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7/28/2019 5138_5602_Chapter 02 - The Derivatives Market in India
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The Derivatives Market in India
Chapter 2
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Objectives
Which of the exchanges in India trade in derivative
products?
What are the various types of orders used in
derivatives exchanges? What is the trading mechanism in derivatives
exchanges?
What is an OTC derivatives market? How are
derivatives traded on it? What contracts are available in Indian exchanges?
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Development of Derivative Markets
Internationally, earlier derivative contracts were over-
the-counter
Over-the-counter markets suffer from counterparty
risk, lack of transparency, and are mostly unregulated
Derivative exchanges were created to solve theseissues
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The International Derivatives Market
1710 Dojima Rice Exchange, Japan
1848 Chicago Board of Trade (CBOT), USA
1874 Chicago Produce Exchange, USA
1919 Chicago Mercantile Exchange (CME), USA
1972, International Money Market (IMM) under the
CME, USA
1973 Chicago Board of Options Exchange (CBOE),
USA
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Derivatives Contracts Traded
Commodity derivatives on agricultural commodities,cattle, metal and energy products like oil andelectricity
Equity derivatives on single-stock and stock indices
Interest rate derivatives on short-term and long-terminterest rates
Currency derivatives
Credit derivatives
Traded on exchanges and over-the-counter markets
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Derivatives in India Financial derivatives in NSE and BSE in 2000 Commodity derivatives started in MCX, NMCE and
NCDEX in 2003
Index futures (2000) and index options (2001) as wellas stock futures and options (2001) are traded
Short- and long-term interest rate futures wereintroduced in 2003, but withdrawn in 2006; in 2009they were re-introduced
Currency futures introduced in 2008 and traded inNSE, BSE and MCX
Interest rate swaps, currency swaps, forward rateagreements and credit derivatives traded in the over-the-counter market
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The Operation of Derivative
Exchanges
Three major operations of an exchange are:
Trading
Clearing
Settlement
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The Trading System
Fully automated screen-based system
Based on order-driven market
Provides transparency
Orders are time-stamped as they arrive and stored inorder books if not marked
Storage based on price-time priority, according to bestprice and time
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Types of Orders
Market order
Limit order
Stop-loss order
Immediate or cancel order
Good-till day order
Good-till cancelled order
Good-till date order Spread order
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Order Matching Rules
The best buy order will be matched with the best sellorder
An order may match partially with another order,resulting in multiple trades
Orders will be entered by members, and will remain inthe system until matched
Any new order will be matched first with ordersremaining in the system
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Order Conditions
On the basis of time:
Day orders
Immediate or Cancel orders
On the basis of price:
Limit price/orders
Market price/orders Stop-loss price/orders
Sell orders
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Clearing System
Clearingmeans that a transaction is clearly recorded,
and provides for orderly settlement
Is done by the clearing corporation, a subsidiary of
the derivatives exchange
E.g. in the NSE, the National Securities Clearing
Corporation Limited (NSCCL) is the clearing agency
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Members of the Clearinghouse Clearing members are authorized to clear trades
undertaken by traders
Trading members are members who can trade onbehalf of clients, and match orders that membersreceive
A clearing member performs:
a. Clearance
b. Settlement
c. Risk management
The clearing corporation provides qualifications for atrader to be a clearing member
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Clearing Mechanisms
When a trading member matches an order received
from a client, the trading member will approach a
clearing member to clear the trade
The clearing member takes the position of
counterparty for every contract that they clear
The exchange will keep record of all trades cleared by
a clearing member
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Margins
The cleaning member will be required to post acertain amount of money, known as a margin, on alltrades cleared
This margin will be based on the value of the contractcleared
The margin account will be updated daily, usingmarking-to-marketprocedure
If the margin account balance falls below a certainlevel, a margin callwill be issued by the clearingcorporation and the member will have to put upadditional costs as margin
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Settlement Settlementmeans that parties will be settling their
obligations under the contract
Daily mark-to-market settlement of margins typicallyupdates margin accounts, and issues margin calls
when necessary
Final settlement occurs when contracts are closedout, or on maturity date
If the final settlement calls for delivery, the party thathas an open position to deliver will be called upon todo so
If the final settlement is for cash, the losing party willpay the winning party
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Trading Process The contract is brokered and an order will be place
The broker enters the order in the order book
When the order is matched, the broker will clear thetransaction through a clearing member
The broker will ask the client to post a margin
The margin account will be updated daily through thedaily settlement price, and a margin call will be issuedwhen necessary
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Trading Process (Continued) If the client wants to close the position, he or she will
inform the broker, who will match the order, close the
margin account, and pay the balance
If the contract is held until maturity, the marginaccount will be closed with the final settlement
amount and balance given to the client