TYBMS SEM 5 Finance: Commodity & Derivatives Market (Q.P. November 2024 with Solution)

Paper/Subject Code: 46006/Finance: Commodity & Derivatives Market

TYBMS SEM 5 

Finance: 

Commodity & Derivatives Market 

(Q.P. November 2024 with Solution)

1. All questions are compulsory. (Subject to internal Choice)

2. Figures to the right indicate full marks.

3. Use of non-programmable calculator, is allowed and mobile phones are not allowed. 

4. Support your answers with diagrams/illustrations, wherever necessary

Q1) A Choose the correct alternative (Any 8 out of 10)                    (8)

1) ________ market helps to trade the goods on future basis.

a) Derivatives

b) Commodities

c) Stock

d) Capital 

2) _______ helps trade in two different markets.

a) Day

b) Speculators

c) Hedgers

d) Arbitrageurs

3) _______ is a place where the buying and selling of securities takes place

a) Market

b) Exchange

c) Trading Ring

d) Warehouse

4) Buying and selling of shares is called as _______.

a) Commodities

b) Derivatives

c) Trading

d) Warrants

5) The investor who invest in the market to reduce the risk are called as ________.

a) Hedgers

b) Arbitrageurs

c) Speculators

d) Traders

6) Derivatives are based on ________ amount.

a) Notional

b) Actual

c) Trading

d) Specific

7) __________ are options dates with 1 year and above maturity.

a) LEAPS

b) Warrants

c) Futures

d) Forwards

8) Call options means an option to _______

a) Buy

b) Sell

c) Trade

d) Encounter

9) Arbitrageur deals only when there is a _______

a) Loss

b) Profit

c) Benefit

d) Growth

10) Futures are _______ in nature

a) Customized

b) Valuable

c) Safer

d) Standardized

Q.1. [B] Match the column:- (Any 7)                    [07]

Column A	Column B
1 Forwards	A Yet to expire
2 Futures	B Regulatory Body
3 Baskets	C Market Risk
4 Leaps	D Indian Commodity exchange
5 SPAN	E Multiple securities
6 Outstanding Interest	F Risky
7 MCX	G Counter Party Risk
8 CME	H Equity schemes
9 OTC	I Margin System
10 FMC	J International commodity exchange

Ans:

Column A	Column B
1 Forwards	G Counter Party Risk
2 Futures	C Market Risk
3 Baskets	E Multiple securities
4 Leaps	H Equity schemes
5 SPAN	I Margin System
6 Outstanding Interest	A Yet to expire
7 MCX	D Indian Commodity exchange
8 CME	J International commodity exchange
9 OTC	F Risky
10 FMC	B Regulatory Body

Q.2. Answer the following:

[A] Explain the history & origin of derivatives market.

1. Ancient Beginnings:

• The concept of derivatives is thousands of years old.

• The earliest known example dates back to ancient Mesopotamia (around 1750 BC), where farmers used forward contracts to lock in prices for crops before harvest.

• In ancient Greece, the philosopher Thales is believed to have used options on olive presses, anticipating a good harvest.

2. Japan – The Rice Exchange (1700s):

• The Dōjima Rice Exchange in Osaka, Japan, established in the early 18th century, is considered the first organized futures market.

• Samurai and merchants traded rice coupons, which functioned similarly to futures contracts to hedge against rice price volatility.

3. United States – Formal Derivatives Market (1800s):

• In 1848, the Chicago Board of Trade (CBOT) was established.

• Initially, it facilitated forward contracts in agricultural commodities like corn and wheat.

• Over time, standardized futures contracts emerged to improve trust and liquidity.

• In 1973, the Chicago Board Options Exchange (CBOE) was launched, introducing standardized options trading.

4. Modern Derivatives Market:

• With the growth of global finance, derivatives expanded to include financial instruments such as:

  • Interest rates

  • Stock indices

  • Currencies

  • Credit risk

• The development of over-the-counter (OTC) derivatives markets allowed for customized contracts between parties.

• In the 1980s–90s, the market saw massive growth, aided by computing technology and financial innovation.

5. India’s Derivatives Market:

• Derivatives trading in India started with forwards in commodities and informal contracts.

• In 2000, SEBI allowed exchange-traded derivatives:

  • NSE launched index futures on the Nifty 50

  • Later followed by stock futures, index options, and stock options

The derivatives market has evolved from ancient tools for managing risk in agriculture to a sophisticated global financial ecosystem. Today, it is a crucial part of modern finance, used for hedging, speculation, and arbitrage across various asset classes.

