Origin of Derivative Market

Since past 200 years ago the evolution of commodity market emerged for products like metals, crude oil and agriculture. As a result, physical contracts for forward delivery evolved into price risk management instruments known as futures contracts. These were made available to trade on centralized markets known as derivatives exchanges. Derivatives exchanges provide markets for trading futures and options contracts, providing all parties from producers to consumers with a method of immediate price discovery, price protection and the transfer of risk of volatile commodity markets. The first derivatives exchange was the Chicago Board of Trade, established over 150 years ago, providing futures trading in grains. In the early 20th century, derivatives exchanges were established in London and Amsterdam, in particular for futures contracts in soft commodities such as cocoa, coffee and rubber. Today, derivatives exchanges have been established all across the globe offering all kinds of futures and options contracts and Nepal couldn’t be exceptional.

Types of Derivative Market

Broadly there are two types of derivative market; over the counter (OTC) and organized market. Trading held by formalized channels including exchange center is organized trading.  Whereas when exchange center are not involved then its OTC. Swaps, options, futures and forward are the types of contracts involved. Currently, futures contracts are popularly traded in Nepal and Swell has also opted futures contract in its clearing function.

Derivative & Commodity Market 

 Derivative Market refers to the market where trading of security takes place 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.

Commodity Market are characterized by trading of the  commodities, that are bulk goods and raw materials, such as grains, metals, livestock, oil, cotton, coffee, sugar, and cocoa those are used to produce consumer products.

Earlier, all the sellers and buyers of a commodity used to come to a common market place for the trade. Buyer could judge the amount of produce that year while the seller could judge the amount of demand of the commodity. Thus they could dictate their terms and hence the counter party was left with no choice. Thus, in order to hedge from this unfavorable price movement, need of the commodity exchange was felt.

 Commodity Exchange and Stock Exchange

The basic difference between the commodity exchange and stock exchange is that in commodity exchange non-financial commodities i.e. agro products such as castor, groundnut, sesame etc. and non agro products such as aluminum, zinc, nickel etc. are traded. However in a stock exchange all financial products are traded such as stocks, indexes, interest rate, government securities etc. are traded.

Futures

'Futures' is a contract to buy or sell the underlying asset for a specific price at a pre-determined time. If you buy a futures contract, it means that you promise to pay the price of the asset at a specified time. If you sell a future, you effectively make a promise to transfer the asset to the buyer of the future at a specified price at a particular time.

Difference between Futures and Forward Contracts

Some of the basic differences between the futures and forward contracts are as follows:

• While futures contracts are traded on the exchange, forwards contracts are traded over-the-counter market.
• In case of futures contracts the exchange specifies the standardized features of the contract, while no pre-determined standards are there in the forward contracts.
• Exchange provides the mechanism that gives the two parties a guarantee that the contract will be honored whereas there is no surety/guarantee of the trade settlement in case of forward contract.

Benefits of Futures Contracts

• Futures provide the opportunity to take advantages of movement in prices of the underlying commodity
• "Margin" allows one to be eligible for trading. i.e, to take positions; either "SHORT" or "LONG"
• “Going SHORT” means that one can gain profit when the market falls by selling Futures Contract whereas, "LONG" position is profitable while buying the contract
• Futures help in budget efficiency planning by fixing the price and income in present
•  In futures contract buyers have the advantage of determining their purchase price now with an assurance of delivery of the contracted product in future.
• With futures contracts, one can buy or sell the underlying commodity without ever having to take or make delivery of the physical product.

Margins & Payments

At the time when the futures contract is agreed, the price of the commodity is determined but not paid or received in full because delivery or settlement takes place at an agreed point in the future. However, an initial margin has to be deposited with the bank or broker by both the buyer and seller. This margin serves as a “deposit” to ensure that both parties can fulfill the obligations of the contract. Note that margin amounts can change as and when the futures price moves.

 Price Determination in Futures Market

The price in future is also determined in a similar way where demand and supply intersect and the equilibrium price determines the price of the future contracts. The parties involved are buyers and suppliers as in physical market.

Future Contract as Hedging and Risk Management

 “Hedging” is a method where client is protected against the movement and uncertainty of price of underlying assets. The most sympathetic method to hedge is through future contracts.  For example, producers, merchants, jewelers, corporate entities, trade houses, manufacturers, refiners, etc, may all look to use futures contracts to insure themselves against the risk of movement in the price of commodities or currencies.

Hedging involves buying or selling futures contracts to protect the physical asset that we already own, or are going to buy in the future.

• Selling futures contracts (i.e. going short of futures)

• Buying futures contracts (i.e. going long of futures)

 Types of Traders/Participants in Derivatives Market

Hedgers: They are in a position where they face risk associated with the price of an asset. They use derivatives to reduce or eliminate risk. For example, a farmer may use futures or options to establish the price for his crop long before he harvests it. Various factors affect the supply and demand for that crop, causing prices to rise and fall over the growing season. The farmer can watch the prices discovered in trading at the CBOT and, when they reflect the price he wants, he will then sell futures contracts to assure him of a fixed price for his crop.

Speculators: Speculators wish to bet on the future movement in the price of an asset. They use derivatives to get an extra leverage. A speculator will buy and sell in anticipation of future price movements, but has no desire to actually own the physical commodity.

Arbitrators: They are in the business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the future prices of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

(Source: Options, Futures and Other Derivatives by John C. Hull).

Parties Involved in the Market

Clearing Member:  An agency or separate corporation of a futures exchange responsible for settling trading  accounts, clearing trades, collecting and maintaining margin monies, regulating delivery and reporting trading data. Clearing members 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.

Non-clearing member: An agent between investors and exchange, which provide platform for investors. It is a body which is closely regulated by exchange. 

 Market Trend

Market moves in two different trends and that is categorized as either ‘bullish’ or a ‘bearish’ market. A bullish market is a period of rising market prices while a bearish market is a period of declining market prices.

When the price oscillates between a narrow range and market experience neither an uptrend, nor a downtrend the sideways trading occurs.