DERIVATIVE MARKETS

SETTELMENT PROCEDURES
COURTEY: PROF. MR. ATUL SATHE SYBFM SEMESTER 5 SALONI SARVAIYA ROLL NO-46

ACKNOWLEDGEMENT:We would like to express our gratitude to Prof. Atul Sathe for giving me this topic for my project as it gave me the opportunity to go beyond the book and look at the topic from a more practical point of view. It broadened my horizons and improved my understanding of this topic. Thank You.

INTRODUCTION TO DERIVATIVES
A derivative is a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Derivatives are contracts and can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region. Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company off of an American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros. Derivatives Market has been divided in two parts: 1.) Over-the-counter (OTC) Market 2.) Exchange-traded Market Where derivatives like, Forwards, Futures, Swaps and Options are traded.

Forwards:
A forward contract is the customized contract between two parties, where settlement takes place on a specific date in future at today's pre-agreed price. Forwards represent the obligation to make a transaction at a set point in time in the future. Once you enter into a forward-based contract, you are obligated to make the transaction unless both parties agree to cancel or otherwise modify the agreement. Forward contracts trade over the counter (OTC), thus the terms of the deal can be customized to fit the needs of both the buyer and the seller. They are unique in terms of contract size, expiry date, asset type and quality. Forward contracts draw in counter-party risk i.e. the counter-party defaults and is unable to pay the cash difference or deliver the asset.

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. When a forward contract is traded on a recognized exchange, it is referred to as a futures contract". Examples of futures include commodities, interest rates, currencies, and stock market indices. Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, an airline uses crude oil futures for hedging purpose to lock in a certain price and reduce risk. Similarly, anybody could speculate on the price movement of crude oil by going long or short using futures. Some future contracts may call for physical delivery of the asset, while others are settled in cash.

How Futures Contract work?

The futures market is a centralized market place for buyers and sellers from around the world who meet and enter into futures contracts. Pricing is done based on bids and the bids and offers can be matched electronically. The futures contract will state the price that will be paid and the date of delivery, also known as the expiry date.

Options: An option gives the contract holder the right to buy or sell on a specified date
in the future - but they are under no obligation. 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.

Players in the Options Market:

Developmental institutions, Mutual Funds, Financial Institutions, FIIs, Brokers, and Retail Participants are the likely players in the Options Market. Some of the examples of Options are Index Options, Options on individual stocks, Bond options, Interest Rate Futures Options, etc.

Swaps: Swaps are the types of Forward contracts and they occupy an important role in
International Finance. They are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They are generally an agreement to exchange one stream of cash flows to another.

Swaps have been categorized into four parts:

Interest rate swaps Currency swaps Commodity swaps Equity swaps

EQUITY DERIVATIVES CLEARING AND SETTLEMENT

National Securities Clearing Corporation Limited (NSCCL) is the clearing and settlement agency for all deals executed on the Derivatives (Futures & Options) segment. NSCCL acts as legal counter-party to all deals on NSEs F&O segment and guarantees settlement. A Clearing Member (CM) of NSCCL has the responsibility of clearing and settlement of all deals executed by Trading Members (TM) on NSE, who clear and settle such deals through them.

SETTLEMENT SCHEDULE
Product Settlement Schedule Pay-in: T+1 working day at or after 11.30 a.m. Futures Contracts on Index & Individual Securities Daily Mark-to-Market Payout: T+1 working day at Settlement or after 12.00 p.m. (T is trade day) Pay-in: T+1 working day at or after 11.30 a.m. Futures Contracts on Index & Individual Securities Final Settlement Payout: T+1 working day at or after 12.00 p.m. (T is expiration day of contract) Pay-in: T+1 working day on or after 11.30 a.m. Interest Rate Futures Contracts Daily Mark-to-Market Payout: T+1 working day on Settlement or after 12.00 p.m. (T is trading day) Interest Rate Futures Contracts Final Settlement Pay-in: T+1 working day on or after 11.30 a.m. Payout: T+1 working day on

or after 12.00 p.m. (T is expiration day) Pay-in: T+1 working day at or after 11.30 a.m. Options Contracts on Index & Individual Securities Premium Settlement Payout: T+1 working day at or after 12.00 p.m. (T is trade day) Pay-in: T+1 working day at or after 11.30 a.m. Options Contracts on Index Exercise & Final Settlement Payout: T+1 working day at or after 12.00 p.m. (T is expiration day of contract) Pay-in: T+2 working days at or after 11.30 a.m. Options Contract on Individual Interim Exercise Securities Settlement Payout: T+2 working day at or after 12.00 p.m. (T is exercise day) Pay-in: T+2 working day at or after 11.30 a.m. Options Contract on Individual Exercise & Final Securities Settlement Payout: T+2 working day at or after 12.00 p.m. (T is expiration day)

