In other words, the intrinsic value of a put is
max (X − S, O).

Time Value of Options: The time value of an option is the difference between
its premium and its intrinsic value. Time value is the amount option buyers
are willing to pay for the possibility that the option may become profitable
prior to expiration due to favourable change in the price of the underlying.
Thus, it is a payment for the possibility that the intrinsic value might
increase prior to the expiry date. When an option is sold, rather than
exercised, time value is received in addition to the intrinsic value. Time

70
value cannot be negative. An option loses its time value as its expiration
date nears. Time value premium decreases at an accelerated rate as the
option approaches maturity. At expiration, an option is worth only its
intrinsic value. A call that is out of the money or at the money has only
time value. Usually, the maximum time value exists when the option is at
the money. One of the factors that determine time value is the market
expectation of price volatility. If the market expectation of price volatility of
an underlying asset is high, the time value will also be high, reflecting the
strong possibility of a substantial increase in intrinsic value. Time value
premium is maximum when the stock price and the strike price are the
same. When stock price is far above or below the strike price, the option is
worth only its intrinsic value. Consider a stock which is currently selling at
Rs. 50. The call option to buy the stock at Rs. 49 costs Rs. 4. Here, the call
premium is Rs. 4, which is a sum of both the intrinsic value and time value.
The intrinsic value of the option is Re 1 (50 − 49). The time value is Rs. 3 (4
− 1).

Example: For each of the following options, find out the Intrinsic value and
Time value. The premium paid by the buyer is given in brackets.
a. HLL 180 PUT (Rs.9)
b. L&T 1510 PUT (Rs.7)
c. HLL 205 CALL (Rs.2)
d. L&T 1500 CALL (Rs.12)
e. RIL 800 CALL (Rs.37)
f. ACC 540 PUT (Rs.39)
On the day of expiry the prices of stocks were: HLL Rs.200, L&T Rs.1510,
RIL Rs.825 & ACC Rs.515

Shar Strik Marke Natur Premiu ITM Exercis Intrinsi Time

e e t Price e of m paid / e c Value Value =
Price Optio ATM Premiu
n /OT m paid
M –
Intrinsi
c value
HLL 180 200 PUT 9 OTM NO 0 9
L&T 1510 1510 PUT 7 ATM NO 0 7
HLL 205 200 CALL 2 OTM NO 0 2
L&T 1500 1510 CALL 12 ITM YES 10 2
RIL 800 825 CALL 37 ITM YES 25 12
ACC 540 515 PUT 39 ITM YES 25 14

71
Profit and Payoff from Option Positions

Buying a call option: Buying a call option means that the option holder
may or may not exercise the right to buy a specific quantity at a strike price.
For example, an investor has purchased a call option with strike price
of Rs.1,000 at a premium of Rs.100. The option holder will exercise the
option only when the actual market price of the share on the specified date
it is more than and Rs.1,000. At a price below Rs.1,000 he would instead
prefer to buy the asset from the market. The investor would just break even
if the market price is Rs.1,100.

Profit Net Payoff of Call

0 Rs.1000 Rs.1,100 Market Price

-100

Loss

The above figure shows that if the price of the underlying asset is less than
the strike price, the loss of the call option holder is constant (restricted to
the premium paid Rs.100). However, as the price increases beyond the
strike price, his loss reduces and becomes zero when the actual price is
equal to the strike price plus premium i.e. Rs.1,100. So, the loss of the call
option holder is restricted to the amount of premium paid. But his profit
opportunities are infinite depending upon the market price on the specified
day.

Selling a call option: In case of an option writer (seller), he makes the profit
when the price of the asset is less than premium + strike price i.e Rs.1,100.
He will be called upon to supply the underlying asset only when the market
price of the asset is more than Rs.1,000. His gain will be Rs.100 as so long
as the price is Rs.1,000. However, The profit starts reducing and even
becomes loss when the price increases beyond Rs.1,000. So, the profit
opportunity of the call option writer is limited to Rs.100 only (i.e. the
premium) but chances of losses are unlimited depending upon the market
price of the underlying asset.

72
Profit

100

0 1000 1100 Market Price

73
Buying a put option: In this case, the option holder has a right to sell the
underlying asset at the specified price i.e. the strike price. The position of
the put option holder has been shown in the below figure.

0 900 1000 Market Price

-100

It shows that the put option holder would exercise the option so long as the
market price is less than Rs.900 and profit. However, if the market price is
Rs.900 or more, he would let the option to lapse, otherwise he would incur
losses. The figure shows that for market price above Rs.1,000, the put
option holder would be better off by selling in the market rather than
exercising the option.

Selling a put option: The position of the put option seller (writer) has been
shown in the below figure.

Profit

100

0 900 1000 Market Price

Loss

The put option will be exercised against the seller so long as the market
price is Rs.1,000 or less. The loss of option writer decreases when the
market price increases up to (Strike price - premium) i.e Rs.1,000 - Rs.100 =
Rs.900.

74
The Break Even positions of parties under different situations can be
summarized as follows:

Party Break Even Level

1. Call Option Holder Strike Price + Option Premium
2. Call Option Writer Strike Price + Option Premium
3. Put Option Holder Strike Price - Option Premium
4. Put Option Writer Strike Price - Option Premium

75
Understanding option pricing (Option Premium Explained)

Option pricing is the amount per share you have to pay to trade an option.
The price of an option is also known as the premium. The buyer of an option
needs to pay the premium amount to the seller to earn the rights granted by
the option. Option premiums are priced per share. Since options are
available in lots of shares called lot size, you need to pay:

Total Premium Amount= (premium price per share) X (lot size)

For example, say TCS option with a strike price of Rs.2,500 is available at a
premium of Rs.20 per share for a lot size of 100 shares. To buy the option,
you need to pay a premium amount of Rs.20 X 100 = Rs.2,000. The
premium paid is non-refundable whether you choose to exercise your option
or not.

