Derivative market in nepal
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  • 1. A REPORT ON DERIVATIVE MARKET IN NEPAL SUBMITTED TO MR. NARENDRA BISTA UNIGLOBE COLLEGE FACULTY OF MANAGEMENT SUBMITTED BY ANKUR SHRESTHA DIPIKA SHRESTHA KRISHNA CHALISE PAWAN KAWAN RITU JOSHI SARITA MAHARJAN SONA SHRESTHA (GROUP 2) MASTERS IN BUSINESS ADMINISTRATION (FINANCE) UNIGLOBE COLLEGE JULY, 2013
  • 2. Table of Content ACKNOWLEDGEMENT.............................................................................................................. 3 CHAPTER ONE............................................................................................................................. 4 INTRODUCTION .......................................................................................................................... 4 1.1 Background of the study........................................................................................................... 4 1.2 History of Derivative Market in Nepal ..................................................................................... 5 1.3 Statement of Problems.............................................................................................................. 7 1.4 Objectives of the study.............................................................................................................. 7 CHAPTER TWO ............................................................................................................................ 8 ACTIVITIES INVOLVED IN DERIVATIVE MARKET............................................................. 8 2.1 Major Commodities .................................................................................................................. 8 2.2 Party Involved........................................................................................................................... 9 2.3 Types of Derivative Contract of Nepal................................................................................... 10 CHAPTER THREE ...................................................................................................................... 13 MAJOR ISSUES AND DISCUSSION ........................................................................................ 13 3.1 Benefits of Derivative Market ................................................................................................ 13 3.2 Drawbacks of Derivative Market............................................................................................ 14 3.3 Regulation............................................................................................................................... 16 3.4 Process .................................................................................................................................... 17 3.5 Settlement ............................................................................................................................... 21 3.6 Trend of Trading..................................................................................................................... 24 3.7 The Present Situation of Derivative Market in Nepal............................................................. 26 CHAPTER FOUR......................................................................................................................... 28 CONCLUSION............................................................................................................................. 28 4.1 Conclusion .............................................................................................................................. 28
  • 3. ACKNOWLEDGEMENT We hereby express our deep sense of gratitude to all the personalities involved directly and indirectly in our course report preparation. Being the student of management and to prepare report on the specified topic, we accept it as a great opportunity. The report on ―Derivative Market of Nepal‖ had not been possible without the help from many people. We would like to thank Mr. Narendra Bista for such a great opportunity. Firstly, we would like to thank our course instructor for his valuable guidance and timely advice. He inspired us greatly to work in this report. We would also like to thank Uniglobe College for assisting for the completion of the report. We express our gratitude to Pokhara University for making this type of practical course and hope this type of practical work will be continued in future. Group 2
  • 4. CHAPTER ONE INTRODUCTION 1.1 Background of the study Derivatives are financial contracts or financial instruments whose prices are derived from the price of something else. The underlying price on which a derivative is based can be that of an asset (e.g., commodities, equities (stock), residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI) i.e. inflation derivatives), or other items. Credit derivatives are based on loans, bonds or other forms of credit. Derivatives allow risk about the price of the underlying asset to be transferred from one party to another. The word ―Derivative‖ is a magic word. There can be derivative of everything e.g., commodities, equities (stock), residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI) i.e. inflation derivatives), or other items. So there is scope for every one and every sector like growers, traders, exporters, importers, financial institutions, industrialists, investors and end users. The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets. A derivative is a financial instrument which derives its value from the value of underlying entities such as an asset, index, or interest rate—it has no intrinsic value in itself. Derivatives can be used either for risk management (i.e. to "hedge" by providing offsetting compensation in case of an undesired event, a kind of "insurance") or for speculation (i.e. making a financial "bet"). This distinction is important because the former is a legitimate, often prudent aspect of operations and financial management for many firms across many industries; the latter offers managers and investors a seductive opportunity to increase profit, but not without incurring additional risk that is often undisclosed to stakeholders.
