Future Trading

Derivatives
A derivative is an instrument whose value is
derived from the value of one or more of
underlying assets in a contractual manner.
The underlying asset could be equity, forex,
metals, agri commodities.

Types of Derivative
Futures

Forwards

The value of the derivative

instrument is DERIVED
from the underlying
security/Commodity

Swaps

Options

Transactions have three components

i) Trading (buyer and seller negotiating and
arriving at a Price)
ii) Clearing ( Finding out the net outstanding i.e
how much money the two should exchange)
iii) Settlement (the actual process of
exchanging goods and money)
In Spot market all these happen simultaneously
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In a forward market
Trading takes place one day
Clearing and Settlement takes place at a
future date
at a specified period
It is an agreement between the two entities to
buy or sell the asset at a future date at todays
pre agreed price
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bilateral agreement in which the buyer and

seller agree upon the delivery of a specified
quantity and quality of an asset at a
specified date and agreed price

Price

of contract is called a delivery price:

usually is equal to spot price plus cost of
carry
Contracts are custom designed
Actual delivery has to take place
No exchange guarantee
6

Futures
A futures contract is a binding agreement between a
seller and a buyer to make (seller) and to take (buyer)
delivery of underlying commodity (or financial instrument)
at a specified future date with agreed upon payment
terms.
Futures contract are normally traded on an exchange. To
make trading possible the exchange specifies certain
standardized features of the contract.
As the two parties do not necessarily know each other
the exchange also provides a mechanism that gives
the two parties a guarantee that the contract will be
honoured.
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A major difference between forwards and futures

is that futures contracts have standardized
contract terms.
Futures contracts specify the quality and
quantity of goods that can be delivered, the
delivery time, and the manner of delivery.
Standardization tells traders exactly what is
being traded and the conditions of the
transaction.
it enables the traders to focus on one variable
namely price

The purchaser of a futures contract is

said to have gone long or taken a long
position.
The seller of a futures contact is said to
have gone short or taken a short
position

 Short selling is the selling of a

security/commodity that the seller does
not own.
Short sellers assume the risk that they will
be able to buy at a more favorable price
than the price at which they sold short.
Holding a Long Position Investors are
legally owning a security/commodity.

Clearing House
Derivatives contracts are cleared by a
Clearinghouse the foundation of all
derivatives markets
A CH is a central counterparty to all
transactions
CH assumes the role of buyer to the seller and
seller to the buyer

Each futures exchange has a clearinghouse.

The clearing house guarantees that traders in the
futures market will honor their obligations.
Clearinghouse guarantees financial integrity of
derivatives markets
The clearing house splits each trade and acts as
the opposite side of each position.
CH assigns deliveries of commodities from seller
to buyer
Either side of the trade can reverse positions at a
future date without having to contact the other
side of the initial trade.

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

MCX

NCDEX

Details

Trading
cum Institution Trading cum Professional
clearing
Clearing
clearing
Clearing
member
Member
member
Membership
(deposit based)

Admission Fee

5,00,000

10,00,000

15,00,000

25,00,000

Interest Free Security 50,00,000

Deposit

50,00,000

15,00,000

25,00,000

Processing Fee

10,000

10,000

5,00,000

Annual Subscription

50,000

50,000

--

1,00,000

Annual insurance fee

5,600

5,600

--

--

VSAT cost

1,65,000

1,65,000

--

--

Advance maintenance -charges

--

50,000

1,00,000

Net
requirement

--

5,00,00,000

5,00,00,000

worth --

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Settlement
Settlement in the future market is done in
three ways:
-- Physical Delivery on Expiration
-- Closing out open positions
-- Cash Settlement on Expiration

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Financial derivates vs Commodity Derivatives

Varying quality of asset
Not there in financial derivatives
-- In commodities the quality of the asset vary
Bulky in nature
-- Physical settlement in financial derivatives
do not need storage facility
-- Commodities need warehousing facility
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Quality
Assayers

Hedger
(Exporters/
Millers/
Industry)