Factors determining an Option's Price or Premium:

1. Value of the option's underlying asset

As we know, options are derived from underlying instruments like shares,

gold, currency etc. The current value or price of the option's underlying
instrument has a direct effect on the price of the call or put option. If the
value of the underlying instrument is on the rise then the call option price
will increase and put option price will decrease. If the price of the underlying
instrument decreases then call option price will decrease and put option
price will increase.

2. Strike Price of the option

The exercise of the option depends upon the difference between the strike
price and actual price of the underlying asset, therefore, the strike price is
an important factor for valuation of options. In case of call option, the value
of the option will decline as the strike price increases, and in case of put
option, the value of the option will increase as the strike price increases.

3. Expiration time of Option

The time value is directly related to how much time an option has until it
expires. Generally, the longer the time for an option to expire, the higher is
the premium. And it decreases as you come closer to the expiry date of the
option.

76
4. Volatility

Volatility is the probability of the price fluctuation (up or down) of the

underlying instrument in the market. The higher the volatility of the
underlying instrument, the higher the premium. It is because highly volatile
stocks have a higher possibility of bringing profits to investors in a short
time.

Volatility is of two types - historical and implied. Historical volatility

measures the fluctuations observed in an underlying instrument in the past.
Implied volatility predicts the fluctuations in the future.

5. Interest Rates

Increase in interest rates will increase the value of a call option and will
reduce the value of a put option. Cash spent on owning the underlying stock
is opportunity (interest) cost and hence the value of premium is affected.

6. Dividends on underlying stocks

During the life of the option, there may be income in the form of interest or
dividend on the underlying asset. The value of the asset will decrease, as the
interest or dividend is paid. So, the value of a call option decreases and the
value of put option increases as more and more interest and dividends are
paid on the underlying asset.

Factors Affecting Effect on Call Option Effect on Put Option

Option Premium Price/Premium Price/Premium
Increase in the value Increase Decrease
of the underlying
instrument
Increase in Strike Price Decrease Increase
Increase in Time Value Increase Increase
Increase in Volatility Increase Increase
Increase in Interest Increase Decrease
rates
Increase in Dividends Decrease Increase

77
Option Greeks

Option Greeks measure sensitivity of the option price to various parameters

that impact the value of an option. Such sensitivity can either be on the
positive side or on the negative side.

1. Delta: Measures the sensitivity of an option’s premium/price to a

change in the value of the underlying asset. Delta is the ratio of the
change in an option’s price for a small change in the price of the
underlying asset. An option’s delta may be positive or negative. An
option that has a positive delta will increase in value as the underlying
asset increases in value; it will decrease in value as the underlying
asset decreases in value. A negative delta means that an option’s price
moves in an opposite direction from that of the underlying asset’s
price. A long call and short put have a positive delta as their values
rise and fall along with the underlying asset. A long put and a short
call have negative deltas.

2. Gamma: Measures the change in delta of an option for a change in

the price of the underlying asset. Gamma is expressed as a number
between zero and one for both calls and puts. Gamma can be positive
or negative. A positive gamma means that an options’ delta rises and
falls along with the underlying asset. A negative gamma means that
the delta of an option will decrease with the increase in the underlying
price and will increase with the decrease in the underlying price. The
long call and the long put have a positive gamma as their delta
increase and decrease with the underlying asset. The short put and
the short call have a negative gamma.
Like the delta, the gamma is constantly changing, even with tiny
movements of the underlying stock price. It generally is at its peak
value when the stock price is near the strike price of the option and
decreases as the option goes deeper into or out of the money. Options
that are very deeply into or out of the money have gamma values close
to 0.
3. Theta: Measures the rate at which an option’s time premium
diminishes as time passes. The theta of an option is expressed as a
negative number so as to reflect the losing theoretical value of an
option. Theta is always negative for both calls and puts as with a
decrease in the time to maturity, the option loses value. Theta is the
most negative for at-the-money option and low for deep in or out-of-
the money option.

78
4. Rho: Measures the change in the option price for a change in the
risk-free interest rates. In other words, it measures the sensitivity of
option prices to changes in interest rates. Rho is a positive number for
calls and a negative number for puts. Long-term options have greater
rhos than short-term options. Hence, the greater the amount of time
to expiry the greater the effect of change in interest rates.

5. Vega: Measures the sensitivity of an option’s price to a change in its

implied volatility. The options that have the same strike prices but
have longer time to expiry have larger vega as volatility has more
opportunities to make its presence felt. Vega is the rate of change of
the option price with respect to volatility of the stock. A high vega
implies that the option is highly sensitive to small changes in
volatility. Volatility enhances the value of an option as an increase in
volatility increases the chances of a higher return but does not affect
risk in an options contract. Vega has the same significance for both
calls and puts—they gain value when volatility increases and lose
value when volatility falls.

