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Chapter 2

The Derivatives Market in India

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 these

issues

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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 and electricity Equity derivatives on single-stock and stock indices Interest rate derivatives on short-term and long-term interest 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 well as stock futures and options (2001) are traded Short- and long-term interest rate futures were introduced in 2003, but withdrawn in 2006; in 2009 they were re-introduced Currency futures introduced in 2008 and traded in NSE, BSE and MCX Interest rate swaps, currency swaps, forward rate agreements and credit derivatives traded in the overthe-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 in

order books if not marked


Storage based on price-time priority, according to best

price 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 sell

order
An order may match partially with another order,

resulting in multiple trades


Orders will be entered by members, and will remain in

the system until matched


Any new order will be matched first with orders

remaining 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
Clearing means 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 on behalf of clients, and match orders that members receive A clearing member performs: a. Clearance b. Settlement c. Risk management The clearing corporation provides qualifications for a trader 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 a

certain amount of money, known as a margin, on all trades cleared


This margin will be based on the value of the contract

cleared
The margin account will be updated daily, using

marking-to-market procedure
If the margin account balance falls below a certain

level, a margin call will be issued by the clearing corporation and the member will have to put up additional costs as margin Dorling Kindersley India Pvt. Ltd. 2011

Settlement
Settlement means that parties will be settling their

obligations under the contract


Daily mark-to-market settlement of margins typically

updates margin accounts, and issues margin calls when necessary


Final settlement occurs when contracts are closed

out, or on maturity date


If the final settlement calls for delivery, the party that

has an open position to deliver will be called upon to do so


If the final settlement Dorling Kindersley India Pvt. Ltd. 2011is for cash, the losing party will

pay the winning party

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 the

transaction through a clearing member


The broker will ask the client to post a margin The margin account will be updated daily through the

daily settlement price, and a margin call will be issued when 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 margin

account will be closed with the final settlement amount and balance given to the client

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