SETTLEMENT PRICE
Product Futures Contracts on Index or Individual Security Un-expired illiquid futures contracts Settlement Daily Settlement Daily Settlement Settlement Price Closing price of the futures contracts on the trading day. (The closing price is the last half hour weighted average price of the contract). Theoretical Price computed as per formula F=S * e rt Closing price of the relevant underlying index / security in the Capital Market segment of NSE, on the last trading day of the futures contracts. (The closing price of the underlying index / security is its last half an hour weighted average value / price in the Capital Market segment of NSE). Closing price of such underlying security on the day of exercise of the options contract. (The closing price of the underlying security is its last half an hour weighted average price in the Capital Market Segment of NSE).

Futures Contracts on Index or Individual Securities

Final Settlement

Options Contracts on Individual Securities

Interim Exercise Settlement

Options Contracts on Index and Individual Securities

Closing price of such underlying security (or index) on the last trading day of the options contract. Final Exercise (The closing price of the underlying Settlement security (or index) is its last half an hour weighted average price in the Capital Market Segment of NSE).

SETTLEMENT MECHANISM FUTURES CONTRACTS ON INDEX AND INDIVIDUAL SECURITIES

The position in the futures contracts for each member is marked-to-market to the daily settlement price of the futures contracts at the end of each trade day. The profits/ losses are computed as the difference between the trade price or the previous days settlement price, as the case may be, and the current days settlement price. The CMs who have suffered a loss are required to pay the mark-to-market loss amount to NSCCL which is in turn passed on to the members who have made a profit. This is known as daily mark-to-market settlement. Theoretical daily settlement price for unexpired futures contracts, which are not traded during the last half an hour on a day, is currently the price computed as per the formula detailed below: F = S * e rt Where: F = theoretical futures price S = value of the underlying index r = rate of interest (MIBOR) t = time to expiration Rate of interest may be the relevant MIBOR rate or such other rate as may be specified. After daily settlement, all the open positions are reset to the daily settlement price. CMs are responsible to collect and settle the daily mark to market profits / losses incurred by the TMs and their clients clearing and settling through them. The pay-in and pay-out of the mark-to-market settlement is on T+1 days (T = Trade day). The mark to market losses or profits are directly debited or credited to the CMs clearing bank account.

FINAL SETTLEMENT
On the expiry of the futures contracts, NSCCL marks all positions of a CM to the final settlement price and the resulting profit / loss is settled in cash. The final settlement of the futures contracts is similar to the daily settlement process except for the method of computation of final settlement price. The final settlement profit / loss is computed as the difference between trade price or the previous days settlement price, as the case may be, and the final settlement price of the relevant futures contract. Final settlement loss/ profit amount is debited/ credited to the relevant CMs clearing bank account on T+1 day (T= expiry day).Open positions in futures contracts cease to exist after their expiration day

SETTLEMENT PROCEDURE
Daily MTM settlement on T+0 day Clearing members who opt to pay the Daily MTM settlement on a T+0 basis would compute such settlement amounts on a daily basis and make the amount of funds available in their clearing account before the end of day on T+0 day. Failure to do so would tantamount to non payment of daily MTM settlement on a T+0 basis. Further, partial payment of daily MTM settlement would also be considered as non payment of daily MTM settlement on a T+0 basis. These would be construed as non compliance and penalties applicable for fund shortages from time to time would be levied. A penalty of 0.07 % of the margin amount at end of day on T+0 would be levied on the clearing members. Further, the benefit of scaled down margins shall not be available in case of non payment of daily MTM settlement on a T+0 basis from the day of such default to the end of the relevant quarter.