Binomial Option Pricing Model (BOPM)

The Binomial Option Pricing Model is a discrete time model i.e. time is
broken down into discreet bits and only at these time points the model
is applied. The Binomial Option Pricing Model assumes that the
underlying price follows a binomial process i.e. at a given discreet
point in time there would be two possibilities. The stock price will
wither move up or move down. It is not know whether the stock price
will move up or down, however, the amount by which it may move up
or down is assumed as known. This can be viewed in the form of a
Binomial Tree, which is depicted in the illustration below:

The notations that we will use are as under:

t = time period, 0 signifying starting period and 1, 2, ... signifying
subsequent time till expiration
X = Exercise price
S0 = Stock price at the beginning (at the time of valuation)
u = 1 + Percentage of upswing in S0
d = 1 - Percentage of downswing in S0
Su = Subsequent period stock price, if there is upswing
Sd = Subsequent period stock price, if there is downswing

79
r = risk-free interest rate
p = probability of upswing = (ert - d) / (u – d)
1 – p = probability of downswing

Assumptions of BOPM:
1) The current underlying asset price can only take two possible
values i.e upward (Su) or downward (Sd)
2) The financial markets are perfect and competitive i.e.
a) No transaction cost, no taxes and no margin requirements
b) It is possible to predict r, u, d
c) Risk-free rate is the only prevailing interest rate in the
markets. Thus, lending and borrowing by investors are at risk-
free interest rate.
d) Underlying assets are divisible and thus tradable in fractions
3) The investors want to maximise their wealth

80
Black–Scholes Option Pricing Model

The Black–Scholes option pricing model is an analytical model that helps in

pricing options within the framework of its assumptions.
With Black–Scholes option calculators available, an investor has to key in
the basic parameters, such as current share price, option strike price, time
left for expiry, volatility, and interest rate. This model helps in assessing the
fair price of an option, risks that are associated with a position and how an
option’s value changes as market conditions change. The theoretical value of
an option arrived at with the help of this model is then compared with the
actual market price prevailing and the difference between the two reflects
whether the option is underpriced or overpriced.

Assumptions for the Black–Scholes Option Pricing Model:

1) The call option is the European option i.e. it cannot be exercised

before the specified date.

2) There are no dividends on the stock during the life of the options.

3) There are no riskless arbitrage opportunities.

4) Investors can borrow or lend at the same risk-free rate of interest.

5) The short-term risk-free rate of interest, r, is constant.

6) The short selling in shares is permitted without penalty.

81
Value of a Call Option

V (C ) = So x N(d1) – (E x e-rt) x N(d2)

d1 = {Ln(So / E) + [r + (0.5 x σ2)] x t}

σ√t

d2 = d1 - σ√t

Ln = Natural Log

S0 = Present Market Price of the share

E = Exercise price

t = Time remaining for maturity in years

r = Risk free rate based on continuous compounding

σ = Standard deviation of share price

N = Cumulative area under normal curve

Example : Present market price of the share Rs.415

A 3 month call option is available at an exercise price of Rs.400
The continuous compounded risk-free interest rate is 5%p.a.
Volatility of share price 0.22 or 22%
Using Black and Scholes Model, determine the value of call option and put
option.

Solution:

S0 = Rs.415

E = Rs.400

t = 3/12 years = 0.25 years

r = 5% p.a.

σ = 0.22 or 22%

N = Cumulative area under normal curve

d1 = {Ln(So / E) + [r + (0.5 x σ2)] x t}

σ√t

d1 = {Ln(415 / 400) + [0.05 + (0.5 x 0.222)] x 0.25}

0.22 √0.25

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d1 = {Ln(1.04) + [0.05 + 0.0242)] x 0.25}
0.22 x 0.5

= {0.03922 + 0.01855}
0.11

= 0.5252 or 0.53

d2 = d1 - σ√t

= 0.53 – 0.11 = 0.42

Calculation of N(d1) and N(d2)

For Normal distribution or normal curve – side is – Infinite and + side is +

Infinite

In finance the dimension is -4 to +4. So, this area is considered under

Standard Normal curve and the area in between that is called area under
normal curve represents overall probability which is 1.

Area from – 4 to 0 and from 0 to +4 will be 0.5 as the total probability is 1.

83
We are tracing D1 as it is 0.53, it will come between 0 and +1and horizontal
line is the Z line. So we require the area from 0.53 to extreme left. Area from
0.53 to 0 can be found out in a Z-table.

Cumulative Area for d1 = 0.53 will be 0.7019

84
Calculation of N(d2)

Cumulative Area for d2 = 0.42 will be 0.6628

V (C ) = So x N(d1) – (E x e-rt) x N(d2)

= 415 x 0.7019 – (400 / 2.71830.05x3/12) x 0.6628

= 291.29 – (400 / 2.71830.0125) x 0.6628

= 291.29 – (400 / Antilog (0.0125 Log 2.7183) x 0.6628

= 291.29 – (400 / Antilog (0.0125 x 0.4343) x 0.6628

= 291.29 – (400 Antilog (0.0054) x 0.6628

= 291.29 – (400 / 1.013) x 0.6628

= 291.29 – 394.87 x 0.6628

= Rs.29.57

Therefore, Value of a Call Option is Rs.29.57

85
Put Call Parity Theory

Put-call parity is an important concept in options pricing which shows how

the prices of puts, calls, and the underlying asset must be consistent with
one another. This equation establishes a relationship between the price of a
call and put option which have the same underlying asset. For this
relationship to work, the call and put option must have an identical
expiration date and strike price.

The put-call parity theory is important to understand because this

relationship must hold in theory. With European put and calls, if this
relationship does not hold, then that leaves an opportunity for arbitrage.