[B] What are the types of commodities?

Commodities are raw materials or primary agricultural products that can be bought, sold, or exchanged, and are usually standardized. They are often traded on specialized exchanges like MCX (India), NYMEX, or LME.

They are broadly classified into two main categories:

• Hard Commodities

• Soft Commodities

1. Hard Commodities

These are natural resources that are mined, extracted, or processed from the earth. They typically involve industrial use and are influenced by global economic conditions.

a) Energy Commodities

These commodities are used to generate power and fuel industries.

Commodity	Use/Importance
Crude Oil	Primary source for fuels (petrol, diesel), plastics, chemicals
Natural Gas	Used for heating, electricity, industrial operations
Coal	Thermal energy production, metallurgy
Gasoline	Refined product of crude oil, used in transport fuels

🔹 Energy commodities are highly sensitive to geopolitical tensions, global demand, and OPEC policies.

b) Metal Commodities

These are used across construction, electronics, investment, and manufacturing.

i) Precious Metals

• Gold: Investment, jewelry, financial reserves

• Silver: Jewelry, electronics, medical tools

• Platinum & Palladium: Automotive (catalytic converters), jewelry

ii) Industrial/Base Metals

• Copper: Electrical wiring, electronics, plumbing

• Aluminum: Packaging, transportation, construction

• Zinc: Galvanization, alloys

• Nickel: Stainless steel production

🔹 Prices are driven by construction and industrial activity globally, especially in growing economies.

2. Soft Commodities

These are agricultural products or livestock that are grown or raised, rather than mined.

a) Agricultural Commodities

These include staple crops essential for food production and processing industries.

Commodity	Use/Importance
Wheat	Bread, flour, pasta
Corn	Animal feed, biofuel, processed food
Rice	Staple food, especially in Asia
Soybeans	Oil production, animal feed, tofu
Barley, Oats	Beer production, breakfast cereals

🔹 Prices depend on climate, global demand, government subsidies, and crop yield.

b) Softs (Tropical Agriculture)

These are non-staple agricultural commodities, usually grown in tropical climates.

Commodity	Use/Importance
Coffee	Beverage industry
Cocoa	Chocolate production
Sugar	Food, biofuel
Cotton	Textile and fabric industries
Rubber	Tires, industrial and medical equipment

🔹 Highly sensitive to weather conditions, pests, and labor policies in producing countries.

c) Livestock & Meat

These are animal-based commodities, widely used in food industries.

Commodity	Use/Importance
Live Cattle	Beef production
Feeder Cattle	Young cattle raised for slaughter
Lean Hogs	Pork products
Poultry	Meat and egg production (less often traded)

🔹 Demand fluctuates based on festivals, dietary trends, and animal disease outbreaks.

3. Other / Emerging Commodities 

With evolving environmental and economic trends, some non-traditional commodities have emerged:

Commodity	Use/Importance
Carbon Credits	Emission trading to fight climate change
Water Rights	Water supply management in agriculture
Renewable Energy Certificates	For trading green energy production

OR

[C] What are the reasons for investing in derivatives?

Derivatives are financial instruments whose value is derived from an underlying asset (stocks, bonds, currencies, commodities, etc.). Investors and institutions use them for various purposes. Here are the main reasons:

1. Hedging (Risk Management)

To reduce or eliminate risk due to price fluctuations in the underlying asset.

• Derivatives allow investors or businesses to lock in prices, protecting themselves against adverse movements.

Example:

• A farmer uses futures contracts to lock in the price of wheat in advance, avoiding losses if market prices fall at harvest.

Very common among producers, exporters, and institutional investors.

2. Speculation (Profit from Price Movements)

To profit from expected movements in asset prices without owning the asset.

• Traders speculate using options or futures, aiming to gain from market direction, volatility, or timing.

Example:

• A trader buys call options on a stock, expecting its price to rise, and profits from the increased option value.

Riskier but offers high return potential.

3. Arbitrage Opportunities

To earn risk-free profits by exploiting price differences of the same asset in different markets or forms.

Example:

• If gold is cheaper in one market and costlier in another, an arbitrageur buys low and sells high simultaneously using derivatives.

Common among institutional investors and hedge funds.

