Author: indiafreenotes

A Derivatives Market is a financial marketplace where financial instruments, such as options and futures, and other derivative instruments are traded. Different types of investors take part in this market with varying objectives. For instance, some want to earn a profit, some speculate, while some enter the market to hedge their risk.

The derivatives market refers to the financial market for financial instruments such as futures contracts or options that are based on the values of their underlying assets.

Derivatives are financial instruments used for trading in the market whose value is dependent upon one or more underlying assets. It is a security that derived its value from underlying assets such as stocks, currencies, commodities, precious metals, stock indices, etc. Derivatives represent a contract that is entered into by two or more parties.

This contract is regarding the money payments and sell/purchase of assets between the parties. There are certain conditions which are attached to this contract while entering into such as contractual obligations of parties, date of maturity, notional amount and resulting values of underlying instruments. Derivative instruments are mainly used for hedging the risk or earning profit through speculation on value of underlying security.

These instruments are either traded over the counter or via an exchange. Over-the-counter (OTC) derivatives are one which is traded privately and without any intermediary whereas exchange-traded derivatives are traded via specialized exchanges such as Bombay stock exchange. Futures, forwards, options and swaps are four main types of derivative instruments.

Functions:

Transfer Of Risk

Derivatives are used for transferring the risk from one party to another that is a buyer of a derivative product to the seller. It is an effective risk management tool that transfers the risk from those having a low-risk appetite to those having a high-risk appetite.

Price Discovery

Derivative contract helps in determining the prices of the underlying assets. Future and forward contract prices are used in determining the future spot prices for the commodity. This way it is beneficial in discovering the prices for underlying assets.

Hedging Risk

It helps in hedging risk against unfavorable price movements of an underlying asset. By entering into a forward contract, the buyer and seller agrees to complete the deal at a pre-decided price at some specific date in the future. Any unexpected price hikes or drop will not influence the contract value, thereby providing protection against these types of risks.

Provide Access to Unavailable Assets And Markets

Derivative enables business in reaching out to hard to trade assets and markets. Organizations with the application of interest rate swaps can obtain better interest rates than available in the current market.

Lower Transaction Cost

The cost of trading in derivative instruments is quite low as compared to other segments in financial markets. They act as a risk management tool and thereby lower the transaction costs of the market.

Higher Leverage

Derivatives instruments provide higher leverage than any other instrument available in the financial market. Capital required to take positions in derivative instruments is very low as compared to the stock market. In the case of a future contract, only 20-40% of the contract value is needed whereas, in case of options, only the amount of premium is required for trading.

Hedgers

These are the investors who enter the derivative market to reduce their risk or hedge their risk. In fact, hedging is the biggest motive that drives investors to the derivative market. The option route is preferred by the hedgers to reduce their risks.

Advantages of Hedging

• Futures and options are very good short-term risk-minimizing strategy for long-term traders and investors.
• Hedging tools can also be used for locking the profit.
• Hedging enables traders to survive hard market periods.
• Successful hedging gives the trader protection against commodity price changes, inflation, currency exchange rate changes, interest rate changes, etc.
• Hedging can also save time as the long-term trader is not required to monitor/adjust his portfolio with daily market volatility.
• Hedging using options provide the trader an opportunity to practice complex options trading strategies to maximize his return.

Disadvantages of Hedging

• Hedging involves cost that can eat up the profit.
• Risk and reward are often proportional to one other; thus reducing risk means reducing profits.
• For most short-term traders, e.g.: for a day trader, hedging is a difficult strategy to follow.
• If the market is performing well or moving sidewise, then hedging offer little benefits.
• Trading of options or futures often demand higher account requirements like more capital or balance.
• Hedging is a precise trading strategy and successful hedging requires good trading skills and experience.

Speculators

It is the most common market activity in any financial market. This basically involves betting against the future price movement and taking positions accordingly. It is a risky activity involving buying the underlying asset and then betting on its price. Earning a big profit is the driving force for speculative activities.

For example, an investor expects the price of a share to drop going ahead. Thus, to profit from this, the investor will short sell the share now and buy later when the price drops.

Advantages of Speculation:

• Liquidity, mobility and price continuity. It makes the market broad-based.
• It makes the price uniform, stable and minimizes the risk of price fluctuations.
• Speculation enables diversion of savings and flow of funds into productive channels.
• Speculators acts as an insurer by providing price insurance or hedging services.
• Speculation is responsible for rational and optimum utilization of scarce natural resources.
• Speculation provides the needed liquidity and marketability to securities so that savings can be converted into investment and capital investment is made easy and smooth.