Value of a Put Option = Value of Call Option + PV of Exercise Price –

Present Market Price

Therefore, Value of a Put Option = 29.57 + (400 / 1.013) – 415 = Rs.9.44

Value of Put Option = Rs.9.44.

Q2. Share of FM Ltd. is currently sold for Rs.60. There is a Call option
available at a strike price of Rs.56 for a period of 6 Months. Find out the
value of a Call option given that the rate of interest is 14% and Standard
deviation of the return of the share is 30%. Use Black and Scholes Model.

Solution:

S0 = Rs.60

E = Rs.56

t = 6/12 years = 0.5 years

r = 14% p.a.

σ = 0.30 or 30%

N = Cumulative area under normal curve

d1 = {Ln(So / E) + [r + (0.5 x σ2)] x t}

σ√t

d1 = {Ln(60 / 56) + [0.14 + (0.5 x 0.302)] x 0.5}

0.30 √0.5

d1 = {Ln(1.07) + [0.14 + 0.045)] x 0.5}

0.2121

86
= {0.06766+ 0.0925}
0.2121

= 0.7551 or 0.76

d2 = d1 - σ√t

= 0.76 – 0.2121 = 0.55

Calculation of d1 = 0.76 in Z Table = 0.7764

Calculation of d2 = 0.55 in Z Table = 0.7088

V (C ) = So x N(d1) – (E x e-rt) x N(d2)

= 60 x 0.7764 – (56 / 2.71830.14x0.5) x 0.7088

= 46.584 – (56 / 2.71830.07) x 0.7088

= 46.584 – (56 / Antilog (0.07 Log 2.7183) x 0.7088

= 46.584 – (56 / Antilog (0.07 x 0.4343) x 0.7088

= 46.584 – (56 / Antilog (0.0304) x 0.7088

= 46.584 – (56 / 1.073) x 0.7088

= 46.584 – (56 / 1.073) x 0.7088

= Rs.9.59

Therefore, Value of a Call Option is Rs.9.59

Q3. What would be a price of a Call, if Value of a Put is Rs.5, Strike price is
Rs.100, Current price is Rs.100, rate of interest is 6% and time period is 2
months.

Solution:

Value of a Put Option = Value of Call Option + PV of Exercise Price – Present

Market Price

Rs.5 = Value of a Call Option + Rs.100 / (2.71830.06x2/12) – Rs.100

Rs.5 = Value of a Call Option + Rs.100 / Antilog 0.0043 - Rs.100

Rs.5 = Value of a Call Option + Rs.100 / 1.010 – Rs.100

Value of a Call Option = Rs.5.99

87
Q4.The common share of a company is selling at Rs.90. A 26 week call is
selling at Rs.8. The call’s exercise price is Rs.100. The risk free rate is 10%
p.a. What should be the price of a 26 week put of Rs.100?

Solution:

Value of a Put Option = Value of Call Option + PV of Exercise Price – Present

Market Price

= Rs.8 + Rs.100 / 2.71830.10 x 26/52 – Rs.90

= Rs.8 + Rs.100 / Antilog 0.0217 – Rs.90

= Rs.8 + Rs.100 / 1.052 – Rs.90

= Rs.13.06

Q5. GESCO has both European Call and Put options traded on NSE. Both
options have same exercise price of Rs.40 and both expire in one year.
GESCO does not pay any dividends. The call and the put are currently
selling at Rs.8 and Rs.2 respectively. The risk free rate of interest is 10%
p.a. What should be the stock price of GESCO trade in order to prevent
arbitrage?

Solution:

Value of a Put Option = Value of Call Option + PV of Exercise Price –

Present Market Price

Rs.2 = Rs.8 + Rs.40 / 2.71830.10 - Present Market Price

Rs.2 = Rs.8 + Rs.40 / Antilog 0.0434 - Present Market Price

Rs.2 = Rs.8 + 40 / 1.105 - Present Market Price

Rs.2 = Rs.8 + Rs.36.20 - Present Market Price

Present Market Price = Rs.42.2

88
 Trading In Derivatives:

NSE’s automated screen based trading, modern, fully computerised trading

system designed to offer investors across the length and breadth of the
country a safe and easy way to invest. The NSE trading system called
'National Exchange for Automated Trading' (NEAT) is a fully automated
screen based trading system, which adopts the principle of an order driven
market.
Unlike shares trading, whether position of the defaulting party is auctioned
and the loss is recovered through the broker of the party, the situation in
futures trading is different. When a deal by a seller or buyer of the party of a
particular contract is finalized, on the basis of quotes etc, the clearing house
emerges as a party to contract but invisibly. The clearing house becomes the
seller to the long offer and buyer to the short offer. The clearing house is
required to perform the contract to both the parties i.e. to deliver the
underlying asset to the long position holder and pay to the short position
holder. The net position of the clearing house always remains zero because
it does not trade on its own but only on behalf of other parties. So, the
clearing house becomes a party to two contracts at a time and is bound to
perform its obligation under both the contracts.
Clearing house performs several functions such as:
1. Recording and matching of trades.
2. To calculate net open positions of members at the end of each
settlement period.
3. To calculate and collect different types of margins from the members.
4. To provide guarantee to the members that all trades will be performed.