4. Leverage

To control a large position with a relatively small amount of capital.

• Derivatives, especially futures and options, require only a margin, allowing traders to amplify returns (and risks).

Example:

• With ₹10,000 margin, a trader may take a futures position worth ₹1,00,000.

Leverage magnifies both gains and losses.

5. Portfolio Diversification

To broaden investment exposure across various asset classes and risk types.

• Derivatives can be based on equity, commodities, currencies, interest rates, etc.

• They help reduce portfolio concentration risk.

Example:

• An investor in stocks adds commodity futures to balance the risk during stock market downturns.

6.  Price Discovery

To determine fair market prices through active participation and volume in derivatives markets.

• Prices in futures and options markets often reflect market expectations, guiding decisions in the spot market.

Example:

• If crude oil futures show a rising trend, it can indicate future price expectations and influence physical market prices.

7. Hedge Against Inflation and Interest Rates

To protect purchasing power or manage cost uncertainties.

• Derivatives on interest rates, commodities, or currencies help manage exposure to inflation and monetary shifts.

[D] What are the participants under derivatives market in India.

The derivatives market in India, regulated by SEBI (Securities and Exchange Board of India), includes four key categories of participants:

1. Hedgers

• Corporates, farmers, exporters/importers, or investors who face price risk in their normal business.

Objective:

• To protect themselves against adverse price movements in the underlying asset.

Example:

• An oil importing company may hedge against rising crude oil prices by buying crude oil futures on MCX.

2. Speculators

• Individual or institutional traders who aim to profit from price fluctuations.

Objective:

• To earn profit by predicting market direction—without any interest in the actual underlying asset.

Example:

• A trader buys Nifty futures, expecting the market to rise, and sells at a higher price later.

They add liquidity but also increase market volatility.

3. Arbitrageurs

• Professional traders or institutions that take advantage of price differences in different markets or instruments.

Objective:

• To make risk-free profits by buying in one market and simultaneously selling in another.

Example:

• If Reliance stock is priced differently in the spot market vs. futures market, an arbitrageur exploits the difference.

Their activity helps keep markets efficient.

4. Margin Traders

• Traders who take leveraged positions using margin money, usually in futures and options.

Objective:

• To gain higher exposure with lower capital, often for short-term gains.

Example:

• With ₹10,000, a trader can take a futures position worth ₹1,00,000, magnifying both profit and risk.

Q.3. Answer the following:

[A] Explain the various terms under futures contract.

A futures contract is a standardized legal agreement to buy or sell an asset at a predetermined price at a specified time in the future, traded on an exchange.

Here are the most important terms associated with it:

1. Contract Maturity / Expiry Date

• The date on which the futures contract expires.

• After this date, the contract can no longer be traded.

• In India, futures contracts typically expire on the last Thursday of the month.

2. Contract Size / Lot Size

• The minimum quantity of the asset that can be traded in a contract.

• It is standardized by the exchange.

Example:
Nifty Futures may have a lot size of 50 units.

3. Tick Size

• The minimum price movement allowed in the trading of a futures contract.

• Set by the exchange.

Example:
If the tick size is ₹0.05, price can move in multiples of ₹0.05 only.

4. Initial Margin

• The minimum deposit required to enter into a futures position.

• It's a percentage of the total contract value, calculated using SPAN (Standard Portfolio Analysis of Risk).

5. Mark-to-Market (MTM)

• Daily process of settling gains and losses based on the closing price of the futures contract.

• Profits/losses are credited or debited to traders' margin accounts every day.

6. Maintenance Margin

• The minimum balance that must be maintained in the margin account.

• If your balance falls below this level, you'll receive a margin call to add more funds.

7. Open Interest

• The total number of outstanding futures contracts (not yet settled) at a given point in time.

• It shows the liquidity and activity level in that contract.

8. Settlement Price

• The price used to calculate daily MTM settlements.

• On expiry, it becomes the final settlement price.

9. Final Settlement

• The process of closing the contract on the expiry date.

• Can be done by:

  • Cash settlement (based on final price)

  • Physical delivery (in commodity futures)

In equity futures in India, cash settlement is most common.

10. Underlying Asset

• The financial instrument or commodity on which the futures contract is based.

