Derivative Faq's

“Underlying” prices are the source of value for derivatives such as futures and options. Wheat farmers, for example, may want to enter into a contract to sell their harvest at a future date in order to eliminate the risk of a change in prices by that date. The futures or forwards market would facilitate such a transaction. Derivatives are traded on this market, and their prices are determined by the spot price of wheat, the “underlying”. The term “contracts” is often used to refer to a specific traded instrument, such as a wheat derivative contract, gold derivative contract, or equity derivative contract, for example.Derivatives are a key part of the financial system around the world. Futures and options are the most important contract types, and equity, Treasury bills, commodities, foreign exchange, and real estate are the most important underlying markets.

When two parties enter into a forward contract, they agree to make a trade at a specified price and quantity at a specified future date. When the deal is signed, no money exchanges hands.

Hedging and speculation both benefit from forward contracts.
In order to eliminate price risk, a wheat farmer would sell his harvest in advance at a known price, a classic example of hedging in action. A bread factory, on the other hand, may want to buy bread in advance in order to help with production planning without the risk of price volatility. If a speculator has information or analysis that predicts an increase in a price, he can buy on the forward market instead of the cash market. It is possible to make money by buying a futures contract and then selling it back.

Futures markets were designed to solve all three of forward markets’ problems. In terms of basic economics, futures markets are identical to forward markets. There are standardised contracts and trading is centralised, however (on a stock exchange). Clearing corporations act as counterparties to both sides of every transaction and guarantee the trade. Contrary to forward markets, the counterparty risk does not increase as the expiration date approaches. Comparatively, the forward markets are much less liquid.

Indices and single stocks are traded as futures and options.
In June 2000, the NSE began trading futures on the Nifty 50. Futures and options contracts on the following products are now available on the NSE: 1. The Nifty 50, CNX IT Index, Bank Nifty Index, CNX Nifty Junior, CNX 100, Nifty Midcap 50, Mini Nifty, and long-dated options contracts on the Nifty 50 comprise the following indices.
2. Two hundred and twenty-eight (228) single stocks

Futures/options contracts in both indexes and stocks can be purchased and sold through NSE trading members. Some trading members also offer internet access to trade in the futures and options markets. You must open an account with one of the trading members and complete the necessary formalities, which include signing the member-constituent agreement, the Know Your Client (KYC) form, and the risk disclosure document. You will be assigned a unique client identification number by the trading member. To start trading, you must deposit cash and/or other collaterals with your trading member as he may specify.

It is the last day for the contracts to expire. Contracts for futures and options expire on the last Thursday of the expiry month. Contracts expire on the previous trading day if last Thursday is a trading holiday. For example, the January 2008 contracts will expire on January 31, 2008.

Except for Long dated Options contracts, futures and options contracts have a maximum trading cycle of three months: the near month (one), the next month (two), and the far month (three).
On the trading day following the expiration of the near month contracts, new contracts are introduced. The new contracts will be in effect for three months. As a result, at any point in time, there will be three contracts available for trading in the market (one for each security), namely one for the near month, one for the mid month, and one for the far month. On January 26, 2008, for example, there would be three-month contracts, i.e.Contracts that are set to expire on January 31, 2008, February 28, 2008, and March 27, 2008. On the expiration date, January 31, 2008, new contracts with an April 24, 2008 maturity date would be introduced for trading.

Yes. At the client level, margins are computed and collected in real time on a portfolio basis. Members are required to collect the margin from the client in advance and report it to the Exchange.

All Futures and Options contracts are settled in cash on a daily basis and at the expiration or exercise of the contracts, as applicable. Clients/Trading Members are not required to own any underlying stock in order to trade in the Futures / Options market.
On the expiration date, all out-of-the-money and at-the-money option contracts with a near-month maturity are worthless.

Cash market transactions (for example, the sale of potatoes from a farmer to detection traders) are transactions between two parties based on effective accomplishment. The actual exchange of goods is thus the primary reason for being active in the spot market. The term encompasses both spot trading (immediate fulfilment) and forward trading (subsequent fulfilment) with goods. The prices obtained are referred to as spot market prices. A key distinction between the cash market and the futures market is that the actual exchange of goods in commodity futures transactions is neither intentional nor possible, for example, in potato futures at Eurex in Frankfurt. Because the futures market is a parallel market to the spot market, it can be used to hedge price risks as well as for speculation.

Commodity futures contracts (futures) are legally binding agreements that specify a specific performance to occur at a future date.

