FINAL PROJECT REPORT ON DETAILED STUDY ON HEDGING, ARBITRAGE AND SPECULATION

A report submitted to IIMT, Greater Noida as a partial fulfillment of full time Post Graduate Diploma in Management

Under the guidance of Mr. Abhishek Kumar Verma Submitted To: Dr.D.K.Garg, Chairman, IIMT.Gr. Noida Submitted By: Anima Mishra ENR. FMR-3007 15th Batch

Ishan Institute of Management &Technology 1A, Knowledge Park -1,Greater Noida, Dist.-G.B.Nagar (U.P.) Website:www.ishanfamily.com E-Mail: student@ishanfamily.com

PREFACE

Project Work is a very essential component of learning in a management program. It is the best way to practice what a student has learnt in the classrooms or through books. It enables a student to apply his/her conceptual knowledge to live It helps the student to practice the art of

organizational problem and issues.

conducting a study in a systematic and scientific manner and then presenting their finding and recommendations in a coherent report. It is an Action Research and as a manager it will be constantly required to identify real problem and collect related information for making sound decisions. This work on Project Work has been written for easy comprehension of managements participants. It is aimed to provide basic insight into the subject on a very simple and clear manner. It is hoped that it will generate due interest and motivate to further learn the subject in greater detail and practice this in their professional life. The objective of my project was to know about the real working of mutual fund. This is in fact, a partial fulfillment of the requirements for obtaining final PGDFM diploma from ISHAN INSTITUTE OF MANAGEMENT &TECHNOLOGY. This project work has been a first-hand experience of the real condition, which provided an opportunity to utilize managerial knowledge and skill and to bring out some solutions to the problems identified during project study.

DECLARATION

The Final project on DETAILED STUDY ON HEDGING, ARBITRAGE AND SPECULATION is the original work done by me. This is the property of the Institute and use of this report without prior permission of the Institute will be considered illegal and actionable.

DATE 2/08/2011

KUMARI ANIMA (Finance) ENR- FMR 3007, 15thBATCH

TABLE OF CONTENT

CHAPTERS

PAGE NO

CHAPTER 1: INDIAN FINANCIAL MARKET

1.1 MONEY MARKET Introduction Instruments

9-81

1.2 CAPITAL MARKET A. Primary Market Meaning Mode of issuing Securities Public issue Private Placement Right issue Activities in case of public issue and right issue Intermediaries in raising the funds IPO Grading Grading Process and Methodology B. Secondary Market Meaning of stock exchange History and organization of stock market in India Functions of stock exchange Market mechanism Buying & selling Procedure including online trading system Placing an order Execution of order Reporting and confirmation of transaction Functional specialization of Brokers Speculator Hedger Arbitrager 4

CHAPTER 2: 2.1 Derivatives

DERIVATIVE MARKET

82-98

Introduction Product, Participant and Function Types of derivatives

2.2 Introduction to future and Options Forward contract Limitations of forward contract Introduction to futures Distinction between futures and Forward contract Futures terminology Options Introduction Options terminology Index future Feature of Index future SWAP APPLICATION OF FUTURE & OPTION 99-118

CHAPTER 3:

3.1 Application of futures Hedging :long security ,sell future Speculation: Bullish security, buy futures Speculation : Bearish security ,sell futures Arbitrage :overpriced future: buy spot ,sell future Arbitrage : Underpriced future: buy future, sell spot

3.2 Application of options Hedging :Have underlying buy puts Speculation: Bullish security, buy calls & sell puts Speculation : Bearish security ,sell calls & buy puts Bull spreads : Buy a call and sell another Bear spreads : sell a call and buy another

CHAPTER 4: TRADING OF FUTURES & OPTIONS 4.1 Futures and Options trading system Entities in the trading system Basis of trading Corporate hierarchy Client Broker relationship in derivative segment

119-126

4.2 Criteria for stocks and Index eligibility for trading Eligibility Criteria of stocks Eligibility Criteria of indices Eligibility Criteria of stocks for derivative trading

4.3 charges

CHAPTER 5: CLEARANCE AND SETTLEMENT OF FUTURES & OPTIONS 5.1Clearing Entities Clearing Members Clearing banks 127-138

5.2 Clearing Mechanism Settlement Mechanism Settlement of future Contract Settlement of options Contract Adjustment for corporate actions Risk management COMMODITY DERIVATIVES TRADING IN INDIA 138-160

CHAPTER 6: 6.1 Introduction

6.2 Using commodity Futures Hedging Basic Principles of hedging 6

 Short Hedge Long Hedge Advantage & Limitations of hedging Speculation Speculation: Bullish commodity, buy futures Speculation : Bearish commodity ,sell futures Arbitrage Overpriced commodity futures: Buy spot ,sell futures Underpriced commodity future : buy futures , sell spot CHAPTER 7: TRADING OF COMMODITY 161-192

7.1 Futures Trading System Entities in the trading system Guidelines for allotment of client code Contract specification Order types and trading parameter Permitted lot size Pick size for contracts Quantity freeze Base Price Price range of contracts 7.2 Margins for trading in futures 7.3 charges CHAPTER 8: CLEARANCE AND SETTLEMENT OF COMMODITY FUTURES 8.1 Clearing Clearing Mechanism Clearing Banks Depository Participants 192-215

8.2 Settlement 7 Settlement Mechanism Settlement Methods Entities involved in Physical Settlement

8.3 Margining at NCDEX SPAN Initial Margin Computation of Initial margins 215-293

CHAPTER 9: REGULATORY FRAMEWORK 9.1 Securities Contracts (Regulation) Act 1956 9.2 Securities and exchange Board of India Act 1992 9.3 Regulation for Derivative Trading Forms of collaterals acceptable at NSCCL

9.4 Regulations for commodity Derivative Exchanges Rules governing Intermediaries Trading Clearance Rules governing investor grievances, arbitration

CHAPTER 10: LIMITATION SUGGESTION WORD OF THANKS BIBLIOGRAPHY 244 245 246 247

CHAPTER1 INDIAN FINANCIAL MARKET

INTRODUCTION

What is India Financial Market?

In economics, a financial market is a mechanism that allows people to buy and sell (trade) financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and other fungible items of value at low transaction costs and at prices that reflect the efficient-market hypothesis. Both general markets (where many commodities are traded) and specialized markets (where only one commodity is traded) exist. Markets work by placing many interested buyers and sellers in one "place", thus making it easier for them to find each other. An economy which relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy in contrast either to a command economy or to a non-market economy such as a gift economy. In finance, financial markets facilitate:

The raising of capital (in the capital markets) The transfer of risk (in the derivatives markets) The transfer of liquidity (in the money markets) International trade (in the currency markets)

and are used to match those who want capital to those who have it. Typically a borrower issues a receipt to the lender promising to pay back the capital. These receipts are securities which may be freely bought or sold. In return for lending money to the borrower, the lender will expect some compensation in the form of interest or dividends. India Financial market comprise of the primary market, FDIs, alternative investment options, banking and insurance and the pension sectors, asset management segment as well. With all these elements in the India Financial market, it happens to be one of the oldest across the globe and is definitely the fastest growing and best among all the financial markets of the emerging economies. The history of Indian capital
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markets spans back 200 years, around the end of the 18th century. It was at this time that India was under the rule of the East India Company. The capital market of India initially developed around Mumbai; with around 200 to 250 securities brokers participating in active trade during the second half of the 19th century. Scope of Indian Financial Market The financial market in India at present is more advanced than many other sectors as it became organized as early as the 19th century with the securities exchanges in Mumbai, Ahmedabad and Kolkata. In the early 1960s, the number of securities exchanges in India became eight - including Mumbai, Ahmedabad and Kolkata. Apart from these three exchanges, there was the Madras, Kanpur, Delhi, Bangalore and Pune exchanges as well. Today there are 23 regional securities exchanges in India.

The Indian stock markets till date have remained stagnant due to the rigid economic controls. It was only in 1991, after the liberalization process that the India securities market witnessed a flurry of IPOs serially. The market saw many new companies spanning across different industry segments and business began to flourish. The launch of the NSE (National Stock Exchange) and the OTCEI (Over the Counter Exchange of India) in the mid 1990s helped in regulating a smooth and transparent form of securities trading. The regulatory body for the Indian capital markets was the SEBI (Securities and Exchange Board of India). The capital markets in India experienced turbulence after which the SEBI came into prominence. The market loopholes had to be bridged by taking drastic measures. Potential of the India Financial Market India Financial Market helps in promoting the savings of the economy - helping to adopt an effective channel to transmit various financial policies. The Indian financial sector is well-developed, competitive, efficient and integrated to face all shocks. In the India financial market there are various types of financial products whose prices are determined by the numerous buyers and sellers in the market. The other determinant factor of the prices of the financial products is the market forces of
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demand and supply. The various other types of Indian markets help in the functioning of the wide India financial sector. Features of the Financial Market in India

India Financial Indices - BSE 30 Index, various sector indexes, stock quotes, Sensex charts, bond prices, foreign exchange, Rupee & Dollar Chart

Indian Financial market news Stock News - Bombay Stock Exchange, BSE Sensex 30 index, S&P CNXNifty, company information, issues on market capitalization, corporate earnings statements

Fixed Income - Corporate Bond Prices, Corporate Debt details, Debt trading activities, Interest Rates, Money Market, Government Securities, Public Sector Debt, External Debt Service

Foreign Investment - Foreign Debt Database composed by BIS, IMF, OECD,& World Bank, Investments in India & Abroad

Global Equity Indexes - Dow Jones Global indexes, Morgan Stanley Equity Indexes

Currency Indexes - FX & Gold Chart Plotter, J. P. Morgan Currency Indexes National and Global Market Relations Mutual Funds Insurance Loans Forex and Bullion

If an investor has a clear understanding of the India financial market, then formulating investing strategies and tips would be easier.

Types of Financial Market

The financial markets can be divided into different subtypes:

Capital markets which consist of:

Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof.

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Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof.

Commodity markets, which facilitate the trading of commodities. Money markets, which provide short term debt financing and investment. Derivatives markets, which provide instruments for the management of financial risk.

Futures markets, which provide standardized forward contracts for trading products at some future date; see also forward market.

Insurance markets, which facilitate the redistribution of various risks. Foreign exchange markets, which facilitate the trading of foreign exchange.

The capital markets consist of primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets. Secondary markets allow investors to sell securities that they hold or buy existing securities. The transaction in primary market exist between investors and public while secondary market its between investors

Raising the capital To understand financial markets, let us look at what they are used for, i.e. what where firms make the capital to invest Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks help in this process. Banks take deposits from those who have money to save. They can then lend money from this pool of deposited money to those who seek to borrow. Banks popularly lend money in the form of loans and mortgages. More complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and where existing borrowing or lending commitments can be sold on to other parties. A good example of a financial market is a stock exchange. A company can raise money by selling shares to investors and its existing shares can be bought or sold.

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The following table illustrates where financial markets fit in the relationship between lenders and borrowers: Relationship between lenders and borrowers Financial Intermediaries Financial Markets Interbank Companies Funds Stock Money Bond

Lenders

Borrowers

Banks Individuals Companies Insurance Pension Mutual Funds

Individuals Exchange Companies Market Central Market Municipalities Government

Foreign Exchange Public Corporations

Lenders Who have enough money to Lend or to give someone money from own pocket at the condition of getting back the principal amount or with some interest or charge, is the Lender.

Individuals & Doubles Many individuals are not aware that they are lenders, but almost everybody does lend money in many ways. A person lends money when he or she:

puts money in a savings account at a bank; contributes to a pension plan; pays premiums to an insurance company; invests in government bonds; or Invests in company shares.

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Companies Companies tend to be borrowers of capital. When companies have surplus cash that is not needed for a short period of time, they may seek to make money from their cash surplus by lending it via short term markets called money markets. There are a few companies that have very strong cash flows. These companies tend to be lenders rather than borrowers. Such companies may decide to return cash to lenders (e.g. via a share buyback.) Alternatively, they may seek to make more money on their cash by lending it (e.g. investing in bonds and stocks.

Borrowers Individuals borrow money via bankers' loans for short term needs or longer term mortgages to help finance a house purchase. Companies borrow money to aid short term or long term cash flows. They also borrow to fund modernization or future business expansion. Governments often find their spending requirements exceed their tax revenues. To make up this difference, they need to borrow. Governments also borrow on behalf of nationalized industries, municipalities, local authorities and other public sector bodies. In the UK, the total borrowing requirement is often referred to as the Public sector net cash requirement (PSNCR). Governments borrow by issuing bonds. In the UK, the government also borrows from individuals by offering bank accounts and Premium Bonds. Government debt seems to be permanent. Indeed the debt seemingly expands rather than being paid off. One strategy used by governments to reduce the value of the debt is to influence inflation. Municipalities and local authorities may borrow in their own name as well as receiving funding from national governments. In the UK, this would cover an authority like Hampshire County Council. Public Corporations typically include nationalized industries. These may include the postal services, railway companies and utility companies. Many borrowers have difficulty raising money locally. They need to borrow internationally with the aid of Foreign exchange markets.
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Borrower's having same need can form them into a group of borrowers. It can also take an organizational form. just like Mutual Fund. They can provide mort gaze on weight basis. The main advantage is that it lowers their cost of borrowings.

Derivative products During the 1980s and 1990s, a major growth sector in financial markets is the trade in so called derivative products, or derivatives for short. In the financial markets, stock prices, bond prices, currency rates, interest rates and dividends go up and down, creating risk. Derivative products are financial products which are used to control risk or paradoxically exploit risk. It is also called financial economics. Derivative products or instruments help the issuers to gain an unusual profit from issuing the instruments. For using the help of these products a contract have to be made. Derivative contracts are mainly 3 types: 1. Future Contracts 2. Forward Contracts 3. Option Contracts.

Currency markets Seemingly, the most obvious buyers and sellers of currency are importers and exporters of goods. While this may have been true in the distant past, when international trade created the demand for currency markets, importers and exporters now represent only 1/32 of foreign exchange dealing, according to the Bank for International Settlements. The picture of foreign currency transactions today shows:

Banks/Institutions Speculators Government spending (for example, military bases abroad) Importers/Exporters Tourists

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1.1MONEY MARKET
1.1(a) Introduction The money market is a market for short-term funds, which deals in financial assets whose period of maturity is upto one year. It helps in meeting the short-term and very short-term requirements of banks, financial institutions, firms, companies and also the Government. It should be noted that money market does not deal in cash or money as such but simply provides a market for credit instruments such as bills of exchange, promissory notes, commercial paper, treasury bills, etc. These financial instruments are close substitute of money. These instruments help the business units, other organizations and the Government to borrow the funds to meet their short-term requirement.

Money market does not imply to any specific market place. Rather it refers to the whole networks of financial institutions dealing in short-term funds, which provides an outlet to lenders and a source of supply for such funds to borrowers. Most of the money market transactions are taken place on telephone, fax or Internet. The Indian money market consists of Reserve Bank of India, Commercial banks, Co-operative banks, and other specialized financial institutions. The Reserve Bank of India is the leader of the money market in India. Some Non-Banking Financial Companies (NBFCs) and financial institutions like LIC, GIC, UTI, etc. also operate in the Indian money market.

On the other hand, the surplus funds for short periods, with the individuals and other savers, are immobilized through the market and made available to the aforesaid entities for utilization by them. Thus, the money market provides a mechanism for evening out short-term liquidity imbalances within an economy. The development of the money market is, thus, a prerequisite for the growth and development of the economy of a country.

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1.1(b) PARTICIPANTS IN MONEY MARKET

The major participants who supply the funds and demand the same in the money market are as follows:

1. Reserve Bank of India: Reserve Bank of India is the regulator over the money market in India. As the Central Bank, it injects liquidity in the banking system, when it is deficient and contracts the same in opposite situation.

2. Banks: Commercial Banks and the Co-operative Banks are the major participants in the Indian money market. They mobilize the savings of the people through acceptance of deposits and lend it to business houses for their short term working capital requirements. While a portion of these deposits is invested in medium and long-term Government securities and corporate shares and bonds, they provide short-term funds to the Government by investing in the Treasury Bills. They employ the short-term surpluses in various money market instruments.

3. Discount and Finance House of India Ltd. (DFHI): DFHI deals both ways in the money market instruments. Hence, it has helped in the growth of secondary market, as well as those of the money market instruments.

4. Financial and Investment Institutions: These institutions (e.g. LIC, UTI, GIC, Development Banks, etc.) have been allowed to participate in the call money market as lenders only.

5. Corporate: Companies create demand for funds from the banking system. They raise short-term funds directly from the money market by issuing commercial paper. Moreover, they accept public deposits and also indulge in intercorporate deposits and investments.
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6. Mutual Funds: Mutual funds also invest their surplus funds in various money market instruments for short periods. They are also permitted to participate in the Call Money Market. Money Market Mutual Funds have been set up specifically for the purpose of mobilization of short-term funds for investment in money market instruments.

1.1(b) INSTRUMENTS

1. TREASURY BILLS

A Treasury Bill is an instrument for short-term borrowing by the Government of India. It is issued by the Reserve Bank of India on behalf of the Government of India in the form of a promissory note. The necessity for issuing treasury bills arises because of the periodic nature of receipts of Government while the Government expenditure is on a continuing basis. Taxes are payable to the Government after quarterly intervals or so, but Government has to meet its expenditure on daily or monthly basis. Thus, to bridge this mis-match between the timings of Government receipts and expenditure, Government borrows money on short-term basis by issuing Treasury Bills. The Treasury Bills are issued for different maturity periods. Till May 14, 2001, the maturity periods were 14 days, 91 days, 182 days and 365 days. But with effect from May 14, 2001 auctions of 14 days and 182 days Treasury Bills have been discontinued. The Treasury Bills are sold through auctions. While auctions of 91 days Treasury Bills take place on a weekly basis, the auctions for 364, days Treasury Bills are held on a fortnightly basis.

2. COMMERCIAL BILLS OF EXCHANGE

Commercial Bills of Exchange arise out of genuine trade transactions and are drawn by the seller of the goods on the buyers (i.e. debtors), where goods are sold on credit. They are called 'Demand Bills', when payable on demand or on presentment before the buyer, who is called the 'drawee' of the bill. Alternatively, the bills may
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be payable after a specified period of time, e.g. 30, 60 or 90 days. Such bills are called 'Usance Bills and need acceptance by the drawee.

By accepting the bills, the drawee gives his consent to make payment of the bills on the due date. Thus, payment of the bills is assured on the dates of maturity. These bills are, therefore, called self-liquidating in nature. The drawee or the bill (i.e. the seller of the goods) generally discounts the bill with a commercial bank. By discounting is meant that the bill is endorsed in favour of the banker, who makes payment of the amount of the bill less discount (interest on the amount for the period of the bill) to the drawee. Thus, the drawee gets payment of the bill (discount) immediately. The discounting banker, however, recovers the money from the acceptor of the bill on the due date of the bill. The bill is thereafter extinguished.

Commercial bill of exchange is a negotiable instrument i.e.it may be negotiated (or endorsed transferred) any number of times till its maturity. When the discounting bank falls short of liquidity, it may negotiate the bill in favor of any other bank financial institution or the Reserve Bank of India and may receive payment of the bill less re-discounting charges (i.e. interest for the unexpired period of the bill).This process is called re-discounting of Commercial Bills and may be undertaken several times, till the date of maturity of the bill. The Reserve Bank of India introduced a Bills Re-discounting Scheme in 1970. Under this scheme bills are re-discounted by Reserve Bank of India or by any scheduled bank/financial institution/investment institution/mutual fund. But important pre-conditions are that the bill should arise out of a genuine trade transaction, must be accepted by the buyer's banker either singly or jointly with him and the period of maturity should not exceed 90 days.

Commercial bill of exchange, thus, is an instrument through which the banks, financial institutions/mutual funds may park their surplus funds for a shorter period as they can afford. Thus liquidity imbalances in the financial system are removed or minimized. Reserve Bank of India has taken several steps in the past, but the practice of drawing bills has not become very popular in India. The obvious reason is the strict discipline that it imposes on the acceptor of the bill to make payment of the bill on the due date. Bills purchased and discounted by Scheduled Commercial Banks in India as on March 31, 2001 constituted just 3.88% of their total assets (i.e.
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Rs. 50224 crores). Rut the outstanding amount of commercial bills re-discounted by them with various financial institutions was Rs. 1013 crores as on the same date. This shows that bills re-discounting with other financial institutions is to a limited extent only.

3. CERTIFICATES OF DEPOSITS

A Certificate of Deposit is a receipt for a deposit of money with a bank or a financial institution. It differs from a fixed Deposit Receipt in two respects. First, it is issued for a big amount and second, it is freely negotiable. The Reserve Bank of India announced the scheme of Certificates of Deposit in March 1989. The main features of the scheme are as follows: i) Certificate of Deposits can be issued by Scheduled Commercial Banks (excluding Regional Rural Banks) and the specified All-India Financial Institutions like Industrial Development Bank of India (IDBI), Industrial Finance Corporation of lndia (IFCI), Industrial Credit and Investment Corporation of lndia (ICICI), Small Industries Development Bank of India (SIDBI), Industrial Investment Bank of India (IDBI), and the Export Import Bank of India (Exim Bank).

ii) Certificates of Deposits can be issued to Individuals, Associations, Companies and Trust Funds.

iii) Certificates of Deposits are freely transferable by endorsement and delivery after an initial lock-in period of 15 days after which they may be sold to any of the above participants or to the Discount and Finance House of India (DFHI).

iv) The maturity period of Certificate of Deposits issued by Banks may range from 3 months to 12 months while those issued by specified Financial Institutions may range from 1 to 3 years.

v) Certificate of Deposits are to be issued at a discount to the face value.

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vi) Presently there is no limit on the amount which a Bank may raise through Certificate of Deposits. Initially, though, there was a limit linked is the fortnightly aggregate average deposits of the bank.

vii) The minimum amount for which they may be issued is now pegged at Rs. 5 Lacs. (Reduced from Rs. 25 Lacs).

viii) The minimum size of issue of Certificate of Deposits to a single investor is Rs. 5 Lacs, thereafter they can be issued in multiples of Rs. 1 Lac, (with effect from October1997).

ix) Banks and Financial Institutions are required to issue CDa only in dematerialized form with effect from June 30, 2002. The existing CDs are to be converted into demat forms by October 2002. Certificate of Deposits are a popular avenue for companies to invest their short-term surpluses because Certificate of Deposits offer n risk-free investment opportunity at rates of interest higher than Treasury bills and term deposits, besides being fairly liquid. For the Issuing Banks, Certificate of Deposits provides another source of mobilizing funds in bulk.

4. TRADE BILL:

Normally the traders buy goods from the wholesalers or manufactures on credit. The sellers get payment after the end of the credit period. But if any seller does not want to wait or in immediate need of money he/she can draw a bill of exchange in favour of the buyer. When buyer accepts the bill it becomes a negotiable instrument and is termed as bill of exchange or trade bill. This trade bill can now be discounted with a bank before its maturity. On maturity the bank gets the payment from the drawee i.e., the buyer of goods. When trade bills are accepted by Commercial Banks it is known as Commercial Bills. So trade bill is an instrument, which enables the drawer of the bill to get funds for short period to meet the working capital needs.

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6.2CAPITAL MARKET Introduction

Capital Market may be defined as a market dealing in medium and long-term funds. It is an institutional arrangement for borrowing medium and long-term funds and which provides facilities for marketing and trading of securities. So it constitutes all long-term borrowings from banks and financial institutions, borrowings from foreign markets and raising of capital by issue various securities such as shares debentures, bonds, etc. The market where securities are traded known as Securities market. It consists of two different segments namely primary and secondary market. The primary market deals with new or fresh issue of securities and is, therefore, also known as new issue market; whereas the secondary market provides a place for purchase and sale of existing securities and is often termed as stock market or stock exchange.

6.2(a) PRIMARY MARKET

I.

New issue market

The primary market is an intermittent and discrete market where the initially listed shares are traded first time, changing hands from the listed company to the investors. It refers to the process through which the companies, the issuers of stocks, acquire capital by offering their stocks to investors who supply the capital. In other words primary market is that part of the capital markets that deals with the issuance of new securities. Companies, governments or public sector institutions can obtain funding through the sale of a new stock or bond issue. This is typically done through a syndicate of securities dealers. The process of selling new issues to investors is called underwriting. In the case of a new stock issue, this sale is called an initial public offering (IPO). Dealers earn a commission that is built into the price of the security offering, though it can be found in the prospectus.

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The Primary Market consists of arrangements, which facilitate the procurement of long term funds by companies by making fresh issue of shares and debentures. We know that companies make fresh issue of shares and/or debentures at their formation stage and, if necessary, subsequently for the expansion of business. It is usually done through private placement to friends, relatives and financial institutions or by making public issue.

In any case, the companies have to follow a well-established legal procedure and involve a number of intermediaries such as underwriters, brokers, etc. who form an integral part of the primary market. You must have learnt about many initial public offers (IPOs) made recently by a number of public sector undertakings such as ONGC, GAIL, NTPC and the private sector companies like Tata Consultancy Services (TCS), Biocon, Jet-Airways and so on.

II.

Mode of issuing securities

Most companies are usually started privately by their promoter(s). However, the promoters' capital and the borrowings from banks and financial institutions may not be sufficient for setting up or running the business over a long term. So companies invite the public to contribute towards the equity and issue shares to individual investors. The way to invite share capital from the public is through a 'Public Issue'. Simply stated, a public issue is an offer to the public to subscribe to the share capital of a company. Once this is done, the company allots shares to the applicants as per the prescribed rules and regulations laid down by SEBI. Primarily, issues can be classified as a Public, Rights or Preferential issues (also known as private placements). While public and rights issues involve a detailed procedure, private placements or preferential issues are relatively simpler. The classification of issues is illustrated below:

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a) Initial Public Offering (IPO) is when an unlisted company makes either a fresh issue of securities or an offer for sale of its existing securities or both for the first time to the public. This paves way for listing and trading of the issuer's securities. An initial public offering (IPO), referred to simply as an "offering" or "flotation", is when a company (called the issuer) issues common stock or shares to the public for the first time. They are often issued by smaller, younger companies seeking capital to expand, but can also be done by large privately owned companies looking to become publicly traded. In an IPO the issuer obtains the assistance of an underwriting firm, which helps determine what type of security to issue (common or preferred), best offering price and time to bring it to market.

ADVANTAGES OF AN IPO

Bolstering and diversifying equity base Enabling cheaper access to capital Exposure, prestige and public image Attracting and retaining better management and employees through liquid equity participation

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Facilitating acquisitions Creating multiple financing opportunities: equity, convertible debt, cheaper bank loans, etc.

Increased liquidity for equity holder

Disadvantages of an IPO There are several disadvantages to completing an initial public offering, namely:

Significant legal, accounting and marketing costs Ongoing requirement to disclose financial and business information Meaningful time, effort and attention required of senior management Risk that required funding will not be raised Public dissemination of information which may be useful to competitors, suppliers and customers.

Procedure IPOs generally involve one or more investment banks known as "underwriters". The company offering its shares, called the "issuer", enters a contract with a lead underwriter to sell its shares to the public. The underwriter then approaches investors with offers to sell these shares. The sale (allocation and pricing) of shares in an IPO may take several forms. Common methods include: A large IPO is usually underwritten by a "syndicate" of investment banks led by one or more major investment banks (lead underwriter). Upon selling the shares, the underwriters keep a commission based on a percentage of the value of the shares sold (called the gross spread). Usually, the lead underwriters, i.e. the underwriters selling the largest proportions of the IPO, take the highest commissionsup to 8% in some cases. Multinational IPOs may have many syndicates to deal with differing legal requirements in both the issuer's domestic market and other regions. For example, an
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issuer based in the E.U. may be represented by the main selling syndicate in its domestic market, Europe, in addition to separate syndicates or selling groups for US/Canada and for Asia. Usually, the lead underwriter in the main selling group is also the lead bank in the other selling groups. Because of the wide array of legal requirements and because it is an expensive process, IPOs typically involve one or more law firms with major practices in securities law, such as the Magic Circle firms of London and the white shoe firms of New York City. Public offerings are sold to both institutional investors and retail clients of underwriters. A licensed securities salesperson ( Registered Representative in the USA and Canada ) selling shares of a public offering to his clients is paid a commission from their dealer rather than their client. In cases where the salesperson is the client's advisor it is notable that the financial incentives of the advisor and client are not aligned. In the US sales can only be made through a final Prospectus cleared by the Securities and Exchange Commission. A follow on public offering (Further Issue) is when an already listed company makes either a fresh issue of securities to the public or an offer for sale to the public, through an offer document. b) Rights Issue A rights issue is a way in which a company can sell new shares in order to raise capital. Shares are offered to existing shareholders in proportion to their current shareholding, respecting their pre-emption rights. The price at which the shares are offered is usually at a discount to the current share price, which gives investors an incentive to buy the new shares if they do not, the value of their holding is diluted. A rights issue by a highly geared company intended to strengthen its balance sheet is often a bad sign. Profits are already low (or negative) and future profits are diluted. Unless the underlying business is improved, changing its capital structure achieves little.

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A rights issue to fund expansion can usually be regarded somewhat more optimistically, although, as with acquisitions, shareholders should be suspicious because management may be empire-building at their expense (the usual agency problem with expansion). The rights are normally a trade able security themselves (a type of short dated warrant). This allows shareholders who do not wish to purchase new shares to sell the rights to someone who does. Whoever holds a right can choose to buy a new share (exercise the right) by a certain date at a set price. Some shareholders may choose to buy all the rights they are offered in the rights issue. This maintains their proportionate ownership in the expanded company, so that an x% stake before the rights issue remains an x% stake after it. Others may choose to sell their rights, diluting their stake and reducing the value of their holding. If rights are not taken up the company may (and in practice, in many markets, does) sell them on behalf of the rights holder. Because the rights are usually worth enough to cover the price difference between the market price of the shares and the exercise price of the rights (because of the law of one price), shareholders do not lose if the rights are issued at a steep discount. It is therefore usual for the discount to be large (especially of the share price is volatile) to ensure that the rights are exercised. A rights issue is an issue of additional shares by a company to raise capital under a seasoned equity offering. The rights issue is a special form of shelf offering or shelf registration. With the issued rights, existing shareholders have the privilege to buy a specified number of new shares from the firm at a specified price within a specified time. A rights issue is in contrast to an initial public offering, where shares are issued to the general public through market exchanges. Closed-end companies cannot retain earnings, because they distribute essentially all of their realized income, and capital gains each year. They raise additional capital by rights offerings. Companies usually opt
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for a rights issue either when having problems raising capital through traditional means or to avoid interest charges on loans. A rights issue is directly offered to all shareholders of record or through broker dealers of record and may be exercised in full or partially. Subscription rights may either be transferable, allowing the subscriptionright shareholder to sell them privately, on the open market or not at all. A right issuance to shareholders is generally issued as a tax-free dividend on a ratio basis (e.g. a dividend of one subscription right for one share of Common stock issued and outstanding). Because the company receives shareholders' money in exchange for shares, a rights issue is a source of capital in an organization. Considerations Issue rights the financial manager has to consider:

Engaging a Dealer-Manager or Broker Dealer to manage the Offering processes Selling Group and broker dealer participation Subscription price per new share Number of new shares to be sold The value of rights vs. trading price of the subscription rights The effect of rights on the value of the current share The effect of rights to shareholders of record and new shareholders and right shareholders.

c) Preferential issue It is an issue of shares or of convertible securities by listed companies to a select group of persons under Section 81 of the Companies Act, 1956 which is neither a rights issue nor a public issue. This is a faster way for a company to raise equity capital. The issuer company has to comply with the Companies Act and the requirements contained in the Chapter pertaining to preferential allotment in SEBI guidelines which inter-alia include pricing, disclosures in notice etc.
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d) Private Placement The sale of securities to a relatively small number of select investors as a way of raising capital. Investors involved in private placements are usually large banks, mutual funds, insurance companies and pension funds. Private placement is the opposite of a public issue, in which securities are made available for sale on the open market. Since a private placement is offered to a few, select individuals, the placement does not have to be registered with the Securities and Exchange Commission. In many cases, detailed financial information is not disclosed and a need for a prospectus is waived. Finally, since the placements are private rather than public, the average investor is only made aware of the placement after it has occurred.

ACTIVITIES IN CASE OF PUBLIC ISSUE AND RIGHT ISSUES

I.

Listing for Public issue

Listing means admission of securities of an issuer to trading privileges (dealings) on a stock exchange through a formal agreement. The prime objective of admission to dealings on the exchange is to provide liquidity and marketability to securities, as also to provide a mechanism for effective control and supervision of trading. When a company lists its securities on a public exchange, the money paid by investors for the newly-issued shares goes directly to the company (in contrast to a later trade of shares on the exchange, where the money passes between investors). An IPO, therefore, allows a company to tap a wide pool of investors to provide it with capital for future growth, repayment of debt or working capital. A company selling common shares is never required to repay the capital to investors.

Once a company is listed, it is able to issue additional common shares via a secondary offering, thereby again providing itself with capital for expansion without incurring any debt. This ability to quickly raise large amounts of capital from the market is a key reason many companies seek to go public.

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II.

Underwriting for right issues

Rights issues may be underwritten. The role of the underwriter is to guarantee that the funds sought by the company will be raised. The agreement between the underwriter and the company is set out in a formal underwriting agreement. Typical terms of an underwriting require the underwriter to subscribe for any shares offered but not taken up by shareholders. The underwriting agreement will normally enable the underwriter to terminate its obligations in defined circumstances. A sub-underwriter in turn sub-underwrites some or all of the obligations of the main underwriter; the underwriter passes its risk to the subunderwriter by requiring the sub-underwriter to subscribe for or purchase a portion of the shares for which the underwriter is obliged to subscribe in the event of a shortfall. Underwriters and sub-underwriters may be financial institutions, stock-brokers, major shareholders of the company or other related or unrelated parties.

Basic example
An investor: Mr. A had 100 shares of company X at a total investment of $40,000, assuming that he purchased the shares at $400 per share and that the stock price did not change between the purchase date and the date at which the rights were issued. Assuming a 1:1 subscription rights issue at an offer price of $200, Mr. A will be notified by a broker dealer that he has the option to subscribe for an additional 100 shares of common stock of the company at the offer price. Now, if he exercises his option, he would have to pay an additional $20,000 in order to acquire the shares, thus effectively bringing his average cost of acquisition for the 200 shares to $300 per share

((40,000+20,000)/200=300). Although the price on the stock markets should reflect a new price of $300 (see below), the investor is actually not making any profit nor any loss. In many cases, the stock purchase right (which acts as an option) can be traded at an exchange. In this example, the price of the right would adjust itself to $100 (ideally).

The company: Company X has 100 million outstanding shares. The share price currently quoted on the stock exchanges is $400 thus the market capitalization of the stock would be $40 billion (outstanding shares times share price). 30

If all the shareholders of the company choose to exercise their stock option, the company's outstanding shares would increase by 100 million. The market capitalization of the stock would increase to $60 billion (previous market capitalization + cash received from owners of rights converting their rights to shares), implying a share price of $300 ($60 billion / 200 million shares). If the company were to do nothing with the raised money, its Earnings per share (EPS) would be reduced by half. However, if the equity raised by the company is reinvested (e.g. to acquire another company), the EPS may be impacted depending upon the outcome of the reinvestment.

6.2(c) Intermediaries for raising fund Financial intermediaries as the name suggests are middlemen, i.e institutions that stand between investors and companies raising capital/funds. They include banks, insurance companies, investment dealers, mutual and pension funds. An institution that acts as the middleman between investors and firms raising funds. Often referred to as financial institutions.

6.2(d) IPO Grading IPO grading is the grade assigned by a Credit Rating Agency registered with SEBI, to the initial public offering (IPO) of equity shares or any other security which may be converted into or exchanged with equity shares at a later date. The grade represents a relative assessment of the fundamentals of that issue in relation to the other listed equity securities inIndia. Such grading is generally assigned on a fivepoint point scale with a higher score indicating stronger fundamentals and vice versa as below IPO grade 1: Poor fundamentals IPO grade 2: Below-average fundamentals IPO grade 3: Average fundamentals IPO grade 4: Above-average fundamentals IPO grade 5: Strong fundamentals

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IPO grading has been introduced as an endeavor to make additional information available for the investors in order to facilitate their assessment of equity issues offered through an IPO. IPO grading can be done either before filing the draft offer documents with SEBI or thereafter. However, the Prospectus/Red Herring Prospectus, as the case may be, must contain the grade/s given to the IPO by all CRAs approached by the company for grading such IPO.Further information regarding the grading process may be obtained from the Credit Rating Agencies Grading process and methodology

IPO Grading is designed to provide investors an independent, reliable and consistent assessment of the fundamentals of IPO Issuer Companies. As IPO Grading is decided much earlier than the issue price or issue dates are finalize (usually on the IPO filing) and they only tells the fundamentals of the company, investors should not consider them as 'Buy IPO' or 'Skip IPO' recommendations.
IPO Ratings, IPO Grading and IPO Ranking are among the few popular inputs investor's uses before applying in an initial public offerings IPO. IPO Ratings are provided by various financial institutions & independent brokers. Few popular IPO Rating providers in India are Capital Market, Money Control, S P Tulsian's IPO recommendations etc.

IPO Grading is provided by SEBI approved rating agencies including CRISIL, CARE and ICRA. IPO Grading is designed to provide investors an independent, reliable and consistent assessment of the fundamentals of IPO Issuer Companies. As IPO Grading is decided much earlier than the issue price or issue dates are finalize (usually on the IPO filing) and they just tell about the fundamentals of the company, investors should not consider them as 'Buy IPO' or 'Skip IPO'

recommendations.

It is a rating assigned by the Securities and Exchange Board of Indiaregistered credit rating agencies to initial public offerings (IPOs) of various firms. The grade indicates an assessment of business fundamentals and

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market conditions in comparison to other listed equities at the time of the issuance. These ratings are generally assigned on a five-point scale, with a higher score indicating stronger companies. IPO grading can be done either before filing the draft offer documents or thereafter. However, the red herring prospectus must have the grades given by all the rating agencies.

A company which has filed the draft offer document for an IPO on or after May 1, 2007, must be rated by at least one agency. Companies cannot reject the grade. If dissatisfied, they can opt for another agency. But, all grades obtained for the IPO must be disclosed to the regulator and the investors.

6.2(b) SECONDARY MARKET

The secondary market, also known as the aftermarket, is the financial market where previously issued securities and financial instruments such as stock, bonds, options, and futures are bought and sold. The term "secondary market" is also used to refer to the market for any used goods or assets, or an alternative use for an existing product or asset where the customer base is the second market (for example, corn has been traditionally used primarily for food production and feedstock, but a "second" or "third" market has developed for use in ethanol production). Another commonly referred to usage of secondary market term is to refer to loans which are sold by a mortgage bank to investors such as Fannie Mae and Freddie Mac. In the secondary market, stocks and shares in publicly traded companies are bought and sold through one of the major stock exchanges, which serve as managed auctions for stock. A stock exchange, share market, or bourse is a company, corporation, or mutual organization that provides facilities for stockbrokers and traders to trade stocks and other securities. Stock exchanges also provide facilities for the issue and redemption of securities, trading in other financial instruments, and the payment of income and dividends. With primary issuances of securities or financial instruments, or the primary market, investors purchase these securities directly from issuers such as corporations issuing shares in an IPO or private placement, or directly from the federal government in the
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case of treasuries. After the initial issuance, investors can purchase from other investors in the secondary market. Secondary market refers to a market where securities are traded after being initially offered to the public in the primary market and/or listed on the Stock Exchange. Majority of the trading is done in the secondary market. Secondary market comprises of equity markets and the debt markets. The secondary market enables participants who hold securities to adjust their holdings in response to changes in their assessment of risk and return. They also sell securities for cash to meet their liquidity needs. The secondary market has further two components, namely the overthe-counter (OTC) market and the exchange-traded market.

OTC is different from the market place provided by the Over The Counter Exchange of India Limited. OTC markets are essentially informal markets where trades are negotiated. Most of the trades in government securities are in the OTC market. All the spot trades where securities are traded for immediate delivery and payment take place in the OTC market. The exchanges do not provide facility for spot trades in a strict sense. Closest to spot market is the cash market where settlement takes place after some time. Trades taking place over a trading cycle, i.e. a day under rolling settlement, are settled together after a certain time (currently 2 working days). Trades executed on the leading exchange (National Stock Exchange of India Limited (NSE) are cleared and settled by a clearing corporation which provides novation and settlement guarantee.

Nearly 100% of the trades settled by delivery are settled in demat form. NSE also provides a formal trading platform for trading of a wide range of debt securities including government securities. A variant of secondary market is the forward market, where securities are traded for future delivery and payment. Pure forward is outside the formal market. The versions of forward in formal market are futures and options. In futures market, standardized securities are traded for future delivery and settlement. These futures can be on a basket of securities like an index or an individual security.