Disadvantages of Speculation:

• A speculator, by virtue of his ability can influence the prices of securities in the market. This manipulation may not be healthy.
• Speculation facilitates wash sales wherein one fictitious dealings are carried out by one broker to another at artificially created higher prices. This misleads the other brokers.
• Speculator gives different orders to different brokers. Some for buying and some for selling. This stirs the market and the markets price appears what is predetermined by the speculator.
• Bulls monopolise the supply and bears must deliver within a certain period or submit to ruin.

Arbitrageurs

Arbitrage is also a profit-making activity by taking advantage of the price volatility in the different financial markets. Arbitrageurs earn a profit using the price difference resulting in investment between the two markets. Or, we can say they buy an asset at less price in one market and sell it in another at a higher price.

Arbitrage Advantages

• The biggest benefit of doing arbitrage is that the risk element is next to nil, it can better understood with the help of an example, if a multinational company is listed in stock markets of New York and London and in New York market it trade at $100 and in London market it trades at € 160 and exchange rate is $1 = €2 than ideally it should trade in London markets at €200. Now a person thinking of doing arbitrage would sell stock in New York market and buy the same stock in London market and thus he or she would be able to make risk-less profit.
• Arbitrage helps in keeping the price of securities across the markets more or less same and therefore it help in better price discovery of an asset and also put an end to price variances in securities across various markets.
• It helps in making the financial markets more efficient because imagine if there were no arbitrageurs than stocks would have kept trading at different prices in different markets leading to speculation by few individuals which would have damaged the real investors’ confidence in stock market.

Arbitrage Disadvantages

• Many individuals only into take into account the price aspect and they ignore the transactions costs and taxes associated with buying and selling of asset which in turn results in wrong estimation of profits and may even lead to loss if price difference is not much.
• In real life there are not many arbitrage opportunities and even if there are then in order to make profit put of such situations you need to have latest technology in order to take positions quickly and also expertise to make such transactions which only few people possess.
• One requires lot of money in order to do arbitrage, it is not as if you have $2000 then you can do it rather one need to have much more money in order to do a profitable arbitrage.

Margin traders

Another derivative market participant is margin traders. The margin is the initial deposit that an investor makes at the time of entering into a contract.

Benefits of Margin Trading

Increased Buying Power

The most obvious benefit of margin trading is that it increases an investor’s buying power. If your brokerage lets you use the largest amount of margin allowed by law, it effectively doubles your buying power.

Diversification

Margin gives investors more buying power, which means they can purchase more different securities, such as stocks and bonds, in their portfolios.

For investors who don’t want to use mutual funds or ETFs, it can be difficult to build a diversified portfolio, especially if you don’t have a large amount of money to invest.

Margin can increase the amount of money you can use to buy stocks and bonds, making it easier to spread your investments out and buy a variety of securities, diversifying your portfolio.

Higher Potential Returns

Increased buying power gives you the chance to buy more securities than you could otherwise afford. The more securities you own, the greater your potential profit if those securities gain value.

Drawbacks of Margin Trading

Higher Risk

Borrowing money for almost any purpose is risky. You have to pay back the loan eventually.

Borrowing money to invest is doubly risky. There’s no guarantee that an investment will succeed. Whether the securities you buy gain or lose value, you will have to pay back the amount that you borrowed.

If you use margin to buy stocks that fall in price, you will lose more money than you would have lost if you didn’t use margin. In some cases, you could wind up losing more money than was put into your portfolio.

Maintenance Requirements

Brokerages that offer margin typically have two margin requirements: one for opening a new position and one for maintaining an existing position.

For example, a brokerage may let you open a new position with 50% margin. Effectively, you can borrow up to the amount of money you’ve put into your portfolio so that half of the purchase comes from your own funds and half is borrowed from the brokerage.

Once you open a position by buying shares, the portfolio has to maintain enough value to meet the brokerage’s maintenance margin requirement.

Interest

Borrowing money isn’t free. Almost every loan means paying interest, and margin is no different. When you use margin to invest, you have to pay interest based on the amount of money that you’re borrowing.

Each brokerage can set its margin interest rates. Some charge the same rates regardless of how much you borrow while others adjust the rate as you borrow more often lowering the rate the more you borrow.

Investors need to account for the cost of borrowing money to invest on margin before borrowing money. The interest charges reduce gains on successful investments and increase losses from poor-performing investments.

Commodities are the standardised resources or raw materials with intrinsic value that are used to manufacture refined goods. It can be categorised as every kind of movable good that can be bought and sold, except for actionable claims and money. The quality of commodities may be variable, but they must be substantially uniform on some criteria across different producers.

