LOVELY PROFESSIONAL UNIVERSITY

Mittal School of Business (MSOB)

Name of the faculty: Dr. Pratap Chahal

Course Code: FIN208 Course Title: Derivative Market Operation

Academic Task No: 2 Academic Task Title: Assignments

Date of Allotment: 03/10/2023 Date of Submission: 24/10/2023

Student Roll No: A06, A07, A08, A09, Student Reg. No: 12100766, 12100822, 12101018,
A10 12101502, 12102046

Term: 05 Section: Q2113

Max. Marks: 30 Marks. Obtained:

Learning Outcomes: (Student to write briefly about learning obtained from the academic
tasks)

Declaration:
I declare that this Assignment is my individual work. I have not copied it from any other
students’ work or from any other source except where due acknowledgement is made explicitly
in the text, nor has any part been written for me by any other person.
Evaluation Criterion: Rubrics on different parameters

Evaluator’s Comments (For Instructor’s use only)

General Observations Suggestions for Improvement Best part of assignment

Evaluator’s Signature and Date:

 Derivative Markets

Derivatives trading can be traced back to Mesopotamia in the 2nd century BCE and, more
recently, to the Dojima Rice Exchange in eighteenth-century Japan. The trade in derivatives
became more common in the modern era when traders needed a system to account for the
fluctuation of prices or the different values for various national currencies. Derivative markets
are now a cornerstone of modern finance, playing critical economic roles.
Derivatives markets are generally divided into two groups: Exchange Traded Derivatives and
Over Counter Derivatives.
 Exchange-Traded Derivatives: Exchange-traded derivatives markets involve the trading
of regulated and standardized contracts through a stock exchange. These transactions are
generally settled with a CCP, a central counterparty.
 Over the Counter (OTC) Derivatives: Over-The-Counter derivatives refer to the
trading of customized transactions between two parties directly, without the oversight of
an exchange. Since such trading involves direct exposure of the parties, OTCs may lead
to counterparty risk.

 Design possibly best to depict the working of Derivatives Market Operations in term
of a FLOW CHART capable to be registered as an intellectual property right (IPR)
as Copyright/Design/Patent.

We may think about taking the following actions to create the best possible flow chart that
represents how derivatives market operations operate and can be registered as an intellectual
property right (IPR) as a copyright, design, or patent:
1. Identify the key elements and processes of derivatives market operations. This may
include:
o Participants: market makers, brokers, exchanges, clearinghouses, investors
o Products: futures, options, swaps, forwards
o Processes: order placement, order matching, execution, clearing, settlement.
 Derivative Market Operations

The main workings of the derivative markets are as follows -

Flow Chart 1:

Explanation:

Order placement:
When an investor wants to trade a derivatives contract, they place an order with their broker. The
broker then transmits the order to the exchange where the contract is traded.
Orders can be placed online, through a broker's trading platform, or by phone. The order should
specify the type of contract, the underlying asset, the quantity, and the price at which the investor
wants to trade.

Once the broker has received the order, they will check to make sure that the investor has enough
funds to cover the trade. If the investor has enough funds, the broker will transmit the order to
the exchange.
Order matching:
Once the broker has transmitted the order to the exchange, the exchange will match it with a
counterparty order. A counterparty order is an order to buy or sell the same contract at the same
price.
If there is a counterparty order that matches the investor's order, the exchange will execute the
trade. This means that the investor and the counterparty will be bound to the terms of the trade.

Trade clearing:
After the trade has been executed, the clearinghouse, which is a financial institution that
guarantees the performance of derivatives contracts, will clear the trade. This means that the
clearinghouse will become the buyer to every seller and the seller to every buyer.
The clearinghouse will then collect margin from both the buyer and seller. Margin is a deposit
that is used to protect the clearinghouse in case party defaults on the trade.

Trade settlement:
On the settlement date, the clearinghouse will exchange the underlying asset or cash between the
buyer and seller. If the investor is long on the contract, they will receive the underlying asset. If
the investor is short on the contract, they will deliver the underlying asset.