  • 5. The main types of derivatives are forward, futures, options and swaps:  Forward  Bilateral contract exposing counter party risk including specified price, specified time, specified quantity but it does not need daily settlement and organized exchange.  Future  Agreement between two parties with specified time specified price, specified quantity including daily settlement and organized exchange.  Option  Instrument which has both obligation and option for the rights of buying and selling the shares.  Swap  Agreement of exchange in terms of cash flow, interest rates, currency, etc. 1.2 History of Derivative Market in Nepal Markets for futures trading were developed initially to help agricultural producers and consumers manage the price risks they faced harvesting, marketing and processing food crops each year. Today, futures exist not only on agricultural products, but also a wide array of financial, stock and forex markets. The world's oldest established futures exchange, the Chicago Board of Trade, was founded in 1848 by 82 Chicago merchants. The first of what were then called "to arrive" contracts were flour, timothy seed and hay, which came into use in 1849.Meanwhile, what is now the USA's largest futures exchange, the Chicago Mercantile Exchange, was founded as the Chicago Butter and Egg Board in 1898.In the 21st century, online commodity trading has become increasingly popular, and
  • 6. commodity brokers offer front-end interfaces to trade these electronic-based markets. A commodities broker may also continue to offer access to the traditional pit-traded, or open-outcry, markets that established the commodity exchanges. In Nepal, three commodities exchanges — Commodities & Metal Exchange Nepal Ltd (COMEN), Mercantile Exchange Nepal Ltd (MEX) and Nepal Derivative Exchange (NDEX) — are working to provide investment opportunities to around 2,000-3,000 people. The majority of transactions of community exchange are in gold and crude oil, products not produced in Nepal. In Nepal, commodity market is introduced by Commodities Exchange Nepal Ltd (COMEN). COMEN have been providing trade services in agriculture goods. It will build warehouses to improve services. It also applied to Securities Board of Nepal (SEBON) on November 11, 2009 for starting a new stock exchange. Now with new vision and new technology Mercantile Exchange Nepal Ltd. (MEX) has been established. MEX has also made immense contribution in raising awareness about and catalyzing implementation of policy reforms in the commodity sector. MEX is the first Exchange to take up the issue of differential treatment of speculative loss. It is also the first Exchange to enroll participation of high net-worth corporate securities members in commodity derivatives market. Nepal Derivative Exchange (NDEX) is an Electronic Commodity and derivative Market which provides online state-of-the-art platform for traders to buy and sell Commodities and derivatives products efficiently and at a justified price. NDEX aims to facilitate trading on commodities, metals, energies, currencies and others. NDEX was developed considering all the sophisticated needs of traders. It contains tools and information that a trader needs to successfully engage in trading and investment. Here one will find the easy-to-use and pioneering trading software that gives fast and accurate prices of various products. At NDEX, people can trade in its products through its software and fulfill their respective needs. NDEX is a professionally managed on-line multi commodities and derivatives exchange. NDEX is a public limited company incorporated on November 20, 2008 under the Companies Act, 2063.
  • 7. 1.3 Statement of Problems Derivative market is the place where people can still earn the profit even if there is downfall in the price of commodity. The major problem is that the people do not have enough knowledge about commodity exchange. They do not know how they function and risk associates with the exchanges. There are many areas where the commodity exchanges need to work on. Some problem in the derivative market is that there is proper governance, lack of warehouse etc. 1.4 Objectives of the study The Objectives of Derivatives are: - To study in detail the role of the future and options. - To study the role of derivatives in Nepalese financial market. - To study various trends in derivative market. - To find the barriers of the derivative market - To study various trends in derivative market. - Comparison of the profits/losses in derivative market.
  • 8. CHAPTER TWO ACTIVITIES INVOLVED IN DERIVATIVE MARKET 2.1 Major Commodities Commodities are objects that come out of the earth such as orange juice, wheat, cattle, gold and oil. People buy and sell commodities based on speculation. For instance, if you thought hurricanes over Latin America were going to destroy much of the coffee crop, you would call your commodity broker and have them purchase as much coffee as possible. If you were correct, the price of coffee would be driven up drastically because the crop had been destroyed by weather, making the surviving harvest worth more. The most common commodities that are traded in derivative market are: Gold Silver Crude oil Cotton Copper Corn Cocoa Sugar Coffee Platinum Palladium
  • 9. Heating oil Natural gas Soyabean Soyabean oil Wheat Brent crude 2.2 Party Involved Commodities derivatives market of Nepal has already celebrated more than a half decade in Nepal. The progress which the concept achieved and the popularity that has been prevailing is due to the numerous uses of derivatives like hedging, arbitraging and speculating, which could provide not just the platform to minimize the risk but also make income. Because of this, derivative market is slowing booming. There is involvement of mainly three parties; client, broker and clearing house.  Client/Investor: Client or investor is the one who is ready to invest on the derivative market and ready to bear the risk. He is the person who needs to choose his broker carefully.  Broker: A derivatives broker is an investment professional who advises individuals and corporations about how to buy, trade, and sell derivatives. Most of the time, brokers work in brokerage firms where they are a part of a derivative investment team. The day-to-day life of a derivatives broker can vary, depending on the client. Brokers negotiate deals between entities for derivative swaps, research international investment opportunities, counsel individual investors, and analyze corporate asset portfolios to calculate how much a company should risk in the derivatives market. His main job is to present options to a client, help the client make a decision on how to proceed, and execute the final choice.