Examples:

• Stocks (e.g., Reliance, Infosys)

• Indices (e.g., Nifty 50, Bank Nifty)

• Commodities (e.g., Gold, Crude Oil)

11. Long and Short Position

• Long Position: Buying a futures contract (expecting price to rise)

• Short Position: Selling a futures contract (expecting price to fall)

12. Clearing House

• An institution that guarantees the contract and ensures smooth settlement.

• Acts as a counterparty to both buyers and sellers.

13. Hedging vs. Speculation

• Hedging: Using futures to reduce risk.

• Speculation: Using futures to profit from price movement.

[B] Explain concept of contango and backwardation.

Contango

Contango is a market condition where futures prices are higher than the current spot price of an asset. This happens when traders expect prices to rise in the future due to factors like storage costs, interest rates, and inflation.

Futures Price > Spot Price

Contango happens when:

Storage Costs Exist – Storing commodities (oil, gold, wheat) adds costs, making future prices higher.
Higher Demand for Future Delivery – Traders prefer buying later due to economic expectations.
Inflation Expectations – Prices are expected to increase over time.
Interest Rate Impact – Higher rates increase the cost of holding the asset today.

Common in Commodities Markets – Seen in oil, gold, and agricultural products.

Example of Contango

Let’s assume:

• Spot Price of Crude Oil = ₹6,000 per barrel

• 3-Month Futures Price = ₹6,300 per barrel

• 6-Month Futures Price = ₹6,600 per barrel

Since the futures prices are higher than the spot price, this is a contango market.

🔹 A trader may buy oil today at ₹6,000, expecting to sell it later at a higher futures price.

Impact of Contango on Traders & Investors

Profitable for Arbitrageurs – Traders use cash & carry arbitrage to profit from price differences.
Good for Long-Term Investors – Investors expect prices to rise in the future.
Bad for Short-Term Traders – Futures contracts may depreciate as they approach expiry.
Higher Costs for Hedgers – Hedging in a contango market can be expensive.

Backwardation.

Backwardation is a market condition where the futures price is lower than the spot price of the underlying asset.

Futures Price < Spot Price

Backwardation is a market condition where the futures price of a commodity or asset is lower than its current spot price. It typically occurs when investors expect the price of the underlying asset to decrease over time. In such scenarios, buyers are willing to pay a premium for the immediate delivery of the commodity rather than waiting for a future date, often due to supply shortages or high immediate demand.

Backwardation contrasts with contango, where futures prices are higher than the spot price, reflecting expectations of rising prices over time. Backwardation can benefit traders who hold short positions in futures contracts, as the futures price converges upward toward the spot price as the contract nears expiration.

OR

[C] The spot price of gold is 1,00,000, locker rent is 16,000 pa, and insurance is 9,500 for six months, interest rate on borrowed funds is 12% p.a. Calculate the fair value of 3 months futures contract, compounded monthly.                [08]

[D] An investor took two position in futures market. He sold the 1 futures of Infosys stock. The futures price for 8,500. On the expiry the cash market price 8,000. He bought 2 fatures of Jindal Steels at 20,500, on expiry the price was 22,000 Find the profit & loss for å lost size of 50 sing in one contract. Also draw a payoff diagram for the same.                 [07]

Q.4. Answer the following:

[A] Explain black & Scholes a pricing model

The Black-Scholes Model is a mathematical formula used to calculate the theoretical price of European-style options (especially call and put options), based on certain market conditions.

It was developed in 1973 by Fischer Black, Myron Scholes, and Robert Merton.

Purpose of the Model:

To determine a fair value of an option based on:

• Current stock price

• Strike price

• Time to maturity

• Risk-free interest rate

• Volatility of the stock

Assumptions of the Model:

1. The option is European (exercised only at expiry).

2. No dividends are paid during the option’s life.

3. Markets are efficient (no arbitrage).

4. There are no transaction costs or taxes.

5. Interest rates and volatility are constant.

6. The stock price follows a lognormal distribution (random walk model).

Real-Life Example (Simple)

Let’s say:

• Stock price $S_0=\text{₹}100$

• Strike price $K = ₹105$

• Time to expiry $T = 0.5$ years

• Risk-free rate $r = 6\%$

• Volatility $\sigma = 20\%$
  

Using the Black-Scholes formula (you can use a calculator or spreadsheet), you’ll get the theoretical value of the call and put options.

• Standard tool in the options market.

• Widely used by traders, portfolio managers, and investment analysts.

• Basis for option valuation, risk management, and strategy building.