For Example:
An investor wants to buy a futures contract on the Nifty 50 index. The investor places an order
with their broker.
The broker transmits the order to the National Stock Exchange (NSE), where Nifty 50 futures
contracts are traded.
The NSE matches the investor's order with a counterparty order. Once the orders are matched, a
trade is executed.
The National Securities Clearing Corporation (NSCC), which is the clearinghouse for derivatives
contracts traded on the NSE, clears the trade.
On the settlement date, the NSCC exchanges cash between the buyer and seller.
Participants:
Individuals and companies that trade derivatives contracts are known as derivative market
players. Financial products known as derivatives contracts get their value from an underlying
asset, which could be a stock, commodity, currency, or interest rate.
Derivative market participants can be divided into further categories:
 Hedgers
 Speculators
 Broker
 Exchange
 Clearing House
 Market Maker

Flow Chart 2:
Explanation:

Overview of how the participants of the derivative markets in India work together:
1. An investor places an order with their broker. The investor specifies the type of contract,
the underlying asset, the quantity, and the price at which they want to trade.
2. The broker transmits the order to the exchange. The broker also collects margin from the
investor to protect themselves in case the investor defaults on the trade.
3. The exchange matches the investor's order with a counterparty order. Once the orders are
matched, a trade is executed.
4. The exchange reports the trade to the clearing house. The clearing house then guarantees
the performance of the trade.
5. The clearing house collects margin from both the buyer and seller. The clearing house
also holds the underlying assets for the contract.
6. On the settlement date, the clearing house exchanges the underlying asset or cash
between the buyer and seller.

Hedgers:
The main players in the futures markets are hedgers. Any person or business that purchases or
sells the real physical commodity is a hedger. Derivatives let hedgers lower their exposure to
unfavorable changes in the value of the underlying asset. A farmer might utilize futures contracts,
for instance, to fix the price at which their crops will be sold before harvest. The farmer can
guard against a drop in crop prices in this way. Changes in interest rates, exchange rates, and
commodity prices have an impact on a large number of hedgers who are producers, wholesalers,
merchants, or manufacturers.
When a company brings products to market, changes to any of these factors may influence the
company's bottom line. In order to mitigate the impact of these modifications, hedgers will
employ futures contracts. Hedgers utilize the futures markets to manage and offset risk, as
opposed to speculators who take on market risk in the hopes of making money.

Speculators:
Individuals and businesses that trade derivatives contracts in the hopes of profiting from changes
in the underlying asset's price are known as speculators in the derivatives market. In the hopes of
earning a larger return, speculators are more prepared to take on risk than hedgers.
Because they provide liquidity and aid in determining the fair price of underlying assets,
speculators are crucial players in the derivative market. But speculating is not without risk;
speculators stand to lose money should the market turn against them.
Some common types of speculators in the derivative market include:
 Day traders: Day traders buy and sell derivatives contracts within the same trading day.
They typically use technical analysis to try to identify short-term price movements.
 Swing traders: Swing traders hold derivatives contracts for a few days or weeks. They
typically use fundamental analysis and technical analysis to identify trading
opportunities.
 Position traders: Position traders hold derivatives contracts for months or even years.
They typically use fundamental analysis to identify long-term trends.

Brokers:
Individuals and businesses that assist in trading between buyers and sellers of derivatives
contracts are known as brokers in the derivatives markets. They facilitate investors' access to the
markets and aid in trade execution.
Because they facilitate trading and offer liquidity, brokers are crucial players in the derivatives
market. They provide several services to their clients, such as:
 Education and training on derivatives trading
 Research and analysis on derivatives markets
 Risk management advice
 Account management and support
Financial regulators like the Securities and Exchange Board of India usually regulate brokers.
This guarantees that brokers adhere to particular behavior and skill requirements.

Exchanges:
There are two main exchanges in the derivatives market in India:
 National Stock Exchange (NSE): NSE is the largest stock exchange in India, and it also
offers derivatives trading on a wide range of underlying assets, including stocks, indices,
commodities, and currencies.
 Bombay Stock Exchange (BSE): BSE is the oldest stock exchange in India, and it also
offers derivatives trading on a wide range of underlying assets.
There are other smaller exchanges that provide derivatives trading on particular kinds of
underlying assets in addition to these two major exchanges. One of the top exchanges for trading
commodities derivatives is the Multi commodities Exchange (MCX).
Market Makers:
In the derivatives market, market makers are people and companies that purchase and sell
derivatives contracts with the goal of supplying the market with liquidity. For a variety of
derivatives contracts, they usually quote both the ask and bid prices, and they are willing to trade
at those rates.
By facilitating trade and assisting in the mitigation of price volatility, market makers play a
crucial role in the derivatives market. Additionally, they support the maintenance of an equitable
and well-organized market for futures contracts.