  • 10. There are several different types of derivative investments available. The broker's job is to work with a client to make an appropriate investment plan, and to provide investment tips. Sometimes, the plan will be to invest entirely in one sort of derivative, for instance, in foreign exchange derivatives. Other times, a more mixed portfolio is preferable, combining equity derivatives, insurance derivatives, or credit derivatives in some fixed proportion. Understanding risk is one of the most essential tasks of the derivatives broker. It is imperative that the broker get to know the client and the client‘s financial goals in preparing a strategy for investing in derivatives. One of the first things a derivatives broker will do is to inventory the client‘s assets as a way of gauging what sort of risk is appropriate. Because the derivatives broker acts for the client in many aspects of the investment process, it is very important that a client choose a derivatives broker that he or she trusts and works well with.  Clearing House: It is an agency or separate corporation of a futures exchange responsible for settling trading accounts, clearing trades, collecting and maintaining margin money, regulating delivery and reporting trading data. Clearing houses act as third parties to all futures and options contracts - as a buyer to every clearing member seller and a seller to every clearing member buyer. Each futures exchange has its own clearing house. All members of an exchange are required to clear their trades through the clearing house at the end of each trading session and to deposit with the clearing house a sum of money (based on clearinghouse margin requirements) sufficient to cover the member's debit balance. 2.3 Types of Derivative Contract of Nepal There are two distinct groups of derivative contracts, which are distinguished by the way that they are traded in market: 1. Over-the-counter (OTC) derivatives These derivative contracts are traded directly between two parties, without going through an intermediary product. For example, forward rate agreements or exotic options. OTC derivatives offer flexibility in reducing risk exposure. For example, an electric utility can use OTC
  • 11. derivatives to hedge the risk of increases in fuel costs on the specific quantity of fuel it plans to purchase over a period of time so that its customers are protected against rate increases. OTC derivatives also help financial institutions hedge their exposure to credit risk, which then helps the financial institution expand their lending capabilities. 2. Exchange-traded derivatives These derivative contracts are traded via derivatives exchanges. Here the exchange acts as an intermediary and takes initial margins from both sides of the trade. The difference to OTC is that there is no direct link between the parties, but the exchange is playing the counterpart role. Various types of derivative instruments are future, forward, swap and option. Among all, only future contracts are traded in our country. The mostly used derivatives are: Economic derivatives They pay off according to economic reports as measured and reported by national statistical agencies. Energy derivatives They pay off according to a wide variety of indexed energy prices. They are classified as either physical or financial. Physical derivatives include the obligation to actual delivery of the underlying energy commodity, whatever this may be. Freight derivatives They represent trading in future levels of freight rates, primarily for dry bulk carriers and tankers. They include exchange traded futures and options as well as freight forward contracts. They are used by ship owners and operators, oil companies, trading companies and grain houses as tools for managing freight market risks.
  • 12. Insurance derivatives It is a financial instrument that derives its value from an underlying insurance index or the characteristics of an event related to insurance. Insurance derivatives helps to hedge their exposure to catastrophic losses due to exceptional events, such as earthquakes or hurricanes. Weather derivatives They can be used by organizations or individuals as part of a risk management strategy to reduce risk associated with adverse or unexpected weather conditions. Here the underlying asset rain/ temperature / snow have no direct value. Farmers can use weather derivatives to hedge against poor harvests caused by drought or frost, theme parks may want to insure against rainy weekends during peak summer seasons, and gas and power companies may use heating (HDD) or cooling degree days (CDD) contracts to smooth earnings. Credit derivatives They transfer credit risk from a protection buyer to a credit protection seller. Credit derivative products can take many forms, such as credit default options, credit limited notes and total return swaps.