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In case of options, securities are traded for conditional future delivery. There are two types of optionsa put option permits the owner to sell a security to the writer of options at a predetermined price while a call option permits the owner to purchase a security from the writer of the option at a predetermined price. These options can also be on individual stocks or basket of stocks like index. Two exchanges, namely NSE and the Bombay Stock Exchange, (BSE) provide trading of derivatives of securities. The past few years in many ways have been remarkable for securities market in India. It has grown exponentially as measured in terms of amount raised from the market, number of stock exchanges and other intermediaries, the number of listed stocks, market capitalization, trading volumes and turnover on stock exchanges, and investor population. Along with this growth, the profiles of the investors, issuers and intermediaries have changed significantly. The market has witnessed fundamental institutional changes resulting in drastic reduction in transaction costs and significant improvements in efficiency, transparency and safety.

Reforms in the securities market, particularly the establishment and empowerment of SEBI, market determined allocation of resources, screen based nation-wide trading, dematerialization and electronic transfer of securities, rolling settlement and ban on deferral products, sophisticated risk management and derivatives trading, have greatly improved the regulatory framework and efficiency of trading and settlement. Indian market is now comparable to many developed markets in terms of a number of qualitative parameters.

ADVANTAGES Capital markets provide the lubricant between investors and those needing to raise capital. Capital markets create price transparency and liquidity. They provide a safe platform for a wide range of investors including commercial and investment banks, insurance companies, pension funds, mutual funds, and retail investorsto hedge and speculate.

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Holding different shares or bonds allows an investor to spread investment risk.

The secondary market gives important pricing information that permits efficient use of limited capital.

DISADVANTAGES In capital markets, bond prices are influenced by economic data such as employment, income growth/decline, consumer prices, and industrial prices. Any information that implies rising inflation will weaken bond prices, as inflation reduces the income from a bond. Prices for shares in capital markets can be very volatile. Their value depends on a number of external factors over which the investor has no control. Different shares can have different levels of liquidity, i.e. demand from buyers and sellers.

DISTINCTION BETWEEN PRIMARY MARKET AND SECONDARY MARKET

The main points of distinction between the primary market and secondary market are as follows:

1. Function: While the main function of primary market is to raise long-term funds through fresh issue of securities, the main function of secondary market is to provide continuous and ready market for the existing long-term securities.

2. Participants: While the major players in the primary market are financial institutions, mutual funds, underwriters and individual investors, the major players in secondary market are all of these and the stockbrokers who are members of the stock exchange.

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3. Listing Requirement: While only those securities can be dealt within the secondary market, which have been approved for the purpose (listed), there is no such requirement in case of primary market.

4. Determination of prices: In case of primary market, the prices are determined by the management with due compliance with SEBI requirement for new issue of securities. But in case of secondary market, the price of the securities is determined by forces of demand and supply of the market and keeps on fluctuating.

MEANING OF STOCK EXCHANGE Stock markets refer to a market place where investors can buy and sell stocks. The price at which each buying and selling transaction takes is determined by the market forces (i.e. demand and supply for a particular stock). Let us take an example for a better understanding of how market forces determine stock prices. ABC Co. Ltd. enjoys high investor confidence and there is an anticipation of an upward movement in its stock price. More and more people would want to buy this stock (i.e. high demand) and very few people will want to sell this stock at current market price (i.e. less supply). Therefore, buyers will have to bid a higher price for this stock to match the ask price from the seller which will increase the stock price of ABC Co. Ltd. On the contrary, if there are more sellers than buyers (i.e. high supply and low demand) for the stock of ABC Co. Ltd. in the market, its price will fall down.

In earlier times, buyers and sellers used to assemble at stock exchanges to make a transaction but now with the dawn of IT, most of the operations are done electronically and the stock markets have become almost paperless. Now investors dont have to gather at the Exchanges, and can trade freely from their home or office over the phone or through Internet.

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As indicated above, stock exchange is the term commonly used for a secondary market,which provide a place where different types of existing securities such as shares, debentures and bonds, government securities can be bought and sold on a regular basis. A stock exchange is generally organised as an association, a society or a company with a limited number of members. It is open only to these members who act as brokers for the buyers and sellers. The Securities Contract (Regulation) Act has defined stock exchange as an association, organisation or body of individuals, whether incorporated or not, established for the purpose of assisting, regulating and controlling business of buying, selling and dealing in securities.

THE MAIN CHARACTERISTICS OF A STOCK EXCHANGE ARE:

1. It is an organised market. 2. It provides a place where existing and approved securities can be bought and sold easily. 3. In a stock exchange, transactions take place between its members or their authorized agents. 4. All transactions are regulated by rules and by laws of the concerned stock exchange. 5. It makes complete information available to public in regard to prices and volume of transactions taking place every day.

It may be noted that all securities are not permitted to be traded on a recognized stock exchange. It is allowed only in those securities (called listed securities) that have been duly approved for the purpose by the stock exchange authorities.

The method of trading now-a-days, however, is quite simple on account of the availability of on-line trading facility with the help of computers. It is also quite fast as it takes just a few minutes to strike a deal through the brokers who may be available close by. Similarly, on account of the system of scrip-less trading and rolling settlement, the delivery of securities and the payment of amount involved also take very little time, say, 2 days.
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 HISTORY AND ORIGANIZATION OF STOCK MARKET IN

The Origin One of the oldest stock markets in Asia, the Indian Stock Markets have a 200 years old history. 18th Century East India Company was the dominant institution and by end of the century, busuness in its loan securities gained full momentum 1830's Business on corporate stocks and shares in Bank and Cotton presses started in Bombay. Trading list by the end of 1839 got broader 1840's 1850's Recognition from banks and merchants to about half a dozen brokers Rapid development of commercial enterprise saw brokerage business attracting more people into the business 1860's 1860-61 The number of brokers increased to 60 The American Civil War broke out which caused a stoppage of cotton supply from United States of America; marking the beginning of the "Share Mania" in India 1862-63 1865 The number of brokers increased to about 200 to 250 A disastrous slump began at the end of the American Civil War (as an example, Bank of Bombay Share which had touched Rs. 2850 could only be sold at Rs. 87)

Pre-Independance Scenario - Establishment of Different Stock Exchanges 1874 With the rapidly developing share trading business, brokers used to gather at a street (now well known as "Dalal Street") for the purpose of transacting business. The origin of the stock market in India goes back to the end of the eighteenth century when long-term negotiable securities were first issued. However, for all practical purposes, the real beginning occurred in the middle of the nineteenth century after the enactment of the companies Act in 1850, which introduced the features of limited liability and generated investor interest in corporate securities.
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The first organised stock exchange in India was started in Mumbai known as Bombay Stock Exchange (BSE). It was followed by Ahmedabad Stock Exchange in 1894 and Kolkata Stock Exchange in 1908. The number of stock exchanges in India went upto 7 by 1939 and it increased to 21 by 1945 on account of heavy speculation activity during Second World War. A number of unorganised stock exchanges also functioned in the country without any formal set-up and were known as kerb market. The Security Contracts (Regulation) Act was passed in 1956 for recognition and regulation of Stock Exchanges in India. At present we have 23 stock exchanges in the country. Of these, the most prominent stock exchange that came up is National Stock Exchange (NSE). It is also based in Mumbai and was promoted by the leading financial institutions in India. It was incorporated in 1992 and commenced operations in 1994. This stock exchange has a corporate structure, fully automated screen-based trading and nation-wide coverage. Another stock exchange that needs special mention is Over The Counter Exchange of India (OTCEI). It was also promoted by the financial institutions like UTI, ICICI, IDBI, An important early event in the development of the stock market in India was the formation of the native share and stock brokers 'Association at Bombay in 1875, the precursor of the present day Bombay Stock Exchange. This was followed by the formation of associations/exchanges in Ahmedabad (1894), Calcutta (1908), and Madras (1937). In addition, a large number of ephemeral exchanges emerged mainly in buoyant periods to recede into oblivion during depressing times subsequently. Stock exchanges are intricacy inter-woven in the fabric of a nation's economic life. Without a stock exchange, the saving of the community- the sinews of economic progress and productive efficiency- would remain underutilized. The task of mobilization and allocation of savings could be attempted in the old days by a much less specialized institution than the stock exchanges. But as business and industry expanded and the economy assumed more complex nature, the need for 'permanent finance' arose. Entrepreneurs needed money for long term whereas investors demanded liquidity the facility to convert their investment into cash at any given
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time. The answer was a ready market for investments and this was how the stock exchange came into being. Stock exchange means anybody of individuals, whether incorporated or not, constituted for the purpose of regulating or controlling the business of buying, selling or dealing in securities. These securities include: a. Shares, scrip, stocks, bonds, debentures stock or other marketable securities of a like nature in or of any incorporated company or other body corporate; b. Government securities; and c. Rights or interest in securities.

The Bombay Stock Exchange (BSE) and the National Stock Exchange of India Ltd (NSE) are the two primary exchanges in India. In addition, there are 22 Regional Stock Exchanges. However, the BSE and NSE have established themselves as the two leading exchanges and account for about 80 per cent of the equity volume traded in India. The NSE and BSE are equal in size in terms of daily traded volume. The average daily turnover at the exchanges has increased from Rs 851 crore in 1997-98 to Rs 1,284 crore in 1998-99 and further to Rs 2,273 crore in 1999-2000 (April - August 1999). NSE has around 1500 shares listed with a total market capitalization of around Rs 9, 21,500 crore.

The BSE has over 6000 stocks listed and has a market capitalization of around Rs 9, 68,000 crore. Most key stocks are traded on both the exchanges and hence the investor could buy them on either exchange. Both exchanges have a different settlement cycle, which allows investors to shift their positions on the bourses. The primary index of BSE is BSE Sensex comprising 30 stocks. NSE has the S&P NSE 50 Index (Nifty) which consists of fifty stocks. The BSE Sensex is the older and more widely followed index.

Both these indices are calculated on the basis of market capitalization and contain the heavily traded shares from key sectors. The markets are closed on Saturdays and Sundays. Both the exchanges have switched over from
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the open outcry trading system to a fully automated computerized mode of trading known as BOLT (BSE on Line Trading) and NEAT (National Exchange Automated Trading) System.

It facilitates more efficient processing, automatic order matching, faster execution of trades and transparency; the scrip's traded on the BSE have been classified into 'A', 'B1', 'B2', 'C', 'F' and 'Z' groups. The 'A' group shares represent those, which are in the carry forward system (Badla). The 'F' group represents the debt market (fixed income securities) segment. The 'Z' group scrip's are the blacklisted companies. The 'C' group covers the odd lot securities in 'A', 'B1' & 'B2' groups and Rights renunciations. The key regulator governing Stock Exchanges, Brokers, Depositories, Depository participants, Mutual Funds, FIIs and other participants in Indian secondary and primary market is the Securities and Exchange Board of India (SEBI) Ltd. IFCI, LIC etc. in September 1992 specially to cater to small and medium sized companies with equity capital of more than Rs.30 lakh and less than Rs.25 crore. It helps entrepreneurs in raising finances for their new projects in a cost effective manner. It provides for nationwide online ringless trading with 20 plus representative offices in all major cities of the country. On this stock exchange, securities of those companies can be traded which are exclusively listed on OTCEI only. In addition, certain shares and debentures listed with other stock exchanges in India and the units of UTI and other mutual funds are also allowed to be traded on OTCEI as permitted securities. It has been noticed that, of late, the turnover at this stock exchange has considerably reduced and steps have been afoot to revitalize it. In fact, as of now, BSE and NSE are the two Stock Exchanges, which enjoy nation-wide coverage and handle most of the business in securities in the country. REGULATIONS OF STOCK EXCHANGES

As indicated earlier, the stock exchanges suffer from certain limitations and require strict control over their activities in order to ensure safety in dealings thereon. Hence, as early as 1956, the Securities Contracts (Regulation) Act was passed which
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provided for recognition of stock exchanges by the central Government. It has also the provision of framing of proper bylaws by every stock exchange for regulation and control of their functioning subject to the approval by the Government. All stock exchanges are required submit information relating to its affairs as required by the Government from time to time. The Government was given wide powers relating to listing of securities, make or amend bylaws, withdraw recognition to, or supersede the governing bodies of stock exchange in extraordinary/abnormal situations. Under the Act, the Government promulgated the Securities Regulations (Rules) 1957, which provided inter alia for the procedures to be followed for recognition of the stock exchanges, submission of periodical returns and annual returns by recognised stock exchanges, inquiry into the affairs of recognised stock exchanges and their members, and requirements for listing of securities FUNCTIONS OF A STOCK EXCHANGE

The functions of stock exchange can be enumerated as follows:

1. Provides ready and continuous market: By providing a place where listed securities can be bought and sold regularly and conveniently, a stock exchange ensures a ready and continuous market for various shares, debentures, bonds and government securities This lends a high degree of liquidity to holdings in these securities as the investor can encash their holdings as and when they want.

2. Provides information about prices and sales: A stock exchange maintains complete record of all transactions taking place in different securities every day and supplies regular information on their prices and sales volumes to press and other media. In fact, now-a-days, you can get information about minute to minute movement in prices of selected shares on TV channels like CNBC, Zee News, NDTV and Headlines Today. This enables the investors in taking quick decisions on purchase and sale of securities in which they are interested. Not only that, such information helps them in ascertaining the trend in prices and the worth of their holdings. This enables them to seek bank loans, if required.

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3. Provides safety to dealings and investment: Transactions on the stock exchange are conducted only amongst its members with adequate transparency and in strict conformity to its rules and regulations which include the procedure and timings of delivery and payment to be followed. This provides a high degree of safety to dealings at the stock exchange. There is little risk of loss on account of non-payment or nondelivery. Securities and Exchange Board of India (SEBI) also regulates the business in stock exchanges in India and the working of the stock brokers. Not only that, a stock exchange allows trading only in securities that have been listed with it; and for listing any security, it satisfies itself about the genuineness and soundness of the company and provides for disclosure of certain information on regular basis. Though this may not guarantee the soundness and profitability of the company, it does provide some assurance on their genuineness and enables them to keep track of their progress.

5. Helps in mobilisation of savings and capital formation: Efficient functioning of stock market creates a conducive climate for an active and growing primary market. Good performance and outlook for shares in the stock exchanges imparts buoyancy to the new issue market, which helps in mobilizing savings for investment in industrial and commercial establishments. Not only that, the stock exchanges provide liquidity and profitability to dealings and investments in shares and debentures. It also educates people on where and how to invest their savings to get a fair return. This encourages the habit of saving, investment and risktaking among the common people. Thus it helps mobilising surplus savings for investment in corporate and government securities and contributes to capital formation.

6. Barometer of economic and business conditions: Stock exchanges reflect the changing conditions of economic health of a country, as the shares prices are highly sensitive to changing economic, social and political conditions. It is observed that during the periods of economic prosperity, the share prices tend to rise. Conversely, prices tend to fall when there is economic stagnation and the business activities slow down as a result of depressions. Thus, the intensity of trading at stock exchanges and the corresponding rise on fall in the prices of securities reflects the investors assessment of the economic and business conditions
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in a country, and acts as the barometer which indicates the general conditions of the atmosphere of business.

7. Better Allocation of funds: As a result of stock market transactions, funds flow from the less profitable to more profitable enterprises and they avail of the greater potential for growth. Financial resources of the economy are thus better allocated.

ADVANTAGES OF STOCK EXCHANGES

Having discussed the functions of stock exchanges, let us look at the advantages which can be outlined from the point of view of (a) Companies, (b) Investors, and (c) the Society as a whole.

(a) To the Companies (i) The companies whose securities have been listed on a stock exchange enjoy a better goodwill and credit-standing than other companies because they are supposed to be financially sound. (ii) The market for their securities is enlarged as the investors all over the world become aware of such securities and have an opportunity to invest (iii) As a result of enhanced goodwill and higher demand, the value of their securities increases and their bargaining power in collective ventures, mergers, etc. is enhanced. (iv) The companies have the convenience to decide upon the size, price and timing of the issue.

(b) To the Investors: (i) The investors enjoy the ready availability of facility and convenience of buying and selling the securities at will and at an opportune time. Because of the assured safety in dealings at the stock exchange the investors are free from any anxiety about the delivery and payment problems. (iii) Availability of regular information on prices of securities traded at the stock exchanges helps them in deciding on the timing of their purchase and sale.
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(iv) It becomes easier for them to raise loans from banks against their holdings in securities traded at the stock exchange because banks prefer them as collateral on account of their liquidity and convenient valuation.

(c) To the Society (i) The availability of lucrative avenues of investment and the liquidity thereof induces people to save and invest in long-term securities. This leads to increased capital formation in the country. (ii) The facility for convenient purchase and sale of securities at the stock exchange provides support to new issue market. This helps in promotion and expansion of industrial activity, which in turn contributes, to increase in the rate of industrial growth. (iii) The Stock exchanges facilitate realisation of financial resources to more profitable and growing industrial units where investors can easily increase their investment substantially. (iv) The volume of activity at the stock exchanges and the movement of share prices reflect the changing economic health. (v) Since government securities are also traded at the stock exchanges, the government borrowing is highly facilitated. The bonds issued by governments, electricity boards, municipal corporations and public sector undertakings (PSUs) are found to be on offer quite frequently and are generally successful.

LIMITATIONS OF STOCK EXCHANGES

Like any other institutions, the stock exchanges too have their limitations. One of the common evils associated with stock exchange operations is the excessive speculation. You know that speculation implies buying or selling securities to take advantage of price differential at different times. The speculators generally do not take or give delivery and pay or receive full payment. They settle their transactions just by paying the difference in prices. Normally, speculation is considered a healthy practice and is necessary for successful operation of stock exchange activity. But, when it becomes excessive, it leads to wide fluctuations in prices and various malpractices by the vested interests. In the process, genuine investors suffer and are driven out of the market. Another shortcoming of stock exchange operations is that
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security prices may fluctuate due to unpredictable political, social and economic factors as well as on account of rumors spread by interested parties. This makes it difficult to assess the movement of prices in future and build appropriate strategies for investment in securities. However, these days good amount of vigilance is exercised by stock exchange authorities and SEBI to control activities at the stock exchange and ensure their healthy functioning.

MARKET MECHANISM
BUYING AND SELLING PROCEDURE INCLUDING ONLINE TRADING Placing an order

An order in a market such as a stock market, bond market, commodity market or financial derivative market is an instruction from customers to brokers to buy or sell on the exchange. These instructions can be simple or complicated. There are some standard instructions for such orders. A market order is a buy or sells order to be executed immediately at current market prices. As long as there are willing sellers and buyers, market orders are filled. Market orders are therefore used when certainty of execution is a priority over price of execution. A market order is the simplest of the order types. This order type does not allow any control over the price received. The order is filled at the best price available at the relevant time. In fast-moving markets, the price paid or received may be quite different from the last price quoted before the order was entered.[1] A market order may be split across multiple participants on the other side of the transaction, resulting in different prices for some of the shares. Limit order A limit order is an order to buy a security at not more, or sell at not less, than a specific price. This gives the trader control over the price at which the trade is executed; however, the order may never be executed ("filled").[2] Limit orders are used when the trader wishes to control price rather than certainty of execution.

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A buy limit order can only be executed at the limit price or lower. For example, if an investor wants to buy a stock, but doesn't want to pay more than $20 for it, the investor can place a limit order to buy the stock at $20 "or better". By entering a limit order rather than a market order, the investor will not buy the stock at a higher price, but, may get fewer shares than he wants or not get the stock at all. A sell limit order is analogous; it can only be executed at the limit price or higher. Both buy and sell orders can be additionally constrained. Two of the most common additional constraints are Fill Or Kill (FOK) and All Or None (AON). FOK orders are either filled completely on the first attempt or canceled outright, while AON orders stipulate that the order must be filled with the entire number of shares specified, or not filled at all. If it is not filled, it is still held on the order book for later execution. Time in force A day order or good for day order (GFD) (the most common) is a market or limit order that is in force from the time the order is submitted to the end of the day's trading session. For equity markets, the closing time is defined by the exchange. For the foreign exchange market, this is until 5pm EST/EDT for all currencies except NZD. A good-till-cancelled (GTC) order requires a specific cancelling order. It can persist indefinitely (although brokers may set some limits, for example, 90 days). An immediate-or-cancel order (IOC) will be immediately executed or cancelled by the exchange. Unlike a fill-or-kill order, IOC orders allow for partial fills. Fill-or-kill orders (FOK) are usually limit orders that must be executed or cancelled immediately. Unlike IOC orders, FOK orders require the full quantity to be executed. Most markets have single-price auctions at the beginning ("open") and the end ("close") of regular trading. An order may be specified on the close or on the open, and then it is entered in an auction but has no effect otherwise. There is often some deadline; for example, orders must be in 20 minutes before the auction. They are single-price because all orders, if they transact at all, transact at the same price, the open price and the close price respectively.
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Combined with price instructions, this gives market on close (MOC), market on open (MOO), limit on close (LOC), and limit on open (LOO). For example, a market-on-open order is guaranteed to get the open price, whatever that may be. A buy limit-on-open order is filled if the open price is lower, not filled if the open price is higher, and may or may not be filled if the open price is the same. Regulation NMS (Reg NMS),which applies to U.S. stock exchanges, supports two types of IOC orders, one which is Reg NMS compliant and will not be routed during an exchange sweep, and one that can be routed to other exchanges.Optimal order routing is a difficult problem that cannot be addressed with the usual perfect market paradigm. Liquidity needs to be modeled in a realistic way if we are to understand such issues as optimal order routing and placement. Conditional orders A conditional order is any order other than a limit order which is executed only when a specific condition is satisfied.

Stop orders A stop order (also stop loss order) is an order to buy (or sell) a security once the price of the security has climbed above (or dropped below) a specified stop price. (Note that both bid and ask prices can trigger a stop order.) When the specified stop price is reached, the stop order is entered as a market order (no limit). This means the trade will definitely be executed, but not necessarily at or near the stop price, particularly when the order is placed into a fast-moving market, or if there is insufficient liquidity available relative to the size of the order. The use of stop orders is much more frequent for stocks and futures that trade on an exchange than those that trade in the over-the-counter (OTC) market. Charles Schwab definition: Stop orders and stop-limit orders are very similar, the primary difference being what happens once the stop price is triggered. A standard sell-stop order is triggered when the bid price is equal to or less than the stop price specified or when an execution occurs at the stop price.
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Key point is "bid/ask" which are cues and do not represent the stocks value. The broker above moves the stop order to the market queue based on a BID queue not on a completed transaction. For instance, on a stock XYZ closing at $20 the day before with a stop-loss order at $19 and which trades on low volume, the bid/ask at the open can be skewed in that at the open all the market interest is not represented. The bid queue shows $18.5, the market opens, being the highest bid the broker triggers the stop-loss and moves the order to the market, for which there has not even been a trade, an agreed value. The stock trades for $20.50, never even trading at or below the stop-loss order. Brokers who use the BID queue as a trigger violate the stop-loss definition as per the SEC who define it as a trade. The impetus for the broker definition is commissions. A sell stop order is an instruction to sell at the best available price after the price goes below the stop price. A sell stop price is always below the current market price. For example, if an investor holds a stock currently valued at $50 and is worried that the value may drop, he/she can place a sell stop order at $40. If the share price drops to $40, the broker sells the stock at the next available price. This can limit the investor's losses (if the stop price is at or above the purchase price) or lock in some of the investor's profits. A buy stop order is typically used to limit a loss (or to protect an existing profit) on a short sale.[12] A buy stop price is always above the current market price. For example, if an investor sells a stockshorthoping for the stock price to go down so they can return the borrowed shares at a lower price (Covering)the investor may use a buy stop order to protect against losses if the price goes too high. It can also be used to advantage in a declining market when you want to enter a long position close to the bottom after turn-around. A stop limit order combines the features of a stop order and a limit order. Once the stop price is reached, the stop-limit order becomes a limit order to buy (or to sell) at no more (or less) than another, pre-specified limit price.As with all limit orders, a stop-limit order doesn't get filled if the security's price never reaches the specified limit price. A trailing stop order is entered with a stop parameter that creates a moving or trailing activation price, hence the name. This parameter is entered as a percentage change or actual specific amount of rise (or fall) in the security price.
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Trailing stop sell orders are used to maximize and protect profit as a stock's price rises and limit losses when its price falls. Trailing stop buy orders are used to maximize profit when a stock's price is falling and limit losses when it is rising. For example, a trader has bought stock ABC at $10.00 and immediately places a trailing stop sell order to sell ABC with a $1.00 trailing stop. This sets the stop price to $9.00. After placing the order, ABC doesn't exceed $10.00 and falls to a low of $9.01. The trailing stop order is not executed because ABC has not fallen $1.00 from $10.00. Later, the stock rises to a high of $15.00 which resets the stop price to $14.00. It then falls to $14.00 ($1.00 from its high of $15.00) and the trailing stop sell order is entered as a market order. A trailing stop limit order is similar to a trailing stop order. Instead of selling at market price when triggered, the order becomes a limit order. A trailing stop trailing limit order is the most flexible possible order.

Market-if-touched order A buy market-if-touched order is an order to buy at the best available price, if the market price goes down to the "if touched" level. As soon as this trigger price is touched the order becomes a market buy order. A sell market-if-touched order is an order to sell at the best available price, if the market price goes up to the "if touched" level. As soon as this trigger price is touched the order becomes a market sell order.

One cancels other orders One cancels other orders (OCO) are used when the trader wishes to capitalize on only one of two or more possible trading possibilities. For instance, the trader may wish to trade stock ABC at $10.00 or XYZ at $20.00. In this case, they would execute an OCO order composed of two parts: A limit order for ABC at $10.00, and a limit order for XYZ at $20.00. If ABC reaches $10.00, ABC's limit order would be executed, and the XYZ limit order would be canceled.

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Tick sensitive orders An uptick is when the last (non-zero) price change is positive, and a downtick is when the last (non-zero) price change is negative. Any tick sensitive instruction can be entered at the trader's option, for example buy on downtick, although these orders are rare. In markets where short sales may only be executed on an uptick, a short-sell order is inherently tick-sensitive.

Discretionary order A discretionary order is an order that allows the broker to delay the execution at its discretion to try to get a better price. These are sometimes called not held orders. Bracket Puts to the market a pair of two orders: For the same title, for the same direction, i.e. both to sell:

One sell order is to realize the profit, the second to lock the loss, not to get even deeper.

Quantity and display instructions A broker may be instructed not to display the order to the market. For example an "All-or-none" buy limit order is an order to buy at the specified price if another trader is offering to sell the full amount of the order, but otherwise not display the order. A so-called "iceberg order" requires the broker to display only a small part of the order, leaving a large undisplayed quantity "below the surface".

Electronic markets All of the above orders could be entered in an electronic market, but order priority rules encourage simple market and limit orders. Market orders receive highest priority, followed by limit orders. If a limit order has priority, it is the next trade executed at the limit price. Simple limit orders generally get high priority, based on a first-come-first-served rule. Conditional orders generally get priority based on the time the condition is met. Iceberg orders and dark pool orders (which are not displayed) are given lower priority.
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All About Stop Loss Order The stop loss is the order placed to limit the losses when the stock price moves against your trade. 1. Generally stop loss order are used during day trading/Intraday trading. 2. Stop loss can be used for buy order as well as for short sell order. 3. Stop loss order can be used for stocks, futures and options, currency (forex) trading.

How to place the Stop loss for sell order? For example Suppose if you bought Cairn India Ltd at Rs 250 and if the stock price starts moving down and if you want to limit your losses and plan to take risk of Rs 10 then you can place the stop loss order at Rs 240.

How to place the stop loss order? Trigger price 241 Sell price 240 If the share price of Cairn India Ltd moves down and crosses Rs 241 then your order will be sent to exchange to sell your shares at Rs 240. So instead of accepting big loss, only loss of Rs 10 per share has been accepted.

How to place stop loss for Buy order? Stop loss order for buy order is placed if you have short sell the trade. What is the short sell? Selling stocks at higher level and buying them at lower levels is called short selling method. This method is only adopted during intraday/day trading. For example Suppose if the stock of Tata steel is at Rs 700 and expected to come down then the trader can sell the stocks of Tata steel at Rs 700 and buy at lower levels to take the profit. But if in case the stock price starts increasing at upper direction then there is need to limit the losses. The trader can place the stop loss order at Rs 730 taking into consideration the risk of Rs 30.

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Execution of Order

Often investors and traders alike do not fully understand what happens when you click the "enter" button on your online trading account. If you think your order is always filled immediately after you click the button in your account, you are mistaken. In fact, you might be surprised at the variety of possible ways in which an order can be filled and the associated time delays. How and where your order is executed can affect the cost of your transaction and the price you pay for the stock.

A Broker's Options A common misconception among investors is that an online account connects the investor directly to the securities markets. This is not the case. When an investor places a trade, whether online or over the phone, the order goes to a broker. The broker then looks at the size and availability of the order to decide which path is the best way for it to be executed. A broker can attempt to fill your order in a number of ways:

Order to the Floor - For stocks trading on exchanges such as the New York Stock Exchange(NYSE), the broker can direct your order to the floor of the stock exchange, or to a regional exchange. In some instances regional exchanges will pay a fee for the privilege to execute a broker's order, known as payment for order flow. Because your order is going through human hands, it can take some time for the floor broker to get to your order and fill it.

Order to Third Market Maker - For stocks trading on an exchange like the NYSE, your brokerage can direct your order to what is called a third market maker. A third market maker is likely to receive the order if: A) they entice the broker with an incentive to direct the order to them or B) the broker is not a member firm of the exchange in which the order would otherwise be directed.

Internalization - Internalization occurs when the broker decides to fill your order from the inventory of stocks your brokerage firm owns. This can make for quick execution. This type of execution is accompanied by your broker's firm making additional money on the spread.

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Electronic Communications Network (ECN) - ECNs automatically match buy and sell orders. These systems are used particularly for limit orders because the ECN can match by price very quickly.

Order to Market Maker - For over-the-counter markets such as the Nasdaq, your broker can direct your trade to the market maker in charge of the stock you wish to purchase or sell. This is usually timely, and some brokers make additional money by sending orders to certain market makers (payment for order flow). This means your broker may not always be sending your order to the best possible market maker.

As you can see your broker has different motives for directing orders to specific places. Obviously, they may be more inclined to internalize an order to profit on the spread or send an order to a regional exchange or willing third market maker and receive payment for order flow. The choice the broker makes can affect your bottom line. However, as we explore below we will see some of the safeguards in place to limit any unscrupulous broker activity when executing trades. (For more information, check out The Basics Of Order Entry.)

Broker's Obligations By law, brokers are obligated to give each of their investors the best possible order execution. There is, however, debate over whether this happens, or if brokers are routing the orders for other reasons, like the additional revenue streams we outlined above.

Let's say, for example, you want to buy 1,000 shares of the TSJ Sports Conglomerate, which is selling at the current price of $40. You place the market order and it gets filled at $40.10. That means the order cost you an additional $100. Some brokers state that they always "fight for an extra 1/16th", but in reality the opportunity for price improvement is simply an opportunity and not a guarantee. Also, when the broker tries for a better price (for a limit order), the speed and the likelihood of execution also diminishes. However the market itself, and not the broker, may be the culprit of an order not being executed at the quoted price, especially in fast moving markets.

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It is somewhat of a high-wire act that brokers walk in trying to execute trades in the best interest of their clients as well as their own. But as we will learn the Securities and Exchange Commission (SEC) has put measures in place to tilt the scale towards the clients best interests. The SEC Steps In By invoking a rule made effective April 2001 (SEC Disclosure Rule), the SEC has recently taken steps to ensure that investors get the best execution. This rule forces brokers to report the quality of executions on a stock-by-stock basis, including how market orders are executed and what the execution price is compared to the public quote's effective spreads. In addition, when a broker, while executing an order from an investor using a limit order, provides the execution at a better price than the public quotes, that broker must report the details of these better prices. With these rules in place it is much easier to determine which brokers actually get the best prices and which ones use them only as a marketing pitch. (To learn more, see What is the difference between a stop and a limit order?) Because the rule imposes significant fines and penalties on the brokers failing to provide the best execution service, it is debatable whether this rule will be effective in helping investors because should these fines start occurring, investors will ultimately be the ones to absorb these costs in paying higher commissions. This is something only time will tell. Additionally, the SEC requires broker/dealers to notify their customers if their orders are not routed for best execution. Typically, this disclosure is on the trade confirmation slip you receive in the mail a week after placing your order. Unfortunately, this disclaimer almost always goes unnoticed. Is Order Execution Important? The importance and impact order execution can have really depends on the circumstances, in particular the type of order you submit. For example, if you are placing a limit order, your only risk is the order might not fill. If you are placing a market order, speed and price execution becomes increasingly important.
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When considering an investor with a long-term time horizon, an order for $2,000 of stock the difference of 1/16th is less than $20 - a small extra when entering a stock for the long haul. Contrast this to an active trader who attempts to profit from the small ups and downs in day-to-day or intraday stock prices. The same $20 on a $2,000 order eats into a jump of a few percentage points. Therefore, order execution is much more important to active traders who scratch and claw for every percentage they can get. Conclusion Remember, the best possible execution is no substitute for a sound investment plan. Fast markets involve substantial risks and can cause execution of orders at prices significantly different than expected. With a long-term horizon, however, these differences are merely a bump on the road to successful investing.

FUNCTIONAL SPECIALIZATION OF BROKER

1. SPECULATOR Before we get too deep, we have to make a distinction between a speculator and your typical middleman. A middleman can be thought of as the means by which products are dispersed. It would be a very different world if the products we need and/or want were produced nearby. More often than not, every product in your house has at least a component that has taken an international voyage to get there.

The markup of the middleman usually matches the materials and overhead costs used to ship, sort, bag and display those products in a store near you, plus some profit to keep the middleman fulfilling this function. This gets maple syrup to Hawaii, Korean laptops to New York and other products to destinations where a higher profit can be realized.

In contrast, the speculator makes his/her money through contracts that allow him/her to control commodities without ever directly handling them. Generally speaking, speculators don't arrange shipment and storage for the
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commodities that they control. This hands-off approach has given speculators the erroneous image of aloof financers jumping into markets they care nothing about in order to make profits from the producers the salt-ofthe-earth types that legislators are always claiming to defend

Avoiding Shortages

The most obvious function that people overlook when criticizing speculators is their ability to head off shortages. Shortages are dangerous because they lead to price spikes and/or rationing of resources. If a drought kills off half the yield of hay in a given year, it's natural to expect the price of hay to double in the fall. On wider economies of scale, however, these shortages are not as easy to spot. That's why commodities speculators help to keep an eye on overall production, recognizing shortages and moving product to places of need (and consequently higher profit) through intermediaries the middlemen who use futures contracts to control their costs. In this sense, speculators act as financers to allow the middleman to keep supply flowing around the world.

More than merely financing middlemen, speculators influence prices of commodities, currencies and other goods by using futures to encourage stockpiling against shortages. Just because we want cheap oil or mangoes doesn't mean we should blame speculators when prices rise. More often, other factors, such as OPEC and tropical hurricanes, have raised the risk of a more volatile price in the future, so speculators raise prices now to smooth down the potentially larger future price.

A higher price dampens current demand, decreasing consumption and prompting more resources more people to take up mango growing or more funds for oil exploration to go into increasing stockpiles. This price smoothing means that, while you might not appreciate paying $5 for gas or a mango, you will always be able to find some.

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Preventing Manipulation

While people may recognize speculators' importance in preventing shortages and smoothing prices, very few associate speculation with guarding against manipulation. In markets with healthy speculation, that is many different speculators participating, it is much harder to pull off a large-scale manipulation and much more costly to attempt it (and even costlier upon failing). Both Mr. Copper and Silver Thursday are examples of ongoing manipulations that eventually collapsed as more market speculators entered opposing trades. To avoid manipulation in markets we need more speculation, not less. (For more, read The Copper King: An Empire Built On Manipulation.) In thinly traded markets, prices are necessarily more volatile, and the chances for manipulation are increased because a few speculators can have a much bigger impact. In markets with no speculators, the power to manipulate prices swings yearly between producers and middlemen/buyers according to the health of the crop or yield of a commodity. These mini-monopolies and monopsonies result in more volatility being passed on to consumers in the form of varying prices.

Consequences and Currency

Even when we leave the level of commodities and go into one of the largest markets in the world, forex, we can see how speculators are essential for preventing manipulation. Governments are some of the most blatant manipulators. Governments want more money to fund programs while also wanting a robust currency for international trade. These conflicting interests encourage governments to peg their currencies while inflating away true value to pay for domestic spending. It's currency speculators,

through shorting and other means, that keep governments honest by speeding up the consequences of inflationary policies. (To learn more, check out Forces Behind Exchange Rates.)

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Speculators can make a lot of money when they are right, and that can anger producers and consumers alike. But these outsized profits are balanced against the risks they protect those same consumers and producers from. For every speculator making millions on a single contract, there is at least an equal number losing millions on the trade - or a dollar on each of a million smaller trades. In very volatile markets, like those after a natural disaster or black swan event, speculators often lose money on the whole, keeping prices stable by making up the difference out of their deep pockets.

Taken cumulatively, speculation helps us far more than it could ever hurt us by moving risk to those who can financially handle it. Despite the misunderstanding and negativity speculators have to face, the potential for outsized profits will continue to attract people, as long as governments don't regulate them into oblivion. With all the negativity aimed towards shortsellers and speculators, it's easy for us to forget that their activities maintain prices, prevent shortages and increase the amount of risk they undertake. I don't want to become a speculator, but it's important that we preserve speculative investing for the people who do more than important, it's a necessity for a healthy market and vibrant economy. You don't have to become a speculator, or even hug the next one you see, just remember that the next time you pay $5 a gallon for gas, it's so we'll still have some left over for next week, year, decade and century. (For more, see Getting A Grip On The Cost Of Gas.) In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum. Speculation typically involves the lending of money for the purchase

of assets,equity or debt but in a manner that has not been given thorough analysis or is deemed to have low margin of safety or a significant risk of the loss of the principal investment. The term, "speculation," which is formally defined as above in Graham and Dodd's 1934 text, Security Analysis, contrasts with the term "investment," which is a financial operation that, upon thorough analysis, promises safety of principal and a satisfactory return.

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In a financial context, the terms "speculation" and "investment" are actually quite specific. For instance, although the word "investment" is commonly used to mean any act of placing money in a financial vehicle with the intent of producing returns over a period of time, most ventured moneyincluding funds placed in the world's stock marketsis technically not investment, but speculation. Speculators may rely on an asset appreciating in price due to any
of a number of fact rs that cannot be well enough understood by the speculator

to make an investment-quality decision. Some such factors are shifting consumer tastes, fluctuating economic conditions, buyers' changing perceptions of the worth of a stock security, economic factors associated with market timing, the factors associated with solely chart-based analysis, and the many influences over the short-term movement of securities. There are also some financial vehicles that are, by definition, speculation. For instance, trading commodity futures contracts, such as for oil and gold, is, by definition, speculation. Short selling is also, by definition, speculative. Financial speculation can involve the trade (buying, holding, selling) and short-selling of stocks, bonds, commodities, currencies, collectibles, real estate, derivatives, or any valuable financial instrument to attempt to profit from fluctuations in its price irrespective of its underlying value. In architecture, speculation is used to determine works that show a strong conceptual and strategic focus

HEDGER
An investor who takes steps to reduce the risk of an investment by making an offsetting investment. There are a large number of hedging strategies that a hedger can use. Hedgers may reduce risk, but in doing so they also reduce their profit potential. Hedgers in the futures market try to offset potential price changes in the spot market by buying or selling a futures contract. In general, they are either producers or users of the commodity or financial product underlying that contract. Their goal is to protect their profit or limit their expenses.
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For example, a cereal manufacturer may want to hedge against rising wheat prices by buying a futures contract that promises delivery of September wheat at a specified price. If, in August, the crop is destroyed, and the spot price increases, the manufacturer can take delivery of the wheat at the contract price, which will probably be lower than the market price. Or the manufacturer can trade the contract for more than Agricultural commodity price hedging A typical hedger might be a commercial farmer. The market values of wheat and other crops fluctuate constantly as supply and demand for them vary, with occasional large moves in either direction. Based on current prices and forecast levels at harvest time, the farmer might decide that planting wheat is a good idea one season, but the forecast prices are only that forecasts. Once the farmer plants wheat, he is committed to it for an entire growing season. If the actual price of wheat rises greatly between planting and harvest, the farmer stands to make a lot of unexpected money, but if the actual price drops by harvest time, he could be ruined. If the farmer sells a number of wheat futures contracts equivalent to his crop size at planting time, he effectively locks in the price of wheat at that time: the contract is an agreement to deliver a certain number of bushels of wheat to a specified place on a certain date in the future for a certain fixed price. The farmer has hedged his exposure to wheat prices; he no longer cares whether the current price rises or falls, because he is guaranteed a price by the contract. He no longer needs to worry about being ruined by a low wheat price at harvest time, but he also gives up the chance at making extra money from a high wheat price at harvest times. Hedging a stock price A stock trader believes that the stock price of Company A will rise over the next month, due to the company's new and efficient method of producing widgets. He wants to buy Company A shares to profit from their expected price increase. But Company A is part of the highly volatile widget industry. If the trader simply bought the shares based on his belief that the Company A shares were underpriced, the trade would be a speculation.
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Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk by short selling an equal value (number of shares price) of the shares of Company A's direct competitor, Company B. The first day the trader's portfolio is:

Long 1,000 shares of Company A at $1 each Short 500 shares of Company B at $2 each

(Notice that the trader has sold short the same value of shares) If the trader was able to short sell an asset whose price had a mathematically defined relation with Company A's stock price (for example a put option on Company A shares), the trade might be essentially riskless. In this case, the risk would be limited to the put option's premium. On the second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. Company A, however, because it is a stronger company, increases by 10%, while Company B increases by just 5%:

Long 1,000 shares of Company A at $1.10 each: $100 gain Short 500 shares of Company B at $2.10 each: $50 loss

(In a short position, the investor loses money when the price goes up.) The trader might regret the hedge on day two, since it reduced the profits on the Company A position. But on the third day, an unfavorable news story is published about the health effects of widgets, and all widgets stocks crash: 50% is wiped off the value of the widgets industry in the course of a few hours. Nevertheless, since Company A is the better company, it suffers less than Company B: Value of long position (Company A):

Day 1: $1,000 Day 2: $1,100 Day 3: $550 => ($1,000 $550) = $450 loss

Value of short position (Company B):

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Day 1: $1,000 Day 2: $1,050 Day 3: $525 => ($1,000 $525) = $475 profit

Without the hedge, the trader would have lost $450 (or $900 if the trader took the $1,000 he has used in short selling Company B's shares to buy Company A's shares as well). But the hedge the short sale of Company B gives a profit of $475, for a net profit of $25 during a dramatic market collapse. Types of hedging Hedging can be used in many different ways including forex trading.[3] The stock example above is a "classic" sort of hedge, known in the industry as a pairs trade due to the trading on a pair of related securities. As investors became more sophisticated, along with the mathematical tools used to calculate values (known as models), the types of hedges have increased greatly. Hedging strategies Examples of hedging include:

Forward exchange contract for currencies Currency future contracts Money Market Operations for currencies Forward Exchange Contract for interest Money Market Operations for interest Future contracts for interest

This is a list of hedging strategies, grouped by category. Financial derivatives such as call and put options

Risk reversal: Simultaneously buying a call option and selling a put option. This has the effect of simulating being long on a stock or commodity position.