Trading on the derivatives segment takes place on all days of the week
(except Saturdays and Sundays and holidays declared by the Exchange in
advance). The market timings of the derivatives segment are:
Normal market / Exercise market open time : 09:15 hrs
Normal market close time : 15:30 hrs

There are no day minimum/maximum price ranges applicable in the

derivatives segment. However, in order to prevent erroneous order entry,
operating ranges and day minimum/maximum ranges are kept as below:

 For Index Futures: at 10% of the base price

 For Futures on Individual Securities: at 10% of the base price
 For Index and Stock Options: A contract specific price range based on its
delta value is computed and updated on a daily basis.
In view of this, orders placed at prices which are beyond the operating
ranges would reach the Exchange as a price freeze.

89
 Note:
Base Price: Base price of futures contracts on the first day of trading (i.e. on
introduction) would be the theoretical futures price. The base price of the
contracts on subsequent trading days would be the daily settlement price of
the futures contracts as computed by Clearing Corporation.

Price Freeze: In accordance with SEBI circular, informing members about the
price range of 20% in respect of securities, for which derivative products are
available or scrips, included in indices on which derivative products are
available and the procedure for relaxing the same. As per the said circular,
any order above or below 20% over the base price shall be subject to price
freeze. The Exchange may suo motto cancel the orders in the absence of any
immediate confirmation from the members that these orders are genuine or for
any other reason as may be deemed fit. Once the order for a particular
security above / below the operating range resulted in price freeze is being
approved, all the orders under price freeze for that particular security at that
point of time within the revised price range shall automatically be approved.
All the orders entered subsequently within that price range shall be directly
entered into the order book and shall not come as price freeze.

Delta: Option ‘Delta’ captures the effect of the directional movement of the
market on the Option’s premium.

Orders, as and when they are received, are first time stamped and then
immediately processed for potential match. If a match is not found, then the
orders are stored in different 'books'. Orders are stored in price-time priority
in various books in the following sequence:

 Best Price
 Within Price, by time priority.

Order Matching Rules

The best buy order will match with the best sell order. An order may match
partially with another order resulting in multiple trades. For order matching,
the best buy order is the one with highest price and the best sell order is the
one with lowest price. This is because the computer views all buy orders
available from the point of view of a seller and all sell orders from the point
of view of the buyers in the market. So, of all buy orders available in the

90
market at any point of time, a seller would obviously like to sell at the
highest possible buy price that is offered. Hence, the best buy order is the
order with highest price and vice-versa.

Members can pro actively enter orders in the system which will be displayed
in the system till the full quantity is matched by one or more of counter-
orders and result into trade(s). Alternatively members may be reactive and
put in orders that match with existing orders in the system. Orders lying
unmatched in the system are 'passive' orders and orders that come in to
match the existing orders are called 'active' orders. Orders are always
matched at the passive order price. This ensures that the earlier orders get
priority over the orders that come in later.

Order Conditions
A Trading Member can enter various types of orders depending upon
his/her requirements. These conditions are broadly classified into 2
categories: time related conditions and price-related conditions.

Time Conditions

DAY - 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 matched during the day, the
order gets cancelled automatically at the end of the trading day.

IOC - An Immediate or Cancel (IOC) order allows a Trading Member to buy

or sell a security as soon as the order is released into the market, failing
which the order will be removed from the market. Partial match is possible
for the order, and the unmatched portion of the order is cancelled
immediately.

Price Conditions

Limit Price /Order - An order that allows the price to be specified while
entering the order into the system.

Market Price/Order - An order to buy or sell securities at the best price

obtainable at the time of entering the order.

Stop Loss (SL) Price/Order - The one that allows the Trading Member to
place an order which gets activated only when the market price of the
relevant security reaches or crosses a threshold price. Until then the order
does not enter the market.

91
 A sell order in the Stop Loss book gets triggered when the last traded price
in the normal market reaches or falls below the trigger price of the order. A
buy order in the Stop Loss book gets triggered when the last traded price in
the normal market reaches or exceeds the trigger price of the order.

E.g. If for stop loss buy order, the trigger is 93.00, the limit price is 95.00
and the market (last traded) price is 90.00, then this order is released into
the system once the market price reaches or exceeds 93.00. This order is
added to the regular lot book with time of triggering as the time stamp, as a
limit order of 95.00

Clearing and Settlement

National Clearing Limited (NSE Clearing) formerly known as National

Securities Clearing Corporation Limited (NSCCL) is the clearing and
settlement agency for all deals executed on the Derivatives (Futures &
Options) segment. NSE Clearing acts as legal counter-party to all deals on
NSE's F&O segment and guarantees settlement.

Clearing Members

A Clearing Member (CM) of NSE Clearing has the responsibility of clearing

and settlement of all deals executed by Trading Members (TM) on NSE, who
clear and settle such deals through them.

Primarily, the CM performs the following functions:

 Clearing - Computing obligations of all his TM's i.e. determining positions to

settle.
 Settlement - Performing actual settlement. Only funds settlement is allowed
at present in Index as well as Stock futures and options contracts
 Risk Management - Setting position limits based on upfront deposits /
margins for each TM and monitoring positions on a continuous basis.

Types of Clearing Members

 Trading Member Clearing Member (TM-CM)

A Clearing Member who is also a TM. Such CMs may clear and settle their
own proprietary trades, their clients' trades as well as trades of other TM's &
Custodial Participants

92
 Professional Clearing Member (PCM)
A CM who is not a TM. Typically banks or custodians could become a PCM
and clear and settle for TM's as well as of the Custodial Participants

 Self Clearing Member (SCM)

A Clearing Member who is also a TM. Such CMs may clear and settle only
their own proprietary trades and their clients' trades but cannot clear and
settle trades of other TM's.