There are two types of commodities in the market, i.e. hard commodities and soft commodities. Hard commodities are often used as inputs to make other goods and provide services while soft commodities are mainly used for initial consumption. Inputs such as metals and minerals are classified as hard commodities while agricultural products like rice and wheat are softer commodities.

Commodities are traded on the spot market or exchanges. The commodities must meet minimum standards set by the exchanges to be able to trade. Traders can either buy these commodities on the spot market or through derivatives such as options or futures. Commodity trading offers portfolio diversification beyond traditional securities. And since commodity price moves in the opposite direction of stocks, investors indulge in commodity trading during the periods of market volatility.

Similar to any other market, the commodities market is either a physical or a virtual space, where interested parties can trade commodities (raw or primary products) at present or future date. The price is dictated by the economic principles of supply and demand.

Types of commodities

There are about fifty major commodity markets worldwide trading in more than 100 commodities. Traders can trade in four major categories of commodities:

Metal: A wide variety of metals like iron, copper, aluminium, and nickel, which are used in construction and manufacturing, are available for trading in the market, along with precious metals like gold, silver, and platinum.

Energy goods: Energy goods used in households and industries are traded in bulk. These are natural gas and oils. Other energy commodities that trade are uranium, ethanol, coal, and electricity.

Agricultural goods: A wide variety of agricultural and livestock products trade in the commodity market. For example, sugar, cocoa, cotton, spices, grains, oilseeds, pulses, eggs, feeder cattle and more.

Environmental goods: This group includes renewable energy, carbon emission, and white certificates.

Globally, the most-traded commodities include gold, silver, crude oil, Brent oil, natural gas, soybean, cotton, wheat, corn, and coffee. 

Types of commodities traded in India (Multi Commodity Exchange of India – MCX)

• Agricultural commodities: Black pepper, castor seed, crude palm oil, cardamom, cotton, mentha oil, rubber, Palmolein
• Energy:Natural gas, Crude oil
• Base Metals: Brass, Aluminium, Lead, Copper, Zinc, Nickel
• Bullion: Gold, Silver

Types of commodities traded in India (National Commodity and Derivatives Exchange – NCDEX):

• Cereals and pulses: Maize Kharif/south, Maize rabi, Barley, Wheat, Chana, Moong, Paddy (basmati)
• Soft: Sugar
• Fibres: Kappa’s, Cotton, Guar seed, Guar gum
• Spices: Pepper, Jeera, Turmeric, Coriander
• Oil and Oil seeds: Castor seed, Soybean, Mustard seed, Cottonseed oil cake, Refined soy oil, Crude palm oil

Commodity Trading in India

The legal entity that decides, regulates and enforces the rules and procedures for trading commodities, such as the standardised commodity contracts, and other related investment products is the commodities exchange. It is an organised market where various commodities and derivatives are traded.

In India, one can trade commodities by going on any of the 20+ exchanges which facilitate this trade under the regulatory eye of the Securities and Exchange Board of India. Till 2015, the market was regulated by the Forward Markets Commission which was finally merged with SEBI to create a unified regulatory environment for commercial investing.

To start trading in commodities, you will need a Demat account, Trading account and a Bank account. The Demat account will function as a keeper of all your trades and holdings but you will still need to go through a good broker to place orders on the exchanges.

India has six major commodity trading exchanges, namely,

• National Multi Commodity Exchange India (NMCE)
• National Commodity and Derivative Exchange (NCDEX)
• Multi Commodity Exchange of India (MCX)
• Indian Commodity Exchange (ICEX)
• National Stock Exchange (NSE)
• Bombay Stock Exchange (BSE)

Working

Suppose you bought a gold futures contract on MCX at Rs. 72,000 for every 100 gm. Gold’s margin is 3.5% on MCX. So you will be paying Rs. 2,520 for your gold. Suppose that the following day, the cost of gold increases to Rs. 73,000 per 100 gm. Rs 1,000 will be credited to the bank account you have linked to the commodity market. Assume that the day-after, it drops to Rs. 72,500. Accordingly, Rs. 500 will be debited from your bank account.

While you get higher leverage with commodity trading, the risk associated with trading in commodities is also higher as market fluctuations are common.

Types of Commodity Market:

• Spot markets are also known as “cash markets” or “physical markets” where traders exchange physical commodities, and that too for immediate delivery.
• Derivatives markets in India involve two types of commodity derivatives: futures and forwards; these derivatives contracts use the spot market as the underlying asset and give the owner control of the same at a point in the future for a price that is agreed upon in the present. When the contracts expire, the commodity or asset is delivered physically.