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Delta neutral: This is a market neutral position that allows a portfolio to maintain a positive cash flow by dynamically re-hedging to maintain a market neutral position. This is also a type of market neutral strategy.

Natural hedges Many hedges do not involve exotic financial instruments or derivatives such as the married put. A natural hedge is an investment that reduces the undesired risk by matching cash flows (i.e. revenues and expenses). For example, an exporter to the United States faces a risk of changes in the value of the U.S. dollar and chooses to open a production facility in that market to match its expected sales revenue to its cost structure. Another example is a company that opens a subsidiary in another country and borrows in the foreign currency to finance its operations, even though the foreign interest rate may be more expensive than in its home country: by matching the debt payments to expected revenues in the foreign currency, the parent company has reduced its foreign currency exposure. Similarly, an oil producer may expect to receive its revenues in U.S. dollars, but faces costs in a different currency; it would be applying a natural hedge if it agreed to, for example, pay bonuses to employees in U.S. dollars. One common means of hedging against risk is the purchase of insurance to protect against financial loss due to accidental property damage or loss, personal injury, or loss of life. Categories of hedgeable risk There are varying types of risk that can be protected against with a hedge. Those types of risks include:

Commodity risk: the risk that arises from potential movements in the value of commodity contracts, which include agricultural products, metals, and energy products.[4]

Credit risk: the risk that money owing will not be paid by an obligor. Since credit risk is the natural business of banks, but an unwanted risk for

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commercial traders, an early market developed between banks and traders that involved selling obligations at a discounted rate.

Currency risk (also known as Foreign Exchange Risk hedging) is used both by financial investors to deflect the risks they encounter when investing abroad and by non-financial actors in the global economy for whom multicurrency activities are a necessary evil rather than a desired state of exposure.

Interest rate risk: the risk that the relative value of an interest-bearing liability, such as a loan or a bond, will worsen due to an interest rate increase. Interest rate risks can be hedged using fixed-income instruments orinterest rate swaps.

Equity risk: the risk that one's investments will depreciate because of stock market dynamics causing one to lose money.

Volatility risk: is the threat that an exchange rate movement poses to an investor's portfolio in a foreign currency.

Volumetric risk: the risk that a customer demands more or less of a product than expected.

Hedging equity and equity futures Equity in a portfolio can be hedged by taking an opposite position in futures. To protect your stock picking against systematic market risk, futures are shorted when equity is purchased, or long futures when stock is shorted. One way to hedge is the market neutral approach. In this approach, an equivalent dollar amount in the stock trade is taken in futures for example, by buying 10,000 GBP worth of Vodafone and shorting 10,000 worth of FTSE futures. Another way to hedge is the beta neutral. Beta is the historical correlation between a stock and an index. If the beta of a Vodafone stock is 2, then for a 10,000 GBP long position in Vodafone an investor would hedge with a 20,000 GBP equivalent short position in the FTSE futures (the index in which Vodafone trades).
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Futures contracts and forward contracts are means of hedging against the risk of adverse market movements. These originally developed out of commodity markets in the 19th century, but over the last fifty years a large global market developed in products to hedge financial market risk. Futures hedging Investors who primarily trade in futures may hedge their futures against synthetic futures. A synthetic in this case is a synthetic future comprising a call and a put position. Long synthetic futures means long call and short put at the same expiry price. To hedge against a long futures trade a short position in synthetics can be established, and vice versa. Stack hedging is a strategy which involves buying various futures contracts that are concentrated in nearby delivery months to increase the liquidity position. It is generally used by investors to ensure the surety of their earnings for a longer period of time. Contract for difference A contract for difference (CFD) is a two-way hedge or swap contract that allows the seller and purchaser to fix the price of a volatile commodity. Consider a deal between an electricity producer and an electricity retailer, both of whom trade through an electricity market pool. If the producer and the retailer agree to a strike price of $50 per MWh, for 1 MWh in a trading period, and if the actual pool price is $70, then the producer gets $70 from the pool but has to rebate $20 (the "difference" between the strike price and the pool price) to the retailer. Conversely, the retailer pays the difference to the producer if the pool price is lower than the agreed upon contractual strike price. In effect, the pool volatility is nullified and the parties pay and receive $50 per MWh. However, the party who pays the difference is "out of the money" because without the hedge they would have received the benefit of the pool price

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ARBITRAGE
Arbitrage is the making of a gain through trading without committing any money and without taking a risk of losing money. The term is also used more loosely to cover a range of activities, such as statistical arbitrage, risk arbitrage, and uncovered interest arbitrage, that are not true arbitrage (because they are risky). Many of these strategies bear some similarities to true arbitrage, in that they are market neutral attempts to identify and exploit (usually short lived) anomalies in pricing. The terminology used usually adds a qualifier to make it clear that it is not real arbitrage. The discussion below is of true arbitrage. An arbitrage opportunity exists if it is possible to make a gain that is guaranteed to be at least equal to the risk free rate of return, with a chance of making a greater gain. This is equivalent to the definition of an arbitrage opportunity as the possibility of a riskless gain with a zero cost portfolio, because a portfolio that is guaranteed to make a profit can be bought with borrowed money. Less rigorously, an arbitrage opportunity is a "free lunch", that allows investors to make a gain for no risk. Being less rigorous means that it is not really possible to distinguish between arbitrage and the closely related concepts of dominant trading strategies and the law of one price. Arbitrage should not be possible as, if an arbitrage opportunity exists, then market forces should eliminate it. Taking a simple example, if it is possible to buy a security in one market and sell it at a higher price in another market, then no-one would buy it at the more expensive price, and no one would sell it at the cheaper price. The prices in the two markets would converge. Arbitrage between markets is the simplest type of arbitrage. More complex strategies such as arbitraging the price of a security against a portfolio that replicates its cash flows. These range from the relatively simple, such

as delta and gamma hedges, to extremely complex strategies based on quantitative models.

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Much of financial theory (and therefore most methods for valuing securities) are ultimately built on the assumption that securities will trade at prices that make arbitrage impossible. In particular, if there is no arbitrage then a risk neutral pricing measure exists and vice versa. Although this result is not something that is used by most investors, it is of great importance in the theory of financial economics. Although arbitrage opportunities do exist in real markets, they are usually very small and quickly eliminated; therefore the no arbitrage assumption is a reasonable one to build financial theory on. When persistent arbitrage opportunities do exist it means that there is something badly wrong with financial markets. For example, there is evidence that during the dotcom boom the value of internet related tracker stocks and

listed subsidiaries was not consistent with the market value of parent companies: an arbitrage opportunity existed and persisted. Conditions for arbitrage Arbitrage is possible when one of three conditions is met: 1. The same asset does not trade at the same price on all markets ("the law of one price"). 2. Two assets with identical cash flows do not trade at the same price. 3. An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate (or, the asset does not have negligible costs of storage; as such, for example, this condition holds for grain but not for securities). Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time.The transactions mus

toccur simultaneously to avoid exposure to market risk, or the risk that prices may change on one market before both transactions are complete. In practical terms, this is generally only possible with securities and financial products which can be traded electronically, and even then, when each leg of the trade is executed the prices in the market may have moved. Missing one of the legs of the trade (and subsequently

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having to trade it soon after at a worse price) is called 'execution risk' or more specifically 'leg risk'. In the simplest example, any good sold in one market should sell for the same price in another. Traders may, for example, find that the price of wheat is lower in agricultural regions than in cities, purchase the good, and transport it to another region to sell at a higher price. This type of price arbitrage is the most common, but this simple example ignores the cost of transport, storage, risk, and other factors. "True" arbitrage requires that there be no market risk involved. Where securities are traded on more than one exchange, arbitrage occurs by simultaneously buying in one and selling on the other. Examples

Suppose that the exchange rates (after taking out the fees for making the exchange) in London are 5 = $10 = 1000 and the exchange rates in Tokyo are 1000 = $12 = 6. Converting 1000 to $12 in Tokyo and converting that $12 into 1200 in London, for a profit of 200, would be arbitrage. In reality, this "triangle arbitrage" is so simple that it almost never occurs. But more complicated foreign exchange arbitrages, such as the spot-forward arbitrage (see interest rate parity) are much more common.

One example of arbitrage involves the New York Stock Exchange and the Security Futures Exchange One Chicago (OCX). When the price of a stock on the NYSE and its corresponding futures contract on OCX are out of sync, one can buy the less expensive one and sell it to the more expensive market. Because the differences between the prices are likely to be small (and not to last very long), this can only be done profitably with computers examining a large number of prices and automatically exercising a trade when the prices are far enough out of balance. The activity of other arbitrageurs can make this risky. Those with the fastest computers and the most expertise take advantage of series of small differences that would not be profitable if taken individually.

Economists use the term "global labor arbitrage" to refer to the tendency of manufacturing jobs to flow towards whichever country has the lowest wages per unit output at present and has reached the minimum requisite level of

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political and economic development to support industrialization. At present, many such jobs appear to be flowing towards China, though some which require command of English are going to India and the Philippines. In popular terms, this is referred to as off shoring. (Note that "off shoring" is not synonymous with "outsourcing", which means "to subcontract from an outside supplier or source", such as when a business outsources its bookkeeping to an accounting firm. Unlike off shoring, outsourcing always involves subcontracting jobs to a different company, and that company can be in the same country as the outsourcing company.)

Sports arbitrage numerous internet bookmakers offer odds on the outcome of the same event. Any given bookmaker will weight their odds so that no one customer can cover all outcomes at a profit against their books. However, in order to remain competitive their margins are usually quite low. Different bookmakers may offer different odds on the same outcome of a given event; by taking the best odds offered by each bookmaker, a customer can under some circumstances cover all possible outcomes of the event and lock a small risk-free profit, known as a Dutch book. This profit would typically be between 1% and 5% but can be much higher. One problem with sports arbitrage is that bookmakers sometimes make mistakes and this can lead to an invocation of the 'palpable error' rule, which most bookmakers invoke when they have made a mistake by offering or posting incorrect odds. As bookmakers become more proficient, the odds of making an 'arb' usually last for less than an hour and typically only a few minutes. Furthermore, huge bets on one side of the market also alert the bookies to correct the market.

Exchange-traded fund arbitrage Exchange Traded Funds allow authorized participants to exchange back and forth between shares in underlying securities held by the fund and shares in the fund itself, rather than allowing the buying and selling of shares in the ETF directly with the fund sponsor. ETFs trade in the open market, with prices set by market demand. An ETF may trade at a premium or discount to the value of the underlying assets. When a significant enough premium appears, an arbitrageur will buy the underlying securities, convert them to shares in the ETF, and sell them in the open market. When a discount appears, an arbitrageur will do the reverse. In

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this way, the arbitrageur makes a low-risk profit, while fulfilling a useful function in the ETF marketplace by keeping ETF prices in line with their underlying value.

Some types of hedge funds make use of a modified form of arbitrage to profit. Rather than exploiting price differences between identical assets, they will purchase and sell securities, assets and derivatives with similar

characteristics, and hedge any significant differences between the two assets. Any difference between the hedged positions represents any remaining risk (such as basis risk) plus profit; the belief is that there remains some difference which, even after hedging most risk, represents pure profit. For example, a fund may see that there is a substantial difference between U.S. dollar debt and local currency debt of a foreign country, and enter into a series of matching trades (including currency swaps) to arbitrage the difference, while simultaneously entering into credit default swaps to protect against country risk and other types of specific risk.. Price convergence Arbitrage has the effect of causing prices in different markets to converge. As a result of arbitrage, the currency exchange rates, the price of commodities, and the price of securities in different markets tend to converge to the same prices, in all markets, in each category. The speed at which prices converge is a measure of market efficiency. Arbitrage tends to reduce price discrimination by encouraging people to buy an item where the price is low and resell it where the price is high, as long as the buyers are not prohibited from reselling and the transaction costs of buying, holding and reselling are small relative to the difference in prices in the different markets. Arbitrage moves different currencies toward purchasing power parity. As an example, assume that a car purchased in the United States is cheaper than the same car in Canada. Canadians would buy their cars across the border to exploit the arbitrage condition. At the same time, Americans would buy US cars, transport them across the border, and sell them in Canada. Canadians would have to buy American Dollars to buy the cars, and Americans would have to sell the Canadian dollars they received in exchange for the exported cars. Both actions would increase demand for
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US Dollars, and supply of Canadian Dollars, and as a result, there would be an appreciation of the US Dollar. Eventually, if unchecked, this would make US cars more expensive for all buyers, and Canadian cars cheaper, until there is no longer an incentive to buy cars in the US and sell them in Canada. More generally, international arbitrage opportunities in commodities

goods, securities and currencies, on a grand scale, tend to change exchange rates until the purchasing power is equal. In reality, of course, one must consider taxes and the costs of travelling back and forth between the US and Canada. Also, the features built into the cars sold in the US are not exactly the same as the features built into the cars for sale in Canada, due, among other things, to the different emissions and other auto regulations in the two countries. In addition, our example assumes that no duties have to be paid on importing or exporting cars from the USA to Canada. Similarly, most assets exhibit (small) differences between countries, transaction costs, taxes, and other costs provide an impediment to this kind of arbitrage. Similarly, arbitrage affects the difference in interest rates paid on government bonds, issued by the various countries, given the expected depreciations in the currencies, relative to each other (see interest rate parity). Risks Arbitrage transactions in modern securities markets involve fairly low day-to-day risks, but can face extremely high risk in rare situations, particularly financial crises, and can lead to bankruptcy. Formally, arbitrage transactions have negative skew prices can get a small amount closer (but often no closer than 0), while they can get very far apart. The day-to-day risks are generally small because the transactions involve small differences in price, so an execution failure will generally cause a small loss (unless the trade is very big or the price moves rapidly). The rare case risks are extremely high because these small price differences are converted to large profits via leverage (borrowed money), and in the rare event of a large price move, this may yield a large loss. The main day-to-day risk is that part of the transaction fails execution risk. The main rare risks are counterparty risk and liquidity risk that a counterparty to a
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large transaction or many transactions fails to pay, or that one is required to post margin and does not have the money to do so. In the academic literature, the idea that seemingly very low risk arbitrage trades might not be fully exploited because of these risk factors and other considerations is often referred to as limits to arbitrage.[1][2][3] Execution risk Generally it is impossible to close two or three transactions at the same instant; therefore, there is the possibility that when one part of the deal is closed, a quick shift in prices makes it impossible to close the other at a profitable price. However, this is not necessarily the case. Many exchanges and idbs allow multi legged trades (e.g. basis block trades on LIFFE). Competition in the marketplace can also create risks during arbitrage transactions. As an example, if one was trying to profit from a price discrepancy between IBM on the NYSE and IBM on the London Stock Exchange, they may purchase a large number of shares on the NYSE and find that they cannot simultaneously sell on the LSE. This leaves the arbitrageur in an unhedged risk position. In the 1980s, risk arbitrage was common. In this form of speculation, one trades a security that is clearly undervalued or overvalued, when it is seen that the wrong valuation is about to be corrected by events. The standard example is the stock of a company, undervalued in the stock market, which is about to be the object of a takeover bid; the price of the takeover will more truly reflect the value of the company, giving a large profit to those who bought at the current priceif the merger goes through as predicted. Traditionally, arbitrage transactions in the securities markets involve high speed, high volume and low risk. At some moment a price difference exists, and the problem is to execute two or three balancing transactions while the difference persists (that is, before the other arbitrageurs act). When the transaction involves a delay of weeks or months, as above, it may entail considerable risk if borrowed money is used to magnify the reward through leverage. One way of reducing the risk is through the illegal use of inside information, and in fact risk arbitrage with regard to leveraged buyouts was
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associated with some of the famous financial scandals of the 1980s such as those involving Michael Milken and Ivan Boesky. Mismatch Another risk occurs if the items being bought and sold are not identical and the arbitrage is conducted under the assumption that the prices of the items are correlated or predictable; this is more narrowly referred to as aconvergence trade. In the extreme case this is merger arbitrage, described below. In comparison to the classical quick arbitrage transaction, such an operation can produce disastrous losses. Counterparty risk As arbitrages generally involve future movements of cash, they are subject to counterparty risk: if counterparty fails to fulfill their side of a transaction. This is a serious problem if one has either a single trade or many related trades with a single counterparty, whose failure thus poses a threat, or in the event of a financial crisis when many counterparties fail. This hazard is serious because of the large quantities one must trade in order to make a profit on small price differences. For example, if one purchases many risky bonds, then hedges them with CDSes, profiting from the difference between the bond spread and the CDS premium, in a financial crisis the bonds may default and the CDS writer/seller may itself fail, due to the stress of the crisis, causing the arbitrageur to face steep losses. Liquidity risk Arbitrage trades are necessarily synthetic, leveraged trades, as they involve a short position. If the assets used are not identical (so a price divergence makes the trade temporarily lose money), or the margin treatment is not identical, and the trader is accordingly required to post margin (faces a margin call), the trader may run out of capital (if they run out of cash and cannot borrow more) and go bankrupt even though the trades may be expected to ultimately make money. In effect, arbitrage traders synthesize a put option on their ability to finance themselves.[4]

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Prices may diverge during a financial crisis, often termed a "flight to quality"; these are precisely the times when it is hardest for leveraged investors to raise capital (due to overall capital constraints), and thus they will lack capital precisely when they need it most. Types of arbitrage 1. Merger arbitrage Also called risk arbitrage, merger arbitrage generally consists of buying the stock of a company that is the target of a takeover while shorting the stock of the acquiring company. Usually the market price of the target company is less than the price offered by the acquiring company. The spread between these two prices depends mainly on the probability and the timing of the takeover being completed as well as the prevailing level of interest rates. The bet in a merger arbitrage is that such a spread will eventually be zero, if and when the takeover is completed. The risk is that the deal "breaks" and the spread massively widens. Municipal bond arbitrage Also called municipal bond relative value arbitrage, municipal arbitrage, or just muni arb, this hedge fund strategy involves one of two approaches. Generally, managers seek relative value opportunities by being both long and short municipal bonds with a duration-neutral book. The relative value trades may be between different issuers, different bonds issued by the same entity, or capital structure trades referencing the same asset (in the case of revenue bonds). Managers aim to capture the inefficiencies arising from the heavy participation of noneconomic investors (i.e., high income "buy and hold" investors seeking tax-exempt income) as well as the "crossover buying" arising from corporations' or individuals' changing income tax situations (i.e., insurers switching their munis for corporates after a large loss as they can capture a higher after-tax yield by offsetting the taxable corporate income with underwriting losses). There are additional inefficiencies
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arising from the highly fragmented nature of the municipal bond market which has two million outstanding issues and 50,000 issuers in contrast to the Treasury market which has 400 issues and a single issuer. Second, managers construct leveraged portfolios of AAA- or AA-rated tax-exempt municipal bonds with the duration risk hedged by shorting the appropriate ratio of taxable corporate bonds. These corporate equivalents are typically interest rate swaps referencing Libor or SIFMA The arbitrage manifests itself in the form of a relatively cheap longer maturity municipal bond, which is a municipal bond that yields significantly more than 65% of a corresponding taxable corporate bond. The steeper slope of the municipal yield curve allows participants to collect more aftertax income from the municipal bond portfolio than is spent on the interest rate swap; the carry is greater than the hedge expense. Positive, tax-free carry from muni arb can reach into the double digits. The bet in this municipal bond arbitrage is that, over a longer period of time, two similar instrumentsmunicipal bonds and interest rate swapswill correlate with each other; they are both very high quality credits, have the same maturity and are denominated in U.S. dollars. Credit risk and duration risk are largely eliminated in this strategy. However, basis risk arises from use of an imperfect hedge, which results in significant, but range-bound principal volatility. The end goal is to limit this principal volatility, eliminating its relevance over time as the high, consistent, tax-free cash flow accumulates. Since the inefficiency is related to government tax policy, and hence is structural in nature, it has not been arbitraged away. Note, however, that many municipal bonds are callable, and that this imposes substantial additional risks to the strategy. Convertible bond arbitrage A convertible bond is a bond that an investor can return to the issuing company in exchange for a predetermined number of shares in the company. A convertible bond can be thought of as a corporate bond with a stock call option attached to it. The price of a convertible bond is sensitive to three major factors:
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Interest rate. When rates move higher, the bond part of a convertible bond tends to move lower, but the call option part of a convertible bond moves higher (and the aggregate tends to move lower).

Stock price. When the price of the stock the bond is convertible into moves higher, the price of the bond tends to rise.

Credit

spread.

If

the

creditworthiness

of

the

issuer

deteriorates

(e.g. rating downgrade) and its credit spread widens, the bond price tends to move lower, but, in many cases, the call option part of the convertible bond moves higher (since credit spread correlates with volatility). Given the complexity of the calculations involved and the convoluted structure that a convertible bond can have, an arbitrageur often relies on sophisticated quantitative models in order to identify bonds that are trading cheap versus their theoretical value. Convertible arbitrage consists of buying a convertible bond and hedging two of the three factors in order to gain exposure to the third factor at a very attractive price. For instance an arbitrageur would first buy a convertible bond, then sell fixed income securities or interest rate futures (to hedge the interest rate exposure) and buy some credit protection (to hedge the risk of credit deterioration). Eventually what he'd be left with is something similar to a call option on the underlying stock, acquired at a very low price. He could then make money either selling some of the more expensive options that are openly traded in the market or delta hedging his exposure to the underlying shares. Depository receipts A depository receipt is a security that is offered as a "tracking stock" on another foreign market. For instance a Chinese company wishing to raise more money may issue a depository receipt on the New York Stock Exchange, as the amount of capital on the local exchanges is limited. These securities, known as ADRs (American Depositary Receipt) or GDRs (Global Depositary Receipt) depending on where they are issued, are typically considered "foreign" and therefore trade at a lower value when first released. However, they are exchangeable into the original security (known as fundibility) and actually have the same value. In this case there is
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a spread between the perceived value and real value, which can be extracted. Since the ADR is trading at a value lower than what it is worth, one can purchase the ADR and expect to make money as its value converges on the original. However there is a chance that the original stock will fall in value too, so by shorting it one can hedge that risk. Dual-listed companies A dual-listed company (DLC) structure involves two companies incorporated in different countries contractually agreeing to operate their businesses as if they were a single enterprise, while retaining their separate legal identity and existing stock exchange listings. In integrated and efficient financial markets, stock prices of the twin pair should move in lockstep. In practice, DLC share prices exhibit large deviations from theoretical parity. Arbitrage positions in DLCs can be set up by obtaining a long position in the relatively underpriced part of the DLC and a short position in the relatively overpriced part. Such arbitrage strategies start paying off as soon as the relative prices of the two DLC stocks converge toward theoretical parity. However, since there is no identifiable date at which DLC prices will converge, arbitrage positions sometimes have to be kept open for considerable periods of time. In the meantime, the price gap might widen. In these situations, arbitrageurs may receive margin calls, after which they would most likely be forced to liquidate part of the position at a highly unfavorable moment and suffer a loss. Arbitrage in DLCs may be profitable, but is also very risky, Background material is available at A good illustration of the risk of DLC arbitrage is the position in Royal Dutch Shellwhich had a DLC structure until 2005by the hedge fund Long-Term Capital Management (LTCM, see also the discussion below). Lowenstein (2000) describes that LTCM established an arbitrage position in Royal Dutch Shell in the summer of 1997, when Royal Dutch traded at an 8 to 10 percent premium. In total $2.3 billion was invested, half of which long in Shell and the other half short in Royal Dutch In the autumn of 1998 large defaults on Russian debt created significant losses for the hedge fund and LTCM had to unwind several positions. Lowenstein reports that the premium of Royal Dutch had increased to about 22 percent and LTCM had to close the position and incur a loss. According to

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Lowenstein (p. 234), LTCM lost $286 million in equity pairs trading and more than half of this loss is accounted for by the Royal Dutch Shell trade. Private to public equities The market prices for privately held companies are typically viewed from a return on investment perspective (such as 25%), whilst publicly held and or exchange listed companies trade on a Price to Earnings multiple (such as a P/E of 10, which equates to a 10% ROI). Thus, if a publicly traded company specialises in the acquisition of privately held companies, from a per-share perspective there is a gain with every acquisition that falls within these guidelines. Exempli gratia, BerkshireHathaway. A hedge fund that is an example of this type of arbitrage is Greenridge Capital, which acts as an angel investor retaining equity in private companies which are in the process of becoming publicly traded, buying in the private market and later selling in the public market. Private to public equities arbitrage is a term which can arguably be applied to investment banking in general. Private markets to public markets differences may also help explain the overnight windfall gains enjoyed by principals of companies that just did an initial public offering. Regulatory arbitrage Regulatory arbitrage is where a regulated institution takes advantage of the difference between its real (or economic) risk and the regulatory position. For example, if a bank, operating under the Basel I accord, has to hold 8% capital against default risk, but the real risk of default is lower, it is profitable to securities the loan, removing the low risk loan from its portfolio. On the other hand, if the real risk is higher than the regulatory risk then it is profitable to make that loan and hold on to it, provided it is priced appropriately. This process can increase the overall riskiness of institutions under a risk insensitive regulatory regime, as described by Alan Greenspan in his October 1998 speech on The Role of Capital in Optimal Banking Supervision and Regulation. In economics, regulatory arbitrage (sometimes, tax arbitrage) may be used to refer to situations when a company can choose a nominal place of business with a regulatory, legal or tax regime with lower costs. For example, an insurance company
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may choose to locate in Bermuda due to preferential tax rates and policies for insurance companies. This can occur particularly where the business transaction has no obvious physical location: in the case of many financial products, it may be unclear "where" the transaction occurs. Regulatory arbitrage can include restructuring a bank by outsourcing services such as IT. The outsourcing company takes over the installations, buying out the bank's assets and charges a periodic service fee back to the bank. This frees up cashflow usable for new lending by the bank. The bank will have higher IT costs, but counts on the multiplier effect of money creation and the interest rate spread to make it a profitable exercise. Example: Suppose the bank sells its IT installations for 40 million USD. With a reserve ratio of 10%, the bank can create 400 million USD in additional loans (there is a time lag, and the bank has to expect to recover the loaned money back into its books). The bank can often lend (and securitize the loan) to the IT services company to cover the acquisition cost of the IT installations. This can be at preferential rates, as the sole client using the IT installation is the bank. If the bank can generate 5% interest margin on the 400 million of new loans, the bank will increase interest revenues by 20 million. The IT services company is free to leverage their balance sheet as aggressively as they and their banker agree to. This is the reason behind the trend towards outsourcing in the financial sector. Without this money creation benefit, it is actually more expensive to outsource the IT operations as the outsourcing adds a layer of management and increases overhead.

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CHAPTER 2 DERIVATIVE MARKET

2.1 DERIVATIVES

Introduction

Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the underlying. The International Monetary Fund defines derivatives as "financial instruments that are linked to a specific financial instrument or indicator or commodity and through which specific financial risks can be traded in financial markets in their own right. The value of a financial derivative derives from the price of an underlying item, such as an asset or index. Unlike debt securities, no principal is advanced to be repaid and no investment income accrues". The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by lockingin asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Derivative products initially emerged as hedging devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. The financial derivatives came into
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spotlight in post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously both in terms of variety of instruments available, their complexity and also turnover. The factors generally attributed as the major driving force behind growth of financial derivatives are (a) Increased volatility in asset prices in financial markets, (b)187 increased integration of national financial markets with the international markets, (c) marked improvement in communication facilities and sharp decline in their costs, (d) development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and (e) Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets, leading to higher returns, reduced risk as well as transaction costs as compared to individual financial assets. In the class of equity derivatives, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indices with various portfolios and ease of use. The lower costs associated with index derivatives vis--vis derivative products based on individual securities is another reason for their growing use.

Products, participants and functions

Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. The following three broad categories of participants hedgers, speculators, and arbitrageurs trade in the derivatives market.

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a) Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk. b) Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. c) Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit. The derivatives market performs a number of economic functions. First, prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus, derivatives help in discovery of future as well as current prices. Second, the derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. Third, derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. Fourth, speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets. Fifth, an important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well educated people with an entrepreneurial attitude. They often energies others to create new businesses, new products and new employment opportunities, the benefit of which are immense. Finally, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.
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Instruments Available For Trading

In recent years, derivatives have become increasingly popular due to their applications for hedging, speculation and arbitrage. Before we study about the applications of commodity derivatives, we will have a look at some basic derivative products. While futures and options are now actively traded on many Exchanges, forward contracts are popular on the OTC market. At present, only commodity futures trade on the NCDEX.

TYPES OF DERIVATIVES

The most commonly used derivatives contracts are forwards, futures and options which we shall discuss in detail later. Here we take a brief look at various derivatives contracts that have come to be used. Forwards:

A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price. Futures:

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. Options:

Options are of two types calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having maximum maturity of nine months. Longer dated options are called warrants and are generally traded over-the-counter.
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LEAPS: The acronym LEAPS means Long Term Equity Anticipation Securities. These are options having a maturity of up to three years.

Baskets:

Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options. Swaps:

Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:

a) Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency

b) Currency Swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus, Swaptions is an option on a forward swap. Rather than have calls and puts, the Swaptions market has receiver Swaptions and payer Swaptions A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

2.2 INTRODUCTION TO FUTURES AND OPTIONS In recent years, derivatives have become increasingly important in the field of finance. While futures and options are now actively traded on many exchanges, forward contracts are popular on the OTC market. In this chapter we shall study in detail these three derivative contracts.

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2.2(a) FORWARD CONTRACTS A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges. The salient features of forward contracts are: They are bilateral contracts and hence exposed to counter-party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged. However forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market. Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward. If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing
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transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward markets here supplies leverage to the speculator.

2.2(b) LIMITATIONS OF FORWARD MARKETS Forward markets world-wide are afflicted by several problems: Lack of centralization of trading, Illiquidity, and Counterparty risk In the first two of these, the basic problem is that of too much flexibility and generality. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal which are very convenient in that specific situation, but makes the contracts non-tradable. Counterparty risk arises from the possibility of default by any one party to the transaction.

When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very serious issue.

2.2(c) INTRODUCTION TO FUTURES Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard
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timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way. The standardized items in a futures contract are: i. ii. iii. iv. v. Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change Location of settlement

2.2(d)

DISTINCTION

BETWEEN

FUTURES

AND

FORWARDS

CONTRACTS

Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity.

Distinction between futures and forwards

Futures Trade on an organized exchange Standardized contract terms hence more liquid Requires margin payments Follows daily settlement

Forwards OTC in nature Customized contract terms hence less liquid No margin payment Settlement happens at end of period

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2.2(e) FUTURES TERMINOLOGY i. Spot price: The price at which an asset trades in the spot market.

ii.

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

iii.

Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one- month, two- months and three months expiry cycles which expire on the last Thursday of the month.

Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three- month expiry is introduced for trading.

The commodity futures contracts on the NCDEX have one month, two months, and three months etc (not more than a year) expiry cycles. Most of the agri commodities futures contracts of NCDEX expire on the 20th day of the delivery month.

Thus, a January expiration contract expires on the 20th of January and a February expiration contract ceases to exist for trading after the 20th of February. If 20th happens to be a holiday, the expiry date shall be the immediately preceding trading day of the Exchange, other than a Saturday. New contracts for agri commodities are introduced on the 10th of the month.

iv.

Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist.

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v.

Contract size: The amount of asset that has to be delivered under one contract. Also called as lot size.

vi.

Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.

vii.

Cost of carry: The relationship between futures prices and spot price can be summarized in terms of what is known as the cost of carry.This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.

viii.

Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.

ix.

Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called marking-to-market.

x.

Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

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2.2(f) INTRODUCTION TO OPTIONS

In this section, we look at the next derivative product to be traded on the NSE, namely options. Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an up-front payment.

2.2(g) OPTION TERMINOLOGY i. Index options: These options have the index as the underlying. Some options are European while others are American. Like index futures contracts, index options contracts are also cash settled.

ii.

Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price.

iii.

Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.

iv.

Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.

There are two basic types of options, call options and put options.
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Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price.

Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.

Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.

Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.

Strike price: The price specified in the options contract is known as the strike price or the exercise price.

American options: American options are options that can be exercised at any time up to the expiration date. Most exchange-traded options are American.

European options: European options are options that can be exercise only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart.

In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level

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higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.

At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-themoney when the current index equals the strike price (i.e. spot price = strike price).

Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash flow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.

Intrinsic value of an option: The option premium can be broken down into two components - intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max[0, (St K)] which means the intrinsic value of a call is the greater of 0 or (St K). Similarly, the intrinsic value of a put is Max[0, K St],i.e. the greater of 0 or (K St). K is the strike price and St is the spot price.

Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option's time value, all else equal. At expiration, an option should have no time value.

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HISTORY OF OPTIONS

Although options have existed for a long time, they were traded OTC, without much knowledge of valuation. The first trading in options began in Europe and the US as early as the seventeenth century. It was only in the early 1900s that a group of firms set up what was known as the put and call Brokers and Dealers Association with the aim of providing a mechanism for bringing buyers and sellers together. If someone wanted to buy an option, he or she would contact one of the member firms. The firm would then attempt to find a seller or writer of the option either from its own clients or those of other member firms. If no seller could be found, the firm would undertake to write the option itself in return for a price. This market however suffered from two deficiencies. First, there was no secondary market and second, there was no mechanism to guarantee that the writer of the option would honor the contract. In 1973, Black, Merton and Scholes invented the famed Black-Scholes formula. In April 1973, CBOE was set up specifically for the purpose of trading options. The market for options developed so rapidly that by early '80s, the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the NYSE. Since then, there has been no looking back.

FUTURES AND OPTIONS

An interesting question to ask at this stage is - when would one use options instead of futures? Options are different from futures in several interesting senses. At a practical level, the option buyer faces an interesting situation. He pays for the option in full at the time it is purchased. After this, he only has an upside. There is no possibility of the options position generating any further losses to him (other than the funds already paid for the option). This is different from futures, which is free to enter into, but can generate very large losses. This characteristic makes options attractive to many occasional market participants, who cannot put in the time to closely monitor their futures positions.
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Buying put options is buying insurance. To buy a put option on Nifty is to buy insurance which reimburses the full extent to which Nifty drops below the strike price of the put option. This is attractive to many people, and to mutual funds creating "guaranteed return products".

USE OF OPTIONS IN THE SEVENTEENTH-CENTURY

Options made their first major mark in financial history during the tulip bulb mania in seventeenth-century Holland. It was one of the most spectacular get rich quick binges in history. The first tulip was brought into Holland by a botany professor from Vienna. Over a decade, the tulip became the most popular and expensive item in Dutch gardens. The more popular they became, the more Tulip bulb prices began rising. That was when options came into the picture.

They were initially used for hedging. By purchasing a call option on tulip bulbs, a dealer who was committed to a sales contract could be assured of obtaining a fixed number of bulbs for a set price. Similarly, tulip-bulb growers could assure themselves of selling their bulbs at a set price by purchasing put options. Later, however, options were increasingly used by speculators who found that call options were an effective vehicle for obtaining maximum possible gains on investment.

As long as tulip prices continued to skyrocket, a call buyer would realize returns far in excess of those that could be obtained by purchasing tulip bulbs themselves. The writers of the put options also prospered as bulb prices spiraled since writers were able to keep the premiums and the options were never exercised. The tulip-bulb market collapsed in 1636 and a lot of speculators lost huge sums of money. Hardest hit were put writers who were unable to meet their commitments to purchase Tulip bulbs.

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Distinction between futures and options

Futures Exchange traded, with novation Exchange defines the product Price is zero, strike price moves Price is zero Linear payoff Both long and short at risk

Options Same as futures. Same as futures. Strike price is fixed, price moves. Price is always positive. Nonlinear payoff. Only short at risk.

The Nifty index fund industry will find it very useful to make a bundle of a Nifty index fund and a Nifty put option to create a new kind of a Nifty index fund, which gives the investor protection against extreme drops in Nifty. Selling put options is selling insurance, so anyone who feels like earning revenues by selling insurance can set himself up to do so on the index options market. More generally, options offer "nonlinear payoffs" whereas futures only have "linear payoffs". By combining futures and options, a wide variety of innovative and useful payoff structures can be created.

2.2(h) INDEX DERIVATIVES

Index derivatives are derivative contracts which derive their value from an underlying index. The two most popular index derivatives are index futures and index options. Index derivatives have become very popular worldwide. Index derivatives offer various advantages and hence have become very popular. Institutional and large equity-holders need portfolio-hedging facility. Indexderivatives are more suited to them and more cost-effective than derivatives
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based on individual stocks. Pension funds in the US are known to use stock index futures for risk hedging purposes. Index derivatives offer ease of use for hedging any portfolio irrespective of its composition.

Stock index is difficult to manipulate as compared to individual stock prices, more so in India, and the possibility of cornering is reduced. This is partly because an individual stock has a limited supply, which can be cornered. Stock index, being an average, is much less volatile than individual stock prices. This implies much lower capital adequacy and margin requirements.

Index derivatives are cash settled, and hence do not suffer from settlement delays and problems related to bad delivery, forged/fake certificates.

2.2(I) SWAPS:

Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:

1. Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.

2. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver
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CHAPTER3 OPTIONS

APPLICATIONS

OF

FUTURES

AND

The phenomenal growth of financial derivatives across the world is attributed the fulfillment of needs of hedgers, speculators and arbitrageurs by these products. In this chapter we first look at how trading futures differs from trading the underlying spot. We then look at the payoff of these contracts, and finally at how these contracts can be used by various entities in the economy. A payoff is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on the X-axis and the profits/losses on the Yaxis

3.1 APPLICATION OF FUTURES

Understanding beta

The index model suggested by William Sharpe offers insights into portfolio diversification. It expresses the excess return on a security or a portfolio as a function of market factors and non market factors. Market factors are those factors that affect all stocks and portfolios. These would include factors such as inflation, interest rates, business cycles etc. Non-market factors would be those factors which are specific to a company, and do not affect the entire market. For example, a fire breakout in a factory, a new invention, the death of a key employee, a strike in the factory, etc. The market factors affect all firms. The unexpected change in these factors causes unexpected changes in the rates of returns on the entire stock market. Each stock however responds to these factors to different extents. Beta of a stock measures the sensitivity of the stocks responsiveness to these market factors. Similarly, Beta of a portfolio, measures the portfolios responsiveness to these market movements. Given stock betas, calculating portfolio beta is simple. It is nothing but the weighted average of the stock betas. The index has a beta of 1. Hence the movements of returns on a portfolio with a beta of one will be like the
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index. If the index moves up by ten percent, my portfolio value will increase by ten percent. Similarly if the index drops by five percent, my portfolio value will drop by five percent. A portfolio with a beta of two, responds more sharply to index movements. If the index moves up by ten percent, the value of a portfolio with a beta of two will move up by twenty percent. If the index drops by ten percent, the value of a portfolio with a beta of two will fall by twenty percent. Similarly, if a portfolio has a beta of 0.75, a ten percent movement in the index will cause a 7.5 percent movement in the value of the portfolio. In short, beta is a measure of the systematic risk or market risk of a portfolio. Using index futures contracts, it is possible to hedge the systematic risk. With this basic understanding, we look at some applications of index futures. We look here at some applications of futures contracts. We refer to single stock futures. However since the index is nothing but a security whose price or level is a weighted average of securities constituting an index, all strategies that can be implemented using stock futures can also be implemented using index futures.

