Derivatives Market in Nepal

CONTENTS:
1. INTRODUCTION TO DERVATIVE MARKET IN NEPAL
2. HISTORY OF DERIVATIVE MARKET
3. TYPES OF DERIVATIVE CONTRACTS IN NEPAL
4. BENEFITS OF DERIVATIVE MARKET
5. DRAWBACKS OF DERIVATIVE MARKET
6. THE PRESENT SITUATION OF DERIVATIVE MARKET IN NEPAL
7. CONCLUSION

INTRODUCTION TO DERIVATIVE MARKET:

Derivatives are financial contracts or financial instruments whose prices are derived from the price
of something else (known as the underlying). 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 main types of derivatives are forward, futures, options
and swaps.

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.

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 2007, CME and CBOT officially merged, and are now collectively known as CME group Inc., the
world’s largest and most diverse derivatives exchange.

In the 21st century, online commodity trading has become increasingly popular, and 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 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.

TYPES OF DERIVATIVE CONTRACTS IN 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.

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.

The most 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

 INSURANCE DERIVATIVES

 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 has 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.

BENEFITS OF THE DERIVATIVE MARKET (OF NEPAL)

 Growers, 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.

 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.

DRAWBACKS OF THE DERIVATIVE MARKET (OF NEPAL)

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.

 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 PRESENT SITUATION OF THE NEPALESE DERIVATIVE MARKET

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 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.

CONCLUSION:

All in all the derivatives market in Nepal does not have a longer history and thus seems to be still
underdeveloped. 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. Even
though the focus is for agricultural risk management the overall utilisation of the market is for speculation.
People are utilizing the derivative market for speculating rather than risk hedging. 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 variery 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 infrastructrures 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