Some of the leading market makers in the Indian derivative market include:
 ICICI Securities
 HDFC Securities
 Kotak Securities
 Axis Securities
 SBI Capital Markets

Clearing House:
A financial organization that ensures the settlement of derivatives contracts is known as a
clearinghouse in the derivatives market. Serving as a central counterparty to all transactions, it
puts itself in the middle of buyers and sellers, ensuring that their commitments are met.
Because it lowers risk and boosts efficiency, the clearinghouse is crucial to the derivatives
market. It also contributes to maintaining the market's fair and orderly functioning.
There are two clearinghouses in the Indian derivative market:
 National Securities Clearing Corporation (NSCC): NSCC is the clearinghouse for
derivatives contracts traded on the National Stock Exchange (NSE).
 Indian Clearing Corporation (ICC): ICC is the clearinghouse for derivatives contracts
traded on the Bombay Stock Exchange (BSE).
Products
 Futures
 Options
 Swaps
 Forward

Flow Chart:
Explanation:
Futures
A standardized contract for the purchase or sale of an underlying asset at a fixed price on a future
date is known as a futures contract. Exchanges trade futures, whose underlying assets might be
financial instruments like bonds, currencies, or stock indexes, or they can be real commodities
like oil, wheat, or soybeans.
There are several uses for futures contracts, such as:
 Hedging is a risk management technique in which you take a stake in the underlying asset
that is opposite to your current holdings. For instance, in order to hedge against the
possibility of a drop in maize prices, a farmer would sell maize futures contracts.
 Buying or selling futures contracts with the intention of profiting from fluctuations in the
value of the underlying asset is known as speculation. For instance, if a speculator thinks
that the price of oil will increase, they may purchase oil futures contracts.

Options
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell the
underlying asset at a specified price on or before a specified date. The seller of the option (the
option writer) is obligated to fulfill the contract if the buyer exercises their right.
Call and put options are the two primary categories of options. The buyer of a call option has the
opportunity to purchase the underlying asset at the strike price on or before the option's
expiration date. When purchasing a put option, the buyer has the option to sell the underlying
asset on or before the expiration date at the strike price.
To trade options in India, you need to open a trading account with a broker that is registered with
the NSE or BSE. Once you have opened a trading account, you can start trading options
contracts by placing buy or sell orders with your broker.
Exchanges facilitate the trading of options, wherein the underlying asset can be either a financial
instrument, like a stock index, bond, or currency, or a physical commodity, like oil, wheat, or
soybeans.
An example of how an option might be used for hedging:
A stock investor owns 100 shares of stock A.
The investor believes that the price of stock A may decline in the near future.
To protect themselves from a decline in the price of stock A, the investor buys 100 put options on
stock A with a strike price of $100 and an expiry date of one month.
If the price of stock A does decline, the investor can exercise their put options to sell the stock at
$100 per share, even if the current market price is lower than $100.
Swaps
A swap is a type of derivative contract where two parties consent to trade cash flows for a
predetermined amount of time. A wide range of underlying assets, including interest rates,
currencies, commodities, and stocks, may serve as the basis for the cash flows.
Swaps are traded over-the-counter (OTC), meaning that they are not traded on an exchange.
Instead, they are negotiated directly between the two parties involved. This makes swaps more
flexible than other types of derivative contracts, but it also makes them more complex and risky.
An example of how a swap might be used for hedging:
 A company is borrowing money at a variable interest rate.
 The company is concerned about the possibility of interest rates rising in the future.
 To protect themselves from rising interest rates, the company enters into an interest rate
swap with a bank.
 Under the terms of the swap, the company will pay the bank a fixed interest rate, and the
bank will pay the company a variable interest rate.
 If interest rates do rise in the future, the company will benefit from the swap because they
will be paying a lower interest rate than they would otherwise be paying.

Forwards
A forward contract is a type of derivative agreement wherein two parties commit to the purchase
or sale of an asset at a predetermined price at a future date. Forward contracts are not traded on
an exchange; instead, they are exchanged over the counter (OTC). Rather, they are directly
negotiated between the parties.
Although they are riskier and more complicated than futures contracts, forward contracts offer
greater flexibility. Futures contracts are standardized agreements that are traded on exchanges,
whereas forward contracts can be tailored to the unique requirements of the two parties involved.
An example of how a forward contract might be used for speculating:
 A trader believes that the price of oil is going to rise.
 To capitalize on this belief, the trader buys forward contracts on oil.
 If the price of oil does rise, the trader will make a profit on their forward contracts.
 However, if the price of oil falls, the trader will lose money.