Warehouses

Clearing Bank

Spot Market

Commodities
Ecosystem

Producers

MCX
Traders
(Speculators)
Arbitrageurs/
Client)

Registrar and Transfer

Agents

Global Commodities
Market

Clearing House

Exchange

Bilateral trading

Common platform for all traders

Restricted access

Price transparency

Traded prices unknown to other

players

Low transaction costs

High cost and time consuming

negotiations

Absence of counter party credit

risk

Counter party credit risk

Market prices available to wider

world

Difficulty in price dissemination

Standardized contract size

Customized contracts

Exchange - a common meeting ground for all industry participants

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Institution

Share

Domain Expertise

NABARD

15 % Apex bank for agricultural lending

NSE

15 % Largest stock exchange in India. Highest volume in

single stock futures in world.

LIC

15 % Largest life insurance company in India

CRISIL

12% Indias first & largest credit rating agency. Now a

Standard & Poor company

IFFCO

12% Largest farmer cooperative with affiliation of 36,000

cooperatives

PNB

8% Large public sector bank with strong rural reach

specially in North India

Canara Bank

8% Large public sector bank with strong rural reach

specially in South India

Goldman
Sachs

7% Global Expertise in commodity markets

Intercontine
ntal
Exchange*

8% 6th largest commodity futures exchange in the world

*Acquired from ICICI Bank

- 46% held by public sector and balance by other institutions
- No private shareholding

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Regulatory Structure - Spot & Futures

State Governments

Ministry of Consumer Affairs,

Food and Public Distribution

Forward Markets
Spot Market

Commission (FMC) SEBI

Futures Market/
Commodity Exchange

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There are 5 National Exchanges NCDEX, MCX

(both in Mumbai), NMCE and Ahmedabad
Commodity Exchange (ACE) (Ahmedabad)
Indian Commodity Exchange Gurgaon
Besides 21 Regional Exchanges in different parts
of the country

20

NCDEX
Barley, Cashew, Castor Seed, Chana, Chilli, coffee, cotton seed oilcake,
crude palm oil, coriander, expeller mustard oil, groundnut, groundnut
expeller oil, guar gum, guar seeds, gur
Parboiled rice, basmati rice, cotton, Jeera, jute sacking, masur grain,
menthe oil, raw silk, pepper, potato, raw silk, palmolein, refined soy oil,
rubber, sesame seeds, soybean, sugar, tur, turmeric, urad, peas, maize,
soy meal
MCX
Castor oil, castor seeds, coconut cake, coconut oil, cotton seed, crude
palm oil, groundnut, cotton oil, mustard oil, mustard seed, palm oil,
refined soy oil, sunflower oil, rice bran oil, sesame seed, soy meal,
soybean, cardamom, coriander, jeera, pepper, red chilli, turmeric, chana,
masur, Peas, maize, arecanut, cashew, rubber
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Types of Participants
Hedgers, Speculators, Arbitrageurs
Hedgers
Use derivatives to reduce the risk they face from
potential future
movements in a market
variable. Hedgers want to avoid exposure to
adverse movements in the price of an asset
Speculators
Use them to bet on the future direction of the
market variable.
Take a position in the market either they are
betting that the price of the asset may go up or
down.
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Arbitrageurs
Arbitrage involves locking in a
riskless
profit
by
simultaneously
entering into transactions in two or
more markets

23

The vast majority of futures contracts

do not lead to delivery. The reason is
that most traders choose to close out
their positions prior to the delivery
period specified in the contract.
Closing out a position means entering
into the opposite type of trade from the
original one.

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25

Hedging
Future contracts can be temporary substitutes for
an intended transaction in the cash market that will
occur at a later date.
This is called hedging. Hedging is buying and
selling futures contracts as a protection against
unfavourable price changes.
When an individual or a company decided to use
the future market to hedge a risk the objective is to
take a position that neutralises the risk as much as
possible
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A short hedge is appropriate when the hedger

already owns the assets or is likely to own the
asset and expect it to sell sometime in the
future. A long hedge is appropriate when a
company knows it will have to purchase a
certain asset in the future and wants to lock in a
price now.