3.1(a) Hedging: Long security, sell futures Futures can be used as an effective risk-management tool. Take the case of an investor who holds the shares of a company and gets uncomfortable with market movements in the short run. He sees the value of his security falling from Rs.450 to Rs.390. In the absence of stock futures, he would either suffer the discomfort of a price fall or sell the security in anticipation of a market upheaval. With security futures he can minimize his price risk. All he need do is enter into an offsetting stock futures position, in this case, take on a short futures position. Assume that the spot price of the security he holds is Rs.390. Two-month futures cost him Rs.402. For this he pays an initial margin. Now if the price of the security falls any further, he will suffer losses on the security he holds. However, the losses he suffers on the security will be offset by the profits he makes on his short futures position. Take for instance that the price of his security falls to Rs.350. The fall in the price of the security will result in a fall in the price of futures. Futures will now trade at a price lower than the price at which he entered into a short futures position. Hence his short futures position will start making profits. The loss of Rs.40 incurred on the security he holds, will be made up by the profits made on his short futures position. Index
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futures in particular can be very effectively used to get rid of the market risk of a portfolio. Every portfolio contains a hidden index exposure or a market exposure. This statement is true for all portfolios, whether a portfolio is composed of index securities or not. In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations (unlike individual securities, where only 30-60% of the securities risk is accounted for by index fluctuations). Hence a position LONG PORTFOLIO + SHORT NIFTY can often become one-tenth as risky as the LONG PORTFOLIO position! Suppose we have a portfolio of Rs. 1 million which has a beta of 1.25. Then a complete hedge is obtained by selling Rs.1.25 million of Nifty futures. Warning: Hedging does not always make money. The best that can be achieved using hedging is the removal of unwanted exposure, i.e. unnecessary risk. The hedged position will make less profit than the unhedged position, half the time. One should not enter into a hedging strategy hoping to make excess profits for sure; all that can come out of hedging is reduced risk.

3.1(b) Speculation: Bullish security, buy futures Take the case of a speculator who has a view on the direction of the market. He would like to trade based on this view. He believes that a particular security that trades at Rs.1000 is undervalued and expects its price to go up in the next two-three months. How can he trade based on this belief? In the absence of a deferral product, he would have to buy the security and hold on to it. Assume he buys 100 shares which cost him one lakh rupees. His hunch proves correct and two months later the security closes at Rs.1010. He makes a profit of Rs.1000 on an investment of Rs. 1,00,000 for a period of two months. This works out to an annual return of 6 percent. Today a speculator can take exactly the same position on the security by using futures contracts. Let us see how this works. The security trades at Rs.1000 and the two-month futures trades at 1006. Just for the sake of comparison, assume that the minimum contract value is 1,00,000. He buys 100 security futures for which he pays a margin of Rs.20,000. Two months later the security closes at 1010. On the day of expiration, the futures price converges to the spot price and he makes a profit of Rs.400 on an investment of Rs.20,000. This works out to an annual return of 12
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percent. Because of the leverage they provide, security futures form an attractive option for speculators.

3.1(c) Speculation: Bearish security, sell futures Stock futures can be used by a speculator who believes that a particular security is over-valued and is likely to see a fall in price. How can he trade based on his opinion? In the absence of a deferral product, there wasn't much he could do to profit from his opinion. Today all he needs to do is sell stock futures. Let us understand how this works. Simple arbitrage ensures that futures on an individual securities move correspondingly with the underlying security, as long as there is sufficient liquidity in the market for the security. If the security price rises, so will the futures price. If the security price falls, so will the futures price. Now take the case of the trader who expects to see a fall in the price of ABC Ltd. He sells one two-month contract of futures on ABC at Rs.240 (each contact for 100 underlying shares). He pays a small margin on the same. Two months later, when the futures contract expires, ABC closes at 220. On the day of expiration, the spot and the futures price converges. He has made a clean profit of Rs.20 per share. For the one contract that he bought, this works out to be Rs.2000.

3.1(d) Arbitrage: Overpriced futures: buy spot, sell futures As we discussed earlier, the cost-of-carry ensures that the futures price stay in tune with the spot price. Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. If you notice that futures on a security that you have been observing seem overpriced, how can you cash in on this opportunity to earn riskless profits? Say for instance, ABC Ltd. trades at Rs.1000. One- month ABC futures trade at Rs.1025 and seem overpriced. As an arbitrageur, you can make riskless profit by entering into the following set of transactions. 1. On day one, borrow funds; buy the security on the cash/spot market at 1000. 2. Simultaneously, sell the futures on the security at 1025. 3. Take delivery of the security purchased and hold the security for a month.

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4. On the futures expiration date, the spot and the futures price converge. Now unwind the position. 5. Say the security closes at Rs.1015. Sell the security. 6. Futures position expires with profit of Rs.10. 7. The result is a riskless profit of Rs.15 on the spot position and Rs.10 on the futures position. 8. Return the borrowed funds. When does it make sense to enter into this arbitrage? If your cost of borrowing funds to buy the security is less than the arbitrage profit possible, it makes sense for you to arbitrage. This is termed as cash-and-carry arbitrage. Remember however, that exploiting an arbitrage opportunity involves trading on the spot and futures market. In the real world, one has to build in the transactions costs into the arbitrage strategy.

3.1(e) Arbitrage: Underpriced futures: buy futures, sell spot Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. It could be the case that you notice the futures on a security you hold seem underpriced. How can you cash in on this opportunity to earn riskless profits? Say for instance, ABC Ltd. trades at Rs.1000. One month ABC futures trade at Rs. 965 and seem underpriced. As an arbitrageur, you can make riskless profit by entering into the following set of transactions. 1. On day one, sell the security in the cash/spot market at 1000. 2. Make delivery of the security. 3. Simultaneously, buy the futures on the security at 965. 4. On the futures expiration date, the spot and the futures price converge. Now unwind the position. 5. Say the security closes at Rs.975. Buy back the security. 6. The futures position expires with a profit of Rs.10. 7. The result is a riskless profit of Rs.25 on the spot position and Rs.10 on the futures position.
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If the returns you get by investing in riskless instruments is more than the return from the arbitrage trades, it makes sense for you to arbitrage. This is termed as reverse-cash-and-carry arbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line with the cost-of-carry. As we can see, exploiting arbitrage involves trading on the spot market. As more and more players in the market develop the knowledge and skills to do cashand-carry and reverse cash-andcarry, we will see increased volumes and lower spreads in both the cash as well as the derivatives market.

3.2 APPLICATION OF OPTIONS

We look here at some applications of options contracts. We refer to single stock options here. However since the index is nothing but a security whose price or level is a weighted average of securities constituting the index, all strategies that can be implemented using stock futures can also be implemented using index options.

3.2(a) Hedging: Have underlying buy puts Owners of stocks or equity portfolios often experience discomfort about the overall stock market movement. As an owner of stocks or an equity portfolio, sometimes you may have a view that stock prices will fall in the near future. At other times you may see that the market is in for a few days or weeks of massive volatility, and you do not have an appetite for this kind of volatility. The union budget is a common and reliable source of such volatility: market volatility is always enhanced for one week before and two weeks after a budget. Many investors simply do not want the fluctuations of these three weeks. One way to protect your portfolio from potential downside due to a market drop is to buy insurance using put options. Index and stock options are a cheap and easily implementable way of seeking this insurance. The idea is simple. To protect the value of your portfolio from falling below a particular level, buy the right number of put options with the right strike price. If you are only concerned about the value of a particular stock that you hold, buy put options on that stock. If you are concerned about the overall portfolio, buy put options on the index. When the stoc k price falls your stock will lose value and the
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put options bought by you will gain, effectively ensuring that the total value of your stock plus put does not fall below a particular level. This level depends on the strike price of the stock options chosen by you. Similarly when the index falls, your portfolio will lose value and the put options bought by you will gain, effectively ensuring that the value of your portfolio does not fall below a particular level. This level depends on the strike price of the index options chosen by you. Portfolio insurance using put options is of particular interest to mutual funds who already own well-diversified portfolios. By buying puts, the fund can limit its downside in case of a market fall.

3.2(b) Speculation: Bullish security, buy calls or sell puts There are times when investors believe that security prices are going to rise. For instance, after a good budget, or good corporate results, or the onset of a stable government. How does one implement a trading strategy to benefit from an upward movement in the underlying security? Using options there are two ways one can do this: 1. Buy call options; or 2. Sell put options We have already seen the payoff of a call option. The downside to the buyer of the call option is limited to the option premium he pays for buying the option. His upside however is potentially unlimited. Suppose you have a hunch that the price of a particular security is going to rise in a months time. Your hunch proves correct and the price does indeed rise, it is this upside that you cash in on. However, if your hunch proves to be wrong and the security price plunges down, what you lose is only the option premium. Having decided to buy a call, which one should you buy? Table 4.1 gives the premia for one month calls and puts with different strikes. Given that there are a number of one-month calls trading, each with a different strike price, the obvious question is: which strike should you choose? Let us take a look at call options with different strike prices. Assume that the current price level is 1250, riskfree rate is12% per year and volatility of the underlying security is 30%. The following options are available: 1. A one month call with a strike of 1200.
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2. A one month call with a strike of 1225. 3. A one month call with a strike of 1250. 4. A one month call with a strike of 1275. 5. A one month call with a strike of 1300. Which of these options you choose largely depends on how strongly you feel about the likelihood of the upward movement in the price, and how much you are willing to lose should this upward movement not come about. There are five one-month calls and five one-month puts trading in the market. The call with a strike of 1200 is deep in-the-money and hence trades at a higher premium. The call with a strike of 1275 is out-of-the-money and trades at a low premium. The call with a strike of 1300 is deep-out-of-money. Its execution depends on the unlikely event that the underlying will rise by more than 50 points on the expiration date. Hence buying this call is basically like buying a lottery. There is a small probability that it may be in-the-money by expiration, in which case the buyer will make profits. In the more likely event of the call expiring out-of-the-money, the buyer simply loses the small premium amount of Rs.27.50. As a person who wants to speculate on the hunch that prices may rise, you can also do so by selling or writing puts. As the writer of puts, you face a limited upside and an unlimited downside. If prices do rise, the buyer of the put will let the option expire and you will earn the premium. If however your hunch about an upward movement proves to be wrong and prices actually fall, then your losses directly increase with the falling price level. If for instance the price of the underlying falls to 1230 and you've sold a put with an exercise of 1300, the buyer of the put will exercise the option and you'll end up losing Rs.70. Taking into account the premium earned by you when you sold the put, the net loss on the trade is Rs.5.20. Having decided to write a put, which one should you write? Given that there are a number of one-month puts trading, each with a different strike price, the obvious question is: which strike should you choose? This largely depends on how strongly you feel about the likelihood of the upward movement in the prices of the underlying. If you write an at-the-money put, the option premium earned by you will be higher than if you write an out-of-the-money put. However the chances of an atthe-money put being exercised on you are higher as well.
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Table 3.1 One month calls and puts trading at different strikes The spot price is 1250. There are five one-month calls and five one-month puts trading in the market. The call with a strike of 1200 is deep in-the-money and hence trades at a higher premium. The call with a strike of 1275 is out-of-the-money and trades at a low premium. The call with a strike of 1300 is deep-out-of-money. Its execution depends on the unlikely event that the price of underlying will rise by more than 50 points on the expiration date. Hence buying this call is basically like buying a lottery. There is a small probability that it may be in-the-money by expiration in which case the buyer will profit. In the more likely event of the call expiring out-of-the-money, the buyer simply loses the small premium amount of Rs. 27.50. Figure 4.10 shows the payoffs from buying calls at different strikes. Similarly, the put with a strike of 1300 is deep in-the-money and trades at a higher premium than the at-the-money put at a strike of 1250. The put with a strike of 1200 is deep out-of-the-money and will only be exercised in the unlikely event that underlying falls by 50 points on the expiration date. Following figure shows the payoffs from writing puts at different strikes.

Underlying

Strike option

price

of Call Premium(Rs.)

Put Premium(Rs.)

1250 1250 1250 1250 1250

1200 1225 1250 1275 1300

80.10 63.65 49.45 37.50 27.50

18.15 26.50 37.00 49.80 64.80

In the example in above Figure at a price level of 1250, one opt ion is in-the-money and one is out-of-the-money. As expected, the in-the-money option fetches the

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highest premium of Rs.64.80 whereas the out-of-the-money option has the lowest premium of Rs. 18.15.

3.2(c) Speculation: Bearish security, sell calls or buy puts Do you sometimes think that the market is going to drop? That you could make a profit by adopting a position on the market? Due to poor corporate results, or the instability of the government, many people feel that the stocks prices would go down. How does one implement a trading strategy to benefit from a downward movement in the market? Today, using options, you have two choices: 1. Sell call options; or 2. Buy put options We have already seen the payoff of a call option. The upside to the writer of the call option is limited to the option premium he receives upright for writing the option. His downside however is potentially unlimited. Suppose you have a hunch that the price of a particular security is going to fall in a months time. Your hunch proves correct and it does indeed fall, it is this downside that you cash in on. When the price falls, the buyer of the call lets the call expire and you get to keep the premium. However, if your hunch proves to be wrong and the market soars up instead, what you lose is directly proportional to the rise in the price of the security. Figure 3.1 Payoff for buyer of call options at various strikes The figure shows the profits/losses for a buyer of calls at various strikes. The in-the money option with a strike of 1200 has the highest premium of Rs.80.10 whereas the out-of-the-money option with a strike of 1300 has the lowest premium of Rs.27.50.

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Figure 3.2 Payoff for writer of put options at various strikes The figure shows the profits/losses for a writer of puts at various strikes. The in themoney option with a strike of 1300 fetches the highest premium of Rs.64.80 whereas the out-of-the-money option with a strike of 1200 has the lowest premium of Rs. 18.15.

Having decided to write a call, which one should you write? Table 4.2 gives the premiums for one month calls and puts with different strikes. Given that there are a number of one-month calls trading, each with a different strike price, the obvious question is: which strike should you choose? Let us take a look at call options with different strike prices. Assume that the current stock price is 1250, risk-free rate is 12% per year and stock volatility is 30%. You could write the following options:
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1. A one month call with a strike of 1200. 2. A one month call with a strike of 1225. 3. A one month call with a strike of 1250. 4. A one month call with a strike of 1275. 5. A one month call with a strike of 1300.

Which of this option you write largely depends on how strongly you feel about the likelihood of the downward movement of prices and how much you are willing to lose should this downward movement not come about. There are five one-month calls and five one-month puts trading in the market. The call with a strike of 1200 is deep in-the-money and hence trades at a higher premium. The call with a strike of 1275 is out-of-the-money and trades at a low premium. The call with a strike of 1300 is deep-out-of-money. Its execution depends on the unlikely event that the stock will rise by more than 50 points on the expiration date. Hence writing this call is a fairly safe bet. There is a small probability that it may be in-the-money by expiration in which case the buyer exercises and the writer suffers losses to the extent that the price is above 1300. In the more likely event of the call expiring out of- the-money, the writer earns the premium amount ofRs.27.50. As a person who wants to speculate on the hunch that the market may fall, you can also buy puts. As the buyer of puts you face an unlimited upside but a limited downside. If the price does fall, you profit to the extent the price falls below the strike of the put purchased by you. If however your hunch about a downward movement in the market proves to be wrong and the price actually rises, all you lose is the option premium. If for instance the security price rises to 1300 and you've bought a put with an exercise of 1250, you simply let the put expire. If however the price does fall to say 1225 on expiration date, you make a neat profit of Rs.25. Having decided to buy a put, which one should you buy? Given that there are a number of one-month puts trading, each with a different strike price, the obvious question is: which strike should you choose? This largely depends on how strongly you feel about the likelihood of the downward movement in the market. If you buy an at-the-money put, the option premium paid by you will by higher than if you buy

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an out-of-the-money put. However the chances of an at-the-money put expiring inthe-money are higher as well.

Table 3.2 One month calls and puts trading at different strikes The spot price is 1250. There are five one-month calls and five one-month puts trading in the market. The call with a strike of 1200 is deep in-the-money and hence trades at a higher premium. The call with a strike of 1275 is out-of-the-money and trades at a low premium. The call with a strike of 1300 is deep-out of- money. Its execution depends on the unlikely event that the price will rise by more than 50 points on the expiration date. Hence writing this call is a fairly safe bet. There is a small probability that it may be in-the-money by expiration in which case the buyer exercises and the writer suffers losses to the extent that the price is above 1300. In the more likely event of the call expiring out-of-the-money, the writer earns the premium amount of Rs.27.50. Figure 4.12 shows the payoffs from writing calls at different strikes. Similarly, the put with a strike of 1300 is deep in-the-money and trades at a higher premium than the at-the-money put at a strike of 1250. The put with a strike of 1200 is deep out-of-the-money and will only be exercised in the unlikely event that the price falls by 50 points on the expiration date. The choice of which put to buy depends upon how much the speculator expects the market to fall.

Figure 3.3 shows the payoffs from buying puts at different strikes. Price Strike option 1250 1250 1250 1250 1250 1200 1225 1250 1275 1300 price of Call Premium(Rs.) 80.10 63.65 49.45 37.50 27.50 18.15 26.50 37.00 49.80 64.80 Put Premium(Rs.)

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Figure 3.4 Payoff for seller of call option at various strikes The figure shows the profits/losses for a seller of calls at various strike prices. The in-the-money option has the highest premium of Rs.80.10 whereas the out-of-themoney option has the lowest premium of Rs. 27.50.

Figure 3.5 Payoff for buyer of put options at various strikes The figure shows the profits/losses for a buyer of puts at various strike prices. The in-the-money option has the highest premium of Rs.64.80 whereas the out-of-themoney option has the lowest premium of Rs. 18.50.

3.2(e) Bull spreads - Buy a call and sell another There are times when you think the market is going to rise over the next two months; however in the event that the market does not rise, you would like to limit
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your downside. One way you could do this is by entering into a spread. A spread trading strategy involves taking a position in two or more options of the same type, that is, two or more calls or two or more puts. A spread that is designed to profit if the price goes up is called a bull spread. How does one go about doing this? This is basically done utilizing two call options having the same expiration date, but different exercise prices. The buyer of a bull spread buys a call with an exercise price below the current index level and sells a call option with an exercise price above the current index level. The spread is a bull spread because the trader hopes to profit from a rise in the index. The trade is a spread because it involves buying one option and selling a related option. What is the advantage of entering into a bull spread? Compared to buying the underlying asset itself, the bull spread with call options limits the trader's risk, but the bull spread also limits the profit potential.

Figure 3.6 Payoff for a bull spread created using call options

The figure shows the profits/losses for a bull spread. As can be seen, the payoff obtained is the sum of the payoffs of the two calls, one sold at Rs.40 and the other bought at Rs.80. The cost of setting up the spread is Rs.40 which is the difference between the call premium paid and the call premium received. The downside on the position is limited to this amount. As the index moves above 3800, the position starts making profits (cutting losses) until the index reaches 4200. Beyond 4200, the profits made on the long call position get offset by the losses made on the short call position and hence the maximum profit on this spread is made if the index on the expiration day closes at 4200. Hence the payoff on this spread lies between -40 to 360. Who would buy this spread? Somebody who thinks the index is going to rise, but not above 4200. Hence he does not want to buy a call at 3800 and pay a premium of 80 for an upside he believes will not happen.

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In short, it limits both the upside potential as well as the downside risk. The cost of the bull spread is the cost of the option that is purchased, less the cost of the option that is sold. Table 4.3 gives the profit/loss incurred on a spread position as the index changes. Figure 4.14 shows the payoff from the bull spread.

Broadly, we can have three types of bull spreads: 1. Both calls initially out-of-the-money. 2. One call initially in-the-money and one call initially out-of-the-money, and 3. Both calls initially in-the-money. The decision about which of the three spreads to undertake depends upon how much risk the investor is willing to take. The most aggressive bull spreads are of type 1. They cost very little to set up, but have a very small probability of giving a high payoff.

Table 3.3 Expiration day cash flows for a Bull spread using two-month calls

The table shows possible expiration day profit for a bull spread created by buying calls at a strike of 3800 and selling calls at a strike of 4200. The cost of setting up the spread is the call premium paid (Rs.80) minus the call premium received
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(Rs.40), which is Rs.40. This is the maximum loss that the position will make. On the other hand, the maximum profit on the spread is limited to Rs.360. Beyond an index level of 4200, any profits made on the long call position will be cancelled by losses made on the short call position, effectively limiting the profit on the combination.

Nifty

Buy Jan 3800 Call

Sell Jan 4200 Call

Cash Flow

Profit & Loss (Rs.)

3700 3750 3800 3850 3900 3950 4000 4050 4100 4150 4200 4250 4300

0 0 0 +50 +100 +150 +200 +250 +300 +350 +400 +450 +500

0 0 0 0 0 0 0 0 0 0 0 -50 -100

0 0 0 50 100 150 200 250 300 350 400 400 400

-40 -40 -40 +10 +60 +110 +160 +210 +260 +310 +360 +360 +360

3.2(e) Bear spreads - sell a call and buy another

There are times when you think the market is going to fall over the next two months. However in the event that the market does not fall, you would like to limit your downside. One way you could do this is by entering into a spread. A spread trading strategy involves taking a position in two or more options of the same type, that is, two or more calls or two or more puts. A spread that is designed to profit if the price goes down is called a bear spread. How does one go about doing this? This is
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basically done utilizing two call options having the same expiration date, but different exercise prices. How a bull is spread different from a bear spread? In a bear spread, the strike price of the option purchased is greater than the strike price of the option sold. The buyer of a bear spread buys a call with an exercise price above the current index level and sells a call option with an exercise price below the current index level. The spread is a bear spread because the trader hopes to profit from a fall in the index. The trade is a spread because it involves buying one option and selling a related option. What is the advantage of entering into a bear spread? Compared to buying the index itself, the bear spread with call options limits the trader's risk, but it also limits the profit potential. In short, it limits both the upside potential as well as the downside risk. A bear spread created using calls involves initial cash inflow since the price of the call sold is greater than the price of the call purchased. Table 4.4 gives the profit/loss incurred on a spread position as the index changes.

Figure 3.7 shows the payoff from the bear spread. Broadly we can have three types of bear spreads: 1. Both calls initially out-of-the-money. 2. One call initially in-the-money and one call initially out-of-the-money, and 3. Both calls initially in-the-money. The decision about which of the three spreads to undertake depends upon how much risk the investor is willing to take. The most aggressive bear spreads are of type 1. They cost very little to set up, but have a very small probability of giving a high payoff. As we move from type 1 to type 2 and from type 2 to type 3, the spreads become more conservative and cost higher to set up. Bear spreads can also be created by buying a put with a high strike price and selling a put with a low strike price.

Figure 3.8 Payoff for a bear spread created using call options The figure shows the profits/losses for a bear spread. As can be seen, the payoff obtained is the sum of the payoffs of the two calls, one sold at Rs. 150 and the other bought at Rs.50. The maximum gain from setting up the spread is Rs. 100 which is
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the difference between the call premium received and the call premium paid. The upside on the position is limited to this amount. As the index moves above 3800, the position starts making losses (cutting profits) until the spot reaches 4200. Beyond 4200, the profits made on the long call position get offset by the losses made on the short call position. The maximum loss on this spread is made if the index on the expiration day closes at 2350. At this point the loss made on the two call position together is Rs.400 i.e. (4200-3800). However the initial inflow on the spread being Rs.100, the net loss on the spread turns out to be 300. The downside on this spread position is limited to this amount. Hence the payoff on this spread lies between +100 to -300.

Table 3.4 Expiration day cash flows for a Bear spread using two-month calls

The table shows possible expiration day profit for a bear spread created by selling one market lot of calls at a strike of 3800 and buying a market lot of calls at a strike of 4200. The maximum profit obtained from setting up the spread is the difference between the premium received for the call sold (Rs. 150) and the premium paid for the call bought (Rs.50) which is Rs. 100. In this case the maximum loss obtained is limited to Rs.300. Beyond an index level of 4200, any profits made on the long call
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position will be canceled by losses made on the short call position, effectively limiting the profit on the combination

Nifty 3700 3750 3800 3850 3900 3950 4000 4050 4100 4150 4200 4250 4300

Buy Call

Jan

4200

Sell Call

Jan

3800

Cash Flow

Profit&Loss (Rs.)

0 0 0 0 0 0 0 0 0 0 0 +50 +100

0 0 0 -50 -100 -150 -200 -250 -300 -350 -400 -450 -500

0 0 0 -50 -100 -150 -200 -250 -300 -350 -400 -400 -400

+100 +100 +100 +50 0 -50 -100 -150 -200 -250 -300 -300 -300

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CHAPTER4

TRADING OF FUTURES AND OPTIONS

In this chapter we shall take a brief look at the trading system for NSE's futures and options market. However, the best way to get a feel of the trading system is to actually watch the screen and observe trading.

4.1 FUTURES AND OPTIONS TRADING SYSTEM

The futures & options trading system of NSE, called NEAT-F&O trading system, provides a fully automated screen-based trading for Index futures & options and Stock futures & options on a nationwide basis as well as an online monitoring and surveillance mechanism. It supports an order driven market and provides complete transparency of trading operations. It is similar to that of trading of equities in the cash market segment. The software for the F&O market has been developed to facilitate efficient and transparent trading in futures and options instruments. Keeping in view the familiarity of trading members with the current capital market trading system, modifications have been performed in the existing capital market trading system so as to make it suitable for trading futures and options.

4.1(A) ENTITIES IN THE TRADING SYSTEM

There are four entities in the trading system. Trading members, clearing members, professional clearing members and participants. 1. Trading members: Trading members are members of NSE. They can trade either on their own account or on behalf of their clients including participants. The exchange assigns a trading member ID to each trading member. Each trading member can have more than one user. The number of users allowed for each trading member is notified by the exchange from time to time. Each user of a trading member must be registered with the exchange and is assigned a unique user
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ID. The unique trading member ID functions as a reference for all orders/trades of different users. This ID is common for all users of a particular trading member. It is the responsibility of the trading member to maintain adequate control over persons having access to the firms User IDs.

2. Clearing members: Clearing members are members of NSCCL. They carry out risk management activities and confirmation/inquiry of trades through the trading system.

3. Professional clearing members: A professional clearing members is a clearing member who is not a trading member. Typically, banks and custodians become professional clearing members and clear and settle for their trading members.

4. Participants: A participant is a client of trading members like financial institutions. These clients may trade through multiple trading members but settle through a single clearing member.

4.1(B) BASIS OF TRADING

The NEAT F&O system supports an order driven market, wherein orders match automatically. Order matching is essentially on the basis of security, its price, time and quantity. All quantity fields are in units and price in rupees. The exchange notifies the regular lot size and tick size for each of the contracts traded on this segment from time to time. When any order enters the trading system, it is an active order. It tries to find a match on the other side of the book. If it finds a match, a trade is generated. If it does not find a match, the order becomes passive and goes and sits in the respective outstanding order book in the system.

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4.1(C) CORPORATE HIERARCHY In the F&O trading software, a trading member has the facility of defining a hierarchy amongst users of the system. This hierarchy comprises corporate manager, branch manager and dealer.

a. Corporate manager: The term 'Corporate manager' is assigned to a user placed at the highest level in a trading firm. Such a user can perform all the functions such as order and trade related activities, receiving reports for all branches of the trading member firm and also all dealers of the firm. Additionally, a corporate manager can define exposure limits for the branches of the firm. This facility is available only to the corporate manager.

b. Branch manager: The branch manager is a term assigned to a user who is placed under the corporate manager. Such a user can perform and view order and trade related activities for all dealers under that branch.

c. Dealer: Dealers are users at the lower most level of the hierarchy. A Dealer can perform view order and trade related activities only for oneself and does not have access to information on other dealers under either the same branch or other branches. Below given cases explain activities possible for specific user categories:

1) Clearing member corporate manager: He can view outstanding orders, previous trades and net position of his client trading members by putting the TM ID (Trading member identification) and leaving the Branch ID and Dealer ID blank.

2) Clearing member and trading member corporate manager: He can view:

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a. Outstanding orders, previous trades and net position of his client trading members by putting the TM ID and leaving the Branch ID and the Dealer ID blank. b. Outstanding orders, previous trades and net positions entered for himself by entering his own TM ID, Branch ID and User ID.This is his default screen. c. Outstanding orders, previous trades and net position entered for his branch by entering his TM ID and Branch ID fields. d. Outstanding orders, previous trades, and net positions entered for any of his users/dealers by entering his TM ID, Branch I and user ID fields.

3) Clearing member and trading member dealer: He can only view requests entered by him.

4) Trading member corporate manager: He can view: a. Outstanding requests and activity log for requests entered by him by entering his own Branch and User IDs. This is his default screen. b. Outstanding requests entered by his dealers and/or branch managers by either entering the Branch and/or User IDs or leaving them blank.

5) Trading member branch manager: He can view: a. Outstanding requests and activity log for requests entered by him by entering his own Branch and User IDs. This is his default screen. b. Outstanding requests entered by his users either by filling the User ID field with a specific user or leaving the User ID field blank.

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6) Trading member dealer: He can only view requests entered by him.

4.1(D) CLIENT BROKER RELATIONSHIP IN DERIVATIVE SEGMENT

A trading member must ensure compliance particularly with relation to the following while dealing with clients:

1. Filling of 'Know Your Client' form 2. Execution of Client Broker agreement 3. Bring risk factors to the knowledge of client by getting acknowledgement of client on risk disclosure document 4. Timely execution of orders as per the instruction of clients in respective client codes. 5. Collection of adequate margins from the client 6. Maintaining separate client bank account for the segregation of client money. 7. Timely issue of contract notes as per the prescribed format to the client 8. Ensuring timely pay-in and pay-out of funds to and from the clients 9. Resolving complaint of clients if any at the earliest. 10. Avoiding receipt and payment of cash and deal only through account payee cheques 11. Sending the periodical statement of accounts to clients 12. Not charging excess brokerage 13. Maintaining unique client code as per the regulations.

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4.2 CRITERIA FOR STOCKS AND INDEX ELIGIBILITY TRADING

FOR

4.2(a) Eligibility criteria of stocks The stock is chosen from amongst the top 500 stocks in terms of average daily market capitalization and average daily traded value in the previous six months on a rolling basis. The stock's median quarter-sigma order size over the last six months should be not less than Rs. 5 lakhs. For this purpose, a stock's quarter-sigma order size should mean the order size (in value terms) required to cause a change in the stock price equal to one-quarter of a standard deviation. The market wide position limit in the stock should not be less than Rs.100 crores. The market wide position limit (number of shares) is valued taking the closing prices of stocks in the underlying cash market on the date of expiry of contract in the month. The market wide position limit of open position (in terms of the number of underlying stock) on futures and option contracts on a particular underlying stock shall be 20% of the number of shares held by non promoters in the relevant underlying security i.e. freefloat holding.

For an existing F&O stock, the continued eligibility criteria is that market wide position limit in the stock shall not be less than Rs. 60 crores and stocks median quarter-sigma order size over the last six months shall be not less than Rs. 2 lakh. If an existing security fails to meet the eligibility criteria for three months consecutively, then no fresh month contract will be issued on that security. However, the existing unexpired contracts can be permitted to trade till expiry and new strikes can also be introduced in the existing contract months. Further, once the stock is excluded from the F&O list, it shall not be considered for re-inclusion for a period of one year.

Futures & Options contracts may be introduced on (new) securities which meet the above mentioned eligibility criteria, subject to approval by SEBI.
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4.2(b) Eligibility criteria of indices The exchange may consider introducing derivative contracts on an index if the stocks contributing to 80% weightage of the index are individually eligible for derivative trading. However, no single ineligible stocks in the index should have a weightage of more than 5% in the index. The above criteria is applied every month, if the index fails to meet the eligibility criteria for three months consecutively, then no fresh month contract would be issued on that index, However, the existing unexpired contacts will be permitted to trade till expiry and new strikes can also be introduced in the existing contracts.

4.2(c) Eligibility criteria of stocks for derivatives trading especially on account of corporate restructuring

The eligibility criteria for stocks for derivatives trading on account of corporate restructuring are as under:

a)

All the following conditions shall be met in the case of shares of a company undergoing restructuring through any means for eligibility to reintroduce derivative contracts on that company from the first day of listing of the post restructured company/(s) (as the case may be) stock (herein referred to as post restructured company) in the underlying market, the Futures and options contracts on the stock of the original (pre restructure) company were traded on any exchange prior to its restructuring;

b)

the pre restructured company had a market capitalization of at least Rs.1000 crores prior to its restructuring;

c)

the post restructured company would be treated like a new stock and if it is, in the opinion of the exchange, likely to be at least one-third the size of the pre restructuring company in terms of revenues, or assets, or (where appropriate) analyst valuations; and

d)

In the opinion of the exchange, the scheme of restructuring does not suggest that the post restructured company would have any characteristic

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(for example extremely low free float) that would render the company ineligible for derivatives trading.

II. If the above conditions are satisfied, then the exchange takes the following course of action in dealing with the existing derivative contracts on the prerestructured company and introduction of fresh contracts on the post restructured company. a) In the contract month in which the post restructured company begins to trade, the Exchange introduce near month, middle month and far month derivative contracts on the stock of the restructured company. b) In subsequent contract months, the normal rules for entry and exit of stocks in terms of eligibility requirements would apply. If these tests are not met, the exchange shall not permit further derivative contracts on this stock and future month series shall not be introduced.

4.3 CHARGES

The maximum brokerage chargeable by a trading member in relation to trades effected in the contracts admitted to dealing on the F&O segment o NSE is fixed at 2.5% of the contract value in case of index futures and stock futures. In case of index options and stock options it is 2.5% of notional value of the contract [(Strike Price + Premium) * Quantity)], exclusive of statutory levies. The transaction charges payable to the exchange by the trading member for the trades executed by him on the F&O segment are fixed at the rate of Rs. 2 per lakh of turnover (0.002%) subject to a minimum of Rs. 1,00,000 per year. However for the transactions in the options sub-segment the transaction charges are levied on the premium value at the rate of 0.05% (each side) instead of on the strike price as levied earlier. Further to this, trading members have been advised to charge brokerage from their clients on the Premium price (traded price) rather than Strike price. The trading members contribute to Investor Protection Fund of F&O segment at the rate of Re. 1/- per Rs.100 crores of the traded value (each side).

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CHAPTER 5 CLEARANCE AND SETTLEMENT OF FUTURES & MECHANISM

National Securities Clearing Corporation Limited (NSCCL) undertakes clearing and settlement of all trades executed on the futures and options (F&O) segment of the NSE. It also acts as legal counterparty to all trades on the F&O segment and guarantees their financial settlement.

5.1 CLEARING ENTITIES

Clearing and settlement activities in the F&O segment are undertaken by NSCCL with the help of the following entities:

5.1(a) clearing members In the F&O segment, some members, called self clearing members, clear and settle their trades executed by them only either on their own account or on account of their clients. Some others called trading member-cum-clearing member, clear and settle their own trades as well as trades of other trading members (TMs). Besides, there is a special category of members; called professional clearing members (PCM) who clear and settle trades executed b TMs. The members clearing their own trades and trades of others, and the PCMs are required to bring in additional security deposits in respect of every TM whose trades they undertake to clear and settle.

5.1(b) clearing banks Funds settlement takes place through clearing banks. For the purpose of settlement all clearing members are required to open a separate bank account with NSCCL designated clearing bank for F&O segment. The Clearing and Settlement process comprises of the following three main activities:
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1) Clearing 2) Settlement 3) Risk Management

Table 5.1

Proprietary position of trading member Madanbhai on Day 1

Trading member Madanbhai trades in the futures and options segment for himself and two of his clients.The table shows his proprietary position. Note: A buy position '200@ 1000"means 200 units bought atthe rate of Rs. 1000.

Trading member Madanbhai

Buy

Sell

Proprietary position

200@1000

400@1010

Table 5.2

Client position of trading member Madanbhai on Day 1

Trading member Madanbhai trades in the futures and options segment for himself and two of his clients.The table shows his client position. Trading member Madanbhai

Client position Client

Buy Open A400@1109

Sell Close 200@1000

Sell Open

Buy Close

Client B

600@1100

200@1099

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5.2 CLEARING MECHANISM

The clearing mechanism essentially involves working out open positions and obligations of clearing (self-clearing/trading-cum-clearing/professional clearing) members. This position is considered for exposure and daily margin purposes. The open positions of CMs are arrived at by aggregating the open positions of all the TMs and all custodial participants clearing through him, in contracts in which they have traded. A TM's open position is arrived at as the summation of his proprietary open position and clients' open positions, in the contracts in which he has traded. Whether proprietary (if they are their own trades) or client (if entered on behalf of clients) through 'Pro/Cli' indicator provided in the order entry screen. Proprietary positions are calculated on net basis (buy - sell) for each contract. Clients' positions are arrived at by summing together net (buy - sell) positions of each individual client. A TM's open position is the sum of proprietary open position, client open long position and client open short position. Consider the following example given from Table 6.1 to Table 6.4. The proprietary open position on day 1 is simply = Buy - Sell = 200 - 400 = 200 short. The open position for client A = Buy (O) Sell (C) = 400 - 200 = 200 long, i.e. he has a long position of 200 units. The open position for Client B = Sell (O) Buy (C) = 600 - 200 = 400 short, i.e. he has a short position of 400 units. Now the total open position of the trading member Madanbhai at end of day 1 is 200(his proprietary open position on net basis) plus 600 (the Client open positions on gross basis), i.e. 800. The proprietary open position at end of day 1 is 200 short. The end of day open position for proprietary trades undertaken on day 2 is 200 short. Hence the net open proprietary position at the end of day 2 is 400 short. Similarly, Client A's open position at the end of day 1 is 200 long. The end of day open position for trades done by Client A on day 2 is 200 long. Hence the net open position for Client A at the end of day 2 is 400 long. Client B's open position at the end of day 1 is 400 short. The end of day open position for trades done by Client B on day 2 is 200 short. Hence the net open position for Client B at the end of day 2 is 600 short. The net open position for the trading member at the end of day 2 is sum of the proprietary open position and client open positions. It works out to be 400 + 400 + 600, i.e. 1400. The following table illustrates determination of open position of a CM, who clears for two TMs having two client
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Table 5.1 Proprietary position of trading member Madanbhai on Day 2

Assume that the position on Day 1 is carried forward to the next trading day and the followingtrades are also executed. Trading member Madanbhai

Buy

Sell

Proprietary position

200@1000

400@1010

Table 5.2 Client position of trading member Madanbhai on Day 2

Trading member Madanbhai trades in the futures and options segment for himself and two of his clients. The table shows his client position on Day 2.Trading member Madanbhai

Client position

Buy Open

Sell Close

Sell Open

Buy Close

Client

A400@1109

200@1000

Client B

600@1100

200@1099

5.3 SETTLEMENT MECHANISM

All futures and options contracts are cash settled, i.e. through exchange of cash. The underlying for index futures/options of the Nifty index cannot be delivered. These contracts, therefore, have to be settled in cash. Futures and options on individual securities can be delivered as in the spot market. However, it has been currently mandated that stock options and futures would also be cash settled. The settlement amount for a CM is netted across all their TMs/clients, with respect to their obligations on MTM, premium and exercise settlement.
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5.3(a) Settlement of futures contracts Futures contracts have two types of settlements, the MTM settlement which happens on a continuous basis at the end of each day, and the final settlement which happens on the last trading day of the futures contract.

MTM settlement: All futures contracts for each member are marked-to-market (MTM) to the daily settlement price of the relevant futures contract at the end of each day. The profits/losses are computed as the difference between:

The trade price and the day's settlement price for contracts executed during the day but not squared up. The previous day's settlement price and the current day's settlement price for brought forward contracts. The buy price and the sell price for contracts executed during the day and squared up.

Table 5.3 Computation of MTM at the end of the day

The table gives the MTM charged on various positions. The margin charged on the brought forward contract is the difference between the previous day's settlement price of Rs.100 and today's settlement price of Rs.105. Hence on account of the position brought forward, the MTM shows a profit of Rs.500. For contracts executed during the day, the difference between the buy price and the sell price determines the MTM. In this example, 200 units are bought @ Rs. 100 and 100 units sold @ Rs. 102 during the day. Hence the MTM for the position closed during the day shows a profit of Rs.200. Finally, the open position of contracts traded during the day, is margined at the day's settlement price and the profit of Rs.500 credited to the MTM account. So the MTM account shows a profit of Rs. 1200.
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Trade details

Quantity bought/sold

Settlement price 105

MTM

Brought from

forward 100@100

500

previous day Traded during day Bought Sold Open position (not squared up) Total 1200 100@100 105 500 200@100 100@102 102 200

Final settlement for futures On the expiry day of the futures contracts, after the close of trading hours, NSCCL marks all positions of a CM to the final settlement price and the resulting profit/loss is settled in cash. Final settlement loss/profit amount is debited/ credited to the relevant CM's clearing bank account on the day following expiry day of the contract.

