Derivative Market in Nepal

Group B:Ritu Joshi

Sarita MaharjanAnkur ShresthaKrishna ChaliseDipika Shrestha

Pawan KawanSona Shrestha

Introduction

Derivatives are instruments which include: a) Security derived from a debt instrument share, loan,

risk instrument or contract for differences of any other form of security and,

b) A contract that derives its value from the price/index of prices of underlying securities.

Types of Derivative Market Future contract : is an agreement between two

parties to buy or sell an asset at a certain time in the future, at a certain price. 

Options : A contract that gives its buyer the right but not obligation to buy or sell an asset at a fixed price on or before a given date. An option to buy anything is known as a CALL while an option to sell a thing is called a PUT.

Cont.. Swaps : are private agreements between

two parties to exchange cash flows in the future.

Forward : Customized contract between two entities ,where settlement takes place on a specific date in the future.

History of Derivative Market As early as the 1650s, dealings resembling

present day derivative market transactions were seen in rise markets in Osaka, Japan.

The first leap towards an organized derivatives market came in 1848, when the Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was established.

MAJOR COMMODITIES…….

Gold Silver Crude oil Cotton Copper Corn Cocoa Sugar Coffee

Platinum Palladium Heating oil Natural gas Soyabean Soyabean oil Wheat Brent crude

Parties involved…. Client/Investor: Client or investor is the one who is ready to invest on commodities

of the derivative market and ready to bear the risk. He is the person who needs to choose his broker carefully and should have knowledge about the derivative market before having entry in it.

Broker: A derivatives broker is an investment professional who advises

individuals and corporations about how to buy, trade and sell derivatives.

Brokers negotiate deals between entities for derivative swaps, research international investment opportunities, counsel individual investors, and analyze corporate asset portfolios to calculate how much a company should risk in the derivatives market. His main job is to present options to a client, help the client make a decision on how to proceed and execute the final choice.

Contd…………. The broker's job is to work with a client to make an

appropriate investment plan and to provide investment tips.  

Because the derivatives broker acts for the client in many aspects of the investment process, it is very important that a client choose a derivatives broker that he or she trusts and works well with.

Clearing House: It is an agency or separate corporation of a future

exchange responsible for settling trading accounts, clearing trades, collecting and maintaining margin money, regulating delivery and reporting trading data.

Contd…. Clearing houses act as third parties to all futures

and option contracts - as a buyer to every clearing member seller and a seller to every clearing member buyer.

Each futures exchange has its own clearing house.

All members of an exchange are required to clear their trades through the clearing house at the end of each trading session and to deposit with the clearing house a sum of money (based on clearinghouse margin requirements) sufficient to cover the member's debit balance.

TYPES OF DERIVATIVE CONTRACTS IN NEPAL Over-the-counter (OTC) derivatives Exchange-traded derivatives Economic derivatives Energy derivatives Freight derivatives Insurance derivatives Weather derivatives Credit derivatives

BENEFITS OF THE DERIVATIVE MARKET (OF NEPAL)

Farmers, traders, exporters, importers can insure their risk from the fluctuating product prices by taking futures position in the derivative market.

Financial institutions can mitigate 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.

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.

Trading process of Derivatives Market

InvestTrade Earn

CLEARING MEMBERDual Role of Clearing & Settlement(C&S) and Market Making as a Market Maker(MM)•Clearing & Settlement RoleCan introduce market maker, brokers, clients, and responsible for administrative works (provide margin/ commission leverage, creating client profile, Broker and Sub-broker creation, margin call, fund transfer, offline support etc).

•Market Making RoleProvide frequent bid and ask quotes simultaneously with quantity within the parameter set by the exchange.

Role Perform By Parties In Trading

–Broker Plays a role to introduce sub-brokers /clients or can trade on their own account.•Providing advisory services to clients, training and customer support etc.

Parties involve in commodity trading

MEX

CLEARING MEMBERS

NON CLEARING MEMBERS (Broker) MEMBERS

CLIENTS

BANKS

How to start trading

Trading commodities online is a simple process to get started, but it is not something that should be entered into lightly. The traditional method of calling your commodity broker to place orders and waiting for a callback to give you a filled order price is quickly ending. Therefore, if you want to trade commodities online, we will cover the process of how to start.

Matching PrinciplesWhen orders and quotes are entered into the central order book, they are sorted by , price and entry time. Market orders are always given the highest priority for matching purposes.

Orders and quotes in the central order book are anonymous: A trader never knows the opposite side on a trade executed through the exchange. Orders and quotes at a given price level are aggregated, although the number of orders and quotes making up the total remains unknown. Participants only see the specific details of their own orders.