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A Simple Long Hedge in MCX Potato Futures

Activities in the Commodity

Futures Transactions

On
October,
the
wafer On October he buys 10 potato
manufacturer calculates that he futures contracts in MCX for
may need 300 tonnes of potato in delivery at Rs 350 per quintal.
March. He feels that a price of 350
per quintal would be favourable to
him
On March, he buys 300 tonnes of On March, sells 10 potato futures
potato in the spot market at Rs for Rs 400 per quintal
400 per quintal.
Spot market loss of Rs 50 per Futures market gain is Rs 50 per
quintal is equal to Rs 1,50,000
quintal or Rs 1,50,000

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Suppose the opposite happens that is

the spot market price of potato in March
fell to Rs 300 per quintal. The wafer
manufacturer would buy 300 tonnes from
the spot market in March. He sells his
futures contract at Rs 300 per quintal. He
incurs a loss of Rs 50 per quintal and it
amounts to Rs 1,50,000. His effective
price of potato still is Rs 350 per quintal
Remember the objective is not to make
profit but sure about the price
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Convergence of Futures Price to Spot Price

As the delivery period for a futures contract is
approached the futures price converges to the
spot price of the underlying asset when the
delivery period is reached, the futures price
equals or is very close to the spot price.

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Futures
Price

Spot Price
Futures
Price

Spot Price

Time
(a)

Time
(b)

Only the members of the exchange are eligible to

participate in trading. Persons who are not members
of the exchange can participate in trading only as
approved users or clients through a registered
member of the exchange. There are two types of
members, Trading cum Clearing Member and
Professional Clearing member
A trading cum clearing member is entitled to trade on
his own account as well as on account of his clients
and clear and settle trades himself. The Professional
clearing membership entails the members to clear
trades executed through trading cum clearing
members (TCMs) both for themselves and on behalf
of their clients
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The trading system provides a fully automated

screen based trading for futures on
commodities on a nationwide basis as well as
on online monitoring and surveillance
mechanism. For example, the system supports
an order driven market where orders match
automatically. Order matching is essentially on
the basis of commodity, its price, time and
quantity

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34

Clearing
Clearing of Trade that takes place on the exchange
happens through the exchange clearing house (e.g
National Securities Clearing Corporation of NSE interfaces
with National Securities Depository Ltd (NSDL).
The exchange through the clearing house guarantees the
faithful compliance of all trade
Members of the clearing house are mostly financial
institutions
Main task
Keep track of all the transactions that take place during a
day to calculate the net position of each of its members
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Margin
Initial margin is the money that must be
deposited by the customer at the time of
entering into a contract
It is set for each type of underlying asset.
Initial margin per contract is relatively low and
equals about one days maximum price
fluctuation on the total value of the contracts
underlying asset.
Maintenance margin is the amount of margin
that must be maintained in a futures account.

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If the margin balance in the account falls

below the maintenance margin, additional
funds must be deposited to bring the
margin balance back up to the initial
margin requirements.
If account margin exceeds the initial margin
requirement, funds can be withdrawn or
used as initial margin for additional
positions
a certain minimum amount of funds for
each open position held. --- Good Faith
Deposits

37

The Clearing
Margins

House

and

Clearing

The exchange clearing house is an adjunct

of the exchange and acts as an
intermediary in futures transactions. It
guarantees the performance of the parties
to each transaction. The clearing house has
a number of members who must post funds
with the exchange.
The clearing house clearing margin with
the exchange

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Marked to Market
Buying (Long
Position)
Future
Price
7-Oct

350/qtl

7-Oct

10 Contract

1 cont =30

Settlement
Price
1050000
340 1020000 -30000

8-Oct

340

335 1005000 -15000

9-Oct

335

345 1035000 30000

10-Oct

345

355 1065000 30000

11-Oct

355

Square off
360 1080000 15000
(sell)
30000

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Selling (Short Position)