Clearing Banks:

NSE Clearing has empanelled 15 clearing banks namely Axis Bank Ltd.,
Bank of India, Canara Bank, Citibank N.A, HDFC Bank, Hongkong&
Shanghai Banking Corporation Ltd., ICICI Bank, IDBI Bank, IndusInd
Bank,JPMorgan Chase Bank, Kotak Mahindra Bank, Standard Chartered
Bank, State Bank of India and Union Bank of India.

Every Clearing Member is required to maintain and operate clearing

accounts with any of the empanelled clearing banks at the designated
clearing bank branches. The clearing accounts are to be used exclusively for
clearing & settlement operations.

Clearing Mechanism

A Clearing Member's open position is arrived by aggregating the open

position of all the Trading Members (TM) and all custodial participants
clearing through him. A TM's open position in turn includes his proprietary
open position and clients’ open positions.

 Proprietary / Clients’ Open Position

While entering orders on the trading system, TMs are required to identify
them as proprietary (if they are own trades) or client (if entered on behalf of
clients) through 'Pro / Cli' indicator provided in the order entry screen. The
proprietary positions are calculated on net basis (buy - sell) and client
positions are calculated on gross of net positions of each client.

NSE Clearing provides a facility to entities like FIIs, Mutual Funds, NRIs,
Domestic Body Corporates & Domestic Financial Institutions etc. to execute
trades through any TM, which may be cleared and settled by their own
Clearing Member. To avail this facility the entities are required to take a
Custodian Participant (CP) Code from NSE Clearing through the clearing
member.

93
 Open Position
Open position for the proprietary positions are calculated separately from
client position.
For example,

94
For a CM - XYZ, with TMs clearing through him - ABC and PQR
Proprietary
Position Client 1 Client 2
Securit Buy Sell Net Buy Sell Net Buy Sell Net Net
TM
y Qty Qty Qty Qty Qty Qty Qty Qty Qty Qty

Nifty 50
Januar 200
AB 400 200 2000 300 100 400 200 2000 6000
y 0
C 0 0 Long 0 0 0 0 Long Long
contrac Long
t
Nifty 50 Long
Januar 1000 100 1000 1000
PQ 200 300 200 100 100 200
y Shor 0 Shor
R 0 0 0 0 0 0
contrac t Long t Short
t 2000

XYZ’s open position for Nifty 50 January contract is :

Member Long Position Short Position

ABC 6000 0
PQR 1000 2000
Total for XYZ 7000 2000

95
Settlement Schedule
The settlement of trades is on T+1 working day basis.

Members with a funds pay-in obligation are required to have clear funds in
their primary clearing account on or before 10.30 a.m. on the settlement
day. The payout of funds is credited to the primary clearing account of the
members thereafter.

Product Settlement Schedule

a.Index - Closing price of the futures contracts

on Index on the trading day. (closing price for a
futures contract shall be calculated on the
basis of the last half an hour weighted average
price on NSE of such contract)
b.Individual Security - Closing price of the
Futures futures contracts on Individual security on the
Contracts on trading day. (closing price for a futures contract
Index or shall be calculated on the basis of the last half
Individual Daily an hour weighted average price on NSE of such
Security Settlement contract)
Un-expired
illiquid futures Daily Theoretical Price computed as per formula
contracts Settlement F=S x ert
a. Index - Closing price of the relevant
underlying index in the Capital Market segment
of NSE, on the last trading day of the futures
Futures contract.
Contracts on b. Individual securities - Closing price of the
Index or relevant underlying security in the Capital
Individual Final Market segment of NSE, on the last trading day
Securities Settlement of the futures contract.
a. Index - Closing price of the relevant
underlying index in the Capital Market segment
of NSE, on the last trading day of the options
Options contract.
Contracts on b. Individual securities - Closing price of the
Index and Final relevant underlying security in the Capital
Individual Exercise Market segment of NSE, on the last trading day
Securities Settlement of the options contract.

96
Settlement of futures contracts on index and individual securities

Daily Mark-to-market settlement

The positions in the futures contracts for each member is marked-to-market

to the daily settlement price of the futures contracts at the end of each trade
day.

The profits/ losses are computed as the difference between the trade price or
the previous day's settlement price, as the case may be, and the current
day's settlement price. The CMs who have suffered a loss are required to pay
the mark-to-market loss amount to NSE Clearing which is passed on to the
members who have made a profit. This is known as daily mark-to-market
settlement.

Theoretical daily settlement price for unexpired futures contracts, which are
not traded during the last half an hour on a day, is currently the price
computed as per the formula detailed below:
F=S x ert

where :
F = theoretical futures price
S = value of the underlying index
r = rate of interest (MIBOR)
t = time to expiration

Rate of interest may be the relevant MIBOR rate or such other rate as may
be specified.
After daily settlement, all the open positions are reset to the daily settlement
price.
CMs are responsible to collect and settle the daily mark to market profits /
losses incurred by the TMs and their clients clearing and settling through
them. The pay-in and pay-out of the mark-to-market settlement is on T+1
days (T = Trade day). The mark to market losses or profits are directly
debited or credited to the CMs clearing bank account.

Option to settle Daily MTM on T+0 day

Clearing members may opt to pay daily mark to market settlement on a T+0
basis. Clearing members who wish to opt to pay daily mark to market
settlement on T+0 basis shall intimate the Clearing Corporation as per the
format specified in specified format.