Settlement prices for futures Daily settlement price on a trading day is the closing price of the respective futures contracts on such day. The closing price for a futures contract is currently calculated as the last half an hour weighted average price of the contract in the F&O Segment of NSE. Final settlement price is the closing price of the relevant underlying index/security in the capital market segment of NSE, on the last trading day of the
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contract. The closing price of the underlying Index/security is currently its last half an hour weighted average value in the capital market segment of NSE.

5.3(B) SETTLEMENT OF OPTIONS CONTRACTS Options contracts have three types of settlements, daily premium settlement, exercise settlement, interim exercise settlement in the case of option contracts on securities and final settlement.

Daily premium settlement Buyer of an option is obligated to pay the premium towards the options purchased by him. Similarly, the seller of an option is entitled to receive the premium for the option sold by him. The premium payable amount and the premium receivable amount are netted to compute the net premium payable or receivable amount for each client for each option contract.

Exercise settlement Although most option buyers and sellers close out their options positions by an offsetting closing transaction, an understanding of exercise can help an option buyer determine whether exercise might be more advantageous than an offsetting sale of the option. There is always a possibility of the option seller being assigned an exercise. Once an exercise of an option has been assigned to an option seller, the option seller is bound to fulfill his obligation (meaning, pay the cash settlement amount in the case of a cash-settled option) even though he may not yet have been notified of the assignment.

Interim exercise settlement Interim exercise settlement takes place only for option contracts on securities. An investor can exercise his in-the-money options at any time during trading hours, such options at the close of the trading hours, on the day of exercise. Valid exercised option contracts are assigned to short positions in the option contract with the same series (i.e. having the same underlying, same expiry date and same strike price), on a
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random basis, at the client level. The CM who has exercised the option receives the exercise settlement value per unit of the option from the CM who has been assigned the option contract. Final exercise settlement Final exercise settlement is effected for all open long in-the-money strike price options existing at the close of trading hours, on the expiration day of an option contract. All such long positions are exercised and automatically assigned to short positions in option contracts with the same series, on a random basis.The investor who has long in-the-money options on the expiry date will receive the exercise settlement value per unit of the option from the investor who has been assigned the option contract.

Exercise process The period during which an option is exercisable depends on the style of the option. On NSE, index options are European style, i.e. options are only subject to automatic exercise on the expiration day, if they are in-the-money. As compared to this, options on securities are American style. In such cases, the exercise is automatic on the expiration day, and voluntary prior to the expiration day of the option contract, provided they are in-the-money. Automatic exercise means that all in-the-money options would be exercised by NSCCL on the expiration day of the contract. The buyer of such options need not give an exercise notice in such cases. Voluntary exercise means that the buyer of an in-the-money option can direct his TM/CM to give exercise instructions to NSCCL. In order to ensure that an option is exercised on a particular day, the buyer must direct his TM to exercise before the cut-off time for accepting exercise instructions for that day. Usually, the exercise orders will be accepted by the system till the close of trading hours. Different TMs may have different cut -off times for accepting exercise instructions from customers, which may vary for different options. An option, which expires unexercised, becomes worthless. Some TMs may accept standing instructions to exercise, or have procedures for the exercise of every option, which is in the- money at expiration. Once an exercise instruction is given by a CM to NSCCL, it cannot ordinarily be revoked. Exercise notices given by a buyer at
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anytime on a day are processed by NSCCL after the close of trading hours on that day. All exercise notices received by NSCCL from the NEAT F&O system are processed to determine their validity. Some basic validation checks are carried out to check the open buy position of the exercising client/TM and if option contract is in-the-money. Once exercised contracts are found valid, they are assigned.

Assignment process The exercise notices are assigned in standardized market lots to short positions in the option contract with the same series (i.e. same underlying, expiry date and strike price) at the client level. Assignment to the short positions is done on a random basis. NSCCL determines short positions, which are eligible to be assigned and then allocates the exercised positions to any one or more short positions. Assignments are made at the end of the trading day on which exercise instruction is received by NSCCL and notified to the members on the same day. It is possible that an option seller may not receive notification from its TM that an exercise has been assigned to him until the next day following the date of the assignment to the CM by NSCCL.

Exercise settlement computation In case of index option contracts, all open long positions at in-the-money strike prices are automatically exercised on the expiration day and assigned to short positions in option contracts with the same series on a random basis. For options on securities, where exercise settlement may be interim or final, interim exercise for an open long in-the-money option position can be effected on any day till the expiry of the contract. Final exercise is automatically effected by NSCCL for all open long inthe-money positions in the expiring month option contract, on the expiry day of the option contract. The exercise settlement price is the closing price of the underlying (index or security) on the exercise day (for interim exercise) or the expiry day of the relevant option contract (final exercise). The exercise settlement value is the difference between the strike price and the final settlement price of the relevant option contract. For call options, the exercise settlement value receivable by a buyer is the difference between the final settlement price and the strike price for each unit
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of the underlying conveyed by the option contract, while for put options it is difference between the strike price and the final settlement price for each unit of the underlying conveyed by the option contract. Settlement of exercises of options on securities is currently by payment in cash and not by delivery of securities. It takes place for in-the-money option contracts. The exercise settlement value for each unit of the exercised contract is computed as follows: Call options = Closing price of the security on the day of exercise Strike price Put options = Strike price Closing price of the security on the day of exercise For final exercise the closing price of the underlying security is taken on the expiration day. The exercise settlement value is debited / credited to the relevant CMs clearing bank account on T + 1 day (T = exercise date).

Special facility for settlement of institutional deals NSCCL provides a special facility to Institutions/Foreign Institutional Investors (FIIs)/Mutual Funds etc. to execute trades through any TM, which may be cleared and settled by their own CM. Such entities are called custodial participants (CPs).To avail of this facility; a CP is required to register with NSCCL through his CM. A unique CP code is allotted to the CP by NSCCL. All trades executed by a CP through any TM are required to have the CP code in the relevant field on the trading system at the time of order entry. Such trades executed on behalf of a CP are confirmed by their own CM (and not the CM of the TM through whom the order is entered), within the time specified by NSE on the trade day though the on-line confirmation facility. Till such time the trade is confirmed by CM of concerned CP, the same is considered as a trade of the TM and the responsibility of settlement of such trade vests with CM of the TM. Once confirmed by CM of concerned CP, such CM is responsible for clearing and settlement of deals of such custodial clients. FIIs have been permitted to trade in all the exchange traded derivative contracts subject to compliance of the position limits prescribed for them and their subaccounts, and compliance with the prescribed procedure for settlement and reporting. A FII/a subaccount of the FII, as the case may be, intending to trade in the F&O segment of the exchange, is required to obtain a unique Custodial Participant (CP) code allotted from the NSCCL. FII/sub-accounts of FIIs which have been allotted a unique CP
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code by NSCCL are only permitted to trade on the F&O segment. The FD/subaccount of FII ensures that all orders placed by them on the Exchange carry the relevant CP code allotted by NSCCL.

5.4 ADJUSTMENTS FOR CORPORATE ACTIONS

The basis for any adjustment for corporate actions is such that the value of the position of the market participants, on the cum and ex-dates for the corporate action, continues to remain the same as far as possible. This facilitates in retaining the relative status of positions, namely in-the-money, at-the-money and out-of-money. This also addresses issues related to exercise and assignments. Corporate actions can be broadly classified under stock benefits and cash benefits. The various stock benefits declared by the issuer of capital are bonus, rights, merger/de- merger, amalgamation, splits, consolidations, hiveoff, warrants and secured premium notes (SPNs) among others. The cash benefit declared by the issuer of capital is cash dividend. Any adjustment for corporate actions is carried out on the last day on which a security is traded on a cum basis in the underlying equities market, after the close of trading hours. Adjustments may entail modifications to positions and/or contract specifications as listed below, such that the basic premise of adjustment laid down above is satisfied: 1. Strike price 2. Position 3. Market lot/multiplier The adjustments are carried out on any or all of the above, based on the nature of the corporate action. The adjustments for corporate actions are carried out on all open, exercised as well as assigned positions.

5.5 RISK MANAGEMENT NSCCL has developed a comprehensive risk containment mechanism for theF&O segment. The salient features of risk containment mechanism on theF&O segment are:
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a) The financial soundness of the members is the key to risk management. Therefore, the requirements for membership in terms of capital adequacy (net worth, security deposits) are quite stringent. b) NSCCL charges an upfront initial margin for all the open positions of a CM. It specifies the initial margin requirements for each futures/options contract on a daily basis. It also follows value-at-risk (VaR) based margining through SPAN. The CM in turn collects the initial margin from the TMs and their respective clients. c) The open positions of the members are marked to market based on contract settlement price for each contract. The difference is settled in cash on a T+1 basis. d) NSCCL's on-line position monitoring system monitors a CM's open positions on a real-time basis. Limits are set for each CM based on his capital deposits. The on-line position monitoring system generates alerts whenever a CM reaches a position limit set up by NSCCL. NSCCL monitors the CMs for MTM value violation, while TMs are monitored for contractwise position limit violation. e) CMs are provided a trading terminal for the purpose of monitoring the open positions of all the TMs clearing and settling through him. A CM may set exposure limits for a TM clearing and settling through him. NSCCL assists the CM to monitor the intra-day exposure limits set up by a CM and whenever a TM exceeds the limits, it stops that particular TM from further trading. f) A member is alerted of his position to enable him to adjust his exposure orbring in additional capital. Position violations result in withdrawal of trading facility for all TMs of a CM in case of a violation by the CM. g) A separate settlement guarantee fund for this segment has been created out of the capital of members. The most critical component of risk containment mechanism for F&O segment is the margining system and on-line position monitoring. The actual position monitoring and margining is carried out online through Parallel Risk Management System (PRISM). PRISM uses SPAN(r) (Standard Portfolio Analysis of Risk) system for the purpose of computation of on-line margins, based on the parameters defined by SEBI.

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CHAPTER6 COMMODITY DERIVATIVES TRADING IN INDIA

6.1 INTRODUCTION 6.1(a) Derivatives Markets

Derivatives markets can broadly be classified as commodity derivatives market and financial derivatives markets. As the name suggest, commodity derivatives markets trade contracts are those for which the underlying asset is a commodity. It can be an agricultural commodity like wheat, soybeans, rapeseed, cotton, etc or precious metals like gold, silver, etc. or energy products like crude oil, natural gas, coal, electricity etc. Financial derivatives markets trade contracts have a financial asset or variable as the underlying. The more popular financial derivatives are those which have equity, interest rates and exchange rates as the underlying. The most commonly used derivatives contracts are forwards, futures and options which we shall discuss in detail later. Spot versus Forward Transaction Every transaction has three components - trading, clearing and settlement. A buyer and seller come together, negotiate and arrive at a price. This is trading. Clearing involves finding out the net outstanding, that is exactly how much of goods and money the two should exchange. For instance, A buys goods worth Rs.100 from B and sells goods worth Rs. 50 to B. On a net basis, A has to pay Rs. 50 to B. Settlement is the actual process of exchanging money and goods. Using the example of a forward contract, let us try to understand the difference between a spot and derivatives contract. In spot transaction 20 grams of gold that Aditya wants to buy and Aditya leaves. A month later, he pays the goldsmith Rs. 34,200 and collects his gold. This is a forward contract, a contract by which two parties irrevocably agree to settle a trade at a future date, for a stated price and quantity. No money changes hands when the contract is signed. The exchange of money and the underlying goods only happens at the future date as specified in the contract. In a forward contract, the process of trading, clearing and settlement does not happen instantaneously. The trading happens today, but the clearing and settlement happens at the end of the specified period.
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A forward contract is the most basic derivative contract. We call it a derivative because it derives value from the price of the asset underlying the contract, in this case- gold. If on the 1st of February, gold trades for Rs. 17,200 per 10 grams in the spot market, the contract becomes more valuable to Aditya because it now enables him to buy gold at Rs.17,100 per 10 grams. If however, the price of gold drops down to Rs. 16,900 per 10 grams he is worse off because as per the terms of the contract, he is bound to pay Rs. 17,100 per 10 grams for the same gold. The contract has now lost value from Aditya's point of view. Note that the value of the forward contract to the goldsmith varies exactly in an opposite manner to its value for Aditya. Exchange Traded Versus OTC Derivatives Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century and may well have been around before then. These contracts were typically OTC kind of contracts. Over the counter (OTC) derivatives are privately negotiated contracts. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for prearranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest.

HISTORY OF COMMODITY DERIVATIVES MARKETS

Early forward contracts in the US addressed merchants' concerns about ensuring that there were buyers and sellers for commodities. However, 'credit risk' remained a serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first 'exchange traded' derivatives contract in the US, these contracts were called 'futures contracts'. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and CME remain the two largest organized futures
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exchanges, indeed the two largest 'financial' exchanges of any kind in the world today. The first stock index futures contract was traded at Kansas City Board of Trade. Currently, the most popular stock index futures in the world are based on S&P 500 index traded on Chicago Mercantile Exchange. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in Europe, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc. Later many of these contracts were standardized in terms of quantity and delivery dates and began to trade on an exchange. The OTC derivatives markets have the following features compared to exchange-traded derivatives: 1. The management of counter-party (credit) risk is decentralized and located within individual institutions. 2. There are no formal centralized limits on individual positions, leverage, or margining. 3. There are no formal rules for risk and burden-sharing. 4. There are no formal rules or mechanisms for ensuring market stability integrity, and for safeguarding the collective interests of market participants. 5. The OTC contracts are generally not regulated by a regulatory authority and the exchange's self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance. The derivatives markets have witnessed rather sharp growth over the last few years, which have accompanied the modernization of commercial and investment banking and globalization of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter. The largest OTC derivative market is the inter-bank foreign exchange market.Commodity derivatives, the world over are typically exchange-traded and not OTC in nature.

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6.1 (B) DIFFERENCE BETWEEN COMMODITY AND FINANCIAL DERIVATIVES

The basic concept of a derivative contract remains the same whether the underlying happens to be a commodity or a financial asset. However, there are some features which are very peculiar to commodity derivative markets. In the case of financial derivatives, most of these contracts are cash settled. Since financial assets are not bulky, they do not need special facility for storage even in case of physical settlement. On the other hand, due to the bulky nature of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Similarly, the concept of varying quality of asset does not really exist as far as financial underlyings are concerned. However, in the case of commodities, the quality of the asset underlying a contract can vary largely. This becomes an important issue to be managed. We have a brief look at these issues.

Physical Settlement Physical settlement involves the physical delivery of the underlying commodity, typically at an accredited warehouse. The seller intending to make delivery would have to take the commodities to the designated warehouse and the buyer intending to take delivery would have to go to the designated warehouse and pick up the commodity. This may sound simple, but the physical settlement of commodities is a complex process. The issues faced in physical settlement are enormous. There are limits on storage facilities in different states. There are restrictions on interstate movement of commodities. Besides state level octroi and duties have an impact on the cost of movement of goods across locations.

The process of taking physical delivery in commodities is quite different from the process of taking physical delivery in financial assets we take a general overview at the process flow of physical settlement of commodities.

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Delivery notice period Unlike in the case of equity futures, typically a seller of commodity futures has the option to give notice of delivery. This option is given during a period identified as `delivery notice period'.

Assignment Whenever delivery notices are given by the seller, the clearing house of the Exchange identifies the buyer to whom this notice may be assigned. Exchanges follow different practices for the assignment process.

Delivery The procedure for buyer and seller regarding the physical settlement for different types of contracts is clearly specified by the Exchange. The period available for the buyer to take physical delivery is stipulated by the Exchange. Buyer or his authorized representative in the presence of seller or his representative takes the physical stocks against the delivery order. Proof of physical delivery having been effected is forwarded by the seller to the clearing house and the invoice amount is credited to the seller's account. The clearing house decides on the delivery order rate at which delivery will be settled. Delivery rate depends on the spot rate of the underlying adjusted for discount/ premium for quality and freight costs. The discount/ premium for quality and freight costs are published by the clearing house before introduction of the contract. The most active spot market is normally taken as the benchmark for deciding spot prices. Warehousing One of the main differences between financial and commodity derivative is the need for warehousing. In case of most exchange-traded financial derivatives, all the positions are cash settled. Cash settlement involves paying up the difference in prices between the time the contract was entered into and the time the contract was closed. For instance, if a trader buys futures on a stock at Rs.100 and on the day of expiration, the futures on that stock close at Rs.120, he does not really have to buy the underlying stock. All he does is take the difference of Rs.20 in cash. Similarly, the person who sold this futures contract at Rs.100 does not have to deliver the underlying stock. All he has to do is pay up the loss of Rs.20 in cash. In case of
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commodity derivatives however, there is a possibility of physical settlement. It means that if the seller chooses to hand over the commodity instead of the difference in cash, the buyer must take physical delivery of the underlying asset. This requires the Exchange to make an arrangement with warehouses to handle the settlements. The efficacy of the commodities settlements depends on the warehousing system available. Such warehouses have to perform the following functions: Earmark separate storage areas as specified by the Exchange for storing commodities; Ensure proper grading of commodities before they are stored; Store commodities according to their grade specifications and validity period; and Ensure that necessary steps and precautions are taken to ensure that the quantity and grade of commodity, as certified in the warehouse receipt, are maintained during the storage period. This receipt can also be used as collateral for financing. In India, NCDEX has accredited over 775 delivery centers which meet the requirements for the physical holding of goods that are to be delivered on the platform. As future trading is delivery based, it is necessary to create the logistics support for the same. Quality of Underlying Assets A derivatives contract is written on a given underlying. Variance in quality is not an issue in case of financial derivatives as the physical attribute is missing. When the underlying asset is a commodity, the quality of the underlying asset is of prime importance. There may be quite some variation in the quality of what is available in the marketplace. When the asset is specified, it is therefore important that the Exchange stipulate the grade or grades of the commodity that are acceptable. Commodity derivatives demand good standards and quality assurance/ certification procedures. A good grading system allows commodities to be traded by specification. Trading in commodity derivatives also requires quality assurance and certifications from specialized agencies. In India, for example, the Bureau of Indian Standards (BIS) under the Department of Consumer Affairs specifies standards for processed agricultural commodities. AGMARK, another certifying body under the Department of Agriculture and Cooperation, specifies standards for basic agricultural commodities.

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6.1(c) Commodity Derivatives Derivatives as a tool for managing risk first originated in the commodities markets. They were then found useful as a hedging tool in financial markets as well. In India, trading in commodity futures has been in existence from the nineteenth century with organized trading in cotton through the establishment of Cotton Trade Association in 1875. Over a period of time, other commodities were permitted to be traded in futures exchanges. Regulatory constraints in 1960s resulted in virtual dismantling of the commodity futures market. It is only in the last decade that commodity futures exchanges have been actively encouraged. In the commodity futures market, the quinquennium after the set up of national level exchanges witnessed exponential growth in trading with the turnover increasing from 5.71 lakh crores in 2004-05 to 52.48 lakh crores in 2008-09. However, the markets have not grown to significant levels as compared to developed countries. In this chapter, we take a brief look at the global commodity markets and the commodity markets that exist in India. Evolution of Commodity Exchanges Most of the commodity exchanges, which exist today, have their origin in the late 19th and earlier 20th century. The first central exchange was established in 1848 in Chicago under the name Chicago Board of Trade. The emergence of the derivatives markets as the effective risk management tools in 1970s and 1980s has resulted in the rapid creation of new commodity exchanges and expansion of the existing ones. At present, there are major commodity exchanges all over the world dealing in different types of commodities. Commodity Exchange Commodity exchanges are defined as centers where futures trade is organized in a wider sense; it is taken to include any organized market place where trade is routed through one mechanism, allowing effective competition among buyers and among sellers. This would include auction-type exchanges, but not wholesale markets, where trade is localized, but effectively takes place through many non-related individual transactions between different permutations of buyers and sellers.

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 Role of Commodity Exchanges Commodity exchanges provide platforms to suit the varied requirements of customers. Firstly, they help in price discovery as players get to set future prices which are also made available to all participants. Hence, a farmer in the southern part of India would be able to know the best price prevailing in the country which would enable him to take informed decisions. For this to happen, the concept of commodity exchanges must percolate down to the villages. Today the farmers base their choice for next year's crop on current year's price. Ideally this decision ought to be based on next year's expected price. Futures prices on the platforms of commodity exchanges will hopefully move farmers of our country from the current 'cobweb' effect where additional acreage comes under cultivation in the year subsequent to one when a commodity had good prices; consequently the next year the commodity price actually falls due to oversupply. Secondly, these exchanges enable actual users (farmers, agro processors, industry where the predominant cost is commodity input/output cost) to hedge their price risk given the uncertainty of the future - especially in agriculture where there is uncertainty regarding the monsoon and hence prices. This holds good also for nonagro products like metals or energy products as well where global forces could exert considerable influence. Purchasers are also assured of a fixed price which is determined in advance, thereby avoiding surprises to them. It must be borne in mind that commodity prices in India have always been woven firmly into the international fabric. Today, price fluctuations in all major commodities in the country mirror both national and international factors and not merely national factors. Thirdly, by involving the group of investors and speculators, commodity exchanges provide liquidity and buoyancy to the system. Lastly, the arbitrageurs play an important role in balancing the market as arbitrage conditions, where they exist, are ironed out as arbitrageurs trade with opposite positions on different platforms and hence generate opposing demand and supply forces which ultimately narrows down the gaps in prices. It must be pointed out that while the monsoon conditions affect the prices of agrobased commodities, the phenomenon of globalization has made prices of other products such as metals, energy products, etc., vulnerable to changes in global politics, policies, growth paradigms, etc. This would be strengthened as the world moves closer to the resolution of the WTO impasse, which would become a reality
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shortly. Commodity exchanges would provide a valuable hedge through the price discovery process while catering to the different kind of players in the market.

6.1(d) Commodity Derivative Markets in India Commodity futures markets have a long history in India. Cotton was the first commodity to attract futures trading in the country leading to the setting up of the Bombay Cotton Trade Association Ltd in 1875. The Bombay Cotton Exchange Ltd. was established in 1893 following the widespread discontent amongst leading cotton mill owners and merchants over the functioning of Bombay Cotton Trade Association. Subsequently, many exchanges came up in different parts of the country for futures trading in various commodities. Futures trading in oilseeds started in 1900 with the establishment of the Gujarati Vyapari Mandali, which carried on futures trade in groundnut, castor seed and cotton. Before the Second World War broke out in 1939, several futures markets in oilseeds were functioning in Gujarat and Punjab. Futures trading in wheat existed at several places in Punjab and Uttar Pradesh, the most notable of which was the Chamber of Commerce at Hapur, which began futures trading in wheat in 1913 and served as the price setter in that commodity till the outbreak of the Second World War in 1939. Futures trading in bullion began in Mumbai in 1920 and subsequently markets came up in other centres like Rajkot, Jaipur, Jamnagar, Kanpur, Delhi and Kolkata. Calcutta Hessian Exchange Ltd. was established in 1919 for futures trading in raw jute and jute goods. But organized futures trading in raw jute began only in 1927 with the establishment of East Indian Jute Association Ltd. These two associations amalgamated in 1945 to form the East India Jute & Hessian Ltd. to conduct organized trading in both raw jute and jute goods. In due course several other exchanges were also created in the country to trade in such diverse commodities as pepper, turmeric, potato, sugar and gur (jaggery). After independence, with the subject of `Stock Exchanges and futures markets' being brought under the Union list, responsibility for regulation of commodity futures markets devolved on Govt. of India. A Bill on forward contracts was referred to an expert committee headed by Prof. A. D. Shroff and select committees of two successive Parliaments and finally in December 1952 Forward Contracts (Regulation) Act, 1952, was enacted.
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The Act provided for 3-tier regulatory system: (a) An association recognized by the Government of India on the recommendation of Forward Markets Commission, (b) The Forward Markets Commission (it was set up in September 1953) and (c) The Central Government. Forward Contracts (Regulation) Rules were notified by the Central Government in July, 1954. According to FC(R) Act, commodities are divided into 3 categories with reference to extent of regulation, viz: Commodities in which futures trading can be organized under the auspices of recognized association. Commodities in which futures trading is prohibited. Commodities which have neither been regulated nor prohibited for being traded under the recognized association are referred as Free Commodities and the association organized in such free commodities is required to obtain the Certificate of Registration from the Forward Markets Commission. India was in an era of physical controls since independence and the pursuance of a mixed economy set up with socialist proclivities had ramifications on the operations of commodity markets and commodity exchanges. Government intervention was in the form of buffer stock operations, administered prices, regulation on trade and input prices, restrictions on movement of goods, etc. Agricultural commodities were associated with the poor and were governed by polices such as Minimum Price Support and Government Procurement. Further, as production levels were low and had not stabilized, there was the constant fear of misuse of these platforms which could be manipulated to fix prices by creating artificial scarcities. This was also a period which was associated with wars, natural calamities and disasters which invariably led to shortages and price distortions. Hence, in an era of uncertainty with potential volatility, the government banned futures trading in commodities in the 1960s. The Khusro Committee which was constituted in June 1980 had recommended reintroduction of futures trading in most of the major commodities, including cotton, kapas, raw jute and jute goods and suggested that steps may be taken for introducing futures trading in commodities, like potatoes, onions, etc. at appropriate time. The government, accordingly initiated futures trading in Potato during the latter half of 1980 in quite a few markets in Punjab and Uttar Pradesh.
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With the gradual trade and industry liberalization of the Indian economy pursuant to the adoption of the economic reform package in 1991, GOI constituted another committee on Forward Markets under the chairmanship of Prof. K.N. Kabra. The Committee which submitted its report in September 1994 recommended that futures trading be introduced in the following commodities: Basmati Rice Cotton, Kapas, Raw Jute and Jute Goods Groundnut, rapeseed/mustard seed, cottonseed, sesame seed, sunflower seed, safflower seed, copra and soybean and oils and oilcakes Rice bran oil Castor oil and its oilcake Linseed Silver Onions The committee also recommended that some of the existing commodity exchanges particularly the ones in pepper and castor seed, may be upgraded to the level of international futures markets. Futures Trading The Government of India had appointed a committee under the chairmanship of Prof. Abhijit Sen, Member, Planning Commission to study the impact of futures trading, if any, on agricultural commodity prices. The Committee was appointed on March 2, 2007 and submitted its report on April 29, 2008. The main findings and recommendations of the committee are: negative sentiments have been created by the decision to delist futures trades in some important agricultural commodities; the period during which futures trading has been in operation is too short to discriminate adequately between the effect of opening of futures markets, if any, and what might simply be the normal cyclical adjustments in prices; Indian data analyzed does not show any clear evidence of either reduced or increased volatility; the vibrant agriculture markets including derivatives markets are the frontline institutions to provide early signs of future prospects of the sector. The committee recommended for upgradation of regulation by passing of the proposed amendment to FC(R) Act 1952 and removal of infirmities in the spot market (Economic Survey, 2009-10). The "Study on Impact of Futures Trading in Wheat, Sugar, Pulses and Guar Seeds
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on Farmers" was commissioned by the Forward Markets Commission and undertaken by the Indian Institute of Management, Bangalore. While the study was primarily intended to find out how futures trading is helping major stakeholders in the value chain of these commodities; it also dealt with the impact of futures trading on the prices of these commodities. The study did not find any visible link between futures trading and price movement and suggested that the main reason for price changes seemed to be changes in the fundamentals (mainly on the Supply side) of these commodities, Price changes were also attributed to changes in government policies. Indian Commodity Exchanges There are more than 20 recognized commodity futures exchanges in India under the purview of the Forward Markets Commission (FMC). The country's commodity futures exchanges are divided majorly into two categories: National exchanges Regional exchanges

The four exchanges operating at the national level (as on 1st January 2010) are: i) National Commodity and Derivatives Exchange of India Ltd. (NCDEX) ii) National Multi Commodity Exchange of India Ltd. (NMCE) iii) Multi Commodity Exchange of India Ltd. (MCX) iv) Indian Commodity Exchange Ltd. (ICEX) which started trading operations on November 27, 2009 The leading regional exchange is the National Board of Trade (NBOT) located at Indore. There are more than 15 regional commodity exchanges in India.

6.2 USING COMMODITY FUTURES

For a market to succeed, it must have all three kinds of participants - hedgers, speculators and arbitragers. The confluence of these participants ensures liquidity and efficient price discovery in the market. Commodity markets give opportunity for all three kinds of participants. In this chapter, we look at the use of commodity derivatives for hedging, speculation and arbitrage.
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6.2(a) Hedging Many participants in the commodity futures market are hedgers. They use the futures market to reduce a particular risk that they face. This risk might relate to the price of wheat or oil or any other commodity that the person deals in. The classic hedging example is that of wheat farmer who wants to hedge the risk of fluctuations in the price of wheat around the time that his crop is ready for harvesting. By selling his crop forward, he obtains a hedge by locking in to a predetermined price. Hedging does not necessarily improve the financial outcome; What it does however is, that it makes the outcome more certain. Hedgers could be government institutions, private corporations like financial institutions, trading companies and even other participants in the value chain, for instance farmers, extractors, millers, processors etc., who are influenced by the commodity prices. Basic Principles of Hedging When an individual or a company decides to use the futures markets to hedge a risk, the objective is to take a position that neutralizes the risk as much as possible. Take the case of a company that knows that it will gain Rs.1,00,000 for each 1 rupee increase in the price of a commodity over the next three months and will lose Rs.1,00,000 for each 1 rupee decrease in the price of a commodity over the same period. To hedge, the company should take a short futures position that is designed to offset this risk. The futures position should lead to a loss of Rs.1,00,000 for each 1 rupee increase in the price of the commodity over the next three months and a gain of Rs.1,00,000 for each 1 rupee decrease in the price during this period. If the price of the commodity goes down, the gain on the futures position offsets the loss on the commodity. If the price of the commodity goes up, the loss on the futures position is offset by the gain on the commodity. There are basically two kinds of hedges that can be taken. A company that wants to sell an asset at a particular time in the future can hedge by taking short futures position. This is called a short hedge. Similarly, a company that knows that it is due to buy an asset in the future can hedge by taking long futures position. This is known as long hedge. We will study these two hedges in detail.

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 SHORT HEDGE

A short hedge is a hedge that requires a short position in futures contracts. As we said, a short hedge is appropriate when the hedger already owns the asset, or is likely to own the asset and expects to sell it at some time in the future. For example, a short hedge could be used by a cotton farmer who expects the cotton crop to be ready for sale in the next two months. A short hedge can also be used when the asset is not owned at the moment but is likely to be owned in the future.

For example, an exporter who knows that he or she will receive a dollar payment three months later. He makes a gain if the dollar increases in value relative to the rupee and smakes a loss if the dollar decreases in value relative to the rupee. A short futures position will give him the hedge he desires.

Let us look at a more detailed example to illustrate a short hedge. We assume that today is the 15th of January and that a refined soy oil producer has just negotiated a contract to sell 10,000 Kgs of soy oil. It has been agreed that the price that will apply in the contract is the market price on the 15th April. The oil producer is therefore in a position where he will gain Rs.10000 for each 1 rupee increase in the price of oil over the next three months and lose Rs.10000 for each one rupee decrease in the price of oil during this period. Suppose the spot price for soy oil on January 15 is Rs.450 per 10 Kgs and the April soy oil futures price on the NCDEX is Rs.465 per 10 Kgs. The producer can hedge his exposure by selling 10,000 Kgs worth of April futures contracts (1 unit).

If the oil producers closes his position on April 15, the effect of the strategy would be to lock in a price close to Rs.465 per 10 Kgs. Figure 7.1 gives the payoff for a short hedge. Let us look at how this works.

On April 15, the spot price can either be above Rs.465 or below Rs.465. Figure 6.1 Payoff for buyer of a short hedge. Irrespective of what the spot price of Soy Oil is three months later, by going in for a short hedge he locks on to a price of Rs. 465 per 10 kgs.

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Table 6.1 Refined Soy Oil Futures Contract Specification

Trading system Trading hours

NCDEX trading system Monday- Friday :10:00 AM to 05:00 PM Saturday : 10.00 AM to 2.00 PM

Unit of trading Delivery unit Quotation / base value Tick size

10000 kgs (10 MT) 10000 kgs (10 MT) Rs. per 10 kgs 5 paise

Case 1: The spot price is Rs. 455 per 10 Kgs. The company realises Rs.4,55,000 under its sales contract. Because April is the delivery month for the futures contract, the futures price on April 15 should be very close to the spot price of Rs. 455 on that date. The company closes its short futures position at Rs. 455, making a gain of Rs.465 - Rs.455 = Rs.10 per 10 Kgs, or Rs. 10,000 on its short futures position. The total amount realized from both the futures position and the sales contract is therefore about Rs. 465 per 10 Kgs, Rs.4,65,000 in total.

Case 2: The spot price is Rs.475 per 10 Kgs. The company realises Rs.4,75,000 under its sales contract. Because April is the delivery month for the futures contract, the futures price on April 15 should be very close to the spot price of Rs.475 on that date. The company closes its short futures position at Rs. 475, making a loss of Rs.475 - Rs.465 = Rs.10 per 10 Kgs, or Rs. 10,000 on its short futures position. The total amount realized from both the futures position and the sales contract is therefore about Rs. 465 per 10 Kgs, Rs. 4,65,000 in total. LONG HEDGE

Hedges that involve taking a long position in a futures contract are known as long hedges. A long hedge is appropriate when a company knows it will have to purchase a certain asset in the future and wants to lock in a price now. Suppose that it is now January 15. A firm involved in industrial fabrication knows that it will require 300 kgs of silver on April 15 to meet a certain contract. The spot
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price of silver is Rs.26800 per kg and the April silver futures price is Rs. 27300 per kg. Table 6.2 gives the contract specification for silver. A unit of trading is 30 kgs. The fabricator can hedge his position by taking a long position in ten units of futures on the NCDEX. If the fabricator closes his position on April 15, the effect of the strategy would be to lock in a price close to Rs. 27300 per kg. Let us look at how this works. On April 15, the spot price can either be above Rs. 27300 or below Rs. 27300 per kg.

Case 1: The spot price is Rs. 27800 per kg. The fabricator pays Rs. 83,40,000 to buy the silver from the spot market. Because April is the delivery month for the futures contract, the futures price on April 15 should be very close to the spot price of Rs. 27800 on that date. The company closes its long futures position at Rs. 27800, making a gain of Rs.27800 - Rs.27300 = Rs.500 per kg, or Rs. 1,50,000 on its long futures position. The effective cost of silver purchased works out to be about Rs. 27300 per Kg, or Rs.81,90,000 in total.

Case 2: The spot price is Rs. 26900 per Kg. The fabricator pays Rs.80,70,000 to buy the silver from the spot market. Because April is the delivery month for the futures contract, the futures price on April 15 should be very close to the spot price of Rs. 26900 on that date. The company closes its long futures position at Rs. 26900, making a loss of Rs.27300 - Rs.26900 = Rs.400 per kg, or Rs.1,20,000 on its long futures position. The effective cost of silver purchased works out to be about Rs. 27300 per Kg, or Rs.81,90,000 in total.

Table 6.2 Silver futures contract specification Trading system Trading hours NCDEX trading system Monday-Friday: 10:00 AM to 11:30 PM Saturday : 10.00 AM to 2.00 PM Unit of trading Delivery unit Quotation / base value Tick size 30 kgs 30 kgs Rs. per kg of Silver with 999 fineness Re. 1/-

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Note that the purpose of hedging is not to make profits, but to lock on to a price to be paid in the future upfront. In the industrial fabricator example, since prices of silver rose in three months, on hind sight it would seem that the company would have been better off buying the silver in January and holding it. But this would involve incurring interest cost and warehousing costs. Besides, if the prices of silver fell in April, the company would have not only incurred interest and storage costs, but would also have ended up buying silver at a much higher price. In the examples above, we assume that the futures position is closed out in the delivery month. The hedge has the same basic effect if delivery is allowed to happen. However, making or taking delivery can be a costly process. In most cases, delivery is not made even when the hedger keeps the futures contract until the delivery month. Hedgers with long positions usually avoid any possibility of having to take delivery by closing out their positions before the delivery period. ADVANTAGES OF HEDGING

Besides the basic advantage of risk management, hedging also has other advantages: 1. Hedging stretches the marketing period. For example, a livestock feeder does not have to wait until his cattle are ready to market before he can sell them. The futures market permits him to sell futures contracts to establish the approximate sale price at any time between the time he buys his calves for feeding and the time the fed cattle are ready to market, some four to six months later. He can take advantage of good prices even though the cattle are not ready for market. 2. Hedging protects inventory values. For example, a merchandiser with a large, unsold inventory can sell futures contracts that will protect the value of the inventory, even if the price of the commodity drops. 3. Hedging permits forward pricing of products. For example, a jewellery manufacturer can determine the cost for gold, silver or platinum by buying a futures contract, translate that to a price for the finished products, and make forward sales to stores at firm prices. Having made the forward sales, the manufacturer can use his capital to acquire only as much gold, silver, or platinum as may be needed to make the products that will fill its orders.

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 LIMITATION OF HEDGING: BASIS RISK

In the examples we used above, the hedges considered were perfect. The hedger was able to identify the precise date in the future when an asset would be bought or sold. The hedger was then able to use the futures contract to remove almost all the risk arising out of price of the asset on that date. In reality, hedging is not quite this simple and straightforward. Hedging can only minimize the risk but cannot fully eliminate it. The loss made during selling of an asset may not always be equal to the profits made by taking a short futures position. This is because the value of the asset sold in the spot market and the value of the asset underlying the future contract may not be the same. This is called the basis risk. In our examples, the hedger was able to identify the precise date in the future when an asset would be bought or sold. The hedger was then able to use the perfect futures contract to remove almost all the risk arising out of price of the asset on that date. In reality, this may not always be possible for various reasons. The asset whose price is to be hedged may not be exactly the same as the asset underlying the futures contract. For example, in India we have a large number of varieties of cotton being cultivated. It is impractical for an Exchange to have futures contracts with all these varieties of cotton as an underlying. The NCDEX has futures contracts on medium staple cotton. If a hedger has an underlying asset that is exactly the same as the one that underlies the futures contract, he would get a better hedge. But in many cases, farmers producing small staple cotton could use the futures contract on medium staple cotton for hedging. While this would still provide the farmer with a hedge, since the price of the farmers cotton and the price of the cotton underlying the futures contract would be related. However, the hedge would not be perfect. The hedger may be uncertain as to the exact date when the asset will be bought or sold. Often the hedge may require the futures contract to be closed out well before its expiration date. This could result in an imperfect hedge. The expiration date of the hedge may be later than the delivery date of the futures contract. When this happens, the hedger would be required to close out the futures contracts entered into and take the same position in futures contracts with a later delivery date. This is called a rollover. Hedges can be rolled forward many times. However, multiple rollovers could lead to short-term cash flow problems.
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6.3 SPECULATION

An entity having an opinion on the price movements of a given commodity can speculate using the commodity market. While the basics of speculation apply to any market, speculating in commodities is not as simple as speculating on stocks in the financial market. For a speculator who thinks the shares of a given company will rise, it is easy to buy the shares and hold them for whatever duration he wants to. However, commodities are bulky products and come with all the costs and procedures of handling these products. The commodities futures markets provide speculators with an easy mechanism to speculate on the price of underlying commodities. To trade commodity futures on the NCDEX, a customer must open a futures trading account with a commodity derivatives broker. Buying futures simply involves putting in the margin money. This enables futures traders to take a position in the underlying commodity without having to actually hold that commodity. With the purchase of futures contract on a commodity, the holder essentially makes a legally binding promise or obligation to buy the underlying security at some point in the future (the expiration date of the contract). We look here at how the commodity futures markets can be used for speculation.

6.3(a) Speculation: Bullish Commodity, Buy Futures

Take the case of a speculator who has a view on the direction of the price movements of gold. Perhaps he knows that towards the end of the year due to festivals and the upcoming wedding season, the prices of gold are likely to rise. He would like to trade based on this view. Gold trades for Rs. 16000 per 10 gms in the spot market and he expects its price to go up in the next two-three months. How can he trade based on this belief? In the absence of a deferral product, he would have to buy gold and hold on to it. Suppose he buys a 1 kg of gold which costs him Rs. 16,00,000. Suppose further that his hunch proves correct and three months later gold trades at Rs. 17000 per 10 grams. He makes a profit of Rs. 1,00,000 on an investment of Rs. 16,00,000 for a period of three months. This works out to an annual return of about 25 percent. Today a speculator can take exactly the same position on gold by using gold futures contracts.

