Derivatives & Futures: Types, Mechanics & Nepal’s Market

TAKEAWAYS:

• Derivatives are contracts whose value depends on an underlying asset (e.g., gold, NEPSE index), used to hedge risks or speculate.
• Futures are standardized, exchange-traded derivatives with daily settlement margins (unlike forwards, which are OTC).
• Nepal’s futures market (NEPSE) trades gold, crude oil, and commodities; regulated by SEBON and NRB to prevent systemic risks.
• Key risks: Basis risk (spot vs. futures price mismatch), liquidity risk, and counterparty default (mitigated by clearinghouses).
• Regulatory tools: Margin requirements, position limits, and circuit breakers (e.g., NEPSE halts trading if gold futures move >5% in a day).
• Real-world tie: NEPSE’s gold futures let jewelers (e.g., Kathmandu’s Gyaneshwor Market traders) lock in prices to avoid spot-price volatility.

1. What Are Derivatives?

Derivatives are financial instruments whose value is "derived" from an underlying asset (e.g., stocks, commodities, currencies, or indices). They are used for:

• Hedging: Protecting against price fluctuations (e.g., a wheat farmer in Chitwan buying futures to lock in a sale price).
• Speculation: Betting on price movements (e.g., traders in NEPSE’s gold futures).
• Arbitrage: Exploiting price differences across markets (e.g., buying gold futures in Nepal cheaper than spot in Dubai).

Types of Derivatives

classDiagram
    class Derivatives {
        <<abstract>>
        +value depends on underlying asset
    }
    class Forwards {
        +customized terms
        +OTC (over-the-counter)
        +no daily settlement
    }
    class Futures {
        +standardized contracts
        +exchange-traded (e.g., NEPSE)
        +daily margin calls
    }
    class Options {
        +right (not obligation) to buy/sell
        +premium paid upfront
        +call/put options
    }
    class Swaps {
        +exchange cash flows (e.g., interest rate swaps)
        +used by corporates/banks
    }
    Derivatives <|-- Forwards
    Derivatives <|-- Futures
    Derivatives <|-- Options
    Derivatives <|-- Swaps

2. Futures Contracts: Mechanics

Futures are standardized contracts traded on exchanges (e.g., NEPSE Derivatives Exchange) to buy/sell an asset at a pre-agreed price on a future date. Key features:

• Standardization: Fixed contract size (e.g., 100 oz gold), expiry date, and tick size (minimum price change).
• Exchange-Traded: Traded via brokers (e.g., Nepal Investment Bank or Global IME Bank).
• Daily Settlement (Marking-to-Market): Gains/losses are settled daily via margin accounts.
• Leverage: Only initial margin (e.g., 10% of contract value) is required upfront.

How Futures Pricing Works

The futures price (F) is determined by: $$F=S\times e^{rT}$$ Where:

• $S$ = Spot price (current market price)
• $r$ = Risk-free interest rate (e.g., NRB’s repo rate)
• $T$ = Time to expiry (in years)

Example: If gold spot price = Rs. 100,000/oz, risk-free rate = 6%, and expiry in 3 months ($T=0.25$): $$F=100,000\times e^{0.06\times 0.25}=\text{Rs. }101,507\text{ (theoretical futures price)}$$

3. Nepal’s Futures Market: Products and Regulation

Nepal’s derivatives market is young but growing, with NEPSE as the primary exchange. Key products:

Regulatory Bodies

1. Securities Exchange Board of Nepal (SEBON): Regulates derivatives trading, sets margin rules, and approves clearinghouses.
2. Nepal Rastra Bank (NRB): Oversees systemic risks, monitors leverage, and enforces anti-money laundering (AML) rules.
3. Clearing Corporation of Nepal (CCN): Acts as a central counterparty (CCP) to guarantee trades (reduces counterparty risk).

Mermaid Diagram: Nepal’s Derivatives Market Flow

flowchart TD
    A["Trader (e.g., Jeweler in Kathmandu)"] -->|"Places Order"| B["NEPSE Derivatives Exchange"]
    B -->|"Matches Buy/Sell"| C["Clearing Corporation of Nepal (CCN)"]
    C -->|"Daily Settlement"| D["Margin Account at Bank (e.g., NIBL)"]
    D -->|"Funds Transferred"| E["Trader"]
    NRB["NRB"] -->|"Regulatory Oversight"| B
    SEBON["SEBON"] -->|"Rules & Margin Limits"| B

4. Worked Example: Gold Futures for a Kathmandu Jeweler

Scenario: Mr. Bista, a jeweler in Thamel, wants to hedge against rising gold prices. He enters a short futures position in 10 gold futures contracts at Rs. 102,000/oz (spot price = Rs. 100,000/oz). Each contract = 100 oz.

Step 1: Calculate Initial Margin

• Contract value = 10 contracts × 100 oz × Rs. 102,000 = Rs. 10,200,000
• Margin requirement = 12% of Rs. 10,200,000 = Rs. 1,224,000 (deposited in margin account).