For all products, the best bid and ask prices, as well as their respective aggregated bid and offer sizes, are always available in real time.

Trading Method

Most of the derivatives markets are fully automated electronic exchange, where there is no physical trading floor. The Exchange is controlled through a centralized platform which is connected with different ‘client’ front-ends called MEXN Trader.

Initial MarginThe initial margin (IM) is levied on all open positions (Buy or sell positions) of the Members and their clients. The IM calculation on each commodity varies depending upon its market volatility. The margin so calculated is reduced from the total margin of the Member available with the exchange and accordingly further exposure is given on the balance amount.

•Daily Price LimitDaily price limit is the maximum and minimum level that a price of any contract can reach for that particular day. It is the maximum amount of gain or loss that can occur on a particular contract/s. If a price of the contracts reaches the daily price limit, trading on that contract shall be suspended for certain time period or may be for the remainder of the day. This is also called locked market.

•Trading sessionThe trading session in MEX Nepal is of 23 hours daily from Monday morning to Saturday morning. Market opens at 03:45 on Monday morning and closes at 02:45 Saturday morning during summer and during winter, the market opens and closes one hour later.

Important Papers

You need to open a saving account in BankYou must fill up Client Registration Form and Member Client AgreementRead Risk Disclosure DocumentIdentity Certificate and Address Prove.Bank Statement Certificate

Drawbacks 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.

Disadvantages Raises Volatility: Derivatives require a small initial capital

due to leveraging derivatives provide, therefore a large no. of market participants can take part in derivatives which leads to speculation and raises volatility in the markets.

Higher no. of Bankruptcies: Due to the existence of leveraged in derivatives, participants assume positions which do not match their financial capabilities and eventually lead to bankruptcies.

Increased need of regulation: There a Large no. of participants who take speculative positions. It is necessary to stop these activities and prevent people from getting bankrupt and to stop the chain of defaults.

Regulations No regulatory body for derivative market. SEBON has authorized to control derivative market

but not able to regulate it. Due to lack of expert in Ministry of Finance and

other regulated bodies, there is no proper laws. Still derivative market is existed with huge

transaction

The Present Situation of Derivative Market in Nepal

The Nepalese Derivative Market is very young. The investors haven’t been able to analyze the situation properly.

Nepal has only a recent history of derivative market, which opened with COMEN at the end of 2006

MEX was established in 2007 and NDEX on November 20, 2008.

There is no regulating body in the Nepalese derivative market.

Over 90 percent people want to invest in gold and crude oil

Recently MEX and NSE has been merged to grab the new opportunities in the market.

After merger MEX has now 120 brokers from 90 brokers earlier.

MEX is the leading derivative market in Nepal according to trading volume and trading size.

Software used are MT4, MT5, KAAP, Hybrid Solution, etc. There are altogether 7 derivative exchange in Nepal.

List of Derivative Exchange in Nepal

1) Commodity and Metal Exchange Nepal Limited (COMEN) (2006)

2) Mercantile Exchange Nepal Limited(MEX) (2007)3) Nepal Derivative Exchange Limited(NDEX)

(2008)4) Nepal Spot Exchange Limited(NSE) (2010)5)  Wealth Exchange Limited (WEX) (2011)6) National Spot Exchange Limited(NSX)7) Commodity Future Exchange Nepal Limited(CFX)

Problems in Nepal

No experts to regulate derivative market. No regulatory authority. Lack of awareness among public.

Conclusion• The derivatives market is very dynamic and quickly developed into the

most important segment of the financial market

• All in all the derivatives market in Nepal does not have a longer history and thus seems to be still underdeveloped

• Derivatives play an important role in the economy but are associated with certain risks.

• The crisis has highlighted that these risks are not sufficiently mitigated in the over-the-counter (OTC) part of the market, especially as regards credit default swaps (CDS). Since the beginning of the financial crisis, the Commission has been working to address these risks.

Cont……… The derivatives market functions very well and is constantly

improving. The imperatives for a well functioning market are clear fulfilled:

The exchange segment in particular has put in place very effective risk mitigation mechanisms mostly through the use of automation

For its user, the derivatives market is highly effective transaction costs for exchange traded derivatives are particular low.

The derivatives market needs to focus on variety of commodities that can manage the risks of that particular commodity

Derivative trading is an excellent way to prove money earns money. It will make our investment portfolio more attractive and secure. It offers a wide range of alternatives, including international opportunities. This is the best way to utilize our money

Thank You