Limitations:

• Assumes constant volatility (in real life, volatility changes).

• Doesn’t work well for American options (which can be exercised early).

• Doesn't account for dividends (unless adjusted).

• Not accurate in extreme market conditions.

[B] Explain the terms under options? 

An option is a financial contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (strike price) on or before a certain date (expiration).

Terms in Options

1. Call Option

• A call option gives the buyer the right to buy the underlying asset.

• You profit if the price of the asset goes up.

• Example: Buying a Nifty 22,000 Call means you expect Nifty to rise above 22,000.

2. Put Option

• A put option gives the buyer the right to sell the underlying asset.

• You profit if the price of the asset goes down.

• Example: Buying a Reliance 2500 Put means you expect Reliance to fall below ₹2500.

3. Strike Price (Exercise Price)

• The fixed price at which the option holder can buy (call) or sell (put) the underlying asset.

• It's a key reference point for whether the option is profitable or not.

4. Premium

• The price you pay to buy an option.

• Paid upfront by the option buyer to the option seller (writer).

• Premium = cost of the option, and it’s non-refundable.

5. Underlying Asset

• The asset on which the option contract is based.

• It can be a stock, index, commodity, currency, etc.

• Example: Nifty options are based on the Nifty index, Reliance options are based on Reliance stock.

6. Expiration Date

• The last day the option can be exercised.

• After this date, the option becomes worthless if not used.

• In India: Stock options typically expire on the last Thursday of the month.

7. In the Money (ITM)

• The option is profitable if exercised.

• For Call: When Market Price > Strike Price

• For Put: When Market Price < Strike Price

8. Out of the Money (OTM)

• The option is not profitable if exercised.

• For Call: When Market Price < Strike Price

• For Put: When Market Price > Strike Price

9. At the Money (ATM)

• The market price ≈ strike price.

• The option has no intrinsic value, only time value.

10. Intrinsic Value

• The real value of the option if exercised now.

• It is never negative.

• Formula:

  • Call: Market Price – Strike Price

  • Put: Strike Price – Market Price

11. Time Value

• The extra value over intrinsic value due to time left until expiry.

• Time value decreases as the option approaches expiry (time decay).

• Total Premium = Intrinsic Value + Time Value

12. Option Buyer (Holder)

• Pays the premium.

• Has the right, not the obligation, to exercise the option.

• Risk is limited to the premium paid.

• Profit is potentially unlimited (for calls).

13. Option Seller (Writer)

• Receives the premium.

• Has the obligation to fulfill the contract if exercised.

• Profit is limited to the premium.

• Risk can be unlimited (especially in uncovered call writing).

14. Lot Size

• Options are traded in fixed quantities known as lots.

• You cannot buy just 1 unit — only full lots.

• Example: 1 lot of Nifty = 50 units.

15. Settlement

• Most options are cash-settled (no physical delivery).

• Profits/losses are directly credited/debited to your account.

16. Open Interest (OI)

• The total number of outstanding contracts that haven't been closed or settled.

• High OI = Active interest in that strike price.

17. Volatility

• A measure of how much the price of the underlying asset fluctuates.

• More volatility → higher premiums (more chance to profit from moves).

18. Greeks

These are variables that affect the price of an option:

Delta

Sensitivity to underlying price movement

Theta

Time decay (value lost as expiry approaches) Vega Sensitivity to volatility Gamma Rate of change of Delta Rho Sensitivity to interest rate changes

 OR

[C] The spot price of Silver is 9,500, locker rent is 1200 p.a. and insurance is 2,500 for six months, interest rate on borrowed funds is 10% p.a. Calculate the fair value of 3 months futures contract, compounded monthly. [08]

[D] Riya shorts a call option of YST Ltd at an exercise price of 1000 with a premium of 30. Calculate the profit & loss for Riya if the spot price on expiry was 950,960,970,980,990,1000,1010,1020,1030,1040,1050. Also draw the payoff diagram. [07]

Q.5. Answer the following:

[A] What are the different types of margins?            [08]

margins play a key role in trading, especially in derivatives like options and futures. There are several types of margins, depending on the market and context (e.g., stock trading vs. futures/options trading). 

Margin is essentially collateral — money or securities deposited by an investor with a broker to cover the credit risk involved in trading.

1. Initial Margin

• Definition: The minimum amount of money or collateral a trader must deposit to open a position.

