Role of Clearing House / Corporation

A clearing house /corporation acts as a counter party to all deals in the derivatives market and guarantees settlement. A clearing corporation performs full novation, that is, it interposes itself between both legs of every trade, becoming the legal counterparty to both or alternatively provides an unconditional guarantee for settlement of all trades. It matches the transactions, reconciles sales and purchases, and does daily settlement. It also undertakes risk management of its members and carries on inspection surveillance and so on. Besides collecting margin capital, it also monitors the net worth requirements of the members.

The National Securities Clearing Corporation Limited (NCSSL) undertakes clearing and settlement of all deals executed on the NSE’s F&O (derivatives) segment. NSCCL has an online position monitoring systems which monitors all clearing members’ open position on a real time basis.

Pricing Futures:

The study of futures prices is essential for understanding all features of the futures market. Futures prices bear important relationships with the spot price, expected future spot price, the basis, the spreads, and the cost of storage. These are fundamental factors that affect futures prices.

Spot Price: The price of a good for immediate delivery. It is also referred to as the cash price or the current price.

Basis: The different between cash price and the futures prices of a particular good.

Basis = Current Cash Price – Future Price

As the futures contract approaches maturity, the basis narrows. At the maturity of the futures contact, the basis is zero. This behavior of the basis over time is known as convergence, that is, convergence of futures price towards the spot price. The basis is much more stable than the futures price or the cash price. The futures price or the cash price may vary widely when considered in isolation, but basis tends to be relatively stable. Hence, basis is important for speculation and hedging Arbitrage opportunities can also arise if the basis during the life of a contract is incorrect.

Spreads: A spread is the difference between two futures prices. Spreads may be classified as intra commodity spread and inter-commodity spread. If the two futures prices that form a spread are futures prices for futures contracts on the same underlying good but with different expiration dates, the spread is an intra-commodity spread. An intra-commodity spread indicates the relative price differentials for a commodity to be delivered at two points in time. If two futures prices that form a spread are futures prices for two underlying goods, such as silver futures and gold futures, then the spread is an inter-commodity spread.

Spreads are important for speculators. Spreads are more stable when compared to futures prices. Arbitrage opportunities can arise if the spreads are incorrect.

Expected future spot price: The expectations of market participants also help in determining the futures prices. If market participants believe that silver will sell for Rs 7,000 per kg in three months, then the price of the futures contract for delivery of silver in three months cannot be Rs 9,000 per kg.

Cost of Storage: The price for storing the good underlying the futures contract also affects futures prices. The cost of storing is the cost of storing the underlying good from the present to the delivery date. It is the cost of carry related arbitrage that drives the behavior of the futures prices.

Cost of Carry Model of Futures Prices:

The cost of carry model determines futures prices in such a way that no arbitrage opportunities arise.
The assumptions of this model are:
i) Markets are perfect
ii) Al assets are infinitely divisible
iii) There are no transaction costs
iv) No bid-ask spread exists
v) There are no restrictions on short selling
vi) Forward and futures prices are equal
vii) Borrowing and lending rates are equal
viii) There are no limitations to storing