Step 2: Daily Settlement (After 1 Week)

• New spot price = Rs. 105,000/oz
• Futures price (theoretical) = Rs. 105,000 × $e^{0.06\times 0.03}$ ≈ Rs. 105,190/oz
• Loss per contract = Rs. 105,190 – Rs. 102,000 = Rs. 3,190
• Total loss = 10 contracts × 100 oz × Rs. 3,190 = Rs. 319,000
• Margin account balance = Rs. 1,224,000 – Rs. 319,000 = Rs. 905,000

| Dr. (Debit)               | Rs.       | Cr. (Credit)          | Rs.       |
|---------------------------|-----------|-----------------------|-----------|
| Initial Margin Deposit    | 1,224,000 | Loss on Futures       | 319,000   |
| **Total**                 | 1,224,000 | **Total**             | 319,000   |
|                           |           | **Closing Balance**   | 905,000   |

Step 3: Expiry (3 Months Later)

• Final spot price = Rs. 108,000/oz
• Mr. Bista’s obligation: Deliver 1,000 oz gold at Rs. 102,000/oz = Rs. 102,000,000
• Market value at expiry: 1,000 oz × Rs. 108,000 = Rs. 108,000,000
• Profit = Rs. 108,000,000 – Rs. 102,000,000 = Rs. 6,000,000
• Net profit after initial margin: Rs. 6,000,000 – Rs. 1,224,000 = Rs. 4,776,000

Why? Mr. Bista benefited from rising gold prices while locking in a lower sale price.

5. Risks in Derivatives Trading

6. Advantages and Disadvantages of Derivatives

Advantages

• Hedging: Protects against price volatility (e.g., NTC’s fuel imports hedging crude oil futures).
• Leverage: Small initial margin can control large positions (e.g., trading gold futures with 10% margin).
• Liquidity: Exchange-traded derivatives offer easy entry/exit (unlike OTC forwards).
• Speculation: Allows profit from price movements without owning the asset.

Disadvantages

• High Risk: Can lead to large losses (e.g., 2008 financial crisis due to credit default swaps).
• Complexity: Requires understanding of margins, expiry, and settlement.
• Regulatory Costs: Nepal’s derivatives market has transaction fees (e.g., 0.05% on NEPSE trades).
• Systemic Risk: Uncontrolled speculation can destabilize markets (NRB monitors this).

7. Derivatives in Nepal: Real-World Applications

Example 1: NEPSE’s Gold Futures for Jewelers

• Problem: Gold prices in Nepal are volatile due to imports and demand fluctuations.
• Solution: Jewelers like Mr. Bista use gold futures to lock in selling prices.
• Impact: Reduces uncertainty in inventory valuation and profit margins.

Example 2: NTC’s Crude Oil Futures Hedge

• Problem: Nepal imports 90% of its oil from India/Singapore; price swings hurt subsidies.
• Solution: NTC could use crude oil futures to hedge against price spikes.
• Challenge: Low liquidity in NEPSE’s crude oil contracts limits effectiveness.

Example 3: Agricultural Hedging (Wheat Farmers in Chitwan)

• Problem: Farmers face price risk when selling wheat after harvest.
• Solution: If NEPSE introduced wheat futures, farmers could sell contracts months in advance.
• Current Reality: Nepal lacks an agricultural derivatives market, forcing farmers to rely on spot markets.

8. Regulatory Framework in Nepal

Nepal’s derivatives market is governed by:

1. Securities Board of Nepal Act, 2063:
   • Licenses clearinghouses and brokers.
   • Sets margin requirements and position limits (e.g., no single entity can hold >20% of open interest in gold futures).
2. Nepal Rastra Bank (NRB) Guidelines:
   • Monitors systemic risk from derivatives trading.
   • Requires know-your-customer (KYC) for all participants.
3. Clearing Corporation of Nepal (CCN) Rules:
   • Ensures daily settlement and default risk management.
   • Holds initial and variation margins in segregated accounts.

Comparison Table: Nepal vs. Global Derivatives Markets

Exam Tip: How to Score Full Marks

1. Define Clearly: Always start with definitions (e.g., "A futures contract is a standardized agreement to buy/sell an asset at a predetermined price on a specified future date.").
2. Use Numerical Examples: Worked problems (like Mr. Bista’s gold futures) fetch high marks. Show step-by-step calculations with margin accounts and settlement tables.
3. Link to Nepal’s Market: Examiners love real-world ties. Mention:
   • NEPSE’s gold futures for hedging.
   • NRB’s oversight on systemic risks.
   • SEBON’s role in setting margin rules.
4. Risk Management: Discuss how Nepal mitigates risks (e.g., clearinghouses, position limits).
5. Diagrams: Draw T-accounts for margin accounts or flowcharts of the trading process (like the NEPSE flow above).
6. Common Pitfalls to Avoid:
   • Confusing forwards (OTC) with futures (exchange-traded).
   • Ignoring daily settlement in futures (unlike forwards).
   • Forgetting NRB’s role—many students only mention SEBON.

Sample Exam Question & Answer Structure: Question: "Explain how a jeweler in Kathmandu can use gold futures to hedge against price risk. Calculate the profit/loss if the spot price moves from Rs. 100,000 to Rs. 108,000 at expiry."

Answer Structure:

1. Introduction: Define hedging and gold futures in Nepal.
2. Scenario: Jeweler takes a short position in 10 contracts at Rs. 102,000/oz.
3. Calculations:
   • Initial margin = 12% of Rs. 10,200,000 = Rs. 1,224,000.
   • Profit at expiry = (Rs. 108,000 – Rs. 102,000) × 1,000 oz = Rs. 6,000,000.
   • Net profit = Rs. 6,000,000 – Rs. 1,224,000 = Rs. 4,776,000.
4. Conclusion: Hedging reduces price risk but requires monitoring margins.

Final Note: Focus on Nepal-specific examples (NEPSE, NRB, jewelers) and visuals (T-accounts, flowcharts). Avoid generic global examples unless asked. Good luck!