• Applies to: Futures, options (writers), and margin stock trading.

• Purpose: Protects the broker and the exchange from counterparty risk.

• Example: To sell a futures contract, an initial margin of ₹1,50,000 might be required even though the total value of the contract is ₹10,00,000.

2. Maintenance Margin

• Definition: The minimum equity that must be maintained in your margin account after the trade is placed.

• If your account falls below this level, you’ll get a margin call.

• Margin Call: A demand from your broker to add more funds or liquidate positions.

• Example: If the maintenance margin is ₹1,00,000 and your equity falls to ₹90,000 due to losses, you’ll need to top it up.

3. Variation Margin / Mark-to-Market (MTM) Margin

• Definition: Daily margin adjustment based on market movement.

• Applies to: Futures and some options.

• Purpose: Ensures that gains and losses are settled daily.

• Example: If the market moves against your futures position, you must pay the loss as variation margin daily.

4. Exposure Margin

• Definition: An additional safety buffer over and above the initial margin.

• Purpose: Covers potential market volatility and unexpected losses.

• Applies to: Mainly in Indian derivatives markets (like NSE/BSE).

• Usually: A fixed percentage of the total contract value.

5. Span Margin

• Definition: A sophisticated margining system that calculates the maximum possible loss a portfolio could face in a day.

• Used by: Exchanges like NSE and BSE (SPAN = Standard Portfolio Analysis of Risk).

• Includes: Initial + exposure margins.

• Highly optimized, based on stress scenarios.

6. Premium Margin (for Options Buyers)

• Definition: The total option premium the buyer has to pay upfront.

• For Buyers: That’s all they can lose — no additional margin required.

• For Sellers/Writers: Must post both initial + exposure margins because their risk is theoretically unlimited.

7. Cross Margin

• Definition: Margin benefit available when a trader holds hedged positions across instruments (like futures and options).

• Benefit: Reduces total margin requirement.

• Example: A long Nifty Futures and short Nifty Call Option may offset risks, allowing lower combined margin.

8. Margin for Equity Trading

• In cash equity, margin trading allows you to buy more stock than you can afford using borrowed funds from the broker.

• Types:

  • Margin Against Shares (MAS): Pledge your existing stocks as margin.

  • Margin Trading Facility (MTF): Broker lends you money to buy shares.

[B] Explain the meaning of securities and SEBI guidelines for commodities market. [07]

Securities are financial instruments that hold some type of monetary value. These are tradable and represent either ownership (like stocks) or a creditor relationship (like bonds).

Types of Securities:

Equity Securities

Shares/stocks representing ownership in a company

Debt Securities Bonds, debentures – lender lends money to the issuer Derivatives Options, futures, etc. – value derived from underlying assets Hybrid Securities Combine features of debt and equity (e.g., convertible bonds) So, when you hear "securities market," think of a marketplace where these instruments are issued, bought, and sold. 2. SEBI Guidelines for Commodities Market The commodities market is where raw or primary products like gold, silver, oil, wheat, cotton, etc. are traded — mainly through futures contracts. In 2015, SEBI took over the regulation of commodity markets after the merger with the Forward Markets Commission (FMC). SEBI Guidelines for the Commodities Market: 1. Market Participants SEBI categorizes participants into: Hedgers: Reduce price risk (e.g., farmers, producers). Speculators: Trade to profit from price movements. Arbitrageurs: Take advantage of price differences in different markets. 2. Commodities Derivatives SEBI regulates futures and options in commodities like metals, agricultural products, and energy. Only exchange-traded derivatives are allowed — OTC (over-the-counter) trades are prohibited. 3. Recognized Commodity Exchanges SEBI regulates major exchanges like: MCX (Multi Commodity Exchange) NCDEX (National Commodity and Derivatives Exchange) These exchanges must comply with SEBI rules on risk management, surveillance, settlement, etc. 4. Margins and Risk Management SEBI mandates strict margin requirements (initial, maintenance, exposure). Daily Mark-to-Market settlement is required to minimize credit risk. Risk management systems must include price bands, position limits, and circuit breakers. 5. Position Limits Traders cannot hold more than a specified number of contracts to prevent manipulation. Separate limits for client, member, and near-month contracts. 6. Transparency and Disclosures Exchanges must disclose spot prices, contract specifications, and volume data in real time. Participants must follow strict disclosure norms. 7. Product Approval and Surveillance Exchanges need SEBI’s approval to launch new commodity derivatives. SEBI conducts regular surveillance to prevent market abuse, insider trading, and manipulation. 8. Warehousing and Delivery For physically settled contracts, SEBI ensures proper warehousing infrastructure and delivery mechanisms. Warehouses must be registered with WDRA (Warehousing Development and Regulatory Authority). 9. Investor Protection SEBI encourages investor education, ensures grievance redressal, and monitors mis-selling by brokers.