97
Clearing members who opt for payment of daily MTM settlement amount on
a T+0 basis shall not be levied the scaled up margins.
The pay-out of MTM settlement shall continue to be done on T+1 day basis.

Final Settlement

On the expiry of the futures contracts, NSE Clearing marks all positions of a
CM to the final settlement price and the resulting profit / loss is settled in
cash.
The final settlement of the futures contracts is similar to the daily
settlement process except for the method of computation of final settlement
price. The final settlement profit / loss is computed as the difference
between trade price or the previous day's settlement price, as the case may
be, and the final settlement price of the relevant futures contract.
Final settlement loss/ profit amount is debited/ credited to the relevant
CMs clearing bank account on T+1 day (T= expiry day).
Open positions in futures contracts cease to exist after their expiration day

Settlement of Option contracts on index and individual securities

Daily Premium Settlement

Premium settlement is cash settled and settlement style is premium style.

The premium payable position and premium receivable positions are netted
across all option contracts for each CM at the client level to determine the
net premium payable or receivable amount, at the end of each day.
The CMs who have a premium payable position are required to pay the
premium amount to NSE Clearing which is in turn passed on to the
members who have a premium receivable position. This is known as daily
premium settlement.
CMs are responsible to collect and settle for the premium amounts from the
TMs and their clients clearing and settling through them.
The pay-in and pay-out of the premium settlement is on T+1 day (T = Trade
day). The premium payable amount and premium receivable amount are
directly debited or credited to the CMs clearing bank account.

Final Exercise settlement

Final Exercise settlement is effected for option positions at in-the-money

strike prices existing at the close of trading hours, on the expiration day of
an option contract. Long positions at in-the money strike prices are

98
automatically assigned to short positions in option contracts with the same
series, on a random basis.

For index options contracts and options contracts on individual securities,

exercise style is European style. Final Exercise is Automatic on expiry of the
option contracts.
Option contracts, which have been exercised, shall be assigned and
allocated to Clearing Members at the client level.

Exercise settlement is cash settled by debiting/ crediting of the clearing

accounts of the relevant Clearing Members with the respective Clearing
Bank.

Final settlement loss/ profit amount for option contracts on Index and
Individual Securities is debited/ credited to the relevant CMs clearing bank
account on T+1 day (T = expiry day).

Open positions, in option contracts, cease to exist after their expiration day.
The pay-in / pay-out of funds for a CM on a day is the net amount across
settlements and all TMs/ clients, in F&O Segment.

99
Types of Risks

Strategic Risk:

The exposure to loss resulting from a strategy that turns out to be defective
or inappropriate. Strategic risks are often risks that organisations may have
to take in order (certainly) to expand, and even to continue in the long term.
For example, the risks connected with developing a new product may be
very significant – the technology may be uncertain, and the competition
facing the organisation may severely limit sales.

Compliance Risk:

Exposure to legal penalties, and loss an organization faces when it fails to

act in accordance with industry laws and regulations, internal policies or
prescribed best practices.

The following are the few examples of compliance risks:

1. Environmental risk
2. Workplace health and safety
3. Corrupt practices
4. Social Responsibility risk
5. Quality risk

Operational Risk:

It is the risk remaining after determining financing and systematic risk, and
includes risks resulting from breakdowns in internal procedures, people and
systems.
This type of risk relates to internal risk.
It also relates to failure on the part of the company to cope with day to day
operational problems.
It relates to people as well as processes.
It is the risk of business operations failing due to human error.

Financial Risk:

Financial risk is the possibility that shareholders or the other financial

stakeholders will lose money when they invest in a company that has debt if
the company’s cash flow proves inadequate to meet their financial
obligations.

100
Financial risk can be divided into following categories:

1. Counterparty risk: Counterparty risk is the risk of one or more parties

in a financial transaction defaulting on or otherwise failing to meet
their obligations on that trade.
2. Political risk: Political risks are risks associated with changes that
occur within a country's policies, business laws, or investment
regulations. Other influential factors include international
relationships and any other situation which may have an influence on
the economy of a given country.
3. Interest rate risk: Interest rate risk is the probability of a decline in
the value of an asset resulting from unexpected fluctuations in
interest rates. Interest rate risk is mostly associated with fixed-income
assets (e.g., bonds) rather than with equity investments. The interest
rate is one of the primary drivers of a bond’s price. The current
interest rate and the price of a bond demonstrate an inverse
relationship. In other words, when the interest rate increases, the
price of a bond decreases.
4. Currency risk: Currency risk, commonly referred to as exchange-rate
risk, arises from the change in price of one currency in relation to
another. Investors or companies that have assets or business
operations across national borders are exposed to currency risk that
may create unpredictable profits and losses.

Risk Management

A sound risk management system is integral to an efficient clearing and

settlement system. NSE introduced for the first time in India, risk
containment measures that were common internationally but were absent
from the Indian securities markets.

Risk containment measures include capital adequacy requirements of

members, monitoring of member performance and track record, stringent
margin requirements, position limits based on capital, online monitoring of
member positions and automatic disablement from trading when limits are
breached, etc.

Risk Management for Derivative products is managed with Standard

Portfolio Analysis of Risk (SPAN)® is a highly sophisticated, value-at-risk
methodology that calculates performance bond/margin requirements.