7-Oct 350 qtl
7-Oct

1050000
340 qtl 1020000 30000

8-Oct

340

335 1005000 15000

9-Oct

335

345 1035000 -30000

10-Oct

345

355 1065000 -30000

355

Square off
360 1080000 -15000 (buy)

11-Oct

-30000
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41

Types of
Settlement
Daily Settlement

Daily
Settlement Price
Handles Daily Price
fluctuation for all
trades
(mark to market)
Daily Process at
end of day

Final Settlement

Final
Settlement Price
Handles final
settlement of all
open positions
On contract
expiry day

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Daily Settlement (MTM) Final Settlement

Done at the end of the
each trading day

Done on the day of

Contract Expiry

Based on the daily

settlement Prices

Based on the final

settlement price

All open positions are

marked to market

Only trades not closed

till contract expiry

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Settlement
Settlement of futures contract can be done in three
ways by physical delivery of the underlying asset,
by clearing out open position and by cash
settlement.
All contracts materialising into deliveries are settled
in a period of 2-7 days after expiry.
The exact settlement day for each commodity is
specified by the exchange.
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Physical Delivery of the Underlying Asset

Any buyer intending to take physicals has to put a
request to his depository participant.
The DP uploads such requests to the specified
depository who in turn forwards the same to the
registrar and transfer agent (R and T agent)
concerned.
After due verification of the authenticity the R and T
agent forwards delivery details to the warehouse
which in turn arranges to release the commodities
after due verification of the identity of recipient.
On a specified day the buyer would go to the
warehouse and pick up the physicals

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46

47

The National Securities Depository Ltd (NSDL)

and Central Depository Services Ltd., (CDSL), the
depositories of the securities market, had been
facilitating the electronic holding and transfer of
commodity balances for the clients of the
commodity derivatives market. Under the
arrangement, each of the clearing members would
open a member pool account with the depositories
through depository participants to facilitate the
settlement of commodities. The depositories had a
direct connectivity with the clearing house and
effected the transfer of electronic balance to the
member pool account of clearing members as per
instructions from the clearing house.
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Products selected on the basis of Economic

parameters
Price volatility
Share in GDP
Correlation with global markets
Share in external trade
Government intervention
Warehousing facilities
Traders distribution
Geographical spread
Number of varieties

Commodities given priority where they are more relevant to India: where price
discovery takes place domestically
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Deliveries in terms of Value (Rs. In Lakhs)

Period

Total Value

Disputed % of disputed
Value
to total

2005-06

178,287

407

0.23

2006-07

256,524

1346

0.52

52,991

20

0.04

487,802

1773

0.36

Apr- Jun 2007

Grand Total

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Globally less than 2%

volumes result in deliveries
Globally, exchanges are not
used as delivery platform
However, NCDEX has seen
large deliveries
The total number of
accredited delivery centers
are around 660
NCDEX Quality emerging as
benchmark in the market for
cereals, pulses, spices,
oilseeds, sugar & guar
Created warehousing capacity
of 1 million tonnes

Period

Deliveries
(MT)

Q4' FY05

43214

Q1 FY06

109562

Q2 FY06

83081

Q3 FY06

77160

Q4 FY06

134260

Q1 FY07

103,444

Q2 FY07

125,989

Q3 FY07

94,128

Q4 FY07

52,063

Apr-Jul FY08

1,55,813

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Farmers and the Futures Aggregation Model

Electronic Spot Exchanges
NSPOT NCDEX
NSEL -- MCX and Future Technologies

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Options
There are two types of options
a) Call option
b) Put option
Four types of Participants
a) Buyers of Call
b) Sellers of Call
c) Buyers of Put
d) Sellers of Put
Strike Price / Exercise Price
Option Premium

53

Calls and Puts

The

two

types

of

options

are

calls

and

puts:

A call gives the holder the right to buy an asset at a certain

price within a specific period of time.
Call options give the buyer the right but not the obligation to
buy the asset
.
A put gives the holder the right to sell an asset at a certain
price within a specific period of time.
Put options give the buyer the right but not the obligation to
sell an underlying asset at the strike price

54

Strike Price / Exercise Price

Option Premium

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