OR

[C] Write Short Notes on: [Attempt any 3]                [15]

a) Binomial Option Pricing Model

b) Types of settlement

Settlement refers to the process of transferring ownership of securities and payment of money between buyer and seller after a trade is executed. It’s the final step in a trade.

Types of Settlement

There are several types of settlement methods, depending on the asset class and contract type:

1. Cash Settlement

• No physical delivery of the asset.

• Only the difference in price (profit or loss) is paid in cash.

• Common in index derivatives, options, some commodity contracts, etc.

Example:
If you bought a Nifty call option at 22,000 and Nifty closes at 22,200, you’ll receive ₹200 × lot size in cash — not actual Nifty units.

2. Physical Settlement

• Involves actual delivery of the asset.

• Common in equity (stock) derivatives, commodities, and bond markets.

• In India, stock options and futures are now physically settled on expiry.

Example:
If you hold an ITC stock future at expiry, and you don’t square it off, you will either receive or deliver ITC shares.

3. T+1 or T+2 Settlement

• T refers to the Trade Date.

• T+1 means settlement happens 1 business day after trade.

• T+2 means it happens 2 business days after trade.

India shifted from T+2 to T+1 settlement for equity markets starting 2023.

Example:
If you buy a stock on Monday (T), you’ll receive the shares in your demat account on Tuesday (T+1).

4. Rolling Settlement

• Trades are settled continuously, every trading day.

• Opposed to account period settlement, where trades over a week are settled together.

India follows a T+1 rolling settlement cycle — every trade is settled 1 day after it's made.

5. Forward Settlement

• Settlement happens at a later, agreed-upon date.

• Common in forward contracts and some OTC (over-the-counter) trades.

Example:
You agree to buy gold at ₹60,000 per 10g for delivery in 2 months. Settlement will happen then.

6. Novation (via Clearing House)

• In derivatives, settlement is often handled through a clearing corporation.

• The clearing house becomes the counterparty to both buyer and seller, guaranteeing the trade.

This ensures counterparty risk is minimized.

7. Net Settlement

• Only the net obligation (final payable or receivable amount) is settled, not individual trades.

• Common in banking and currency settlement systems.

c) Difference between futures and options

	Future	Options
1. Definition	A contract to buy/sell an asset at a predetermined price at a specified future date.	A contract giving the right (not obligation) to buy/sell an asset at a set price before expiry.
2. Obligation	Both buyer and seller are obligated to execute the contract.	Only the seller is obligated; the buyer can choose to exercise the right.
3. Upfront Cost	No premium is paid, but margin money is required.	Buyer pays a premium to the seller.
4. Risk for Buyer	Unlimited loss potential if the market moves against the position.	Limited to the premium paid.
5. Risk for Seller	Unlimited loss potential, depending on market movement.	Unlimited loss for the seller, especially if the position is uncovered.
6. Profit Potential	Unlimited profit/loss depending on market price movement.	Buyer: Unlimited profit (Call), Limited loss. Seller: Limited profit (premium), unlimited risk.
7. Margin Requirement	Required for both buyer and seller.	Required mainly for option seller (writer). Buyer only pays premium
8. Execution	Must be settled or squared off before expiry.	Buyer can choose to exercise or let the contract expire worthless.
9. Types Available	One type: Buy/Sell contract.	Two types: Call (buy) and Put (sell).
10. Use Case	Used for hedging, speculation, and arbitrage.	Used for hedging, income generation, and speculation.

d) NSCCL

NSCCL stands for National Securities Clearing Corporation Limited.
It is a wholly-owned subsidiary of the National Stock Exchange (NSE), established in 1996, and is the first clearing corporation in India to provide counterparty risk guarantee for trades.

Objective of NSCCL

The primary goal of NSCCL is to act as a central counterparty (CCP) for all trades executed on NSE.
It ensures that trades are:

• Cleared (obligations calculated),

• Settled (funds/securities transferred),

• And guaranteed, even if one party defaults.