SETTLEMENT MECHANISM OPTION CONTRACTS ON INDEX OR INDIVIDUAL SECURITIES DAILY PREMIUM SETTLEMENT
Premium settlement is cash settled and settlement style is premium style. The premium payable position and premium receivable positions are netted across all option contracts for each CM at the client level to determine the net premium payable or receivable amount, at the end of each day. The CMs who have a premium payable positions are required to pay the premium amount to NSCCL which is in turn passed on to the members who have a premium receivable position. This is known as daily premium settlement. CMs are responsible to collect and settle for the premium amounts from the TMs and their clients clearing and settling through them. The pay-in and pay-out of the premium settlement is on T+1 day (T = Trade day). The premium payable amount and premium receivable amount are directly debited or credited to the CMs clearing bank account.

FINAL EXERCISE SETTLEMENT

Final Exercise settlement is effected for option positions at in-the-money strike prices existing at the close of trading hours, on the expiration day of an option contract. Long positions at in-the money strike prices are automatically assigned to short positions in option contracts with the same series, on a random basis. For index options contracts and options contracts on individual securities, exercise style is European style. Final Exercise is Automatic on expiry of the option contracts. Option contracts, which have been exercised, shall be assigned and allocated to Clearing Members at the client level. Exercise settlement is cash settled by debiting/ crediting of the clearing accounts of the relevant Clearing Members with the respective Clearing Bank. Final settlement loss/ profit amount for option contracts on Index is debited/ credited to the relevant CMs clearing bank account on T+1 day (T = expiry day). Final settlement loss/ profit amount for option contracts on Individual Securities is debited/ credited to the relevant CMs clearing bank account on T+1 day (T = expiry day). Open positions, in option contracts, cease to exist after their expiration day. The pay-in / pay-out of funds for a CM on a day are the net amount across settlements and all TMs/ clients, in F&O Segment.

CURRENCY DERIVATIVES CLEARING AND SETTLEMENT

National Securities Clearing Corporation Limited (NSCCL) is the clearing and settlement agency for all deals executed on the Currency Derivatives segment. NSCCL acts as legal counter-party to all deals on NSE's Currency Derivatives segment and guarantees settlement. A Clearing Member (CM) of NSCCL has the responsibility of clearing and settlement of all deals executed by Trading Members (TM) on NSE, who clear and settle such deals through them.

SETTLEMENT SCHEDULE
Settlement of daily mark to market is carried out on T+1 day basis. Final Settlement is carried out on T+2day basis. Members with a funds pay-in obligation are required to have clear funds in their primary clearing account on or before 8.30 a.m. on the settlement day. The payout of funds is credited to the primary clearing account of the members thereafter.

SETTLEMENT PRICE
Daily Settlement Price for mark to market settlement of futures contracts. Daily settlement price for futures contracts is the closing price of such contracts on the trading day. The closing price for a futures contract shall be calculated on the basis of the last half an hour weighted average price of such contract or such other price as may be decided by the relevant authority from time to time. Theoretical daily settlement price for unexpired futures contracts which are not traded during the last half an hour on a day Theoretical daily settlement price for unexpired futures contracts, which are not traded during the last half an hour on a day, shall be the price computed as per the formula: F0=S0 e(r-r) fT where: F0 = Theoretical futures price S0 = Value of the underlying r = Cost of financing (using continuously compounded interest rate) rf = Foreign risk free interest rate T = Time till expiration e = 2.71828

Rate of interest (r) may be the relevant MIFOR rate or such other rate as may be specified by the Clearing Corporation from time to time. Foreign risk free interest rate is the relevant LIBOR rate or such other rate as may be specified by the Clearing Corporation from time to time. Final Settlement Price for mark to market settlement of futures contracts: Final settlement price for a futures contract for the various currencies shall be as mentioned below, or as may be specified by the relevant authority from time to time. USDINR Final settlement price RBI reference rate EURINR RBI reference rate GBPINR Exchange rate published by RBI in its Press Release captioned RBI reference Rate for US$ and Euro JPYINR Exchange rate published by RBI in its Press Release captioned RBI reference Rate for US$ and Euro

SETTLEMENT MECHANISM
Settlement of futures contracts on currency 1.) DAILY MARK-TO-MARKET SETTLEMENT 2.) FINAL SETTLEMENT

DAILY MARK-TO-MARKET SETTLEMENT

The positions in the futures contracts for each member are marked-to-market to the daily settlement price of the futures contracts at the end of each trade day. The profits/ losses are computed as the difference between the trade price or the previous days settlement price, as the case may be, and the current days settlement price. The CMs who have suffered a loss are required to pay the mark-to-market loss amount to NSCCL which is passed on to the members who have made a profit. This is known as daily mark-to-market settlement. Theoretical daily settlement price for unexpired futures contracts, which are not traded during the last half an hour on a day, is currently the price computed as per the formula. After daily settlement, all the open positions are reset to the daily settlement price.