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Let us see how this works. Gold trades at Rs. 16,000 per 10 gms and three-month gold futures trades at Rs. 16,650 per 10 gms. Table 7.3 gives the contract specifications for gold futures. The unit of trading is 1 kg and the delivery unit for the gold futures contract on the NCDEX is 1 kg. He buys one kg of gold futures which have a value of Rs. 16,65,000. Buying an asset in the futures market only requires making margin payments. To take this position, suppose he pays a margin of Rs. 1,66,500. Three months later gold trades at Rs. 17,000 per 10 gms. As we know, on the day of expiration, the futures price converges to the spot price (else there would be a risk-free arbitrage opportunity). He closes his long futures position at Rs. 17,000 in the process making a profit of Rs. 35,000 on an initial margin investment of Rs. 1,66,500. This works out to an annual return of 85 percent. Because of the leverage they provide, commodity futures form an attractive tool for speculators.

6.3(b) Speculation: Bearish Commodity, Sell Futures

Commodity futures can also be used by a speculator who believes that there is likely to be excess supply of a particular commodity in the near future and hence the prices are likely to see a fall. How can he trade based on this opinion? In the absence of a deferral product, there wasn't much he could do to profit from his opinion. Today all he needs to do is sell commodity futures. Let us understand how this works. Simple arbitrage ensures that the price of a futures contract on a commodity moves correspondingly with the price of the underlying commodity. If the commodity price rises, so will the futures price. If the commodity price falls, so will the futures price. Now take the case of the trader who expects to see a fall in the price of pepper. Suppose price of pepper is Rs.14000 per quintal and he sells two pepper futures contract which is for delivery of 2 MT of pepper (1MT each). The value of the contract is Rs. 2,80,000. He pays a small margin on the same. Three months later, if his hunch was correct the price of pepper falls. So does the price of pepper futures. He close out his short futures position at Rs.13000 per quintal i.e. Rs. 2,60,000 making a profit of Rs. 20,000.

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6.4 ARBITRAGE

A central idea in modern economics is the law of one price. This states that in a competitive market, if two assets are equivalent from the point of view of risk and return, they should sell at the same price. If the price of the same asset is different in two markets, there will be operators who will buy in the market where the asset sells cheap and sell in the market where it is costly. This activity termed as arbitrage, involves the simultaneous purchase and sale of the same or essentially similar security in two different markets for advantageously different prices. The buying cheap and selling expensive continues till prices in the two markets reach equilibrium. Hence, arbitrage helps to equalize prices and restore market efficiency.

6.4(a) Overpriced Commodity Futures: Buy Spot, Sell Futures

An arbitrager notices that gold futures seem overpriced. How can he cash in on this opportunity to earn risk less profits? Say for instance, gold trades for Rs. 1600 per gram in the spot market. Three month gold futures on the NCDEX trade at Rs.1685 per gram and seem overpriced. He could make risk less profit by entering into the following set of transactions. On day one, borrow Rs. 1,60,05,100 at 6% per annum to cover the cost of buying and holding gold. Buy 10 kgs of gold on the cash/ spot market at Rs. 1,60,00,000. Pay Rs.5100 (approx) as warehouse costs. Simultaneously, sell 10 gold futures contract at Rs. 1,68,50,000. Take delivery of the gold purchased and hold it for three months. On the futures expiration date, the spot and the futures price converge. Now unwind the position. Say gold closes at Rs. 1635 per gram in the spot market. Sell the gold for Rs. 1,63,50,000. Futures position expires with profit of Rs. 5,00,000 From the Rs. 1,68,50,000 held in hand, return the borrowed amount plus interest of Rs. 1,62,46,986. The result is a risk less profit of Rs. 6,04,014. When does it make sense to enter into this arbitrage? If the cost of borrowing funds to buy the commodity is less than the arbitrage profit possible, it makes sense to arbitrage. This is termed as cash-and-carry arbitrage. Remember however, that exploiting an arbitrage opportunity involves trading on the spot and futures market.

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In the real world, one has to build in the transactions costs into the arbitrage strategy.

6.4(b) Underpriced Commodity Futures: Buy Futures, Sell Spot

An arbitrager notices that gold futures seem underpriced. How can he cash in on this opportunity to earn risk less profits? Say for instance, gold trades for Rs.1600 per gram in the spot market. Three month gold futures on the NCDEX trade at Rs. 1620 per gram and seem underpriced. If he happens to hold gold, he could make risk less profit by entering into the following set of transactions. On day one, sell 10 kgs of gold in the spot market at Rs. 1,60,00,000. Invest the Rs. 1,60,00,000 plus the Rs.5100 saved by way of warehouse costs for three months 6%. Simultaneously, buy three-month gold futures on NCDEX at Rs.1,62,00,000. Suppose the price of gold is Rs.1635 per gram. On the futures expiration date, the spot and the futures price of gold converge. Now unwind the position. The gold sales proceeds grow to Rs. 1,62,46,986 The futures position expires with a profit of Rs. 1,50,000 Buy back gold at Rs.1,63,50,000 on the spot market. The result is a risk less profit of Rs. 46,986.When the futures price of a commodity appears underpriced in relation to its spot price, an opportunity for reverse cash and carry arbitrage arises. It is this arbitrage activity that ensures that the spot and futures prices stay in line with the cost-of-carry. As we can see, exploiting arbitrage involves trading on the spot market. As more and more players in the market develop the knowledge and skills to do cash-and-carry and reverse cash-and-carry, we will see increased volumes and lower spreads in both the cash as well as the derivatives market.

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CHAPTER7 TRADING OF COMMODITY

THE NCDEX PLATFORM National Commodity & Derivatives Exchange Limited (NCDEX), a national level online multicommodity exchange, commenced operations on December 15, 2003. The Exchange has received a permanent recognition from the Ministry of Consumer Affairs, Food and Public Distribution, Government of India as a national level exchange. The Exchange, in just over two years of operations, posted an average daily turnover (one-way volume) of around Rs 4500- 5000 crore a day (over USD 1 billion). The major share of the volumes come from agricultural commodities and the balance from bullion, metals, energy and other products. Trading is facilitated through over 850 Members located across around 700 centers (having ~20000 trading terminals) across the country. Most of these terminals are located in the semi-urbanand rural regions of the country. Trading is facilitated through VSATs, leased lines and the Internet.

Structure Of NCDEX

NCDEX has been formed with the following objectives: To create a world class commodity exchange platform for the market participants. To bring professionalism and transparency into commodity trading. To inculcate best international practices like de-materialised technology platforms, low cost solutions and information dissemination into the trade. To provide nationwide reach and consistent offering. To bring together the entities that the market can trust.

Shareholders of NCDEX

NCDEX is promoted by a consortium of four institutions. These are National Stock Exchange (NSE), ICICI Bank Limited, Life Insurance Corporation of India (LIC) and National Board for Agriculture and Rural Development (NABARD). Later on their shares were diluted and more institutions became shareholders of NCDEX. These are Canara Bank, CRISIL Limited, Indian Farmers Fertilisers Cooperative
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Limited (IFFCO), Punjab National Bank (PNB), Goldman Sachs, Intercontinental Exchange (ICE) and Shree Renuka Sugars Ltd. All the ten shareholders (now ICICI is not a shareholder of NCDEX) bring along with them expertise in closely related fields such as agriculture, rural banking, co-operative expertise, risk management, intensive use of technology, derivative trading besides institution building expertise.

Governance

The governance of NCDEX vests with the Board of Directors. None of the Board of Directors has any vested interest in commodity futures trading. The Board comprises persons of eminence, each an authority in their own right in the areas very relevant to the Exchange. Board appoints an executive committee and other committees for the purpose of managing activities of the Exchange.

The executive committee consists of Managing Director of the Exchange who would be acting as the Chief Executive of the Exchange, and also other members appointed by the board. Apart from the executive committee the board has constituted committees like Membership committee, Audit Committee, Risk Committee, Nomination Committee, Compensation Committee and Business Strategy

Committee, which help the Board in policy formulation.

NCDEX Products

NCDEX currently offers an array of more than 50 different commodities for futures trading. The commodity segments covered include both agri and non-agri commodities [bullion, energy, metals (ferrous and non-ferrous metals) etc]. Before identifying a commodity for trading, the Exchange conducts a thorough research into the characteristics of the product, its market and potential for futures trading. The commodity is recommended for approval of Forward Markets Commission, the Regulator for commodity exchanges in the country after approval by the Product Committee constituted for each of such product and Executive Committee of the Exchange.

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Initiatives NCDEX pioneered constructing four indices: NCDEXAGRI - an agricultural spot price index covering the agricultural spectrum, FUTEXAGRI - an agricultural futures index, FREIGHTEX - a freight index and NCDEXRAIN - a rainfall index. NCDEX is the first commodity exchange in India to provide near real time spot prices of commodities traded on the Exchange. These prices are polled from various principal market places for the commodity two to three times a day. The spot prices that are collected and futures prices that are traded on the Exchange are disseminated through its website, trader work stations, news agencies such as Reuters, Bloomberg, newspapers and journals, rural kiosks (e-chaupals and n-Logue), TV channels such as Doordarshan News, CNBC, etc. Price ticker boards have been widely installed by the Exchange to display both real time futures and spot prices of commodities traded on its platform. NCDEX has also spearheaded several pilot projects for the purpose of encouraging farmers to participate on the Exchange and hedge their price risk. NCDEX took the initiative of establishing a national level collateral management company, National Collateral Management Services Limited (NCMSL) to take care of the issues of warehousing, standards and grades, collateral management as well as facilitate commodity finance by banks. Within a year of operations, NCDEX has accredited and networked around over 320 delivery centres (now over 775). Each warehouse has the services of reputed and reliable assayers through accredited agencies. Very much like holding cash in savings bank accounts and securities in electronic bank accounts, NCDEX has enabled holding of commodity balances in electronic form and dematerialized the warehouse receipt (in partnership with National
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Securities Depository Limited (NSDL) and the Central Depository Services (India) Limited (CDSL)) so as to enable smooth physical commodity settlements. The Exchange was the first to facilitate holding of commodity balances in an electronic form. Physical deliveries in an electronic form (demat mode) have taken place in many commodities across the country. Physical deliveries of commodities take place through the Exchange platform which presently range between 30,000-45,000 tonnes every month.

Spot Price Polling

Like any other derivative, a futures contract derives its value from the underlying commodity. The spot and futures market are closely interlinked with price and sentiment in one market affecting the price and sentiment in the other. Fair and transparent spot price discovery attains importance when studied against the role it plays in a futures market. The availability of spot price data of the basis centre has the following benefits: Near real time spot price information helps the trading members to take a view on the future market and vice versa. The data helps the Exchange to analyze the price data concurrently to make meaningful analysis of price movement in the futures market and helps in the market surveillance function. The Exchange has to track the convergence of spot and futures prices towards the last few days prior to the expiry of a contract. The Exchange need to know the spot prices at around closing time of the contract for the Final Settlement Price on the expiry day. The Exchange needs to know the spot price at the basis centre of the underlying commodity of which the futures are being traded on the platform.
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 The near real-time spot price data when it is disseminated by the Exchange is of great interest to the general public, especially researchers, governmental agencies, international agencies, etc. In India, there is no effective mechanism or real time spot price information of commodities.

The only government agency which collects spot prices is Agmarknet which collects the posttrade mandi data, but even such information is not disseminated real time. The Exchange needs the spot price information real time at several points in time during the trading hours. Moreover, agricultural spot markets in India are spread over 7,000 mandis across the country.

Prices for the same commodity differ from mandi to mandi. This is a direct consequence of the lack of integration of markets and the lack of good transportation facilities. The price differentials create a problem in the development of a unique representative spot price for the commodity. Considering the importance of spot price information to the trader and the unavailability of reliable source of real time spot price data, NCDEX has put in place a mechanism to poll spot prices prevailing at various mandis throughout the country.

This process is analogous to the interest rate polling conducted to find the LIBOR rates. The Exchange collates spot prices for all commodities on which it offers futures trading and disseminates the same to the market via the trading platform. This collection and dissemination of spot prices is done by various reputed external polling agencies which interact directly with market participants and collect feedback on spot prices which are then disseminated to the market.

Polling and Bootstrapping

Polling is the process of eliciting information from a cross section of market players about the prevailing price of the commodity in the market. A panel of polling participants comprising various user class viz. growers, traders/brokers, processors and users is chosen. Primarily, the days prior to the expiry of a contract.

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 The Exchange need to know the spot prices at around closing time of the contract for the Final Settlement Price on the expiry day. The Exchange needs to know the spot price at the basis centre of the underlying commodity of which the futures are being traded on the platform. The near real-time spot price data when it is disseminated by the Exchange is of great interest to the general public, especially researchers, governmental agencies, international agencies, etc. In India, there is no effective mechanism or real time spot price information of commodities.

The only government agency which collects spot prices is Agmarknet which collects the pos ttrade mandi data, but even such information is not disseminated real time. The Exchange needs the spot price information real time at several points in time during the trading hours.

Moreover, agricultural spot markets in India are spread over 7,000 mandis across the country. Prices for the same commodity differ from mandi to mandi. This is a direct consequence of the lack of integration of markets and the lack of good transportation facilities. The price differentials create a problem in the development of a unique representative spot price for the commodity.

Considering the importance of spot price information to the trader and the unavailability of reliable source of real time spot price data, NCDEX has put in place a mechanism to poll spot prices prevailing at various mandis throughout the country. This process is analogous to the interest rate polling conducted to find the LIBOR rates. The Exchange collates spot prices for all commodities on which it offers futures trading and disseminates the same to the market via the trading platform. This collection and dissemination of spot prices is done by various reputed external polling agencies which interact directly with market participants and collect feedback on spot prices which are then disseminated to the market.

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Polling and Bootstrapping

Polling is the process of eliciting information from a cross section of market players about the prevailing price of the commodity in the market. A panel of polling participants comprising various user class viz. growers, traders/brokers, processors and users is chosen. Primarily, the data on spot prices is captured at the identified delivery centres which are also termed as the primary centre of a commodity by asking bid and ask quotes from the empanelled polling participants. Besides the primary centre, spot price of a commodity from a couple of other major centers (subject, sometimes, to adequate number of respondents) are also captured. These centers are termed non-primary or non-priority centers. Multiple-location polling for a commodity helps the Exchange in estimating the price at the primary centre when the market there is closed for some reason. in validating the primary centre price when there are reasons to believe that polled data is not reliable or justified considering the underlying factors. in providing a value addition to the users. Polling is carried out once, twice or hrice a day depending upon the market timings, practices at the physical market.

When polling for the spot price of a commodity, the participant is asked 'what he thinks is the ASK or BID price of the commodity conforming to grade and quality specifications of the Exchange. The respondent may or may not have any buy or sell position of the commodity in the physical market at that point in time. However since the respondent is an active player in the spot trade of the commodity, he has a clear understanding of the prevailing price at that point in time. Considering the vital role the participants play in the process, the polling participants are carefully chosen to ensure that they are active players in the market. For this reason no association, group of persons or a trade body/association has been included as polling participant as it is against the spirit of the polling process.

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Cleansing of data

The spot price polled from each mandi is transmitted electronically to a central database for further process of bootstrapping to arrive at a clean benchmark average price. To arrive at the bootstrapped price, all the BID & ASK quotes are sorted in ascending order and through adaptive trimming procedure the extreme quotes are trimmed from the total quotes. These values are sampled with replacement multiple numbers of times, where software gives different mean with their respective standard deviation. The mean with least standard deviation is the spot price that will be uploaded by the polling agency through the polling application provided by NCDEX. This price is broadcast through the Trader Work Station and also on the NCDEX website without any human intervention.

Outsourcing of Polling

It is prohibitively expensive for the Exchange to post personnel at various mandis to poll prices especially in the initial stages when there is no scope to recover any fee from the sale of price data. Further it is advisable that the spot prices are polled by an agency independently rather than by the Exchange itself for reasons of corporate governance. Thirdly, the agencies chosen will have some expertise and experience in this field which the Exchange can leverage upon.

For the above reasons, NCDEX has outsourced the processes of polling and bootstrapping to external reputed entities. The Product Managers for the various commodities are asked to identify through interactions at the mandis the participants who would form a part of the polling community for a given commodity. They would also explain in detail to the participants about the Exchange, futures trading, need for polling, the reason why they have chosen the polling participant, the grade and other quality specifications of the commodity and the name of the polling agency. After obtaining the concurrence of the participant, the names and contact numbers will be passed on to the polling agency.

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Validation & Checks on the Polling Processes

The Exchange routinely makes daily calls to the polling participants randomly in various commodities and speak to them about the prices quoted to cross check the raw quotes sent by the polling agency. Besides they also talk to them about the demand and supply conditions, mandi arrivals, imports/exports activities, impact of state procurement and agricultural policies, weather conditions impacting the crop, etc. This gives them a feel of the spot market which is a valuable input in tracking and analyzing futures price movements. Necessary precaution/checks are maintained at the Exchange so that any spot price which deviates from the previous day's spot price by +/- 4% is reviewed before uploading. In such case, the Exchange reviews the raw prices as quoted by respondents available with the polling agency and tries independently to ascertain the reason for deviation through interaction with the participants. If the price rise/fall is justified with the feedback received from the participants, the price is uploaded in the system after obtaining necessary approval. If the price rise/fall is not justified with the feedback received from the participants, the polling agency is asked to re-poll the prices and the new bootstrapped price is allowed to be uploaded. Two days prior to the expiry of the contract, the above price limit of 4% will be re-set to 2%. This is done as a precaution in view of the impending expiry and the high risk of accepting what may be an incorrect spot price as the FSP. A check is conducted on the lines describe in the previous paragraph before the prices are uploaded. It is very important that that the polling participants are periodically reinforced about the grade and quality specifications set by the Exchange for the commodity for which he is polled and it is the responsibility of the polling agency to ensure that this is being adhered to.

Independence of the polling agency

To ensure impartiality and to remove any biases, the Exchange or its officials have given themselves no right to alter a spot price provided by the agency.

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Dissemination of spot price data as a service

NCDEX disseminates the spot price data of underlying commodities traded at the Exchange on its website www.ncdex.com. This is done at two or three times a day, depending upon the availability of the price data at the spot market place. The Exchange provides this data as a value added service. At present, the real time prices are disseminated free to the members.

Exchange Membership

Membership of NCDEX is open to any person, association of persons, partnerships, co-operative societies, companies etc. that fulfills the eligibility criteria set by the Exchange. FIs, NRIs, Banks, MFs etc are not allowed to participate in commodity exchanges at the moment. All the members of the Exchange have to register themselves with the competent authority before commencing their operations. NCDEX invites applications for Members from persons who fulfill the specified eligibility criteria for trading commodities. The members of NCDEX fall into following categories:

1. Trading cum Clearing Member (TCM) : Members can carry out the transactions (Trading, clearing and settlement) on their own account and also on their clients' accounts. Applicants accepted for admission as TCM are required to pay the requisite fees/ deposits and also maintain net worth as explained in the following section.

2. Professional Clearing Members (PCM): Members can carry out the settlement and clearing for their clients who have traded through TCMs or traded as TMs. Applicants accepted for admission as PCMs are required to pay the requisite fee/ deposits and also maintain net worth.

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3. Trading Member ( TM ): Member who can only trade through their account or on account of their clients and will however clear their trade through PCMs/STCMs.

4. Strategic Trading cum Clearing Member (STCM): This is up gradation from the TCM to STCM. Such member can trade on their own account, also on account of their clients. They can clear and settle these trades and also clear and settle trades of other trading members who are only allowed to trade and are not allowed to settle and clear.

Capital requirements

NCDEX has specified capital requirements for its members. On approval as a member of NCDEX, the member has to deposit the following capital: Base Minimum Capital (BMC) Base Minimum Capital comprises of the following: Interest Free Cash Security Deposit Collateral Security Deposit

Interest Free Cash Security Deposit

An amount of Rs. 15 Lacs by Trading cum Clearing Members (TCM) and Rs. 25 Lacs by Professional Clearing Members (PCM) is to be provided in cash. The same is to be provided by issuing a cheque / demand draft payable at Mumbai in favour of National Commodity & Derivatives Exchange Limited.

Collateral Security Deposit The minimum-security deposit requirement is Rs. 15 Lacs for TCM and Rs. 25 Lacs for PCM. All Members have to comply with the security deposit requirement before the activation of their trading terminal. Members may opt to meet the security deposit requirement by way of the following:

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Cash

The same is to be provided by issuing a cheque / demand draft payable at Mumbai in favour of 'National Commodity & Derivatives Exchange Limited'.

Bank Guarantee Bank guarantee in favour of NCDEX as per the specified format. The minimum term of the bank guarantee should be 12 months.

Fixed Deposit Receipt Fixed Deposit Receipts (FDRs) issued by approved banks are accepted. The FDR should be issued for a minimum period as specified by the Exchange from time to time from any of the approved banks.

Government of India Securities National Commodity Clearing Limited (NCCL) is the approved custodian for acceptance of Government of India Securities. The securities are valued on a daily basis and a haircut as prescribed the Exchange is levied.

Additional Base Capital (ABC)

In case the members desire to increase their limit, additional capital may be submitted to NCDEX in the following forms: Cash Cash Equivalents - Bank Guarantee (BG) - Fixed Deposit Receipt (FDR) - Government of India Securities - Bullion - Shares (notified list) The haircut for Government of India securities shall be 25% and 50% for the notified shares.
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Risk Management

NCDEX ensures the financial integrity of trades put through on its platform by adopting a comprehensive, unbiased and professional approach to risk management. NCDEX does not have in its governing/management team, any person who has any vested interest in commodity trading. The Value at risk (VaR) based margining and limits on position levels are transparent and applied uniformly across market participants. In commodity futures markets, margins are collected from market participants to cover adverse movements in futures prices. Prudent risk management requires that margining system of the Exchange should respond to price volatility to ensure that members are able to meet their counter party liability. In the long run, this ensures financial discipline in the market and aids in the development of the market. NCDEX provides position monitoring and margining. Position monitoring is carried out on a real-time basis during the trading hours. Margins are calculated intraday to capture the intraday volatility in the futures prices. Other risk management tools like daily price limits and exposure margins have been adopted in line with international best practices. Margins are netted at the level of individual client and grossed across all clients, at the members level, without any set-offs between clients. For orderly functioning of the market, stringent limits for near month contracts are set.

Clearing And Settlement System

Clearing National Commodity Clearing Limited (NCCL) undertakes clearing of trades executed on the NCDEX. Only clearing members including professional clearing members (PCMs) are entitled to clear and settle contracts through the clearing house. At NCDEX, after the trading hours on the expiry date, based on the available information, the matching for deliveries takes place firstly, on the basis of locations and then randomly, keeping in view the factors such as available capacity of the vault/warehouse, commodities already deposited and dematerialized and offered for delivery etc. Matching done by this process is binding on the clearing members. After completion of the matching process, clearing members are informed of the
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deliverable/ receivable positions and the unmatched positions. Unmatched positions have to be settled in cash. The cash settlement is only for the incremental gain/ loss as determined on the basis of final settlement price.

Settlement

Futures contracts have two types of settlements, the Mark-to-Market (MTM) settlement which happens on a continuous basis at the end of the day, and the final settlement which happens on the last trading day of the futures contract. On the NCDEX, daily MTM settlement in respect of admitted deals in futures contracts are cash settled by debiting/ crediting the clearing accounts of clearing members (CMs) with the respective clearing bank. All positions of CM, brought forward, created during the day or closed out during the day, are mark to market at the daily settlement price or the final settlement price on the contract expiry. The responsibility of settlement is on a trading cum clearing member for all trades done on his own account and his client's trades. A professional clearing member is responsible for settling all the participants trades which he has confirmed to the Exchange. Few days before expiry date, as announced by Exchange from time to time, members submit delivery information through delivery request window on the trader workstation provided by NCDEX for all open position for a commodity for all constituents individually. NCDEX on receipt of such information matches the information and arrives at a delivery position for a member for a commodity.

The seller intending to make delivery takes the commodities to the designated warehouse. These commodities have to be assayed by the Exchange specified assayer. The commodities have to meet the contract specifications with allowed variances. If the commodities meet the specifications, the warehouse accepts them. Warehouse then ensures that the receipts get updated in the depository system giving a credit in the depositor's electronic account. The seller then gives the invoice to his clearing member, who would courier the same to the buyer's clearing member. On an appointed date, the buyer goes to the warehouse and takes physical possession of the commodities.

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Clearing Days and Scheduled Time

Daily Mark to Market settlement where 'T' is the trading day Mark to Market Pay-in (Payment): T+1 working day. Mark to Market Pay-out (Receipt): T+1 working day.

Final settlement Final settlement for Futures Contracts

The settlement schedule for Final settlement for futures contracts is given by the Exchange in detail for each commodity.

Timings for Funds settlement:

Pay-in: On Scheduled day as per settlement calendars. Pay-out: On Scheduled day as per settlement calendars.

7.1 FUTURES TRADING SYSTEM

The trading system on the NCDEX, provides a fully automated screen-based trading for futures on commodities on a nationwide basis as well as an online monitoring and surveillance mechanism. It supports an order driven market and provides complete transparency of trading operations.

The NCDEX system supports an order driven market, where orders match automatically. Order matching is essentially on the basis of commodity, its price, time and quantity. All quantity fields are in units and price in rupees. The Exchange specifies the unit of trading and the delivery unit for futures contracts on various commodities.

The Exchange notifies the regular lot size and tick size for each of the contracts traded from time to time. When any order enters the trading system, it is an active order. It tries to find a match on the other side of the book. If it finds a match, a trade is generated. If it does not find a match, the order becomes passive and gets queued
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in the respective outstanding order book in the system. Time stamping is done for each trade and provides the possibility for a complete audit trail if required.

7.2Entities in the Trading System There are following entities in the trading system of NCDEX

1. Trading cum Clearing Member (TCM) : Trading cum Clearing Members can carry out the transactions (trading, clearing and settling) on their own account and also on their clients' accounts. The Exchange assigns an ID to each TCM. Each TCM can have more than one user. The number of users allowed for each trading member is notified by the Exchange from time to time. Each user of a TCM must be registered with the Exchange and is assigned an unique user ID. The unique TCM ID functions as a reference for all orders/trades of different users. It is the responsibility of the TCM to maintain adequate control over persons having access to the firm's User IDs.

2. Professional Clearing Member (PCM) : These members can carry out the settlement and clearing for their clients who have traded through TCMs or traded as TMs.

3. Trading Member (TM): Member who can only trade through their account or on account of their clients and will however clear their trade through PCMs/STCMs.

4. Strategic Trading cum Clearing Member (STCM): This is up gradation from the TCM to STCM. Such member can trade on their own account, also on account of their clients. They can clear and settle these trades and also clear and settle trades of other trading members who are only allowed to trade and are not allowed to settle and clear.

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Structure

Exchange

Member

Client

Box 7.1The open outcry system of trading

While most exchanges the world over are moving towards the electronic form of trading, some still follow the open outcry method. Open outcry trading is a face-toface and highly activate form of trading used on the floors of the exchanges. In open outcry system the futures contracts are traded in pits. A pit is a raised platform in octagonal shape with descending steps on the inside that permit buyers and sellers to see each other. Normally only one type of contract is traded in each pit like a Eurodollar pit, Live Cattle pit etc. Each side of the octagon forms a pie slice in the pit. All the traders dealing with a certain delivery month trade in the same slice. The brokers, who work for institutions or the general public stand on the edges of the pit so that they can easily see other traders and have easy access to their runners who bring orders. The trading process consists of an auction in which all bids and offers on each of the contracts are made known to the public and everyone can see the market's best price.

To place an order under this method, the customer calls a broker, who time-stamps the order and prepares an office order ticket. The broker then sends the order to a
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booth on the exchange floor called broker's floor booth. There, a floor order ticket is prepared, and a clerk hand delivers the order to the floor trader for execution.

In some cases, the floor clerk may use hand signals to convey the order to floor traders. Large orders typically go directly from the customer to the broker's floor booth. The floor trader, standing in a central location i.e. trading pit, negotiates a price by shouting out the order to other floor traders, who bid on the order using hand signals. Once filled, the order is recorded manually by both parties in the trade. At the end of each day, the clearing house settles trades by ensuring that no discrepancy exists in the matched-trade information.

7.2(A) GUIDELINES FOR ALLOTMENT OF CLIENT CODE

The trading members are recommended to follow guidelines outlined by the Exchange for allotment and use of client codes at the time of order entry on the futures trading system: 1. All clients trading through a member are to be registered clients at the member's back office. 2. A unique client code is to be allotted for each client. The client code should be alphanumeric and no special characters can be used. 3. The same client should not be allotted multiple codes.

7.3 CONTRACT SPECIFICATIONS

For derivatives with a commodity as the underlying, the Exchange specifies the exact nature of the agreement between two parties who trade in the contract. In particular, it specifies the underlying asset, unit of trading, price limits, position limits, the contract size stating exactly how much of the asset will be delivered under one contract, where and when the delivery will be made, etc. Here, we look at the contract specifications of some of the commodities traded on the Exchange. Contracts specifications of commodities are revised from time to time in light of changing requirements and feedback of market participants in terms of
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product variety, quality, timings, delivery centers, etc. Most of the agri commodities futures contract traded on NCDEX expire on the 20th of the expiry month. Thus, a November expiration contract would expire on the 20th of November and a December expiry contract would cease trading after the 20th of December. If 20th happens to be a holiday, the expiry date shall be the immediately preceding trading day of the Exchange, other than a Saturday. Some of the contracts of metals, energy etc expire on different dates.

7.3(A) COMMODITY FUTURES TRADING CYCLE

NCDEX trades commodity futures contracts having one-month, two-month, threemonth and more (not more than 12 months) expiry cycles. Most of the futures contracts (mainly agri commodities contract) expire on the 20th of the expiry month. Some contracts traded on the Exchange expire on the day other than 20th of the month. New contracts for most of the commodities on NCDEX are introduced on 10th of every month.

7.4 Order Types and Trading Parameters

An electronic trading system allows the trading members to enter orders with various conditions attached to them as per their requirements. These conditions are broadly divided into the following categories: Time conditions Price conditions Other conditions Several combinations of the above are possible thereby providing enormous flexibility to users. The order types and conditions are summarized below. Of these, the order types available on the NCDEX system are regular market order, limit order, stop loss order, immediate or cancel order, good till day order, good till cancelled order, good till date order and spread order. Time conditions
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Good till day order:

A day order, as the name suggests is an order which is valid for the day on which it is entered. If the order is not executed during the day, the system cancels the order automatically at the end of the day. Example: A trader wants to go long on February 1, 2010 in refined soy oil on the commodity exchange. A day order is placed at Rs.660/ 10 kg. If the market does not reach this price the order does not get filled even if the market touches Rs.661 and closes. In other words, day order is for a specific price and if the order does not get filled that day, one has to place the order again the next day.

Good till cancelled (GTC):

A GTC order remains in the system until the user cancels it. Consequently, it spans trading days, if not traded on the day the order is entered. The maximum number of days an order can remain in the system is notified by the Exchange from time to time after which the order is automatically cancelled by the system. Each day counted is a calendar day inclusive of holidays. The days counted are inclusive of the day on which the order is placed and the order is cancelled from the system at the end of the day of the expiry period. Example: A trader wants to go long on refined soy oil when the market touches Rs.650/ 10kg. Theoretically, the order exists until it is filled up, even if it takes months for it to happen. The GTC order on the NCDEX is cancelled at the end of a period of seven calendar days from the date of entering an order or when the contract expires, whichever is earlier.

Good till date (GTD):

A GTD order allows the user to specify the date till which the order should remain in the system if not executed. The maximum days allowed by the system are the same as in GTC order. At the end of this day/ date, the order is cancelled from the system. Each day/ date counted are inclusive of the

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day/ date on which the order is placed and the order is cancelled from the system at the end of the day/ date of the expiry period.

Immediate or Cancel (IOC)/ Fill or kill order:

An IOC order allows the user to buy or sell a contract as soon as the order is released into the system, failing which the order is cancelled from the system. Partial match is possible for the order, and the unmatched portion of the order is cancelled immediately. All or none order:

All or none order (AON) is a limit order, which is to be executed in its entirety, or not at all.

Price condition Limit order:

An order to buy or sell a stated amount of a commodity at a specified price, or at a better price, if obtainable at the time of execution. The disadvantage is that the order may not get filled at all if the price for that day does not reach the specified price.

Stop-loss:

A stop-loss order is an order, placed with the broker, to buy or sell a particular futures contract at the market price if and when the price reaches a specified level. Futures traders often use stop orders in an effort to limit the amount they might lose if the futures price moves against their position. Stop orders are not executed until the price reaches the specified point. When the price reaches that point the stop order becomes a market order. Most of the time, stop orders are used to exit a trade. But, stop orders can be executed for buying/ selling positions too. A buy stop order is initiated when one wants to buy a contract or go long and a sell stop order when one wants to sell or go short. The order gets filled at the suggested stop order price or at a better price. Example: A trader has purchased crude oil futures at Rs.3750 per barrel. He wishes to limit his loss to Rs. 50 a barrel. A stop order would then
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be placed to sell an offsetting contract if the price falls to Rs.3700 per barrel. When the market touches this price, stop order gets executed and the trader would exit the market.

Other condition

Market price: Market orders are orders for which no price is specified at the time the order is entered (i.e. price is market price). For such orders, the system determines the price. Only the position to be taken long/ short is stated. When this kind of order is placed, it gets executed irrespective of the current market price of that particular commodity.

Trigger price:

Price at which an order gets triggered from the stop-loss book.

Spread order:

A simple spread order involves two positions, one long and one short. They are taken in the same commodity with different months (calendar spread) or in closely related commodities. Prices of the two futures contract therefore tend to go up and down together, and gains on one side of the spread are offset by losses on the other. The spreaders goal is to profit from a change in the difference between the two futures prices. The trader is virtually unconcerned whether the entire price structure moves up or down, just so long as the futures contract he bought goes up more (or down less) than the futures contract he sold.

7.4(a) PERMITTED LOT SIZE

The permitted trading lot size for the futures contracts and delivery lot size on individual commodities is stipulated by the Exchange from time to time. The lot size currently applicable on select individual commodity contracts is given in Table 8.1

7.4. (b) TICK SIZE FOR CONTRACTS & TICKER SYMBOL

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The tick size is the smallest price change that can occur for the trades on the Exchange for commodity futures contracts. The tick size in respect of futures contracts admitted to dealings on the NCDEX varies for commodities. For example: in case of refined soy oil, it is 5 paise, Wheat 20 paise and Jeera Re 1. A ticker symbol is a system of letters that are used to identify a commodity. NCDEX generally uses a system of alphabetic/alphanumeric to identify its commodities uniquely. The symbol Indicate the commodity and it may indicate quality, quantity and base centre of the commodity as well.

7.4(c) QUANTITY FREEZE

All orders placed by members have to be within the quantity specified by the Exchange in this regard. Any order exceeding this specified quantity will not be executed but will lie pending with the Exchange as a quantity freeze. Table 8.2 gives the quantity freeze for some select commodity contracts. In respect of orders which have come under quantity freeze, the order gets deleted from the system at the end of the day's trading session.

Table 7.2 Commodity futures: Quantity freeze unit Commodity Futures Gold Soya bean Chana Silver Guar Seed Chilli RM Seed Jeera Quantity Freeze 51 KG 510 MT 510 MT 1530 KG 510 MT 255 MT 510 MT 153 MT

7.4. (d) BASE PRICE

On introduction of new contracts, the base price is the previous days' closing price of the underlying commodity in the prevailing spot markets. These spot prices are
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polled across multiple centers and a single spot price is determined by the bootstrapping method. The base price of the contracts on all subsequent trading days is the daily settlement price of the futures contracts on the previous trading day.

7.4. (e) PRICE RANGES OF CONTRACTS

To control wide swings in prices, an intra-day price limit is fixed for commodity futures contract. The maximum price movement during the day can be +/- x% of the previous day's settlement price for each commodity. If the price hits the first intraday price limit (at upper side or lower side), there will be a cooling period of 15 minutes. Then price band is revised further and in case the price reach that revised level, no trade is permitted during the day beyond the revised limit. Take an example of Guar Seed- Daily price fluctuation limit is (+/-) 4% (3% +1%). If the trade hits the prescribed first daily price limit of 3 %, there will be a cooling off period for 15 minutes. Trade will be allowed during this cooling off period within the price band. Thereafter, the price band would be raised by (+/-) 1% and trade will be resumed. If the price hits the revised price band (4%) during the day, trade will only be allowed within the revised price band. No trade / order shall be permitted during the day beyond the limit of (+/-) 4%. In order to prevent erroneous order entry by trading members, operating price ranges on the NCDEX are predecided for individual contracts from the base price. Presently, the price ranges for agricultural commodities is (+/-) 4 % from the base price for the day, and upto (+/-) 9 % for non-agricultural commodities. Orders, exceeding the range specified for a day's trade for the respective commodities are not executed.

7.5 MARGINS FOR TRADING IN FUTURES

Margin is the deposit money that needs to be paid to buy or sell each contract. The margin required for a futures contract is better described as performance bond or good faith money. The margin levels are set by the exchanges based on volatility (market conditions) and can be changed at any time. The margin requirements for most futures contracts range from 5% to 15% of the value of the contract, with a minimum of 5%, except for Gold where the minimum margin is 4%. In the futures market, there are different types of margins that a trader has to maintain. We will
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discuss them in more details when we talk about risk management in the next chapter. At this stage we look at the types of margins as they apply on most futures exchanges. Initial margin: The amount that must be deposited by a customer at the time of entering into a contract is called initial margin. This margin is meant to cover the potential loss in one day. The margin is a mandatory requirement for parties who are entering into the contract. The exchange levies initial margin on derivatives contracts using the concept of Value at Risk (VaR) or any other concept as the Exchange may decide periodically. The margin is charged so as to cover one-day loss that can be encountered on the position on 99.95% confidence-interval VaR methodology. Exposure & Mark-to-Market Margin: Exposure margin is charged taking into consideration the back testing results of the VaR model. For all outstanding exposure in the market, the Exchange also collects mark-to-market margin which are positions restated at the daily settlement prices (DSP). At the end of each trading day, the margin account is adjusted to reflect the trader's gain or loss. This is known as marking to market the account of each trader. All futures contracts are settled daily reducing the credit exposure to one day's movement. Based on the settlement price, the value of all positions is marked-tomarket each day after the official close. i.e. the accounts are either debited or credited based on how well the positions fared in that day's trading session. If the account falls below the required margin level the clearing member needs to replenish the account by giving additional funds or closing positions either partially/ fully. On the other hand, if the position generates a gain, the funds can be withdrawn (those funds above the required initial margin) or can be used to fund additional trades. Additional margin: In case of sudden higher than expected volatility, the Exchange calls for an additional margin, which is a preemptive move to prevent potential default. This is imposed when the Exchange/ regulator has view that that the markets have become

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too volatile and may result in some adverse situation to the integrity of the market/ Exchange. Pre-expiry margin: This margin is charged as additional margin for most commodities expiring during the current/near month contract. It is charged on a cumulative basis from typically 3 to 5 days prior to the expiry date (including the expiry date). This is done to ensure that only interested parties remain in the market and speculators roll over their positions to subsequent months and ensure better convergence of the futures and spot market prices. Delivery Margin: This margin is charged only in the case of positions materializing into delivery. Members are informed about the delivery margin payable. Margins for delivery are to be paid the day following expiry of contract. Special Margin: This margin is levied when there is more than 20% uni-directional movement in the price from a pre-determined base and is typically related to the underlying spot price. The base could be the closing price on the day of launch of the contract or the 90 days prior settlement price. This is mentioned in the respective contract specification. Some contracts also have an as-deemed-fit clause for levying of Special margins. It can also be levied by market regulator if market exhibits excess volatility. If required by the regulator, it has to be settled by cash. This is collected as extra margin over and above normal margin requirement. Margin for Calendar Spread positions: Calendar spread is defined as the purchase of one delivery month of a given futures contract and simultaneous sale of another delivery month of the same commodity by a client/ member. At NCDEX, for calendar spread positions, margins are imposed as one half of the initial margin (inclusive of the exposure margin). Such benefit will be given only of there is positive correlation in the prices of the months under consideration and the far month contracts are sufficiently liquid. No benefit of calendar spread is given in the case of additional and special margins.
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However, calendar spread positions in the far month contract are considered as naked position three days before expiry of near month contract. Gradual reduction of the spread position is done at the rate of 33.3% per day from 3 days prior to expiry. Just as a trader is required to maintain a margin account with a broker, a clearing house member is required to maintain collaterals/deposits with the clearing house against which the positions are allowed to be taken.

7.6 CHARGES

Members are liable to pay transaction charges for the trade done through the Exchange during the previous month. The important provisions are listed below. The billing for the all trades done during the previous month will be raised in the succeeding month.