Structure

The commodities market exists in two distinct forms:

• over-the-counter (OTC) market
• exchange based market

Similar to equities, there exists the spot and the derivatives segments. Spot markets are essentially OTC markets and participation is restricted to people who are involved with that commodity, such as the farmer, processor, wholesaler, etc.

A majority of the derivatives trading takes place through the exchange-based markets with standardized contracts, settlements, etc. The exchange-based markets are essentially derivative markets and are similar to equity derivatives in their working, that is, everything is standardized and a person can purchase a contract by paying only a percentage of the contract value.

A person can also go short on these exchanges. Moreover, even though there is a provision for delivery, most contracts are squared-off before expiry and are settled in cash. As a result, one can see an active participation by people who are not associated with the commodity. The typical structure of commodity futures markets in India is as follows.

Ministry of Consumer Affairs, Food, and Public Distribution

The Department pertaining to consumer affairs is responsible for the formulation of policies for:

• Monitoring Prices
• Consumer Movement in the country
• Controlling of statutory bodies (Bureau of Indian Standards (BIS) and Weights and Measures)
• Internal Trade
• Inter-State Trade- The Spirituous Preparations (Inter-State Trade and Commerce) Control Act, 1955 (39 of 1955).
• Control of Futures Trading- the Forward Contracts (Regulations) Act, 1952 (74 of 1952)

The Department for food and public distribution is responsible for the formulation of policies for:

• Ensuring food security for the country through timely and efficient procurement and distribution of food grains.
• Building up and maintenance of food stocks, their storage, movement and delivery to the distributing agencies and monitoring of production, stock and price levels of food grains.
• Incentivizing farmers through fair value of their produce by way of Minimum Support Price mechanism, distribution of food grains to Below Poverty Line (BPL) families.
• Covering poor households at the risk of hunger under Antyodaya Anna Yojna (AAY).
• Establishing grain banks in food scarce areas and involvement of Panchayati Raj Institutions in Public Distribution System (PDS).
• Concerns for the sugar sector such as fixing of Fair and Remunerative Price (FRP) of sugarcane payable by Sugar factories, development and  regulation of sugar industry (including training in sugar technology), fixation of levy price of sugar and its supply for PDS and regulation of supply of free sale sugar.
• Export and import of food grains, sugar and edible oils.

Forward Market Commission

The Commission functions under the control of the Ministry of Consumer Affairs, Food & Public Distribution, Department of Consumer Affairs, Government of India. The functions of the Forward Markets Commission are:

• To advise the Central Government in respect of the recognition or the withdrawal of recognition from any association or in respect of any other matter arising out of the administration of the Forward Contracts (Regulation) Act 1952.
• To keep forward markets under observation and to take such action in relation to them, as it may consider necessary, in exercise of the powers assigned to it by or under the Act.
• To collect and whenever the Commission thinks it necessary, to publish information regarding the trading conditions in respect of goods to which any of the provisions of the Act is made applicable, including information regarding supply, demand and prices, and to submit to the Central Government, periodical reports on the working of forward markets relating to such goods.
• To make recommendations generally with a view to improving the organization and working of forward markets.
• To undertake the inspection of the accounts and other documents of any recognized association or registered association or any member of such association whenever it considers it necessary.

Exchange membership

Trading-cum-clearing members (“TCM”) are entitled to trade on their own account as well as on account of their clients. TCMs can also clear and settle these trades themselves.

Eligibility criteria

Entities: Following entities are eligible to apply for membership subject to the regulatory norms and provisions of SEBI and as provided in the Rules, Regulations, Byelaws and Circulars of the Exchange:

• Corporates
• Registered Partnership Firms
• LLPs
• Sole Proprietors/Individuals (Proprietary Firms)

Self Clearing Member (SCM)

A Clearing Member who is also a TM. Such CMs may clear and settle only their own proprietary trades and their clients’ trades but cannot clear and settle trades of other TM’s.

Professional Clearing Member (PCM)

A CM who is not a TM. Typically banks or custodians could become a PCM and clear and settle for TM’s as well as of the Custodial Participants.

Networth

The minimum networth for the purpose of eligibility is Rs.100 Lakh

While corporations have settled on these five commonly accepted best practices, simply following them will not bring corporations into state or federal legal compliance. However, implementing these best practices will introduce a healthy governance culture with top-down influence. Each category can be broken down further into specific concepts.

Create a diversified board of directors with a wide range of expertise, and evaluate their efforts.

Boards should include members with diverse backgrounds and skill sets. Board members should hold each other accountable for giving board duties adequate time to thoughtfully address important matters and decisions. The board should continually work to develop its members’ knowledge in the area of corporate governance. Boards should collaborate with management, using their expertise to broaden perspectives and analyze decision-making. The board should do self-evaluations as part of strategic planning.