101
 Liquid Assets: Clearing members are required to provide liquid assets
which adequately cover various margins and liquid net worth requirements.
A clearing member may deposit liquid assets in the form of cash, bank
guarantees, fixed deposit receipts, approved securities and any other form of
collateral as may be prescribed from time to time. The total liquid assets
comprise of the cash component and the non cash component wherein the
cash component shall be at least 50% of liquid assets.

 Span Margin

NSE Clearing collects initial margin up-front for all the open positions of a
CM based on the margins computed by NSE Clearing-SPAN®. A CM is in
turn required to collect the initial margin from the TMs and his respective
clients. Similarly, a TM should collect upfront margins from his clients.

Initial margin requirements are based on 99% value at risk over a one day
time horizon. However, in the case of futures contracts (on index or
individual securities), where it may not be possible to collect mark to market
settlement value, before the commencement of trading on the next day, the
initial margin is computed over a two-day time horizon, applying the
appropriate statistical formula. The methodology for computation of Value at
Risk percentage is as per the recommendations of SEBI from time to time.

In case a trading member wishes to take additional trading positions his CM

is required to provide Additional Base Capital (ABC) to NSE Clearing. ABC can
be provided by the members in the form of Cash, Bank Guarantee, Fixed
Deposit Receipts and approved securities.

 Premium Margin
In addition to Span Margin, Premium Margin is charged to members. The
premium margin is the client wise premium amount payable by the buyer of
the option and is levied till the completion of pay-in towards the premium
settlement.

 Assignment Margin
Assignment Margin is levied on a CM in addition to SPAN margin and
Premium Margin. It is levied on assigned positions of CMs towards interim
and final exercise settlement obligations for option contracts on index and
individual securities till the pay-in towards exercise settlement is complete.

Exposure Margin

The exposure margins for options and futures contracts on index are as
follows:

 For Index options and Index futures contracts:

3% of the notional value of a futures contract. In case of options it is

102
 charged only on short positions and is 3% of the notional value of open
positions.

 For option contracts and Futures Contract on individual Securities:

The higher of 5% or 1.5 standard deviation of the notional value of gross
open position in futures on individual securities and gross short open
positions in options on individual securities in a particular underlying.

For this purpose notional value means:

- For a futures contract - the contract value at last traded price/ closing
price.
- For an options contract - the value of an equivalent number of shares as
conveyed by the options contract, in the underlying market, based on the
last available closing price.

103
Value at Risk (VAR)

VAR is a method of measuring the financial risk of an asset, portfolio or

exposure over some specified period of time. It is often used as an
approximation of the “maximum reasonable loss” a company can expect to
realize from all its financial exposures. It a measure of worst expected loss that
a firm may suffer over a period of time.

Measure of risk of investments whether single security or portfolio. When we

measure risk of a portfolio with Beta or Standard Deviation, we measure the
risk in terms of percentage. But with VAR technique, we measure the value of
the risk i.e. in Rupees.

While historical volatility tells us how much the cash flows moved in the past,
the VAR helps to estimate the probability of loss of value of an
asset/firm/investment based on analysis of historical values and prices. VAR
provides a single number summarizing the total risk the firm is exposed to.

VAR is a measure of market risk of the firm, or in other words, a measure of

maximum possible loss over a particular time interval, not in absolute sense
but in probabilistic term. VAR gives a low with reference to a confidence level,
say 99%. It is a measure of loss that would be expected over a period of time
with given probability.

It estimates how much a set of investments might lose, given normal market
conditions, in a set time period such as a day. VAR is typically used by firms
and regulators in the financial industry to gauge the amount of assets needed
to cover the possible losses.

VAR comprises of 3 components:

1) Time period
2) Confidence level
3) VAR amount (Loss amount)

Common parameters for VAR are 1% and 5% probabilities and one day and two
weeks horizons.

VAR assumes that the prices of the assets in the financial assets follow a
normal distribution.

Volatility (in value) = Value of stock x volatility (SD) in %

VAR = Volatility (in value) x Z value x √No of Trading Days

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Example: The portfolio you have invested in has value of Rs.10,00,000 and a
daily volatility of 3%. Therefore, volatility in value = Rs.10,00,000 x 3% =
Rs.30,000

After we calculate volatility in value, we have to refer to the Z-table and

calculate the value at different confidence levels. For Z test there are two
significance levels mentioned i.e. 1% and 5%.

1% level of significance indicates 99% of confidence interval and 5% level of

significance indicates 95% confidence interval.

For the calculation of VAR, we have to do the test at 1% or 5% significance

levels, so the confidence level will be at 99% or 95%.

99% or 95% are the probabilities related to Z distribution or Normal

distribution, where the values of 1% is 2.33 and 5% is 1.645.

An investor holds a shares of ABC Ltd whose value is Rs.2,00,00,000. The

standard deviation of market price is 2% per day. Assuming 5 trading days in a
week and using 99% confidence level, determine the maximum loss level over
the period of:

1 trading day and

2 weeks (10 trading days)

Given that, value of Z for 1% significance level from normal table of cumulative
area = 2.33

Volatility (in value) = Value of stock x volatility (SD) in %

= Rs.2,00,00,000 x 2% = Rs.4,00,000

At 1% significance level:
Maximum loss level over the period of 1 trading day (VAR)

VAR = Volatility (in value) x Z value x √No of Trading Days

= Rs.4,00,000 x 2.33 x √1 = Rs.9,32,000

Maximum loss level over the period of 10 trading day (VAR)

= Rs.4,00,000 x 2.33 x √10 = Rs.29,47,243

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