  • 13. CHAPTER THREE MAJOR ISSUES AND DISCUSSION 3.1 Benefits of Derivative Market Majority of commodities traded on global commodity exchanges are ago-based. Commodity exchanges therefore are of great importance and hold a great potential in case of economies like Nepal, where more than 65 percent of the people are dependent on agriculture. In the present scenario, it is expedient to focus on local farmers to explore their possible roles as aggregator for price risk management and collateralized finance. These aggregators can assume the role of facilitating agents or a risk-bearing layer between the farmers and the commodity exchanges which will motivate them to promote our local product in international market contributing to national Gross Domestic Product. This will encourage making Nepalese commodity viable in international market entailing the advantage of import and export in Nepal. Furthermore, we can also take advantage of our geographical structure between our neighboring countries by establishing the financial hub acting the intermediately role. When the commodity market ecosystem gets benefited the whole economy of the country would also benefit. So, proficient and organized commodity exchange plays a complementary role in the overall development of economy thereby generating the employment opportunities, business generation, investment platform and growth in the financial market. Not only this, the trading of standardized and graded commodities help to bring quality products in market that protects consumer right and so far we could control the level of inflation to some extent. The major benefits of derivative market for the country like Nepal are as follows: Farmers, traders, exporters, importers can insure their risk from the fluctuating product prices by taking futures position in the derivative market. Financial institutions can mitigate or even eliminate the interest rate risk by locking their interest rate with derivative exchange. Investors can invest in the products and can get attractive returns.
  • 14. End users can buy the goods at a pre-determined price so that they can get away from the risk of increase in price. Utilizing this market, investors have the advantage to determine the conditions of the contract they wish to enter, develop tailor-made contracts, while they secure a certain degree of confidentiality in respect to their transactions. 3.2 Drawbacks of Derivative Market Derivatives market plays important function in the market, it have many advantage but some disadvantage. Some people think that derivative market is like gambling, they compare derivative market with gambling. There is much risk in this market, where you have to take risk for make a big money. If you are willing to take risk and speculate, you can make big money but there is equal chance of losing big money. Derivative has become a very important tools in today‘s market, where businesses, exchange, banks, and financial centers are connected. The trade among countries has multiplied but that has also given rise to risk of currency, inflation, and interest rate. Several risks may be involved for those who are not thoroughly familiar with speculative markets. Even though risks can be transferred, remember that the derivatives market operates on a paradigm of uncertainty. An investor who is not comfortable with uncertainty in investment might be more comfortable taking on a different type of investment structure. Different kinds of risks are faced by participants in derivatives market: Credit risk Credit risk on account of default by counter party: This is very low or almost zeros because the Exchange takes on the responsibility for the performance of contracts Market risk Market risk is the risk of loss on account of adverse movement of price.
  • 15. Liquidity risk Liquidity risks are the risk that unwinding of transactions may be difficult, if the market is illiquid. Legal risk Legal risk is that legal objections might be raised; regulatory framework might not allow some activities. Operational risk Operational risk is the risk arising out of some operational difficulties like, failure of electricity, due to which it becomes difficult to operate in the market. The main disadvantage of the derivatives markets arises from the lack of thorough investigation into how to use the risk transfer factor. This can result in difficulty when trying to margin transactions, or to monitor various participants‘ activities and tailor one‘s own activity accordingly. Disadvantages of Derivatives: 1. Raises Volatility: Derivatives require a small initial capital due to leveraging derivatives provide, therefore a large no. of market participants can take part in derivatives which leads to speculation and raises volatility in the markets. 2. Higher no. of Bankruptcies: Due to the existence of leveraged in derivatives, participants assume positions which do not match their financial capabilities and eventually lead to bankruptcies. 3. Increased need of regulation: There a Large no. of participants who take speculative positions. It is necessary to stop these activities and prevent people from getting bankrupt and to stop the chain of defaults.