Define roles, responsibilities, and accountabilities.

Corporate bylaws should include descriptions, duties, and responsibilities of the key roles including board member, chairperson, CEO, and executive officers. The bylaws should clearly outline the responsibility and accountability for each position. Audit, compensation, and certain other responsibilities should be managed by committees. Board members should carefully review management’s reports and perspectives and be willing to expand the scope of discussions with the knowledge and expertise of a qualified, diverse board.

The board should practice and hold good ethics and integrity in high regard. 

The moral compass begins at the top. Corporations should emphasize the importance of integrity and ethics in all decision-making. Directors and officers set a culture of respect and compliance with state and federal laws that sets the standard for everyone else, including vendors and employees. Boards can reduce fear of incrimination by implementing policies for conflicts of interest, codes of conduct and whistleblowing. They should also establish procedures for managing and overseeing ethical matters. The board and its committees should practice financial accountability and transparency.

Tie compensation to performance.

There is a fine balance between establishing directors’ fees that are high enough to recruit qualified members and setting it low enough that the directors will be challenged to perform their very best. Performance goals for all members should be specific and measurable so that their performance can be measured. A separate committee should oversee all executive compensation plans and be given responsibility for tying compensation to performance.

Board members should actively work towards effective risk management.

Board members should accept feedback from management teams about the amount of risk the company can tolerate. Potential risk should be carefully weighed with the potential return on investment. They should also build an internal framework that flags existing and potential risks.

While the Sarbanes-Oxley Act of 2002 has changed the financial climate in a way that better protects consumers, efforts to comply with the Act come with increased legal, managerial, and technological costs. Smaller companies have been either forced to remain private companies or forced to delist their shares from public exchanges.

The current best practices evolved from the downturn in the financial climate in the early-to-mid-2000’s. These are new trends which should be seen as guidelines at best. They are not legal standards and will not reduce exposure to state, federal, corporate, charitable trust, and tax problems. Not having best practices is not a breach of fiduciary duty in any realm. While embracing current best practices is not a legal mandate, establishing best practices is certainly a good practice.

Policies in line with law and applicable regulations

Policies and guidelines are important because they address pertinent issues, such as rules and principles for day-to-day operations. They ensure compliance with laws and regulations, reflect the culture of the organisation, give guidance for decision-making, risk appetite and streamline internal processes. These policies and guidelines should be current and in line with legislation/regulations as well as with the goals and strategy of the organisation.  Additionally, these should be made easily available to ensure that everyone understands the way things should be done and how they are expected to behave.

Documenting processes and procedures

It is important that governance processes/procedures are adequately documented. Often a company/organisation has good corporate governance practices, however, have gaps in terms of documenting the actual processes/procedures in place.

Effective board reporting

Boards perform best when they receive good quality reports that contain sufficient information for them to make well-informed decisions and to develop business strategies for short and long-term growth and overall sustainability of the organisation. 

A corporate governance rating is a final opinion on the importance institutions attach to the shareholder rights, their public disclosure activities, relationship with stakeholders and the overall credibility of the board of directors. Our rating is realized on basis of information provided by the rated entity and acquired from other sources by our analysts. It does not perform any audit activities with respect to a rating, instead uses auditor reports as a source. This rating can be modified when access to changing conditions and information is not possible, and can be temporarily suspended or withdrawn.

A corporate governance rating is provided by a rating entity after deriving information about the adoption of corporate governance by an institution through the reports of analysts. There are many sources where information can be gathered about the relative standing if an entity with respect to corporate governance. This means a rating agency may or may not actively conduct an audit of an entity before the rating is provided. Given that corporate governance rating is dependent on the information provided on a corporation, it can be modified, suspended are withdrawn if counter information is provided. Some of the processes adopted by rating agencies before coming up with corporate governance rating are macro and microanalysis, crucial data such as proceedings of shareholders meetings, minutes of board meetings, cases filed bu consumers, suppliers among others.

Allocates a rating for an institution only when sufficient information is supplied. A rating process includes macro and micro analysis and key data (general shareholders’ meetings, publicly disclosed information and documents, minutes of board meetings, court cases filed, etc.) on the rated institution’s core business are taken into consideration. Any publicly undisclosed information provided to SAHA is stored on the basis of confidentiality rules and principles.

The contents of a final rating report should be interpreted neither as an offer, solicitation or advice to buy, sell or hold securities of any companies referred to in this report nor as a judgment about the suitability of that security to the conditions and preferences of investors.