1. Transaction charges: The transaction charges are payable at the rate of Rs. 4 per Rs.100,000 worth of trade done. This rate is charged for average daily turnover of Rs. 20 crores. Reduced rate is charged for increase in daily turnover. This rate is subject to change from time to time. The average daily turnover is calculated by taking the total value traded by the member in a month and dividing it by number of trading days in the month including Saturdays.

2. Due date: The transaction charges are payable on the 10th day of every month in respect of the trade done in the previous month.

3. Collection: Members keep the Exchange Dues Account opened with the respective Clearing Banks for meeting the commitment on account of transaction charges.

4. Adjustment against advances transaction charges: In terms of the regulations, members are required to remit Rs.50,000 as advance transaction charges on registration. The transaction charges due first will be
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adjusted against the advance transaction charges already paid as advance and members need to pay transaction charges only after exhausting the balance lying in advance transaction.

5. Penalty for delayed payments: If the transaction charges are not paid on or before the due date, a penal interest is levied as specified by the Exchange. Finally, the futures market is a zero sum game i.e. the total number of long in any contract always equals the total number of short in any contract.

The total number of outstanding contracts (long/ short) at any point in time is called the 'Open interest'. This Open interest figure is a good indicator of the liquidity in every contract. Based onstudies carried out in international Exchanges, it is found that open interest is maximum in near month expiry contracts.

7.6 HEDGE LIMITS

The Exchange permits higher client-level open interest (OI) limits (referred to as "Hedge Limits") to Hedgers hedging the price risk of their current cash and expected future commodity requirement subject to their satisfying certain conditions and producing documents as specified by the Exchange.

The Exchange has introduced a Hedge Policy for the benefit of constituents and Members trading in their proprietary account (hereinafter for referred to as "Constituents") who have genuine hedging requirements by virtue of their being an importer or an exporter or those having stocks of physical goods.

Registration: The Hedge Policy covers those Constituents who are processors, importers, exporters and those who have physical stocks of the commodities.

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 The hedge limits against physical stocks are allowed only if the stocks are owned by the Constituent or if they are pledged with any Government/ Scheduled or Cooperative Banks. Warehouses where the physical stock may be kept include the accredited warehouses, or any private warehouse including hedger's own warehouse / factory premises. Such Constituents who have or expect to have one or more of the above requirements for a commodity which exceeds the client-level open interest (OI) limit set by the Exchange may apply for the status of a Hedger on the Exchange platform. A prospective Hedger is required to register with the Exchange as a Hedger by forwarding his request for the Hedger status through a TCM along with the forms, annexure and documents mentioned in the Appendix to the circular related to the Hedge Policy of the Exchange. Hedge limits for a commodity are determined on the basis of applicant's hedging requirement in the cash market and other factors which the Exchange deems appropriate in the interest of market. This is subject to the applicant substantiating his hedging requirement by documentary evidence in support of the stocks carried by him or his export or import obligations. Under the terms and conditions, hedge limits are not allowed in the near month and outstanding open position is required to be brought within normal client level position levels in the near-month period. The hedge limits sanctioned to a Hedger can be utilized only by the hedger and not by anyone else including any subsidiary/associate company. A Hedger registered with the Exchange is allotted a unique participant Code. The Participant Code is used by the Hedger while trading on the Exchange in those commodities in which he has been sanctioned hedge limits. This code should not be used by the Hedger while trading in any other commodity where he has no hedge limits approved to him.

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 The approved hedge limit is valid from the date of sanction for a period specified in the sanction letter. Unless renewed, the hedge limit shall stands cancelled automatically upon expiry of such period without any notice. The Hedger is required to apply for any renewal of limits at least a month before the expiry of approval along with relevant documents as prescribed by the Exchange from time to time. Clients whose applications for Hedge limits have been approved need to submit, through the member through whom they are trading, a monthly statement in respect of physical stock held by them. Members taking Hedge limits are similarly required to submit such a statement of their physical holdings against which hedge limits have been sanctioned in the prescribed format. Such monthly statement as of last day of the calendar month, should reach the Exchange not later than 7th of succeeding month. All applicants seeking Hedge limits are required to give a declaration in the prescribed format for combining of positions taken through various trading members.

Terms and Conditions for the Hedger & the Registering TCM

It is the intention of the Exchange to ensure that the sanction of hedge limits does not result in market concentration or undue influence on the futures market prices. The sanction of the hedge limits, therefore, is subject to certain terms and conditions which include: The additional open position limit granted by way of hedge limit at no point of time shall exceed a quantity equivalent to the prescribed client level open interest position limit prescribed for that commodity. Where a different client level position limit has been prescribed in a particular commodity/contract, to be applicable in the near-month of the given contract, the hedge limit shall be in accordance with the open position as applicable during such period. It would also be the responsibility of the Registering TCM to ensure that the Hedger complies with the above requirement.
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 A Hedger may be sanctioned hedge limits either for long positions or short positions but not for both. Hence the applicant has to state clearly if the application is for long or short position. A fresh application will be needed if the Hedger needs an opposite position in lieu of the existing sanctioned position. The Hedger's sanctioned limit in a commodity will not be allowed to exceed at any time and under any circumstances. If any violations (including intraday violations for whatever reasons) are found, the Exchange may not permit taking of any further position by the Hedger and may reduce his open interest position at market rate, which shall be binding on the Hedger and the Registering TCM. The Registering TCM has a responsibility:

a) Not to put through any trade by a Hedger violating the limits or any of the terms or conditions on which hedge limits are sanctioned to the Hedger by the Exchange.

b) To monitor the Hedger's position continuously to ensure that it does not exceed the sanctioned limit or the terms and conditions of the sanction of the limits.

c) To ensure that the Hedger reduces the open interest positions in the spot month contract within the normal limit for that contract before the last ten days prior to expiry of the contract.

d) To immediately inform the Exchange of any violation of limit or terms and conditions by a Hedger. Though the hedge positions can be liquidated based on sound commercial reasons by the Hedgers, they shall not churn (frequent unwinding and reinitiating) the hedge positions during a hedge period for whatever reasons.

For this purpose, the hedge period is defined as the time between initiation of hedge position in a futures contract and the time of expiry of the contract. The Exchange shall be the sole authority in determining whether frequent churning happens in a
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Hedger's position or not and the decision of the Exchange in this regard shall be final and binding on all parties involved. The margins for any commodity prescribed by the Exchange for the other market participants shall also be applicable to the hedgers. A Hedger shall furnish all information called for by the Exchange at any time and allow officials of Exchange or any person/s authorized by the Exchange or officials of regulatory authorities to inspect their records and account books as also verification of physical stocks for the purpose of verification of information or documents, with or without prior intimation. All parties to the limits sanctioned to a Hedger, i.e. the Hedger and the Registering TCM are required to abide by the Rules, Bye-laws and Regulations of the Exchange and directions of the Regulator, if any, may apart from the terms and conditions under which the hedge limits are sanctioned.

Any violation may result in cancellation of hedger status and appropriate action including penalties on the constituent and/or other parties concerned at the option of the Exchange.

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CHAPTER8

CLEARANCE

AND

SETTLEMENT

OF

COMMODITY FUTURES

Most futures contracts do not lead to the actual physical delivery of the underlying asset. The settlement is done by closing out open positions, physical delivery or cash settlement. All these settlement functions are taken care of by an entity called clearing house or clearing corporation. National Commodity Clearing Limited (NCCL) undertakes clearing of trades executed on the NCDEX.

8.1 CLEARING

Clearing of trades that take place on an Exchange happens through the Exchange clearing house. A clearing house is a system by which Exchanges guarantee the faithful compliance of all trade commitments undertaken on the trading floor or electronically over the electronic trading systems. The main task of the clearing house is to keep track of all the transactions that take place during a day so that the net position of each of its members can be calculated. It guarantees the performance of the parties to each transaction. Typically it is responsible for the following:

1. Effecting timely settlement. 2. Trade registration and follow up. 3. Control of the open interest. 4. Financial clearing of the payment flow. 5. Physical settlement (by delivery) or financial settlement (by price difference) of contracts. 6. Administration of financial guarantees demanded by the participants.

The clearing house has a number of members, who are responsible for the clearing and settlement of commodities traded on the Exchange. The margin accounts for the clearing house members are adjusted for gains and losses at the end of each day (in the same way as the individual traders keep margin accounts with the broker). Everyday the account balance for each contract must be maintained at an amount
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equal to the original margin times the number of contracts outstanding. Thus depending on a day's transactions and price movement, the members either need to add funds or can withdraw funds from their margin accounts at the end of the day. The brokers who are not the clearing members need to maintain a margin account with the clearing house member through whom they trade.

8.1.1 Clearing mechanism

Only clearing members including professional clearing members (PCMs) are entitled to clear and settle contracts through the clearing house. The clearing mechanism essentially involves working out open positions and obligations of clearing members. This position is considered for exposure and daily margin purposes. The open positions of PCMs are arrived at by aggregating the open positions of all the Trading Members clearing through him, in contracts in which they have traded.

A Trading-cum-Clearing Member's (TCM) open position is arrived at by the summation of his clients' open positions, in the contracts in which they have traded. Client positions are netted at the level of individual client and grossed across all clients, at the member level without any set-offs between clients. Proprietary positions are netted at member level without any set-offs between client and proprietary positions.

At NCDEX, after the trading hours on the expiry date, based on the available information, the matching for deliveries takes place firstly, on the basis of locations and then randomly, keeping in view the factors such as available capacity of the vault/ warehouse, commodities already deposited and dematerialized and offered for delivery etc. Matching done by this process is binding on the clearing members. After completion of the matching process, clearing members are informed of the deliverable/ receivable positions and the unmatched positions. Unmatched positions have to be settled in cash. The cash settlement is only for the incremental gain/ loss as determined on the basis of final settlement price.

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8.1.2 Clearing Banks

NCDEX has designated clearing banks through whom funds to be paid and/ or to be received must be settled. Every clearing member is required to maintain and operate a clearing account with any one of the designated clearing bank branches. The clearing account is to be used exclusively for clearing operations i.e., for settling funds and other obligations to NCDEX including payments of margins and penal charges. A clearing member having funds obligation to pay is required to have clear balance in his clearing account on or before the stipulated pay-in day and the stipulated time. Clearing members must authorize their clearing bank to access their clearing account for debiting and crediting their accounts as per the instructions of NCDEX, reporting of balances and other operations as may be required by NCDEX from time to time. The clearing bank will debit/ credit the clearing account of clearing members as per instructions received from NCDEX. Bank of India Canara Bank HDFC Bank Ltd ICICI Bank Ltd Punjab National Bank Axis Bank Ltd IndusInd Bank Ltd Kotak Mahindra Bank Ltd Tamilnad Mercantile Bank Ltd Union Bank of India YES Bank Ltd Standard Chartered Bank Ltd State Bank of India

8.1.3 Depository participants

Every clearing member is required to maintain and operate two CM pool account each at NSDL and CDSL through any one of the empanelled depository participants.

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The CM pool account is to be used exclusively for clearing operations i.e., for effecting and receiving deliveries from NCDEX.

8.2 SETTLEMENT

Futures contracts have two types of settlements, the Mark-to-Market (MTM) settlement which happens on a continuous basis at the end of each day, and the final settlement which happens on the last trading day of the futures contract. On the NCDEX, daily MTM settlement and final MTM settlement in respect of admitted deals in futures contracts are cash settled by debiting/ crediting the clearing accounts of CMs with the respective clearing bank. All positions of a CM, either brought forward, created during the day or closed out during the day, are marked to market at the daily settlement price or the final settlement price at the close of trading hours on a day. Daily settlement price: Daily settlement price is the consensus closing price as arrived after closing session of the relevant futures contract for the trading day. However, in the absence of trading for a contract during closing session, daily settlement price is computed as per the methods prescribed by the Exchange from time to time. Final settlement price: Final settlement price is the polled spot price of the underlying commodity in the spot market on the last trading day of the futures contract. All open positions in a futures contract cease to exist after its expiration day. Settlement involves payments (Pay-Ins) and receipts (Pay-Outs) for all the transactions done by the members. Trades are settled through the Exchange's settlement system.

8.2.1 Settlement Mechanism

Settlement of commodity futures contracts is a little different from settlement of financial futures which are mostly cash settled. The possibility of physical settlement makes the process a little more complicated.

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Daily mark to market settlement

Daily mark to market settlement is done till the date of the contract expiry. This is done to take care of daily price fluctuations for all trades. All the open positions of the members are marked to market at the end of the day and the profit/ loss is determined as below: On the day of entering into the contract, it is the difference between the entry value and daily settlement price for that day. On any intervening days, when the member holds an open position, it is the difference between the daily settlement price for that day and the previous day's settlement price. On the expiry date if the member has an open position, it is the difference between the final settlement price and the previous day's settlement price.

Table 8.1 Explains the MTM for a member who buys one unit of December expiration Chilli contract at Rs.6435 per quintal on December 15. The unit of trading is 5 MT and each contract is for delivery of 5 MT. The member closes the position on December 19. The MTM profit/ loss per unit of trading show that he makes a total loss of Rs.120 per quintal of trading. So upon closing his position, he makes a total loss of Rs.6000, i.e (5 x 120 x 10) on the long position taken by him. The MTM profit and loss is settled through pay in/ pays out on T+1 basis, T being the trade day.

Table 8.1: MTM on a long position in Chilli Futures

Date

Settlement Price

MTM

December 15 December 16 December 17 December 18 December 19

6320 6250 6312 6310 6315

-115 -70 +62 -2 +5

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Table 8.2 explains the MTM for a member who sells December expiration Chilli futures contract at Rs.6435 per quintal on December 15. The unit of trading is 5 MT and each contract is for delivery of 5 MT. The member closes the position on December 19. The MTM profit/ loss show that he makes a total profit of Rs.120 per quintal. So upon closing his position, he makes a total profit of Rs.6000 on the short position taken by him.

Table 8.2: MTM on a short position in Chilli Futures

Date

Settlement Price

MTM

December 15 December 16 December 17 December 18 December 19

6320 6250 6312 6310 6315

+115 +70 -62 +2 -5

Final settlement On the date of expiry, the final settlement price is the closing price of the underlying commodity in the spot market on the date of expiry (last trading day) of the futures contract. The spot prices are collected from polling participants from base centre as well as other locations. The poll prices are bootstrapped and the mid-point of the two boot strapped prices is the final settlement price. The responsibility of settlement is on a trading cum clearing member for all trades done on his own account and his client's trades.

A professional clearing member is responsible for settling all the participants' trades which he has confirmed to the Exchange. Members are required to submit delivery information through delivery request window on the trader workstations provided by NCDEX for all open positions for a commodity for all constituents individually. This information can be provided within the time notified by Exchange separately for each contracts. NCDEX on receipt of such information matches the information and arrives at a delivery position for a member for a commodity. A detailed report containing all matched and unmatched requests is provided to members through the
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extranet. Pursuant to regulations relating to submission of delivery information, failure to submit delivery information for open positions attracts penal charges as stipulated by NCDEX from time to time.

NCDEX also adds all such open positions for a member, for which no delivery information is submitted with final settlement obligations of the member concerned and settled in cash as the case may be. Non-fulfillment of either the whole or part of the settlement obligations is treated as a violation of the rules, bye-laws and regulations of NCDEX and attracts penal charges as stipulated by NCDEX from time to time. In addition, NCDEX can withdraw any or all of the membership rights of clearing member including the withdrawal of trading facilities of all trading members clearing through such clearing members, without any notice.

Further, the outstanding positions of such clearing member and/ or trading members and/ or constituents, clearing and settling through such clearing member, may be closed out forthwith or any time thereafter by the Exchange to the extent possible, by placing at the Exchange, counter orders in respect of the outstanding position of clearing member without any notice to the clearing member and/ or trading member and/ or constituent. NCDEX can also initiate such other risk containment measures as it deems appropriate with respect to the open positions of the clearing members. It can also take additional measures like, imposing penalties, collecting appropriate deposits, invoking bank guarantees or fixed deposit receipts, realizing money by disposing off the securities and exercising such other risk containment measures as it deems fit or take further disciplinary action.

8.2.2 Settlement Methods

Settlement of futures contracts on the NCDEX can be done in two ways - by physical delivery of the underlying asset and by closing out open positions. We shall look at each of these in some detail. All contracts materializing into deliveries are settled in a period as notified by the Exchange separately for each contract. The exact settlement day for each commodity is specified by the Exchange through circulars known as 'Settlement Calendar'.

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a) Physical delivery of the underlying asset

If the buyer/seller is interested in physical delivery of the underlying asset, he must complete the delivery marking for all the contracts within the time notified by the Exchange. The following types of contracts are presently available for trading on the NCDEX Platform. 1. Compulsory Delivery Staggered Delivery Early Delivery 2. Seller's Right 3. Intention Matching

1. Compulsory Delivery Contract

On expiry of a compulsory delivery contract, all the sellers with open position shall give physical delivery of the commodity. That is, the sellers need to deliver the commodity and buyers need to accept the delivery. To allocate deliveries in the optimum location for clients, the members need to give delivery information for preferred location. The information for delivery can be submitted during the trading hours 3 trading days in advance of the expiry date and up to 6 p.m. on the last day of marking delivery intention. For example, for contracts expiring on the 20th of the month, delivery intentions window will be open from the 18th and will close on the 20th.Clients can submit delivery intentions up to the maximum of their open positions. In case the delivery intention is not marked the seller would tender delivery from the base location. Members will be allowed to submit one-time warehouse preference (default location). They can give even multiple warehouse preferences. The same will be sent by the members to the Exchange. This preference will be applicable for all outstanding long and short client positions in that commodity. If the member does not mark any specific location, the default preference will be applied for all open positions. Members can change the default location preference on any day except the last 5 days before the expiry of the contract. For those members, who have not submitted the preference of the default location, delivery will be marked on the base location specified for the commodity. After the trading
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hours on the expiry date, based on the available information, the delivery matching is done. All corresponding buyers with open position as matched by the process put in place by the Exchange shall be bound to settle his obligation by taking physical delivery. The deliveries are matched on the basis of open positions and delivery information received by the Exchange. In the event of default by the seller, penalty as may be prescribed by the Exchange from time to time would be levied. Penal Provisions for a compulsory delivery contract. Total amount of penalty imposed on a seller in case of a delivery default would be 3.0 % of the final settlement price The difference between the Final Settlement Price (FSP) and the average of three highest of the last spot prices of 5 (five) succeeding days after the expiry of contract (E+ 1 to E +5 days) If the average spot price so determined is higher than FSP then this component will be zero

Bifurcation of penalty for a compulsory delivery contract 1.75 % shall be deposited in the Investor Protection Fund of the Exchange. 1 % shall be passed on to the corresponding buyer who was entitled to receive delivery; and The rest 0.25 % shall be retained by the Exchange towards administrative expenses. The difference between the Final Settlement Price (FSP) and the average of three highest of the last spot prices of 5 (five) succeeding days after the expiry of contract (E+ 1 to E +5 days) would also be passed on to the corresponding buyers. It should be noted that Buyers defaults are not permitted. The amount due from the buyers shall be recovered from the buyer as Pay in shortage together with prescribed charges. Exchange shall have right to sell the goods on account of such Buyer to recover the dues and if the sale proceeds are insufficient, the Buyer would be liable to pay the balance. The Sub Types of the compulsory delivery contracts are:

h) Staggered Delivery

In the case of certain commodities like gold and silver, delivery is staggered over last 5 days of the contract. In such contracts, the marking of intention to deliver the
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commodity starts from 5 days prior to the expiry of the near month contract and the physical settlement of the commodity will be the day after the intention is marked. The process of staggered delivery at NCDEX is as follows: Tender period consists of trading hours during 5 trading days prior to and including the expiry date of the contract If a seller marks a delivery intention during the tender period, the corresponding buyer, who has open positions that are matched as per process defined by the Exchange, is bound to settle by taking the delivery on T + 1 day (T is the date of tender) from the delivery centre where the seller has delivered the same The contract will be settled in a staggered system of 5 Pay-ins and Pay-outs starting from T +1. The 5th Pay-in and Pay-out will be the Final Settlement.

ii) Early Delivery System

In case of certain commodities such as Pepper, Mentha Oil, Rubber, Guar Seed, and Soybean, the Exchange introduced early delivery system in 2009. The salient features of this system for commodity futures contracts traded at NCDEX are listed below:

a. An early delivery period is available during E-14 to E-1 days of the contract. During the period from E-14 to E-8, normal client level position limits continue to be in force. Hedgers, allowed higher limits by the Exchange, continue to avail of such limits. If the intentions of the buyers/sellers match, then the respective positions would be closed out by physical deliveries.

b. The near month limits is in force during the period from E-7 till expiry of the contract. During this period also, if the intentions of the buyers / sellers match, then the respective positions would be closed out by physical deliveries.

c. If there is no intention matching for delivery between sellers and buyers, then such delivery intention will get automatically extinguished at the close of E-1 day. The intentions can be withdrawn during the course of E-14 to E-1 day if they remained unmatched. In case intention of delivery gets matched, then the process of

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pay-in and pay-out will be completed on T + 2 basis, where 'T' stands for the day on which matching has been done.

d. In respect of delivery defaults after the matching of delivery intentions, penalty provisions as applicable in the case of delivery defaults in compulsory delivery contracts will be applied.

e. On the expiry of the contract, all outstanding positions would be settled by physical delivery the penalty provisions for delivery default in case of Staggered Delivery and Early delivery contracts shall be same as it is applicable in the compulsory delivery contracts.

5. Sellers Right Contract

In Seller's Right contracts, delivery obligation is created for all valid sell requests received by the Exchange. Simultaneously, the deliveries are allocated to the buyers with open positions on a random basis, irrespective of whether a buy request has been submitted or not. While allocating the deliveries, preference is given to those buyers who have submitted buy requests. The information for delivery can be submitted during the trading hours 3 trading days prior to 5 working days of expiry of contracts. For example, for contracts expiring on the 20th of the month, delivery intentions window will be open from the 13th and will close on the 15th. Clients can submit delivery intentions up to the maximum of their open positions. All open positions of those sellers who fail to provide delivery intention information for physical delivery shall be settled in cash. In case of failure to give any delivery intention the seller shall be charged @ of 0.5 % of the FSP as an Open interest penalty. Ninety percent (90%) shall be paid to the corresponding buyers and ten percent (10%) of the penalty amount shall be retained by the Exchange towards administrative charges.

In settling contracts that are physically deliverable, the clearing house: Assigns longs to shorts (no relationship to original counterparties) Provides a delivery venue

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Successful matching of requests with respect to commodity and warehouse location results in delivery on settlement day. After completion of the matching process, clearing members are informed of the deliverable/ receivable positions.

6. Intention Matching Contract

The delivery position for intention matching contract would be arrived at by the Exchange based on the information to give/take delivery furnished by the seller and buyer as per the process put in place by the Exchange for effecting physical delivery. If the intentions of the buyers and sellers match, the respective positions would be settled by physical deliveries. The information for delivery can be submitted during the trading hours 3 trading days prior to 5 working days of expiry of contracts. For example, for contracts expiring on the 20th of the month, delivery intentions window will be open from the 13th and will close on the 15th. Clients can submit delivery intentions up to the maximum of their open positions. On the expiry of the contract, all outstanding positions not resulting in physical delivery shall be closed out at the Final Settlement Price as announced by the Exchange. Penal Provisions for Intention matching and Seller's Right contract. Total amount of penalty imposed on a seller in case of a delivery default would be 2.5 % of the final settlement price The difference between the Final Settlement Price (FSP) and the spot price on the settlement day, if the said spot price is higher than FSP; else this component will be zero.

Bifurcation of penalty for a Intention matching and Seller's right contract 2% shall be deposited in the Investor Protection Fund of the Exchange. 0.5% % shall be passed on to the corresponding buyer who was entitled to receive delivery; and The difference between the Final Settlement Price (FSP) and the spot price on the settlement day would also be passed on to the corresponding buyer, if the said spot price is higher than FSP; else this component will be zero. Members giving delivery requests for the Seller's right and Intention matching contract are not permitted to square off their open positions. A penalty of 5% of final settlement price on the position squared off will be levied on the Members violating the same. Buyer's
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defaults are not permitted in any of the above said contracts. The amount due from the buyers shall be recovered from the buyer as Pay in shortage along with the prescribed charges. Exchange shall have right to sell the goods on account of such Buyer to recover the dues and if the sale proceeds are insufficient, the Buyer would be liable to pay the balance. In case of international reference able commodity such as Aluminum, Nickel, Zinc etc, the information for delivery can be submitted during the trading hours 3 trading days prior to 3 working days of expiry of contracts. For example, for contracts expiring on the 30th of the month, delivery intentions window will be open from the 25th and will close on the 27th.Clients can submit delivery intentions up to the maximum of their open positions. Any buyer intending to take physicals has to put a request to his depository participant. The DP uploads such requests to the specified depository who in turn forwards the same to the registrar and transfer agent (R&T agent) concerned. After due verification of the authenticity, the R&T agent forwards delivery details to the warehouse which in turn arranges to release the commodities after due verification of the identity of recipient. On a specified day, the buyer would go to the warehouse and pick up the physicals. The seller intending to make delivery has to take the commodities to the designated warehouse. These commodities have to be assayed by the Exchange specified assayer. The commodities have to meet the contract specifications with allowed variances. If the commodities meet the specifications, the warehouse accepts them. Warehouses then ensure that the receipts get updated in the depository system giving a credit in the depositor's electronic account. The seller then gives the invoice to his clearing member, who would courier the same to the buyer's clearing member. NCDEX contracts provide a standardized description for each commodity. The description is provided in terms of quality parameters specific to the commodities. At the same time, it is realized that with commodities, there could be some amount of variances in quality/ weight etc., due to natural causes, which are beyond the control of any person. Hence, NCDEX contracts also provide tolerance limits for variances. A delivery is treated as good delivery and accepted if the delivery lies within the tolerance limits. However, to allow for the difference, the concept of premium and discount has been introduced. Goods that come to the authorized warehouse for delivery are tested and graded as per the prescribed parameters. The premium and discount rates apply depending on the level of variation. The price payable by the party taking delivery is then adjusted as per the premium/ discount
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rates fixed by the Exchange. This ensures that some amount of leeway is provided for delivery, but at the same time, the buyer taking delivery does not face windfall loss/ gain due to the quantity/ quality variation at the time of taking delivery. This, to some extent, mitigates the difficulty in delivering and receiving exact quality/ quantity of commodity.

c) Closing out by offsetting positions

Most of the contracts are settled by closing out open positions. In closing out, the opposite transaction is effected to close out the original futures position. A buy contract is closed out by a sale and a sale contract is closed out by a buy. For example, an investor who took a long position in two gold futures contracts on the January 30 at Rs.16090 per 10 grams can close his position by selling two gold futures contracts on February 13, at Rs.15928. In this case, over the period of holding the position, he has suffered a loss of Rs.162 per 10 grams. This loss would have been debited from his account over the holding period by way of MTM at the end of each day, and finally at the price that he closes his position, that is Rs.15928, in this case.

d) Cash settlement

In the case of intention matching contracts, if the trader does not want to take/ give physical delivery, all open positions held till the last day of trading are settled in cash at the final settlement price and with penalty in case of Sellers Right contract. Similarly any unmatched, rejected or excess intention is also settled in cash. When a contract is settled in cash, it is marked to the market at the end of the last trading day and all positions are declared closed. For example, Paul took a short position in five Silver 5kg futures contracts of July expiry on June 15 at Rs.21500 per kg. At the end of 20th July, the last trading day of the contract, he continued to hold the open position, without announcing delivery intention. The closing spot price of silver on that day was Rs.20500 per kg. This was the settlement price for his contract. Though Paul was holding a short position on silver, he did not have to actually deliver the underlying silver. The transaction was settled in cash and he earned profit of Rs. 5000 per trading lot of silver. As mentioned earlier, unmatched positions of
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contracts, for which the intentions for delivery were submitted, are also settled in cash. In case of NCDEX, all contracts being settled in cash are settled on the day after the contract expiry date. If the cash settlement day happens to be a Saturday, a Sunday or a holiday at the exchange, clearing banks or any of the service providers, Pay-in and Pay-out would be effected on the next working day.

8.2.3 Entities involved in Physical Settlement

Physical settlement of commodities involves the following three entities - an accredited warehouse, registrar & transfer agent and an assayer. We will briefly look at the functions of each.

Accredited warehouse

NCDEX specifies accredited warehouses through which delivery of a specific commodity can be affected and which will facilitate for storage of commodities. For the services provided by them, warehouses charge a fee that constitutes storage and other charges such as insurance, assaying and handling charges or any other incidental charges. Following are the functions of an accredited warehouse:

3. Earmark separate storage area as specified by the Exchange for the purpose of storing commodities to be delivered against deals made on the Exchange. The warehouses are required to meet the specifications prescribed by the Exchange for storage of commodities. 4. Ensure and co-ordinate the grading of the commodities received at the warehouse before they are stored. 5. Store commodities in line with their grade specifications and validity period and facilitate maintenance of identity. On expiry of such validity period of the grade for such commodities, the warehouse has to segregate such commodities and store them in a separate area so that the same are not mixed with commodities which are within the validity period as per the grade certificate issued by the approved assayers.

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Approved Registrar and Transfer agents (R&T agents)

The Exchange specifies approved R&T agents through whom commodities can be dematerialized and who facilitate for dematerialization/re-materialization of commodities in the manner prescribed by the Exchange from time to time. The R&T agent performs the following functions:

1. Establishes connectivity with approved warehouses and supports them with physical infrastructure.

2. Verifies the information regarding the commodities accepted by the accredited warehouse and assigns the identification number (ISIN) allotted by the depository in line with the grade, validity period, warehouse location and expiry.

3. Further processes the information, and ensures the credit of commodity holding to the demat account of the constituent.

4.

Ensures that the credit of commodities goes only to the demat account of the constituents held with the Exchange empanelled DPs.

5. On receiving a request for re-materialization (physical delivery) through the depository, arranges for issuance of authorization to the relevant warehouse for the delivery of commodities. R&T agents also maintain proper records of beneficiary position of constituents holding dematerialized commodities in warehouses and in the depository for a period and also as on a particular date. They are required to furnish the same to the Exchange as and when demanded by the Exchange. R&T agents also do the job of co-ordinating with DPs and warehouses for billing of charges for services rendered on periodic intervals. They also reconcile dematerialized commodities in the depository and physical commodities at the warehouses on periodic basis and co-ordinate with all parties concerned for the same.

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Approved assayer

The Exchange specifies approved assayers through whom grading of commodities (received at approved warehouses for delivery against deals made on the Exchange) can be availed by the constituents of clearing members. Assayers perform the following functions:

1. Make available grading facilities to the constituents in respect of the specific commodities traded on the Exchange at specified warehouse. The assayer ensures that the grading to be done (in a certificate format prescribed by the Exchange) in respect of specific commodity is as per the norms specified by the Exchange in the respective contract specifications.

2.

Grading certificate so issued by the assayer specifies the grade as well as the validity period up to which the commodities would retain the original grade, and the time up to which the commodities are fit for trading subject to environment changes at the warehouses.

8.3 Risk Management

NCDEX has developed a comprehensive risk containment mechanism for its commodity futures market. The salient features of risk containment mechanism are:

1. The financial soundness of the members is the key to risk management. Therefore, the requirements for membership in terms of capital adequacy (net worth, security deposits) are quite stringent.

2. NCDEX charges an upfront initial margin for all the open positions of a member. It specifies the initial margin requirements for each futures contract on a daily basis. It also follows value-at-risk (VaR) based margining through SPAN. The PCMs and TCMs in turn collect the initial margin from the TCMs and their clients respectively.

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3. The open positions of the members are marked to market based on contract settlement price for each contract. The difference is settled in cash on a T+1 basis.

4. A member is alerted of his position to enable him to adjust his exposure or bring in additional capital. Position violations result in withdrawal of trading facility and reinstated only after violation(s) rectified.

5. To safeguard the interest of those trading on the Exchange platform, an Investor Protection Fund is also maintained.

The most critical component of risk containment mechanism for futures market on the NCDEX is the margining system and on-line position monitoring. The actual position monitoring and margining is carried out on-line through the SPAN (Standard Portfolio Analysis of Risk) system.

8.4 MARGINING AT NCDEX

In pursuance of the bye-laws, rules and regulations, the Exchange has defined norms and procedures for margins and limits applicable to members and their clients. The margining system for the commodity futures trading on the NCDEX is explained below.

1. SPAN SPAN (Standard Portfolio Analysis of Risk) is a registered trademark of the Chicago Mercantile Exchange, used by NCDEX under license obtained from CME. The objective of SPAN is to identify overall risk in a portfolio of all futures contracts for each member. Its over-riding objective is to determine the largest loss that a portfolio might reasonably be expected to suffer from one day to the next day based on 99.95% confidence interval VaR methodology.

2. Initial Margins This is the amount of money deposited by both buyers and sellers of futures contracts to ensure performance of trades executed. Initial margin is payable on all
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open positions of trading cum clearing members, up to client level, at any point of time, and is payable upfront by the members in accordance with the margin computation mechanism and/ or system as may be adopted by the Exchange from time to time. Initial margin includes SPAN margins and such other additional margins that may be specified by the Exchange from time to time.

3. COMPUTATION OF INITIAL MARGIN

The Exchange has adopted SPAN (Standard Portfolio Analysis of Risk) system for the purpose of real-time initial margin computation. Initial margin requirements are based on 99.95% VaR (Value at Risk) over a one-day time horizon. Initial margin requirements for a member for each contract are as under: 1. For client positions: These are netted at the level of individual client and grossed across all clients, at the member level without any set-offs between clients. 2. For proprietary positions: These are netted at member level without any setoffs between client and proprietary positions. Consider the case of a trading member who has proprietary and client-level positions in an April 2010 gold futures contract. On his proprietary account, he bought 3000 trading units and sold 1000 trading units within the day. On account of client A, he bought 2000 trading units at the beginning of the day and sold 1500 units an hour later. And on account of client B, he sold 1000 trading units. Table 9.3 gives the total outstanding position for which the TCM would be margined.

Table 8.3 Calculating outstanding position at TCM level

Account

Number of units Number of units Outstanding bought sold 1000 1500 1000 position Long 2000 Long 500 Short 1000 3500

Proprietary Client A Client B Net outstanding

3000 2000

Position

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8.4.4 Implementation Aspects of Margining and Risk Management

We look here at some implementation aspects of the margining and risk management system for trading on NCDEX.

1. Mode of payment of initial margin: Margins can be paid by the members in cash, or in collateral security deposits in the form of bank guarantees, fixed deposits receipts and approved Government of India securities.

2. Payment of initial margin: The initial margin is payable upfront by members.

3. Effect of failure to pay initial margins: Non-fulfillment of either the whole or part of the initial margin obligations is treated as a violation of the rules, bye-laws and regulations of the Exchange and attracts penal charges as stipulated by NCDEX from time to time.

4. Exposure limits: This is defined as the maximum open position that a member can take across all contracts and is linked to the effective deposits of the member available with the Exchange. The member is not allowed to trade once the exposure limits have been exceeded on the Exchange. The trader workstation of the member is disabled and trading permitted only on enhancement of exposure limits by deposit of additional capital or reduction of existing positions.

a. Liquid net worth: Typically Liquid net worth is defined as effective deposits less initial margin payable at any point in time. The minimum cash maintained by the members at any point in time as part of the base capital requirements cannot be less than Rs. 15 lakh or such other amount, as may be specified by the Exchange from time to time.

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b. Effective deposits: This includes all deposits made by the members in the form of cash, cash equivalents and collaterals form the effective deposits. For the purpose of computing effective deposits, cash equivalents mean bank guarantees, fixed deposit receipts and Government of Indian securities.

c. Position limits: Position limit is specified at a member and client level for a commodity and for near month contracts. Typically member level limits are 3-5 times of the client level limits or 15% of the market open interest, whichever is higher. The position limits are prescribed by the FMC from time to time.

d. Calendar spread positions: In case of calendar spread positions in futures contracts are treated as open position of one third of the value of the far month futures contract. However the spread positions is treated as a naked position in far month contract three trading days prior to expiry of the near month contract.

5. Imposition of additional margins and close out of open positions: As a risk containment measure, the Exchange may require the members to make payment of additional margins as may be decided from time to time. This is in addition to the initial margin, which is or may have been imposed. The Exchange may also require the members to reduce/ close out open positions to such levels and for such contracts as may be decided by it from time to time.

6.

Failure to pay additional margins: Non-fulfillment of either the whole or part of the additional margin obligations is treated as a violation of the rules, bye-Laws and regulations of the Exchange and attracts penal charges as stipulated by NCDEX.

7.

Return of excess deposit: Members can request the Exchange to release excess deposits held by it or by a specified agent on behalf of the Exchange. Such requests may be considered by the Exchange subject to the bye-laws, rules and regulations.

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8. Initial margin deposit or additional deposit or additional base capital: Members who wish to make a margin deposit (additional base capital) with the Exchange and/ or wish to retain deposits and/ or such amounts which are receivable by them from the Exchange, at any point of time, over and above their deposit requirement towards initial margin and/ or other obligations, must inform the Exchange as per the procedure.

9.

Position limits: Position wise limits are the maximum open positions that a member or his constituents can have in any commodity at any point of time. This is calculated as the higher of a specified percentage of the total open interest in the commodity or a specified value.

10. Intra-day price limit: The maximum price movement allowed during a day is +/- x% of the previous day's settlement price prescribed for each commodity. (a) Daily settlement price: The daily profit/losses of the members are settled using the daily settlement price. The daily settlement price notified by the Exchange is binding on all members and their constituents.

(b) Mark-to-market settlement: All the open positions of the members are marked to market at the end of the day and the profit/loss determined as below: (a) On the day of entering into the contract, it is the difference between the entry value and daily settlement price for that day. (b) On any intervening days, when the member holds an open position, it is the difference between the daily settlement value for that day and the previous day's settlement price. (c) On the expiry date if the member has an open position, it is the difference between the final settlement price and the previous day's settlement price.

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11. Intra-day margin call:

The Exchange at its discretion can make intra day margin calls as risk containment measure if, in its opinion, the market price changes sufficiently. For example, it can make an intra-day margin call if the intra day price limit has been reached, or any other situation has arisen, which in the opinion of the Exchange could result in an enhanced risk. The Exchange at its discretion may make selective margin calls, for example, only for those members whose variation losses or initial margin deficits exceed a threshold value prescribed by the Exchange.

12. Delivery margin: In case of positions materialising into physical delivery, delivery margins are calculated as N days VaR margins plus additional margins. N days refer to the number of days for completing the physical delivery settlement. The number of days are commodity specific, as described or as may be prescribed by the Exchange from time to time. There is a mark up on the VaR based delivery margin to cover for default.

8.4.5 Effect of violation

Whenever any of the margin or position limits are violated by members, the Exchange can withdraw any or all of the membership rights of members including the withdrawal of trading facilities of all members and/ or clearing facility of custodial participants clearing through such trading cum members, without any notice. In addition, the outstanding positions of such member and/ or constituents clearing and settling through such member can be closed out at any time at the discretion of the Exchange. This can be done without any notice to the member and/ or constituent. The Exchange can initiate further risk containment measures with respect to the open positions of the member and/ or constituent. These could include imposing penalties, collecting appropriate deposits, invoking bank guarantees/ fixed deposit receipts, realizing money by disposing off the securities, and exercising such other risk containment measures it considers necessary.
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CHAPTER 9 REGULATORY FRAMEWORK

The trading of derivatives is governed by the provisions contained in the SC(R)A, the SEBI Act, the rules and regulations framed thereunder and the rules and bye laws of stock exchanges.

9.1 SECURITIES CONTRACTS (REGULATION) ACT, 1956

SC(R)A aims at preventing undesirable transactions in securities by regulating the business of dealing therein and by providing for certain other matters connected therewith. This is the principal Act, which governs the trading of securities in India. The term securities has been defined in the SC(R)A. As per Section 2(h), the Securities include: 1. Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate. 2. Derivative 3. Units or any other instrument issued by any collective investment scheme to the investors in such schemes. 4. Government securities 5. Such other instruments as may be declared by the Central Government to be securities. 6. Rights or interests in securities. Derivative is defined to include: A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. A contract which derives its value from the prices, or index of prices, of underlying securities.
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Section 18A provides that notwithstanding anything contained in any other law for the time being in force, contracts in derivative shall be legal and valid if such contracts are: Traded on a recognized stock exchange Settled on the clearing house of the recognized stock exchange, in accordance with the rules and byelaws of such stock exchanges.

9.2 SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992

SEBI Act, 1992 provides for establishment of Securities and Exchange Board of India(SEBI) with statutory powers for (a) protecting the interests of investors in securities (b) promoting the development of the securities market and (c) regulating the securities market. Its regulatory jurisdiction extends over corporate in the issuance of capital and transfer of securities, in addition to all intermediaries and persons associated with securities market. SEBI has been obligated to perform the aforesaid functions by such measures as it thinks fit. In particular, it has powers for: Regulating the business in stock exchanges and any other securities markets. Registering and regulating the working of stock brokers, subbrokers etc. Promoting and regulating self-regulatory organizations. Prohibiting fraudulent and unfair trade practices. Calling for information from, undertaking inspection, conducting inquiries and audits of the stock exchanges, mutual funds and other persons associated with the securities market and intermediaries and selfregulatory organizations in the securities market. Performing such functions and exercising according to Securities Contracts (Regulation) Act, 1956, as may be delegated to it by the Central Government.