  • 16. 3.3 Regulation Derivatives play an important role in the economy but are associated with certain risks. The crisis has highlighted that these risks are not sufficiently mitigated in the over-the-counter (OTC) part of the market, especially as regards credit default swaps (CDS). Since the beginning of the financial crisis, the Commission has been working to address these risks. The initiative taken by the Securities Board of Nepal (Sebon) to introduce a law to regulate commodities and derivatives markets has fizzled out for now, as the Ministry of Law and Justice has said the platform used by the securities market regulator to bring in the regulation was not appropriate. Earlier, the Sebon had prepared the draft of a regulation to regulate and monitor activities of commodities and derivatives exchanges by stepping on the Administrative Procedure (Regulation) Act 1956. The draft was tabled at the Ministry of Finance in September and was later forwarded to the law ministry seeking approval. The Sebon had drafted the regulation after its survey found that commodities and derivatives exchanges operating in the country were playing with billions of rupees of public´s money without monitoring and supervision of government agencies. What alarmed the securities market regulator the most was revelation that these exchanges were conducting business in an unprofessional and ad-hoc manner, without adopting minimum international standards to minimize risks and protect the interest of investors. To protect people´s money, the Sebon had proposed establishment of a directorate under it with mandate to issue operating licenses to commodities and derivatives exchanges, take action in case of non-compliance, and supervise, monitor and regulate their activities. ―Although the red flag shown by the law ministry has prevented the Sebon from introducing the regulation for now, it can always use the Essential Commodities Control Act 1961 as a platform to introduce a legal document to monitor and regulate commodities and derivatives markets,‖ Dhungana said. ―This can work as a stopgap measure until a separate act to govern the sector is introduced.‖
  • 17. 3.4 Process Trading Mechanism Contracts in Commodity Futures Exchanges are concluded mostly in Cash Settlement, where as Mex Nepal is promoting delivery. Clearing and Settlement Department ensures guarantee of trades executed on the exchange. Delivery Contracts will be delivered and settled through the certified receipts at the end of the contract date. Trading Method Most of the derivatives markets are fully automated electronic exchange, where there is no physical trading floor. The Exchange is controlled through a centralized platform which is connected with different ‗client‘ front-ends called MEXN Trader. All trades are done through MEX Trader. All trades are done through the Exchange Members (Clearing Members) and their affiliates i.e. Non-Clearing Members. Only the Exchange Members can clear with the Exchange and the non- clearing members act as intermediates between the members and clients. MEX has currently 72 members. MEX is planning to introduce trading in local commodity in near future. Traded Commodities Food Grains and Allied Products, Oil Seeds, Vegetable Oils and Fat, Fiber Crops, Other Products, Energy, Precious Metals Industrial Metals
  • 18. Trading Hours MEX initiated trading with 11 products and currently it has made available 21 products for trading. It is the first exchange to offer 24 hours trading in Nepal. Composite trading commences from 10.00 am to 18.00 pm on weekdays. And Electronic trading will be round the clock from Monday 4.45 to Saturday 1.30 AM. The exchange is closed on Sundays and on other national holidays which is notified on the exchange website.Prerequisite documents for trading are as follow:  The non member client registration form  Risk disclosure form  Lot management form  Trading member and client agreement form  Sub-broker application form  Cancelation order form  Application for cancelation of active user ID Trading Session The trading session in MEX Nepal is of 23 hours daily from Monday morning to Saturday morning. Market opens at 03:45 on Monday morning and closes at 02:45 Saturday morning during summer and during winter, the market opens and closes one hour later. However, for some agro commodities, the timings may differ. You are advised to check the contract specification of the respective commodities in our web site for updated trade timing. MEX Clearing and settlement has the option of implementing a "Fast Market" on a per- product basis in unusual circumstances, such as times of high volatility. The difference between a "Fast Market" and the normal Trading Period is that the parameters for maximum quote spread and minimum quote size in response to a quote request are more relaxed during a "Fast Market".
  • 19. Initial Margin The initial margin (IM) is levied on all open positions (Buy or sell positions) of the Members and their clients. The IM calculation on each commodity varies depending upon its market volatility. The margin so calculated is reduced from the total margin of the Member available with the exchange and accordingly further exposure is given on the balance amount. As the IM increases, the exposure shall decrease. Product Symbol Contract Size Contract Unit Price Quoted Regular Margin Brent Crude BRC 250 Barrels NPR/ Barrel 64000 Cocoa CCO 5000 Kilogram NPR/Kilogram 35000 coffee COF 5000 Kilogram NPR/Kilogram 40000 Corn CON 40000 Kilogram NPR/Kilogram 25000 Copper COP 1000 Kilogram NPR/Kilogram 25000 Mini-Copper MCOP 500 Kilogram NPR/Kilogram 17500 Cotton COT 10000 Kilogram NPR/Kilogram 40000 Mini cotton MCOT 2500 Kilogram NPR/Kilogram 11000 Crude Oil CRU 250 U.S Barrels NPR/ Barrel 64000 Mini Crude oil MCRU 50 U.S Barrels NPR/ Barrel 14000 Gold GOL 1000 Grams NPR/10Grams 63000 Mini Gold NGOL 500 Grams NPR/10Grams 35000 Small Gold SGOL 100 Grams NPR/10Grams 7500 Heating Oil HEA 10000 Liters NPR/10Grams 55000 Natural Gas NAG 2500 MMBTU NPR/MMBTU 60000 Mini Natural Gas MNAG 500 MMBTU NPR/MMBTU 12000 Platinum PLT 1000 Grams NPR/10Grams 70000 Palladium PAL 1000 Grams NPR/10Grams 40000 Silver SIL 30000 Grams NPR/10Grams 65000 Mini sliver MSIL 10000 Grams NPR/10Grams 24000 Small Sliver SSIL 5000 Grams NPR/10Grams 12500 Soybean SOY 20000 Kilogram NPR/Kilogram 30000 Soybean oil SBO 22000 Kilogram NPR/Kilogram 65000