This enhances market integrity, reduces risk, and builds investor confidence.

Functions of NSCCL

1. Clearing of Trades

• After a trade is executed on NSE, NSCCL determines obligations of buyers and sellers.

• This includes how much money or securities each party owes or will receive.

2. Settlement of Trades

• NSCCL facilitates the actual transfer of:

  • Securities (via depositories like NSDL/CDSL)

  • Funds (via clearing banks)

• For equity trades, this now happens on a T+1 basis in India.

3. Novation – Becoming the Central Counterparty

• NSCCL replaces the original buyer and seller by interposing itself in the trade.

• This means:

  • NSCCL becomes the buyer to every seller

  • And the seller to every buyer

• This process is called novation, and it removes counterparty credit risk.

4. Risk Management

To maintain financial integrity, NSCCL:

• Calculates and collects various margins:

  • Initial Margin

  • Mark-to-Market (MTM) Margin

  • Exposure Margin

• Monitors position limits, volatility, and member exposures in real-time.

• Maintains a Settlement Guarantee Fund (SGF) to handle defaults.

5. Settlement Guarantee

• If a party defaults (broker/member), NSCCL guarantees the settlement using the SGF.

• Ensures that trades are not reversed or failed — extremely important for maintaining market confidence.

6. Handling Corporate Actions

NSCCL adjusts open positions in derivative contracts during:

• Bonus issues

• Stock splits

• Mergers/demergers

• Dividends

This ensures that traders’ positions remain fair and aligned with corporate changes.

7. Interfacing with Depositories and Banks

• NSCCL works with NSDL and CDSL (for securities) and multiple clearing banks (for funds).

• It coordinates the smooth transfer of securities and cash on settlement days.

Membership with NSCCL

To become a clearing member, an entity must:

• Be SEBI-registered

• Meet capital adequacy and net worth criteria

• Have technical and operational infrastructure

• Be subject to strict compliance and audit

Benefits of NSCCL to the Market

Ensures reliable settlement
Eliminates counterparty risk
Enhances market confidence
Supports complex instruments (derivatives, currency, etc.)
Efficient risk and fund management

e) Long & Short Hedge

Hedging is a strategy used to reduce or eliminate risk due to adverse price movements in an asset.
You use a derivative (like a futures contract) to lock in prices and protect your position.

There are two major types of hedges:

• Long Hedge

• Short Hedge

1. Long Hedge (Buy Hedge)

Definition:

A Long Hedge involves buying futures contracts to protect against a possible rise in the price of an asset that you plan to buy in the future.

• Companies or individuals who will need to buy a commodity or asset in the future (but don’t want to risk price increase).

• Common in manufacturing, airlines, exporters who need raw materials.

Objective:

To lock in a purchase price now, to avoid paying higher prices later.

Example:

Imagine you're a biscuit manufacturer and you need wheat in 3 months.

• Current wheat price = ₹2,000/quintal

• Futures price = ₹2,100/quintal (3-month contract)

You’re worried prices may go up. So, you buy wheat futures now.

• If actual price rises to ₹2,300 later:

  • You gain ₹200 from the futures (buy at ₹2,100, market at ₹2,300)

  • You pay ₹2,300 in the physical market

  • Net effective cost = ₹2,100 

Thus, you’re hedged against price increase.

2. Short Hedge (Sell Hedge)

Definition:

A Short Hedge involves selling futures contracts to protect against a possible fall in the price of an asset that you currently hold or will sell.

• Farmers, producers, or companies that have an inventory or production of a commodity or asset and are worried about falling prices.

• Also used by investors or traders who hold a long portfolio and want to protect its value.

Objective:

To lock in a selling price now, to avoid losses from falling market prices later.

Example:

You’re a farmer expecting to harvest soybean in 2 months.

• Current soybean price = ₹5,000/quintal

• You’re worried prices may fall

• You sell soybean futures today at ₹5,000

If price drops to ₹4,600 in 2 months:

• You lose ₹400 on the physical market

• But gain ₹400 on your futures sale

• So, you’re hedged and still receive ₹5,000 overall 

• Long Hedge = Protection against price increase → Buy futures

• Short Hedge = Protection against price fall → Sell futures

Both are risk management tools used widely in commodities, currencies, interest rates, and equities.