CMs are responsible to collect and settle the daily mark to market profits/losses incurred by the TMs and their clients clearing and settling through them. The pay-in and pay-out of the mark-to-market settlement is on T+1 day (T = Trade day). The mark to market losses or profits are directly debited or credited to the CMs clearing bank account.

FINAL SETTLEMENT
On the expiry of the futures contracts, NSCCL marks all positions of a CM to the final settlement price and the resulting profit / loss is settled in cash. The final settlement profit / loss is computed as the difference between trade price or the previous days settlement price, as the case may be, and the RBI reference rate of the such futures contract on the last trading day. Final settlement loss/ profit amount is debited/ credited to the relevant CMs clearing bank account on T+2 day (T= last trading day). Open positions in futures contracts cease to exist after their last trading day.

INTEREST RATE DERIVATIVES 1.) SETTLEMENT PROCEDURE AND SETTLEMENT PRICE

Daily Mark to Market Settlement and Final settlement for Interest Rate Futures Contract * Daily Mark to Market settlement and Final Mark to Market settlement in respect of admitted deals in Interest Rate Futures Contracts shall be cash settled by debiting/ crediting of the clearing accounts of Clearing Members with the respective Clearing Bank. * All positions (brought forward, created during the day, closed out during the day) of a F&O Clearing Member in Futures Contracts, at the close of trading hours on a day, shall be marked to market at the Daily Settlement Price (for Daily Mark to Market Settlement) and settled. * All positions (brought forward, created during the day, closed out during the day) of a F&O Clearing Member in Futures Contracts, at the close of trading hours on the last trading day, shall be marked to market at Final Settlement Price (for Final Settlement) and settled. * Daily Settlement Price shall be the closing price of the relevant Futures contract for the Trading day. * Final settlement price for an Interest rate Futures Contract shall be based on the value of the notional bond determined using the zero coupon yield curve computed by National Stock Exchange or by any other agency as may be nominated in this regard. * Open positions in a Futures contract shall cease to exist after its expiration day.

DAILY SETTLEMENT PRICE

Daily settlement price for an Interest Rate Futures Contract shall be the closing price of such Interest Rate Futures Contract on the trading day. The closing price for an interest rate futures contract shall be calculated on the basis of the last half an hour weighted average price of such interest rate futures contract. In absence of trading in the last half an hour, the theoretical price would be taken or such other price as may be decided by the relevant authority from time to time. Theoretical daily settlement price for unexpired futures contracts shall be the futures prices computed using the (price of the notional bond) spot prices arrived at from the applicable ZCYC Curve. The ZCYC shall be computed by the Exchange or by any other agency as may be nominated in this regard from the prices of Government securities traded on the Exchange or reported on the Negotiated Dealing System of RBI or both taking trades of same day settlement(i.e. t = 0).

In respect of zero coupon notional bonds, the price of the bond shall be the present value of the principal payment discounted using discrete discounting for the specified period at the respective zero coupon yield. In respect of the notional T-bill, the settlement price shall be 100 minus the annualized yield for the specified period computed using the zero coupon yield curve. In respect of coupon bearing notional bond, the present value shall be obtained as the sum of present value of the principal payment discounted at the relevant zero coupon yield and the present values of the coupons obtained by discounting each notional coupon payment at the relevant zero coupon yield for that maturity. For this purpose the notional coupon payment date shall be half yearly and commencing from the date of expiry of the relevant futures contract. For computation of futures prices from the price of the notional bond (spot prices) thus arrived, the rate of interest may be the relevant MIBOR rate or such other rate as may be specified from time to time.