  • 20. sugar SUG 20000 Kilogram NPR/Kilogram 32000 Wheat WHT 20000 Kilogram NPR/Kilogram 30000 Mark to Market (MTM) Margins MTM is a mechanism devised by the exchanges to prevent the possibility of the potential loss accumulating to the level where the participants might willingly or unwillingly commit default. All trades done on the exchange during the day and all open positions for the days are marked to closing price for the respective contract and notional gain or loss is worked out. Such loss/gain is debited/credited to respective Members account at the end of each day. The outstanding position of the Member is then carried forward the next day at the closing price. Daily Price Limit Daily price limit is the maximum and minimum level that a price of any contract can reach for that particular day. It is the maximum amount of gain or loss that can occur on a particular contract/s. If a price of the contracts reaches the daily price limit, trading on that contract shall be suspended for certain time period or may be for the remainder of the day. This is also called locked market. Clearing Corporation The approved clearing corporation/institution/house clears the trades done by buyer and seller in the exchange. It functioned clearing and settlements of trade smoothly and efficiently, takes the direction from exchange, watch and monitor the market position, also can suspect if market position seemed unnatural by member. Clearing Bank and location of all branches As per the Regulations of NDEX, all Members of the Exchange shall have their client account and segregated account under the registered banks hereinafter referred to as "clearing
  • 21. banks". The accounts are to be named as "Member name – NDEX Settlement A/c". Clearing Bank is Nepal Investment Bank Limited. Daily and Final Settlement On the daily basis open position are settled by calculating the daily settlement price. Here, the calculation methodology for the daily settlement price is included in the trading rules. Similarly, the on expiry of the futures contracts, the settlement of the contract is performed by the exchange specified final settlement technique as mentioned in the trading rules. Here the single price is derived which shall be used to calculate the final adjustment for the particular contract. 3.5 Settlement Settlement Guarantee Fund (SGF) An SGF is a pool of assets used to guarantee the successful settlement of all trades executed on the exchange in the event a clearing member is unable to pay for the securities received through a clearinghouse or depository, the SGF is used to meet the payment obligation the SGF exists solely for the protection of clearing members avoiding the default of one clearing member prevents a "snowballing" effect of defaults among other clearing members and their customers an SGF does not provide insurance against having settlement problems nor does it reduce the risk of settlement default by a clearing member it serves as the last resort to complete settlement m the event of a default, and it is an essential element of a comprehensive settlement-risk-containment system, the other elements of which will be developed later during the CMD project. Creation of an SGF would provide the Clearing, Settlement and Depository Institution with the resources to meet its obligations even when a participant fails to make good on a payment obligation the SGF absorbs the amount of the default and thereby addresses the liquidity of the participant's payment default since both the firm defaulting and the firms receiving the benefits of payment from the SGF are members of the settlement system, the funding source
  • 22. should be the responsibility of Clearing, Settlement and Depository Institution members in general, an SGF should be viewed as mutual insurance for clearing (and settlement) members. Generally speaking, any Clearing Member acts as a Market Maker and takes part in the Market-Making programs and packages that are offered. All CMs are automatically checked to evaluate whether they fulfill Market Maker Obligations and if so, they will benefit from market segment. For selected futures products, so-called "Designated" Market-Making is available. Market Makers take on defined obligations to increase liquidity in their chosen product. Subject to their performance in fulfilling their obligations, members are rewarded with a reduction in their fee levels. Commodities Trading In a nutshell, the commodity market is a platform where commodities are traded through the appointment of the brokers. They help investors to purchase and sell the commodities much like in the stock market. As the Nepali commodity market is not delivering the goods at the moment physically, the investors purchase contracts with conviction that the purchased goods are delivered in the future. The ownership of contract amounts to the possession of the stocks. To purchase such contract, the investor has to deposit up to 6 percent of the total contract amount at the commodity market as a guarantee amount. Both the holder and buyer of the contract have to deposit certain amount at the exchange. The international price of given commodities works as a reference price. If the reference price is higher than contract price, then the buyer is required to pay additional amount to the contract holder. If the said price is lower than the contract price, the contract holder should pay additional gap amount to contract buyers. The deposit should be maintained in order to keep possible defaults at bay. The contract acts as an assurance that the physical delivery takes place if needed. However, the commodity exchanges have failed to ensure delivery of the traded commodities. They claim the lack of quality testing lab in the country is preventing the physical delivery of the commodities.