Contracts for commodity futures are traded on commodity futures exchanges. Exchanges are highly organised market events that are strictly defined in terms of location, time, market participants, and sequence. These are often computer exchanges as a result of modern communication technologies. Supply and demand are combined here via an electronic network and fed into a central computer. As a result, you can trade from wherever you are.

Commodity futures trading can theoretically be done by anyone. There are, however, certain requirements to meet, which may vary between exchanges. The personal requirements, as well as the applicant’s experience, objective, and financial situation, all play a role in the opening of a securities account. These factors also influence how far a relevant market participant can act. The technical prerequisites are an account with a clearing bank and a contractual agreement that is linked to a connected broker.

As a rule of thumb, all exchanges have orders converging at a central location (trading floor or central computer). There are differences in order entry. Proprietary traders (individuals acting on their own behalf) may enter orders directly into the electronic trading system or have a seat on the stock exchanges where they can trade. In the case of all other market participants, orders can be entered orally or via telephone, fax, broker, computer, or e-mail.Requests are stored and executed in the appropriate order situation in electronic trading exchanges. Floor brokers are responsible for executing orders locally.

All price-determining parameters in commodity futures contracts are normalised, which means that the execution depends largely on whether another market participant is willing to offer (demand) contracts to buy at a desired price (sell). A market participant’s choice of order type is also important. So let’s say that a trader wants to capture 20 contracts of potatoes to sell, then this job could (usually called a market order) be carried out in good order immediately to a uniform price It is also possible that ten contracts are traded for the best possible price and ten contracts are traded for the second-best possible price.It is possible that a partial execution in a small market will result in a lack of buying interest. 15 contracts were traded immediately, and the remaining five were initially available at limited rates in the system, according to a limit order recommendation. An all-or-nothing order could also be used with partial execution. Limit orders are probably the most common type of order. Sell or purchase orders will be executed if the stock price crosses the limit or if this occurs

The phrases are used in a session for each contract in accordance with the aforementioned order for the opening, the highest, the lowest and the closing price. According to the name, the starting (closing) price, the price of the first (last) trading account of the day, and the maximum (lowest) price, the price of the highest (lowest) trading account at the time of inspection.

This is the price at which the trading day ended, or in other words, the price at which the last trade accounts were settled. To calculate the daily profit and loss, the settlement price of the valuation price is referred to. In some cases, it corresponds to the closing price, but it’s more common to calculate it based on the day’s last sales.

If a contract is sold, the seller’s contract partner is not another stock exchange customer, but rather a clearinghouse that connects the two market participants. The clearinghouse provides the counter position for all contract purchases and sales (Clearing Bank). All of them offer a performance guarantee on their services as stockbrokers. As a result, the parties are not at risk of default. Additionally, the clearing house ensures that trades are kept anonymous, as required by federal law.

Both the buyer and the seller must pay commissions and deposit collateral if contracts are traded and opened based on futures positions A broker, exchange, clearinghouse of the stock market, or clearing bank and a guarantee fund are all paid commissions for their services in the trading industry. It is based on the current price level, current and/or historical price volatility, and the dealer’s creditworthiness that determines the amount of the initial margin or guarantee. Her share of the contract’s value is typically a small fraction, and she’ll cover any value loss per the contract that occurs within a specified time frame. Position holders suffer an impairment loss when the price of the contract changes to their detriment (either by sale or price increase the declining price of purchase). In addition to the initial margin described, the security system that ensures the completion of transactions on exchanges includes a number of other components.

Holdings of long positions in commodity futures trading are referred to as holdings of long positions. Holders of short positions are also short (in the future). The terms can also be used in the physical goods trade. In this case, farmers who are either growing potatoes or who have them on hand and plan to sell them later want them as long as they are mentioned in the product. Short sellers on the cash market include potato processors who have not yet sold their goods. Due to this, it is wise to buy futures to protect yourself from the risk of rising prices, since they represent a product that potatoes, for example, do not yet have.

For each purchase and sale position, a profit and loss calculation (mark-to-market method) is performed from the moment the position is opened. He has contracts that he has sold (bought), and when prices fall (fall in value), the positions are credited (loaded). Price increases however will result in a credit for both the buyer and the seller’s account. Variation margins are the recorded changes in value. Constant price fluctuation is detrimental to position holders as their accounts continue to be debited on a regular basis. Position holders will be required to pay a margin call if the position has a shortfall.

