The document discusses the derivatives market in India. It describes how derivatives were originally traded over-the-counter but exchanges were later created to provide transparency, reduce counterparty risk, and increase regulation. It then outlines the major derivatives exchanges in India and the types of derivatives contracts available, including those for commodities, equities, interest rates, and currencies. Finally, it explains the key components of how derivatives are traded on exchanges, including the order matching process, clearing, margins, and daily and final settlement.

1. The Derivatives Market in India
Chapter 2

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Objectives
Which of the exchanges in India trade in derivative products?
What are the various types of orders used in derivatives
exchanges?
What is the trading mechanism in derivatives exchanges?
What is an OTC derivatives market? How are derivatives traded
on it?
What contracts are available in Indian exchanges?

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Development of Derivative Markets
Internationally, earlier derivative contracts were over-the-counter
Over-the-counter markets suffer from
counterparty risk
lack of transparency, and
are mostly unregulated
Derivative exchanges were created to solve these issues

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The International Derivatives Market
1710 – Dojima Rice Exchange, Japan
1848 – Chicago Board of Trade (CBOT), USA
1874 – Chicago Produce Exchange, USA
1919 – Chicago Mercantile Exchange (CME), USA
1972, International Money Market (IMM) under the CME, USA
1973 – Chicago Board of Options Exchange (CBOE), USA

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Derivatives Contracts Traded
Commodity derivatives on agricultural commodities, cattle, metal
and energy products like oil and electricity
Equity derivatives on single-stock and stock indices
Interest rate derivatives on short-term and long-term interest
rates
Currency derivatives
Credit derivatives
Traded on exchanges and over-the-counter markets

6. Derivatives in India
Financial derivatives in NSE and BSE in 2000
Commodity derivatives started in MCX, NMCE and NCDEX in
2003
Index futures (2000) and index options (2001) as well as stock
futures and options (2001) are traded
Short- and long-term interest rate futures were introduced in
2003, but withdrawn in 2006; in 2009 they were re-introduced
Currency futures introduced in 2008 and traded in NSE, BSE and
MCX
Interest rate swaps, currency swaps, forward rate agreements and
credit derivatives traded in the over-the-counter market

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The Operation of Derivative Exchanges
Three major operations of an exchange are:
Trading
Clearing
Settlement

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The Trading System
Fully automated screen-based system
Based on order-driven market
Provides transparency
Orders are time-stamped as they arrive and stored in order books
if not marked
Storage based on price-time priority, according to best price and
time

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Types of Orders
Market order
Limit order
Stop-loss order
Immediate or cancel order
Good-till day order
Good-till cancelled order
Good-till date order
Spread order

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Order Matching Rules
The best buy order will be matched with the best sell order
An order may match partially with another order, resulting in
multiple trades
Orders will be entered by members, and will remain in the
system until matched
Any new order will be matched first with orders remaining in the
system

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Order Conditions
On the basis of time:
Day orders
Immediate or Cancel orders
On the basis of price:
Limit price/orders
Market price/orders
Stop-loss price/orders
Sell orders

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Clearing System
Clearing means that a transaction is clearly recorded, and provides
for orderly settlement
Is done by the clearing corporation, a subsidiary of the derivatives
exchange
E.g. in the NSE, the National Securities Clearing Corporation
Limited (NSCCL) is the clearing agency

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Members of the Clearinghouse
Clearing members are authorized to clear trades undertaken by
traders
Trading members are members who can trade on behalf of clients,
and match orders that members receive
A clearing member performs:
a. Clearance
b. Settlement
c. Risk management
The clearing corporation provides qualifications for a trader to be
a clearing member

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Clearing Mechanisms
When a trading member matches an order received from a client,
the trading member will approach a clearing member to clear the
trade
The clearing member takes the position of counterparty for every
contract that they clear
The exchange will keep record of all trades cleared by a clearing
member

15. Margins
The clearing member will be required to post a certain amount of
money, known as a margin, on all trades cleared
This margin will be based on the value of the contract cleared
The margin account will be updated daily, using marking-to-market
procedure
If the margin account balance falls below a certain level, a margin
call will be issued by the clearing corporation and the member will
have to put up additional costs as margin

16. Settlement
Settlement means that parties will be settling their obligations
under the contract
Daily mark-to-market settlement of margins typically updates
margin accounts, and issues margin calls when necessary
Final settlement occurs when contracts are closed out, or on
maturity date
If the final settlement calls for delivery, the party that has an open
position to deliver will be called upon to do so
If the final settlement is for cash, the losing party will pay the
winning party

17. Trading Process
The contract is brokered and an order will be place
The broker enters the order in the order book
When the order is matched, the broker will clear the transaction
through a clearing member
The broker will ask the client to post a margin
The margin account will be updated daily through the daily
settlement price, and a margin call will be issued when necessary

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Trading Process (Continued)
If the client wants to close the position, he or she will inform the
broker, who will match the order, close the margin account, and
pay the balance
If the contract is held until maturity, the margin account will be
closed with the final settlement amount and balance given to the
client