  • 23. Account Structure MEX provides several position accounts where a transaction may be kept until it is closed out. There are three types of accounts: o Customer account o CM/Market Maker accounts o Member accounts Every order entered into the MEX system must be associated with one of these account types. Customer's accounts are kept on a gross basis. If a trader buys and sells identical contracts, s/he will have both a long position and a short position in the same account, unless the second trade is designated as a closing transaction. If an offsetting transaction is not marked as a closing transaction during entry, the designation can be adjusted later. If this is not done in a timely fashion, additional fees will be charged by MEX. Market Maker accounts are kept on a net basis. Customer Account Trades entered into the MEX system on behalf of clients are recorded as customer account. All give-up trades are considered part of this account and are displayed as such trades. The account codes are actually designations that the trade is going to be sent to another Member, usually when a client uses one Member to perform the execution and another to do the clearing. CM/Market Maker account In designating a trade, the trader provides all the information necessary for the give-up at order entry, including the Clearing Member ID of the firm to which the take-up is being transferred. The give-up then happens automatically, assuming that the CM involved has not specified that give-ups will be approved manually.
  • 24. Trades resulting from quotes entered by market makers and from quotes by exchange participants in futures trading are recorded in the market maker accounts. Member Account (Non-Clearing member) These accounts are available for trades made for the participant's own account. The participant has full discretion over which account is used for an opening position, although close-outs must be directed to the same account as the open position. Final Settlement On the expiry of the futures contracts, the settlement procedure followed as seller's option. The pay-in/pay-out for settlement is by way of debit to the buyer and credit to the seller to the relevant CM's clearing bank account on T+1 day (T=date of allocation of settlement). Position then the highest price of the contract during its currency is taken for cash settlement in marking all undelivered outstanding position to final settlement price. Resulting profit/loss settled in cash. Final settlement loss/profit amount is debited/credited to the relevant Clearing Member's clearing bank account on T+2 day. (T=expiry day). 3.6 Trend of Trading In commodities market, future contracts for various commodities are traded with an initial margin amount. A trader gets live access to the price of a commodity based on the globally traded price of that particular commodity. Each commodity has a minimum contract size in which it is traded. The monetary value of a contract changes with the change in the international price of the commodity. Let’s take an example of Gold: The contract size of Gold is 1Kg which suppose is worth Rs. 30 lakhs, whereas the margin requirement is Rs. 75,000.Supposing, a contract is bought with an initial deposit of Rs. 200,000 at the rate of Rs. 30,000/10gm. If the price moves upwards to Rs. 30,500 and the investor decides to sell the holding, he/she books the profit of Rs.50,000 in a contract.
  • 25. In case of a downturn of price, an investor will be asked to put in more margin amount if the loss exceeds Rs. 125,000 as Rs. 75,000 is the margin requirement. Or, will be given the option of selling the holding at the current market price. However, by putting in more margin amount, an investor can observe the price to move upwards, which in a span of time can yield profits. Margin Requirement for MEX Trading Instruments Quantity per contract Trading Instrume nt’s min price change Initial margin per contract Stop loss margin per contract Spread Commission Spot gold (GoldNRs_1 0g) 1 KG 1 Nrs. 70,000 Nrs. 40 Nrs. 15 Nrs. 1000+VAT Spot silver (SLVNRs_1 0g) 30 KG 0.1 Nrs. 70,000 Nrs. 30 Nrs. 1 Nrs. 1000+VAT
  • 26. 3.7 The Present Situation of Derivative Market in Nepal The Nepalese Derivative Market is very young. The investors haven‘t been able to analyze the situation properly. They are not smart enough to study the situation and take good judgments. There is no regulating body in the Nepalese derivative market. Most of the investors find the derivative market as some sorts of gambling place where people gather together for gambling purpose and try to make out high returns with least investments. But it is very important that one must realize that there is a difference between gambling and speculation and the future markets are not like ―Satta‖ markets. Participants in physical markets use futures market for price discovery and price risk management. In fact, in the absence of futures market, they would be compelled to speculate on prices. Futures market helps them to avoid speculation by entering into hedge contracts. It is however extremely unlikely for every hedger to find a hedger counterparty with matching requirements. The hedgers intend to shift price risk, which they can only if there are participants willing to accept the risk. Speculators are such participants who are willing to take risk of hedgers in the expectation of making profit. Speculators provide liquidity to the market; therefore, it is difficult to imagine a futures market functioning without speculators. So there comes a question like what is the difference between a speculator and a gambler. Speculators are not gamblers, since they do not create risk, but merely accept the