FINAL SETTLEMENT PRICE (MTM)

Final settlement price for an Interest rate Futures Contract on zero coupon notional bond and coupon bearing bond shall be based on the price of the notional bond determined using the zero coupon yield curve computed as explained above. In respect of notional Tbill it shall be 100 minus the annualized yield for the specified period computed using the zero coupon yield curve. Settlement value in respect of notional T-bill Since the T-bills are priced at 100 minus the relevant annualized yield, the settlement value shall be arrived at using the relevant multiplier factor. Currently it shall be 91/365

2.) SETTLEMENT SCHEDULE

Product Settlement Schedule Interest Rate Futures Contracts Daily Mark-to-Market Settlement Pay-in: T+1 working day on or after 11.30 a.m. Payout: T+1 working day on or after 12.00 p.m. (T is trading day) Interest Rate Futures Contracts Final Settlement Pay-in: T+1 working day on or after 11.30 a.m. Payout: T+1 working day on or after 12.00 p.m. (T is expiration day)

SETTLEMENT MECHANISM Settlement of Custodial Participant (CP) Deals

NSCCL provides a facility to entities like institutions to execute trades through any TM, which may be cleared and settled by their own CM. Such entities are called Custodial Participants (CP). To avail of this facility, a CP is required to register with NSCCL through his CM, which allots them a unique CP code. The CP and the CM are required to enter into an agreement as per specified format. Thereafter, all trades executed by such CP through any TM are required to have the CP code in the relevant field on the F&O trading system at the time of order entry. Such trades executed on behalf of a CP are required to be confirmed by their CM (and not the CM of the TM through whom the trade was executed), within the time specified by NSE, using the confirmation facility provided by NSCCL to the CMs in the F&O segment. Till such time the trade is confirmed by the CM of the CP, the same is considered as a trade of the TM and the responsibility of settlement of such trade vests with the CM of the TM. Once the trades have been confirmed by the CM of the CP, they form part of the obligations of the CM of the CP and they shall be responsible for all obligations arising out of such trades including the payment of margins and settlement of obligations.

COMMODITY DERIVATIVES
Two important derivatives are futures and options.

1.) Commodity Futures Contracts:

A futures contract is an agreement for buying or selling a commodity for a predetermined delivery price at a specific future time. Futures are standardized contracts that are traded on organized futures exchanges that ensure performance of the contracts and thus remove the default risk. The commodity futures have existed since the Chicago Board of Trade (CBOT) was established in 1848 to bring farmers and merchants together. The major function of futures markets is to transfer price risk from hedgers to speculators. For example, suppose a farmer is expecting his crop of wheat to be ready in two months time, but is worried that the price of wheat may decline in this period. In order to minimize his risk, he can enter into a futures contract to sell his crop in two months time at a price determined now. This way he is able to hedge his risk arising from a possible adverse change in the price of his commodity.

2.) Commodity Options contracts:

Like futures, options are also financial instruments used for hedging and speculation. The commodity option holder has the right, but not the obligation, to buy (or sell) a specific quantity of a commodity at a specified price on or before a specified date. Option contracts involve two parties the seller of the option writes the option in favor of the buyer (holder) who pays a certain premium to the seller as a price for the option. There are two types of commodity options: a call option gives the holder a right to buy a commodity at an agreed price, while a put option gives the holder a right to sell a commodity at an agreed price on or before a specified date (called expiry date). The option holder will exercise the option only if it is beneficial to him; otherwise he will let the option lapse. Futures and options trading therefore helps in hedging the price risk and also provide investment opportunity to speculators who are willing to assume risk for a possible return.

DIFFERENCE BETWEEN COMMODITY FUTURES

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. Even in the case of physical settlement, financial assets are not bulky and do not need special facility for storage. 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 underlying 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.

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.

WAREHOUSING
One of the main differences between financial and a 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.100and on the day of expiration, the futures on that stock close 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 commodity derivatives however, there is a possibility of physical settlement. This 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. Most international commodity exchanges used certified warehouses (CWH) for the purpose of handling physical settlements. Such CWH are required to provide storage facilities for participants in the commodities markets and to certify the quantity and quality of the underlying commodity. The advantage of this system is that a warehouse receipt becomes good collateral, not just for settlement of exchange trades but also for other purposes too. In India, the warehousing system is not as efficient as it is in some of the other developed markets. Central and state government controlled warehouses are the major providers of agricultural produce storage facilities. Apart from these, there are a few private warehousing being maintained. However there is no clear regulatory oversight of warehousing services

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www.nseindia.com http://www.asiaetrading.com/settlements/india/ www.scribd.com Research Arts & Architecture http://www.eurojournals.com/IRJFE%202%2011%20Ahuja.pdf http://www.aryanhellas.com/107/na.pdf