Positions long or short may be opened at any time due to the standardisation of contracts. Standardization also allows for the reversal of this process, allowing for the closing of positions before a contract has matured. Contrary to spot trading on the cash market (e.g. harvest delivery), commodity futures trading is often concluded and fulfilled over a long period of time, and the Exchange’s accounting office is always involved. As a result, the commitments made by an offsetting transaction can be discarded in the interim. It has been proven through experience that almost all market participants can benefit from the “Closing” process. Prior to maturity, a seller (buyer) must buy (sell) contracts based on the number of open positions, which solves its market positions.

The number of open futures positions is referred to as the open interest. Since only one other market participant holds a short position, a contract’s trading volume and number of open positions are both 1. Since the seller’s position, in which he purchases and other participants sell, is represented by the open interest of 1, the number of sales has increased to 2, but the open interest has not changed.

As long as positions are not closed out by the end of the trading day, holders of open short (long) futures contracts must provide a precisely defined quantity and quality of particular base material at the specified location(s) (remove and pay). Any items that are still open after the last trading day are settled (usually against a reference price) for futures with cash settlement (cash settlement). Participants’ accounts are only affected by the credit or debit of the last day’s difference since the income balance had already been held daily by this point. Because the performance obligation must be met in a physical manner, physical delivery is excluded from this process.

On stock exchanges, the market assessments of numerous market participants are condensed into a concise form. The available information is factored into the prices of individual contracts/futures contracts. Commodity futures exchanges are ideal for increasing market transparency and homogenizing information levels because they are published by data providers, the Internet, and print media. In this context, the term “from a price guide function” refers to the fact that contract prices should reliably reflect future market conditions, allowing agri-food companies to use them as the basis for production and marketing decisions. Future prices can also be used as a reference price for spot or forward transactions in the cash market (EFP – see below: point 24). Without participating in the stock market, anyone can benefit from the advantages of information improvement. Price transparency thus contributes significantly to the promotion of competition.

The primary advantage of price hedging is that companies can set prices for future sales or purchases of goods early on. As much as possible, the economic outcome of a manufacturing or processing business can thus be predicted months in advance. The same can be said for a margin trading business’s future. The company gains a solid basis for calculation, from which they can adjust their cash flows and lead to overall stabilisation of its operating results. Banks recognise these positive effects as well. Because a loan’s riskiness has a significant impact on its design, risk-reducing management instruments have a reducing effect on loan terms. Furthermore, price hedges have a positive impact on a company’s positioning and marketing opportunities. Because trading on commodity futures exchanges is done anonymously, market participants can complete forward-looking transactions without their marketing partners or competitors knowing. Furthermore, they can liquidate the performance obligation associated with the futures transaction at any time by offsetting position. Futures trading on the futures exchange also has the advantage that, when compared to an individual forward contract, flexibility is much greater, allowing it to respond to new market conditions much more quickly. Overall, combining supply and demand reduces search and waiting costs for businesses while increasing their competitiveness. In addition to these benefits, price hedging can be used to consolidate or expand existing marketing relationships, as well as to establish new ones. Potato traders can spend a lot of time on price hedging fixed prices to producers, which also provides planning security.

Futures are traded on the major futures exchanges alongside other products. The relevant group for the agricultural sector is the closest of the options, which is briefly outlined below.
The holder of an option has the right, but not the obligation, to buy a futures contract at a specified price (call) or sell a futures contract at a specified price (put) during the term of the option (put). It indirectly creates the right to refer to the underlying commodity or supply in the future. The benefit of options is that they can expire as well. As a result, the buyer of a put (call) option still has the opportunity to profit from rising (falling) cash market prices. As a result, the risk of loss is limited to the option price.

An instrument whose value is derived from one or more underlying assets, which can include commodities, precious metals, currency, bonds, stocks and stock indices among other things, is known as a derivative. Four of the most common derivative instruments are forward contracts, futures contracts, options contracts, and swaps contracts.

Some common types of derivatives are: a) forwards, b) futures, c) options, and d) swaps.

Options are classified into two types: call options and put options. A call option grants the holder the right to purchase a specified amount of the underlying asset at the strike price on a predetermined date.
A put option, on the other hand, grants the holder the right to purchase a predetermined amount of the underlying asset at the strike price on a predetermined date.
Part III of the document goes into detail about the options.

2019 is expected to see global financial derivatives markets with a turnover of over $4,500 trillion U.S. dollars. – (Source: Bank of International Settlements and the World Federation of Exchanges
According to Annexure 1 of the document, global financial derivatives markets have grown in size and in value over the past decade.

Total turnover in the exchange-traded equity derivatives market for the F.Y. Over Rs. 3,400 lakh crores were spent on the project. 2019-20. India’s equity derivatives markets are growing in size and value, according to the document’s annex 2.