risk, which already exists in the market. The speculators are the persons who try to assimilate all the possible price-sensitive information, on the basis of which they can expect to make profit. The speculators therefore contribute in improving the efficiency of price discovery function of the futures market. But it doesn‘t mean that the speculation is always good for the economy of a country. Over- speculation needs to be curbed because it can lead to distortion of price signals. For this in case of the Nepalese Derivative Market, the positions held by speculators are subject to certain margins. In the Nepal‘s economy, there are various factors that are having a real negative impact on the overall performance of the Nepalese markets. First comes is the power supply problem. With the increasing temperature and drought in the country, the power supply is getting poor. Till the
  • 27. month of Magh-2066, the country is facing 11 hrs of load shedding. Because of this, the manufacturing and other industries are suffering a heavy loss everyday. Also, the global economic crisis has forced the industries to cut off the number of employees and thus prevent them from the probable future crisis. The continuous political instability has also hit hard to the market. Nepal Ltd. (MEX), and Nepal Derivative Exchange Ltd. (NDEX) — are working in Nepal to provide investment opportunities to around 10,000-30,000 people. The majority of transactions of commodity exchange are in gold, silver, copper, coffee and crude oil products not produced in Nepal. Over 90 per cent people want to invest in gold and crude oil,‖ said Krishna Giri of Kashtamandap Clearing House. Nepal has only a recent history of derivative market, which opened with COMEN at the end of 2006. MEX was established in 2007 and NDEX on November 20, 2008. According to Santosh Pradhan of NDEX, "The existing exchanges haven‘t been able to explore the real potential of the commodities market." They expect to fill the gap. "For example, our exchange is based on local price base and we will introduce mobile trading as well," he added. In the meanwhile, investors have been complaining about government‘s negligence over the commodity and derivative market. Currently, there are 50 brokers and about 1,500 regular.
  • 28. CHAPTER FOUR CONCLUSION 4.1 Conclusion The derivatives market is very dynamic and quickly developed into the most important segment of the financial market. All in all the derivatives market in Nepal does not have a longer history and thus seems to be still underdeveloped. Derivatives play an important role in the economy but are associated with certain risks. The crisis has highlighted that these risks are not sufficiently mitigated in the over-the-counter (OTC) part of the market, especially as regards credit default swaps (CDS). Since the beginning of the financial crisis, the Commission has been working to address these risks. Government has prepared some concepts on the derivatives market for risk minimizing for farmers but still the investors are motivated towards earning abnormal profits from speculation. Competing for business, both derivatives exchange and over the counter(OTC) providers, which by far account for the largest part of the market, have fuelled growth by constant product and technology innovation. The derivatives market functions very well and is constantly improving. It is effectively fulfills it‘s economic function of price efficiency and risk allocation. The imperatives for a well functioning market are clear fulfilled: The exchange segment in particular has put in place very effective risk mitigation mechanisms mostly through the use of automation For its user, the derivatives market is highly effective transaction costs for exchange traded derivatives are particular low. Innovation has been the market‘s strongest growth driver and has been supported by a beneficial regulatory framework especial in Europe. Even though the focus is for agricultural risk management the overall utilization of the market is for speculation. People are utilizing the derivative market for speculating rather than risk hedging.
  • 29. Existing commodities exchanges and the people who take part in the market phenomena should be aware to keep the future of the derivatives market bright. The derivatives market needs to focus on variety of commodities that can manage the risks of that particular commodity. The derivative market on the resources available locally can help develop the derivatives market as well the infrastructures making people as well as the country resourceful. The people should be aware of these markets and the role it can play in their economic elevation. It can bring the stability in the market condition of derivatives in Nepal. It‘s solely the effect of role that people can play to balance the derivatives economy. How fast and with what level of ease does the economy overcome the imbalance is what determines the future of the Nepalese Derivative Market. Derivative trading is an excellent way to prove money earns money. It will make our investment portfolio more attractive and secure. It offers a wide range of alternatives, including international opportunities. This is the best way to utilize our money.
  • 30. BIBLIOGRAPHY Charles W.Smithson (1998) , Managing Financial Risk , 3d edition. McGraw-Hill, Das Satyajit,(2004) Swaps/Financial Derivatives, 4 Volumes Hull C. John, (2009)‖ Options, Futures, & Other Derivatives”, 7th edition Mengle David. Federal Reserve Bank of Atlanta, Economic Review, Fourth Quarter 2007 Sheldon Natenberg,(1995) Option Volatility and Pricing ,Probus. SOURCES www.google.com www.nepalbank.com www.mex.com www.nepse.com