9.3 REGULATION FOR DERIVATIVES TRADING SEBI set up a 24- member committee under the Chairmanship of Dr. L. C. Gupta to develop the appropriate regulatory framework for derivatives trading in India. On
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May 11, 1998 SEBI accepted the recommendations of the committee and approved the phased introduction of derivatives trading in India beginning with stock index futures. The provisions in the SC(R)A and the regulatory framework developed there under govern trading in securities. The amendment of the SC(R)A to include derivatives within the ambit of securities in the SC(R)A made trading in derivatives possible within the framework of that Act. 1. Any Exchange fulfilling the eligibility criteria as prescribed in the L. C. Gupta committee report can apply to SEBI for grant of recognition under Section 4 of the SC(R)A, 1956 to start trading derivatives. The derivatives exchange/segment should have a separate governing council and representation of trading/clearing members shall be limited to maximum of 40% of the total members of the governing council. The exchange would have to regulate the sales practices of its members and would have to obtain prior approval of SEBI before start of trading in any derivative contract. 2. The Exchange should have minimum 50 members. 3. The members of an existing segment of the exchange would not automatically become the members of derivative segment. The members of the derivative segment would need to fulfill the eligibility conditions as laid down by the L. C. Gupta committee. 4. The clearing and settlement of derivatives trades would be through a SEBI approved clearing corporation/house. Clearing corporations/houses complying with the eligibility conditions as laid down by the committee have to apply to SEBI for grant of approval. 5. Derivative brokers/dealers and clearing members are required to seek registration from SEBI. This is in addition to their registration as brokers of existing stock exchanges. The minimum net worth for clearing members of the derivatives clearing corporation/house shall be Rs.300 Lakh. The net worth of the member shall be computed as follows: Capital + Free reserves Less non-allowable assets viz., (a) Fixed assets
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(b) Pledged securities (c) Members card (d) Non-allowable securities (unlisted securities) (e) Bad deliveries (f) Doubtful debts and advances (g) Prepaid expenses (h) Intangible assets (i) 30% marketable securities 6. The minimum contract value shall not be less than Rs.2 Lakh. Exchanges have to submit details of the futures contract they propose to introduce. 7. The initial margin requirement, exposure limits linked to capital adequacy and margin demands related to the risk of loss on the position will be prescribed by SEBI/Exchange from time to time. 8. The L. C. Gupta committee report requires strict enforcement of Know your customer rule and requires that every client shall be registered with the derivatives broker. The members of the derivatives segment are also required to make their clients aware of the risks involved in derivatives trading by issuing to the client the Risk Disclosure Document and obtain a copy of the same duly signed by the client. 9. The trading members are required to have qualified approved user and sales person who have passed a certification programme approved by SEBI.

Forms of collaterals acceptable at NSCCL Members and dealer authorized dealer have to fulfill certain requirements and provide collateral deposits to become members of the F&O segment. All collateral deposits are segregated into cash component and non-cash component. Cash component means cash, bank guarantee, fixed deposit receipts, T-bills and dated government securities. Non-cash component mean all other forms of collateral deposits like deposit of approved demat securities.

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Requirements to become F&O segment member The eligibility criteria for membership on the F&O segment is as given in Table 7.1. Table 7.2 gives the requirements for professional clearing membership. Anybody interested in taking membership of F&O segment is required to take membership of CM and F&O segment or CM, WDM and F&O segment. An existing member of CM segment can also take membership of F&O segment. A trading member can also be a clearing member by meeting additional requirements. There can also be only clearing members.

7.3.3 Requirements to become authorized / approved user Trading members and participants are entitled to appoint, with the approval of the F&O segment of the exchange authorized persons and approved users to operate the trading workstation(s). These authorized users can be individuals, registered partnership firms or corporate bodies. Authorized persons cannot collect any commission or any amount directly from the clients he introduces to the trading member who appointed him. However he can receive a commission or any such amount from the trading member who appointed him as provided under regulation. Approved users on the F&O segment have to pass a certification program which has been approved by SEBI. Each approved user is given a unique identification number through which he will have access to the NEAT system. The approved user can access the NEAT system through a password and can change such password from time to time.

Position limits Position limits have been specified by SEBI at trading member, client, market and FII levels respectively.

Trading member position limits Trading member position limits are specified as given below:

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1. Trading member position limits in equity index option contracts: The trading member position limits in equity index option contracts is higher of Rs.500 crore or 15% of the total open interest in the market in equity index option contracts. This limit is applicable on open positions in all option contracts on a particular underlying index. 2. Trading member position limits in equity index futures contracts: The trading member position limits in equity index futures contracts is higher of Rs.500 crore or 15% of the total open interest in the market in equity index futures contracts. This limit is applicable on open positions in all futures contracts on a particular underlying index. 3. Trading member position limits for combined futures and options position:

For stocks having applicable market-wise position limit(MWPL) of Rs.500 crores or more, the combined futures and options position limit is 20% of applicable MWPL or Rs.300 crores, whichever is lower and within which stock futures position cannot exceed 10% of applicable MWPL or Rs.150 crores, whichever is lower.

For stocks having applicable market-wise position limit (MWPL) less than Rs.500 crores, the combined futures and options position limit is 20% of applicable MWPL and futures position cannot exceed 20% of applicable MWPL or Rs.50 crore which ever is lower. The Clearing Corporation shall specify the trading member-wise position limits on the last trading day month which shall be reckoned for the purpose during the next month.

Client level position limits The gross open position for each client, across all the derivative contracts on an underlying, should not exceed 1% of the free float market capitalization (in terms of number of shares) or 5% of the open interest in all derivative contracts in the same underlying stock (in terms of number of shares) whichever is higher.

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Market wide position limits The market wide limit of open position (in terms of the number of underlying stock) on futures and option contracts on a particular underlying stock is 20% of the number of shares held by non-promoters in the relevant underlying security i.e. free float holding. This limit is applicable on all open positions in all futures and option contracts on a particular underlying stock. The enforcement of the market wide limits is done in the following manner:

At end of the day the exchange tests whether the market wide open interest for any scrip exceeds 95% of the market wide position limit for that scrip. In case it does so, the exchange takes note of open position of all client/TMs as at end of that day for that scrip and from next day onwards they can trade only to decrease their positions through offsetting positions.

At the end of each day during which the ban on fresh positions is in force for any scrip, the exchange tests whether any member or client has increased his existing positions or has created a new position in that scrip. If so, that client is subject to a penalty equal to a specified percentage (or basis points) of the increase in the position (in terms of notional value). The penalty is recovered before trading begins next day. The exchange specifies the percentage or basis points, which is set high enough to deter violations of the ban on increasing positions.

The normal trading in the scrip is resumed after the open outstanding position comes down to 80% or below of the market wide position limit. Further, the exchange also checks on a monthly basis, whether a stock has remained subject to the ban on new position for a significant part of the month consistently for three months. If so, then the exchange phases out derivative contracts on that underlying.

FII and subaccount position limits FII and subaccount position limits are specified as given below:
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1. The FII position limit in all index options contracts on a particular underlying index is Rs. 500 crore or 15% of the total open interest of the market in index options, whichever is higher, per exchange. This limit is applicable on open positions in all option contracts on a particular underlying index. 2. FII position limit in all index futures contracts on a particular underlying index is the same as mentioned above for FII position limits in index option contracts. This limit is applicable on open positions in all futures contracts on a particular underlying index. In addition to the above, FIIs can take exposure in equity index derivatives subject to the following limits: 1. Short positions in index derivatives (short futures, short calls and long puts) not exceeding (in notional value) the FIIs holding of stocks. 2. Long positions in index derivatives (long futures, long calls and short puts) not exceeding (in notional value) the FIIs holding of cash, government securities, T-bills and similar instruments. The FIIs should report to the clearing member (custodian) the extent of the FIIs holding of stocks, cash, government securities, T-bills and similar instruments before the end of the day. The clearing member (custodian) in turn should report the same to the exchange. The exchange monitors the FII position limits. The position limit for sub-account is same as that of client level position limits.

Position limits for mutual funds Mutual Funds are allowed to participate in the derivatives market at par with Foreign Institutional Investors (FII). Accordingly, mutual funds shall be treated at par with a registered FII in respect of position limits in index futures, index options, stock options and stock futures contracts. Mutual funds will be considered as trading members like registered FIIs and the schemes of mutual funds will be treated as clients like sub-accounts of FIIs. The position limits for Mutual Funds and its schemes shall be as under: 1. Position limit for mutual funds in index options contracts:

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a) The mutual fund position limit in all index options contracts on a particular underlying index shall be Rs.500 crore or 15% of the total open interest of the market in index options, whichever is higher, per stock exchange. b) This limit would be applicable on open positions in all options contracts on a particular underlying index. 2. Position limit for mutual funds in index futures contracts: a) The mutual fund position limit in all index futures contracts on a particular underlying index shall be Rs.500 crore or 15% of the total open interest of the market in index futures, whichever is higher, per stock exchange. b) This limit would be applicable on open positions in all futures contracts on a particular underlying index. 3. Additional position limit for hedging: In addition to the position limits above, mutual funds may take exposure in equity index derivatives subject to the following limits: a) Short positions in index derivatives (short futures, short calls and long puts) shall not exceed (in notional value) the mutual Funds holding of stocks. b) Long positions in index derivatives (long futures, long calls and short puts) shall not exceed (in notional value) the mutual Funds holding of cash, government securities, TBills and similar instruments. 4. Foreign Institutional Investors and Mutual Fund Position limits on individual securities: a) For stoc ks having applicable market-wide position limit (MWPL) of Rs. 500 crores or more, the combined futures and options position limit shall be 20% of applicable MWPL or Rs. 300crores, whichever is lower and within which stock futures position cannot exceed 10% of applicable MWPL or Rs. 150 crores, whichever is lower. b) For stocks having applicable market-wide position limit (MWPL) less than Rs. 500 crores, the combined futures and options position limit shall be 20% of applicable MWPL and stock futures position cannot exceed 20% of applicable MWPL or Rs. 50 crores, whichever is lower.

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5. Position limit for each scheme of a mutual fund: The position limits for each scheme of mutual fund and disclosure requirements shall be identical to that prescribed for a subaccount of a FII. Therefore, the schemewise position limit/disclosure requirements shall be as follows: a) For stock option and stock futures contracts, the gross open position across all derivative contracts on a particular underlying stock of a scheme of a mutual fund shall not exceed the higher of 1% of the free float market capitalisation (number of shares) or 5% of open interest (number of contracts) in derivative contracts on a particular underlying stock. b) This position limits shall be applicable on the combined position in all derivative contracts on an underlying stock at a stock exchange. c) For index based contracts, mutual funds shall disclose the total open interest held by its scheme or all schemes put together in a particular underlying index, if such open interest equals to or exceeds 15% of the open interest of all derivative contracts on that underlying index.

Reporting of client margin Clearing Members (CMs) and Trading Members (TMs) are required to collect upfront initial margins from all their Trading Members/ Constituents. CMs are required to compulsorily report, on a daily basis, details in respect of such margin amount due and collected, from the TMs/ Constituents clearing and settling through them, with respect to the trades executed/ open positions of the TMs/ Constituents, which the CMs have paid to NSCCL, for the purpose of meeting margin requirements. Similarly, TMs are required to report on a daily basis details in respect of such margin amount due and collected from the constituents clearing and settling through them, with respect to the trades executed/ open positions of the constituents, which the trading members have paid to the CMs, and on which the CMs have allowed initial margin limit to the TMs.

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REGULATORY FRAMEWORK OF COMMODITY FUTURES

At present, there are three tiers of regulations of forward/futures trading system in India, namely, Government of India, Forward Markets Commission (FMC) and Commodity Exchanges. The need for regulation arises on account of the fact that the benefits of futures markets accrue in competitive conditions. Proper regulation is needed to create competitive conditions. In the absence of regulation, unscrupulous participants could use these leveraged contracts for manipulating prices. This could also have undesirable influence on the spot prices, thereby affecting interests of society at large. Regulation is also needed to ensure that the market has appropriate risk management system. In the absence of such a system, a major default could create a chain reaction. The resultant financial crisis in a futures market could create systematic risk. Regulation is also needed to ensure fairness and transparency in trading, clearing, settlement and management of the Exchange so as to protect and promote the interest of various stakeholders, particularly non-member users of the market.

RULES

GOVERNING

COMMODITY

DERIVATIVES

EXCHANGES

/PARTICIPANTS

The trading of commodity derivatives on the NCDEX is regulated by Forward Markets Commission (FMC). In terms of Section 15 of the Forward Contracts (Regulation) Act, 1952 (the Act), forward contracts in commodities notified under section 15 of the Act can be entered into only by or through a member of a recognized association, i.e, commodity exchange as popularly known. The recognized associations/commodity exchanges are granted recognition under the Act by the central government (Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution). All the Exchanges, which permit forward contracts for trading, are required to obtain certificate of registration from the Central Government. The other legislations which have relevance to commodity trading are the Companies Act, Stamp Act, Contracts Act, Essential Commodities Act 1955, Prevention of Food Adulteration Act, 1954 and various other legislations, which impinge on their working.

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Forward Markets Commission provides regulatory oversight in order to ensure financial integrity (i.e. to prevent systematic risk of default by one major operator or group of operators), market integrity (i.e. to ensure that futures prices are truly aligned with the prospective demand and supply conditions) and to protect and promote interest of customers/ non-members. Some of the regulatory measures by Forward Markets Commission include:

1. Limit on net open position as on the close of the trading hours. Some times limit is also imposed on intra-day net open position. The limits are imposed member- wise and client wise.

2.

Circuit-filters or limit on price fluctuations to allow cooling of market in the event of abrupt upswing or downswing in prices.

3. Special margin deposit to be collected on outstanding purchases or sales when price moves up or down sharply above or below the previous day closing price. By making further purchases/sales relatively costly, the price rise or fall is sobered down. This measure is imposed by the Exchange (FMC may also issue directive). 4. Circuit breakers or minimum/maximum prices: These are prescribed to prevent futures prices from falling below as rising above not warranted by prospective supply and demand factors. This measure is also imposed on the request of the exchanges (FMC may also issue directive).

5. Stopping trading in certain derivatives of the contract, closing the market for a specified period and even closing out the contract. These extreme measures are taken only in emergency situations.

Besides these regulatory measures, a client's position cannot be appropriated by the member of the Exchange. No member of an Exchange can enter into a forward contract on his own account with a non-member unless such member has secured the consent of the non-member in writing to the effect that the sale or purchase is on
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his own account. The FMC is persuading increasing number of exchanges to switch over to electronic trading, clearing and settlement,which is more safe and customerfriendly. The FMC has also prescribed simultaneous reporting system for the exchanges following open out-cry system. These steps facilitate audit trail and make it difficult for the members to indulge in malpractices like trading ahead of clients, etc. The FMC has also mandated all the exchanges following open outcry system to display at a prominent place in exchange premises, the name, address, telephone number of the officer of the commission who can be contacted for any grievance. The website of the commission also has a provision for the customers to make complaint and send comments and suggestions to the FMC. Officers of the FMC meet the members and clients on a random basis, visit exchanges, to ascertain the situation on the ground to bring in development in any area of operation of the market.

RULES GOVERNING TRADING ON EXCHANGE

The Forward Markets Commission (FMC) is the Regulatory Authority for futures market under the Forward Contracts (Regulation) Act 1952. In addition to the provisions of the Forward Contracts (Regulation) Act 1952 and rules framed thereunder, the exchanges and participants of futures market are governed by the Rules and Bye laws of the respective exchanges, which are published in the Official Gazette and Regulations if any (all approved by the FMC). In this section, we shall have a brief look at the important regulations that govern NCDEX (Exchange). For the sake of convenience, these have been divided into two main divisions pertaining to trading and clearing. The detailed Rules, Bye-laws and Regulations are available on the NCDEX website home page.

Trading

The NCDEX provides an automated trading facility in all the commodities admitted for dealings on the derivative market. Trading on the Exchange is allowed only through approved workstation(s) located at locations for the office(s) of a trading member as approved by the Exchange. The LAN or any other mode of connectivity
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to other workstations at any place connecting an approved workstation of a trading member shall require an approval of the Exchange.

Each trading member is required to have a unique identification number which is assigned by the Exchange and which will be used to log on (sign on) to the trading system. Trading member has a non-exclusive permission to use the trading system as provided by the Exchange in the ordinary course of business as trading member. He does not have any title rights or interest whatsoever with respect to the trading system, its facilities, software and the information provided by the trading system. For the purpose of accessing the trading system, the member will install and use equipment and software as specified by the Exchange at his own cost. The Exchange has the right to inspect equipment and software used for the purposes of accessing the trading system at any time. The cost of the equipment and software supplied by the Exchange, installation and maintenance of the equipment is borne by the trading member.

Trading members and users

Trading members are entitled to appoint, (subject to such terms and conditions, as may be specified by the relevant authority of the Exchange) from time to time Authorised persons Approved users

Trading members have to pass a certification program, which has been prescribed by the Exchange. In case of trading members, other than individuals or sole proprietorships, such certification program has to be passed by at least one of their directors/ employees/ partners/ members of governing body.

Each trading member is permitted to appoint a certain number of approved users as notified from time to time by the Exchange. The appointment of approved users is subject to the terms and conditions prescribed by the Exchange. Each approved user is given a unique identification number through which he will have access to the trading system. An approved user can access the trading system through a password and can change the password from time to time. The trading member or its approved
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users are required to maintain complete secrecy of its password. Any trade or transaction done by use of password of any approved user of the trading member, will be binding on such trading member. Approved user shall be required to change his password at the end of the password expiry period.

Trading days

The Exchange operates on all days except Sunday and on holidays declared from time to time. The types of order books, trade books, price limits, matching rules and other parameters pertaining to each or all of these sessions are specified by the Exchange to the members via its circulars or notices issued from time to time. Members can place orders on the trading system during these sessions, as permitted under the Bye-laws and Regulations prescribed by the Exchange.

Trading hours and trading cycle

The Exchange announces the normal trading hours/ open period in advance from time to time. In case necessary, the Exchange can extend or reduce the trading hours by notifying the members. Trading cycle for each commodity/ derivative contract has a standard period, during which it will be available for trading.

Contract expiration

Derivatives contracts expire on a pre-determined date and time up to which the contract is available for trading. This is notified by the Exchange in advance. The contract expiration period will not exceed twelve months or as the Exchange may specify from time to time.

Trading parameters

The Exchange from time to time specifies various trading parameters relating to the trading system. Every trading member is required to specify the buy or sell orders as either an open order or a close order for derivatives contracts. The Exchange also
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prescribes different order books that shall be maintained on the trading system and also specifies various conditions on the order that will make it eligible to place it in those books. The Exchange specifies the minimum quantity for orders that will be allowed for each commodity/ derivatives contract. It also prescribes the number of days after which `Good Till Cancelled' orders will be cancelled by the system. The Exchange also specifies parameters like lot size in which orders can be placed, tick size in which orders shall be entered on the trading system, position limits in respect of each commodity etc.

Failure of trading member terminal

In the event of failure of trading member's workstation and/ or the loss of access to the trading system, the Exchange can at its discretion undertake to carry out on behalf of the trading member the necessary functions which the trading member is eligible for. Only requests made in writing in a clear and precise manner by the trading member would be considered. The trading member is accountable for the functions executed by the Exchange on its behalf and has to indemnity the Exchange against any losses or costs incurred by the Exchange.

Trade operations

Trading members have to ensure that appropriate confirmed order instructions are obtained from the constituents before placement of an order on the system. They have to keep relevant records or documents concerning the order and trading system order number and copies of the order confirmation slip/modification slip must be made available to the constituents. The trading member has to disclose to the Exchange at the time of order entry whether the order is on his own account or on behalf of constituents and also specify orders for buy or sell as open or close orders. Trading members are solely responsible for the accuracy of details of orders entered into the trading system including orders entered on behalf of their constituents. Trades generated on the system are irrevocable and `locked in'. The Exchange specifies from time to time the market types and the manner if any, in which trade cancellation can be effected. Where a trade cancellation is permitted and trading

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member wishes to cancel a trade, it can be done only with the approval of the Exchange.

Margin requirements

Every clearing member, has to deposit a margin with the Exchange in respect of the trades to which he is party, in the manner prescribed by or under the provisions as contained in the Exchange Bye-laws and Regulations as may be in force, . The Exchange prescribes from time to time the commodities derivative contracts, the settlement periods and trade types for which margin would be attracted. The Exchange levies initial margin on derivatives contracts using the concept of Value at Risk (VaR) or any other concept as the Exchange may decide from time to time. The margin is charged so as to cover one-day loss that can be encountered on the position. Additional margins may be levied for deliverable positions, on the basis of VaR from the expiry of the contract till the actual settlement date plus a mark-up for default. The margin has to be deposited with the Exchange within the time notified by the Exchange. The Exchange also prescribes categories of securities that would be eligible for a margin deposit, as well as the method of valuation and amount of securities that would be required to be deposited against the margin amount. The procedure for refund/ adjustment of margins is also specified by the Exchange from time to time. The Exchange can impose upon any particular trading member or category of trading member any special or other margin requirement. On failure to deposit margin/s as required under this clause, the Exchange/clearing house can withdraw the trading facility of the trading member. After the pay-out, the clearing house releases all margins. Unfair trading practices No trading member shall buy, sell, deal in derivatives contracts in a fraudulent manner, or indulge in any market manipulation, unfair trade practices, including the following: Effect, take part either directly or indirectly in transactions, which are likely to have effect of artificially, raising or depressing the prices of spot/ derivatives contracts. Indulge in any act, which is calculated to create a false or misleading appearance of trading, resulting in reflection of prices, which are not genuine.
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 Buy, sell commodities/ contracts on his own behalf or on behalf of a person associated with him pending the execution of the order of his constituent or of his company or director for the same contract. Delay the transfer of commodities in the name of the transferee. Indulge in falsification of his books, accounts and records for the purpose of market manipulation. When acting as an agent, execute a transaction with a constituent at a price other than the price at which it was executed on the Exchange. Either take opposite position to an order of a constituent or execute opposite orders which he is holding in respect of two constituents except in the manner laid down by the Exchange.

Clearing

National Commodity Clearing Limited (NCCL) as the clearing house, undertakes clearing of trades executed on the NCDEX platform. All deals executed on the Exchange are cleared and settled by the trading members on the settlement date by the trading members themselves as clearing members or through other professional clearing members in accordance with the Regulations, Bye laws and Rules of the Exchange.

Last day of trading

Last trading day for a derivative contract in any commodity is the date as specified in the respective commodity contract specifications. If the last trading day as specified in the respective commodity contract is a holiday, the last trading day is taken to be the previous working day of Exchange. For contracts with Sellers option & Intention matching contract, the trading members/ clearing members have to give delivery information as prescribed by the Exchange from time to time. If a trading member/ clearing member fail to submit such information as permitted by the
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Exchange, the deals have to be settled in accordance with the settlement calendar applicable for such deals, in cash together with penalty as stipulated by the Exchange. For contracts having compulsory delivery, all the open positions at end of trading hours on the expiry date of the contracts, will crystalise in to delivery obligations and the members have to meet the obligation as per the settlement calendar notified by the Exchange by giving or taking delivery as the case may be, of the commodity.

Delivery

During the specified period as per settlement calender, the Exchange provides a window on the trading system to submit delivery information for all open positions for contracts having Sellers option & Intention matching contract. For contracts having compulsory delivery, all the members having open positions at the end of trading hours on the expiry date of the contracts, will have to give or take delivery as the case may be. After the trading hours on the expiry date, based on the available information, the matching for deliveries takes place. Matching done on the basis of procedure of the Exchange is binding on the clearing members. After completion of the matching process, clearing members are informed of the deliverable / receivable positions and the unmatched positions. Unmatched positions have to be settled in cash. The cash settlement is only for the incremental gain/ loss as determined on the basis of the final settlement price. All matched and unmatched positions are settled in accordance with the applicable settlement calendar.

The Exchange may allow an alternate mode of settlement between the constituents directly provided that both the constituents through their respective clearing members notify the Exchange before the closing of trading hours on the expiry date. They have to mention their preferred identified counter-party and the deliverable quantity, along with other details required by the Exchange. The Exchange however, is not responsible or liable for such settlements or any consequence of such alternate mode of settlements. If the information provided by the buyer/ seller clearing members fails to match, then the open position would be treated in same way as other open positions and are settled together with penalty (If any) as may be stipulated by the Exchange. The clearing members are allowed to deliver their
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obligations post expiry of the contract, but before the pay in date as per applicable settlement calendar, whereby the clearing house can reduce the margin requirement to that extent. The Exchange specifies the parameters and methodology for premium/ discount, as the case may be, from time to time for the quality/ quantity differential, sales tax, taxes, government levies/ fees if any. Pay in/ Pay out for such additional obligations are settled through supplemental settlement date as specified in the settlement calendar.

Procedure for payment of sales tax/VAT

The Exchange prescribes the procedure for sales tax/VAT settlement applicable to the deals culminating into sale with physical delivery of commodities. All members have to ensure that their respective constituents, who intend to take or give delivery of commodity, are registered with sales tax authorities of the State/s where the delivery center for a particular commodity is situated and where delivery is allocated. Members shall have themselves registered with the respective Sales Tax/VAT authorities for giving or taking delivery on his own account and shall have to maintain records/details of sales tax registration of each of its constituent giving or taking delivery and shall furnish the same to the Exchange as and when required. The seller is responsible for payment of sales tax/VAT, however the seller is entitled to recover from the buyer, the sales tax and other taxes levied under the local state sales tax law to the extent permitted by law. In no event shall the Exchange/ clearing house be liable for payment of Sales Tax/ VAT or any other local tax, fees, levies etc.

Penalties for defaults

In the event of a default by the seller in delivery of commodities, the Exchange closes out the derivatives contracts and imposes penalties on the defaulting seller. In case of default by a buying member penalty as prescribed by the Exchange is levied on the member till such time that the buyer does not bring in the funds. However it may be noted that buyers default are not permitted by Exchange and amount will be recovered as pay-in shortages together with penalty. It can also use the margins deposited by such clearing member to recover the loss.
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Process of dematerialization

Dematerialization refers to issue of an electronic credit, instead of a vault/ warehouse receipt, to the depositor against the deposit of commodity. Any person (a constituent) seeking to dematerialize a commodity has to open a demat account with an approved Depository Participant (DP). The Exchange provides the list of approved DPs from time to time. In case of commodities (other than precious metals), the constituent delivers the commodity to the Exchange-approved warehouses. The commodity brought by the constituent is checked for the quality by the Exchange-approved assayers before the deposit of the same is accepted by the warehouse. If the quality of the commodity is as per the norms defined and notified by the Exchange from time to time, the warehouse accepts the commodity and sends confirmation in the requisite format to the Registrar & Transfer (R&T) agent who upon verification, confirms the deposit of such commodity to the depository for giving credit to the demat account of the said constituent. In case of precious metals, the commodity must be accompanied with the packing list / shipping certificate. The vault accepts the precious metal, after verifying the contents of the certificate with the precious metal being deposited. On acceptance, the vault issues an acknowledgementto the constituent and sends confirmation in the requisite format to the R&T agent who upon verification, confirms the deposit of such precious metal to the depository for giving credit to the demat account of the said constituent.

Validity date

In case of commodities having validity date assigned to it by the approved assayer, the delivery of the commodity upon expiry of validity date is not considered as a good delivery and such commodities are suspended from delivery. The clearing member has to ensure that his concerned constituent revalidates the commodities for all such commodities to make them deliverable on the Exchange.

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Final Expiry Date (FED)

All the commodities deposited in the warehouse are given an FED. The commodities can not be revalidated after the FED. For the depository, commodities, which have reached the FED, are moved out of the electronic deliverable quantity. Such commodities are suspended from delivery. The constituent has to rematerialize such quantity and remove the same from the warehouse. Failure to remove commodities after FED from the warehouse may be levied a penalty as specified by the relevant authority from time to time.

Process of rematerialisation

Re-materialization refers to issue of physical delivery against the credit in the demat account of the constituent. The constituent seeking to rematerialize his commodity holding has to make a request to his DP in the prescribed format and the DP then routes his request through the depository system to the R&T agent, R&T issues the authorisation addressed to the vault/ warehouse to release physical delivery to the constituent. The vault/warehouse on receipt of such authorization releases the commodity to the constituent or constituent's authorised person upon verifying the identity.

Delivery through the depository clearing system

Delivery in respect of all deals for the clearing in commodities happens through the depository clearing system. The delivery through the depository clearing system into the account of the buyer with the DP is deemed to be delivery, notwithstanding that the commodities are located in the warehouse along with the commodities of other constituents.

Payment through the clearing bank

Payment in respect of all deals for the clearing has to be made through the clearing bank(s); provided however that the deals of sales and purchase executed between
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different constituents of the same clearing member in the same settlement, shall be offset by process of netting to arrive at net obligations.

Clearing and settlement process

The relevant authority from time to time fixes the various clearing days, the pay-in and payout days and the scheduled time to be observed in connection with the clearing and settlement operations of deals in commodities futures contracts.

1. Settlement obligations statements for TCMs:

The Exchange generates and provides to each trading clearing member, settlement obligations statements showing the quantities of the different kinds of commodities for which delivery/ deliveries is/ are to be given and/ or taken and the funds payable or receivable by him in his capacity as clearing member and by professional clearing member for deals made by him for which the clearing member has confirmed acceptance to settle. The obligations statement isdeemed to be confirmed by the trading member for which deliveries are to be given and/ or taken and funds to be debited and/ or credited to his account as specified in the obligations statements and deemed instructions to the clearing banks/ institutions for the same.

2. Settlement obligations statements for PCMs: The Exchange/ clearing house generates and provides to each professional clearing member, settlement obligations statements showing the quantities of the different kinds of commodities for which delivery/ deliveries is/ are to be given and/ or taken and the funds payable or receivable by him. The settlement obligation statement is deemed to have been confirmed by the said clearing member in respect of each and all obligations enlisted therein.

Delivery of commodities

Based on the settlement obligations statements, the Exchange generates delivery statement and receipt statement for each clearing member. The delivery and receipt
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statement contains details of commodities to be delivered to and received from other clearing members, the details of the corresponding buying/ selling constituent and such other details. The delivery and receipt statements are deemed to be confirmed by respective member to deliver and receive on account of his constituent, commodities as specified in the delivery and receipt statements.

On respective pay-in day, clearing members effect depository delivery in the depository clearing system as per delivery statement in respect of depository deals. Delivery has to be made in terms of the delivery units notified by the Exchange. Commodities, which are to be received by a clearing member, are delivered to him in the depository clearing system in respect of depository deals on the respective pay-out day as per instructions of the Exchange/ clearing house.

Delivery units The Exchange specifies from time to time the delivery units for all commodities admitted to dealings on the Exchange. Electronic delivery is available for trading before expiry of the validity date. The Exchange also specifies from time to time the variations permissible in delivery units as per those stated in contract specifications.

Depository clearing system

The Exchange specifies depository(ies) through which depository delivery can be effected and which shall act as agents for settlement of depository deals, for the collection of margins by way of securities for all deals entered into through the Exchange, for any other commodities movement and transfer in a depository(ies) between clearing members and the Exchange and between clearing member to clearing member as may be directed by the relevant authority from time to time. Every clearing member must have a clearing account with any of the Depository Participants of specified depositories.

Clearing Members operate the clearing account only for the purpose of settlement of depository deals entered through the Exchange, for the collection of margins by way of commodities for deals entered into through the Exchange. The clearing member cannot operate the clearing account for any other purpose. Clearing members are
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required to authorize the specified depositories and DP with whom they have a clearing account to access their clearing account for debiting and crediting their accounts as per instructions received from the Exchange and to report balances and other credit information to the Exchange. TCM has to have pool accounts with both the depositories (NSDL and CDSL).

Rules Governing Investor Grievances, Arbitration

The Exchange has put in place a dispute resolution mechanism by way of arbitration for resolution of disputes between members or between a member and client arising out of transactions on the Exchange. The arbitration mechanism and procedure for reference of disputes to arbitration are detailed in the Exchange Bye-laws and Regulations.

Definitions: Arbitrator means a sole arbitrator or a panel of arbitrators. Applicant/Claimant means the person who makes the application for initiating arbitral proceedings. Respondent means the person against whom the applicant/claimant lodges an arbitration application, whether or not there is a claim against such person. The Exchange may provide for different seats of arbitration for different regions of the country termed as Regional Arbitration Centres (RACs). The seat of arbitration shall be Mumbai where no RAC has been notified.

JURISDICTION

In matters where the Exchange is a party to the dispute, the civil courts at Mumbai shall have exclusive jurisdiction and in all other matters, proper courts within the area covered under the respective RAC shall have jurisdiction in respect of the arbitration proceedings falling/ conducted in that RAC.

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PERIOD FOR REFERENCE OF CLAIMS/DISPUTES

All claims shall have to be referred within six months from the date on which such claim, dispute or difference arose. The time taken by the Exchange for administratively resolving the dispute shall be excluded for the purpose of determining the period of six months.

REFERENCE OF CLAIM

If the value of claim, difference or dispute is more than Rs.50 Lakh on the date of application, then such claim, difference or dispute are to be referred to a panel of three Arbitrators. If the value of the claim, difference or dispute is up to Rs.50 Lakh, then they are to be referred to a sole Arbitrator. Where any claim, difference or dispute arises between agent of the member and client of the agent of the member, in such claim, difference or dispute, the member, to whom such agent is affiliated, is impeded as a party. In case the warehouse refuses or fails to communicate to the constituent the transfer of commodities, the date of dispute is deemed to have arisen on 1. The date of receipt of communication of warehouse refusing to transfer the commodities in favour of the constituent; or 2. The date of expiry of 5 days from the date of lodgment of dematerialized request by the constituent for transfer with the seller; whichever is later.

Procedure for Arbitration

The applicant has to submit to the Exchange application for arbitration in the specified form (Form No. I/IA) along with the following enclosures: 1. The statement of case (containing all the relevant facts about the dispute and relief sought). 2. The statement of accounts. 3. Copies of member - constituent agreement. 4. Copies of the relevant contract notes, invoice and delivery challan or any other relevant material in support of the claim.

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The Applicant has to also submit to the Exchange the following along with the arbitration form:

a) A cheque/ pay order/ demand draft for the deposit payable at the seat of arbitration in favour of National Commodity & Derivatives Exchange Limited. b) Form No. II/IIA containing list of names of the persons eligible to act as Arbitrators. Upon receipt of Form No.I/IA, the Exchange forwards a copy of the statement of case along with its enclosures to the respondent. The respondent then has to submit Form II/IIA and also Form III/IIIA (reply) to the Exchange within 7 days from the date of receipt. If the respondent fails to submit the said Forms within the time period prescribed by the Exchange unless the time is extended by the Exchange on request, then the Arbitrator is appointed in the manner as specified Regulation 21 of the Regulations of the Exchange. c) The respondent has to submit the said Forms to the Exchange in three copies in case of sole Arbitrator to be appointed and five copies in case of panel of Arbitrators depending on the claim amount, along with the following enclosures: The statement of reply (containing all available defences to the claim) The statement of accounts Copies of the member constituent agreement Copies of the relevant contract notes, invoice and delivery challan Statement of the set-off or counter claim along with statements of accounts and copies of relevant contract notes and bills The respondent has to submit to the Exchange a cheque/ pay order/ demand draft for the deposit payable at the seat of arbitration in favour of National Commodity & Derivatives Exchange Limited along with Form No.III/IIIA. If the respondent fails to submit Form III/IIIA within the prescribed time, then the Arbitrator can proceed with the arbitral proceedings and make the award ex-parte. Upon receiving the documents as above from the respondent, the Exchange forwards a copy of the reply to the applicant/claimant. The applicant should within seven days from the date of receipt of the same, submit to the Exchange, his reply including reply to counterclaim, if any, which may have
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been raised by the respondent in its reply to the applicant/claimant. The Exchange then forwards such reply to the respondent. The time period to file any pleading referred to herein can be extended for such further periods as may be decided by the Exchange in consultation with the Arbitrator depending on the circumstances of the matter. The manner of selection of Arbitrator is detailed in the Regulations of the Exchange.

Hearings and Arbitral Award

No hearing is required to be given to the parties to the dispute if the value of the claim difference or dispute is Rs.75,000 or less. In such a case, the Arbitrator proceeds to decide the matter on the basis of documents submitted by both the parties provided. However, the Arbitrator for reasons to be recorded in writing may hear both the parties to the dispute.

If the value of claim, difference or dispute is more than Rs.75,000, the Arbitrator offers to hear the parties to the dispute unless both parties waive their right for such hearing in writing. The Exchange in consultation with the Arbitrator determines the date, time and place of the first hearing. Notice for the first hearing is given at least ten days in advance, unless the parties, by their mutual consent, waive the notice. The Arbitrator determines the date, time and place of subsequent hearings of which the Exchange gives a notice to the parties concerned. If after the appointment of an Arbitrator, the parties settle the dispute, then the Arbitrator records the settlement in the form of an arbitral award on agreed terms.

All fees and charges relating to the appointment of the Arbitrator and conduct of arbitration proceedings are to borne by the parties to the reference equally or in such proportions as may be decided by the Arbitrator. The costs, if any, are awarded to either of the party in addition to the fees and charges, as decided by the Arbitrator. The Arbitrator may pronounce an interim arbitral award or interim measures. The arbitral award shall be made within 3 months from the date of entering upon reference by the Arbitrator. However the time limit may be extended by the Exchange for not exceeding 6 months.
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LIMITATION

In every Project there are some limitations and this project is no exception.

LIMITATIONS: Topic of the project is based on lots of practical knowledge. Due to lack of practical exposer to the topic assigned a bit difficulty was faced during making of project.

LIMITATION OF TIME: Time availability was one of the biggest limitations faced. Due to shortage of time we had to limit the Work in its present form

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SUGGESTION

After going through this project I got detailed knowledge about arbitrage, hedging and speculation. And after assessing and going through related books I felt that there are various ways of making investment. It requires knowledge and experience to invest in this mode. While making this project I went through many books,different websites related to the topic in order to enhance the knowledge. I got some information about the investment and want to give some suggestion regarding the same. These are Arbitrage could be used for making investment as it is the making of a gain through trading without committing any money and without taking a risk of losing money.

Arbitrage transactions in modern securities markets involve fairly low dayto-day risks, but can face extremely high risk in rare situations, particularly financial crises, and can lead to bankruptcy.

In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum. Speculation typically involves the lending of money for the purchase of assets, equity or debt but in a manner that has not been given thorough analysis or is deemed to have low margin of safety or a significant risk of the loss of the principal investment.

An investor who takes steps to reduce the risk of an investment by making an offsetting investment. There are a large number of hedging strategies that a hedger can use. Hedgers may reduce risk, but in doing so they also reduce their profit potential.

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WORD OF THANKS

One of the most pleasant aspects of writing a project is the opportunity of thanks those who have made it possible. Unfortunately, the list of expression of gratitude no matter how expensive is always incomplete and inadequate. These

acknowledgements are of no exception. This project report is a result of endless effort & immense degree of toil. I would like to thank all those people who

graciously helped me by sharing their valuable time, experience & knowledge. I would like to express heartiest thanks to Dr. D. K. GARG (Chairman), Mr. M. K. VERMA (Dean) and placement head Mr. T. K. GUHA for lending me their kind support for completion of my project. I thank all those who directly or indirectly supported me morally, financially and through providing knowledge by which I could complete my project as well as summer training. I thank to all those readers who will study this project in the future. I am extremely thankful to all the faculty members for their valuable

guidance, untiring help and advice at every step. Their vast experience helped in setting the direction of my project work. Then my intellectual debt is to those academicians and practioners who have contributed significantly. During the course of my project work I was in constant interaction with many company people who were highly co-operative in laying down the strategy for the project. I am thankful to the management of BMA Wealth Creation Ltd., New Delhi and especially to my guide Abhishek Kumar Verma under whose Cooperation and guidance was a milestone in completion of my project, who influenced me to work positively at each step by giving his precious time to discuss and to provide relevant information. Last but not the least, I express my parents and friends who financed this project and have been a moral support to me during the project.

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ANNEXURE /BIBLIOGRAPHY

Necessary information for my project was obtained through following sources:

BOOKS
NCFM Modules Derivative market dealers module

Commodity market dealers module NSE Debt market basic module

Investment Management Bhalla V.K Capital Market- Dr.S.gurusami Stock exchange , Investment and Derivative- V.Raghunatham

WEBSITES
www.bseindia.com www.nseindia.com www.sebi.gov.in.com www.ncfm.com www.google.com

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