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NEXT Frequently Asked Questions

  • 1. What is a derivative?
    • A derivative is a financial instrument whose characteristics and value depend on an underlying asset. The asset can be an equity, currency, bond, interest rate, commodity or even the weather.
  • 2. What are the different types of derivatives instruments?
    • Derivatives can be broadly classified into four categories:
    1.   Forwards
    2.   Futures
    3.   Options
    4.   Swaps
  • 3. What are the types of derivatives being traded on NEXT?
    • To begin with, NEXT will offer futures contracts. These will be Equity Index Futures and Single Stock Futures.
  • 4. What is a futures contract?
    • A futures contract is a contractual agreement made through an exchange, to buy or sell a particular financial instrument at a pre-determined price in the future.
    • Futures contracts detail the quality and quantity of the underlying assets.
    • They are standardized to facilitate trading on an exchange.
    • Futures contracts require either physical delivery of the asset or settlement in cash.
  • 5. What is a forward contract?
    • This is a non-standardized contract between two parties to buy or to sell an asset at a specified future time, at a price agreed upon today.
  • 6. What are the main problems associated with forward contracts?
    • Counterparty risk
    • Illiquidity
    • Lack of centralization
  • 7. What are the differences between a forward and a futures contract?

     

    Forwards Futures

    Typically traded over the counter (OTC).

    Traded on an exchange.

    Varying specifications.

    Standardized specifications.

    Characterised by bilateral negotiation and assumed credit risk. Credit risk lies with the counterparty.

    Central clearing house removes credit risk.

    No cash flows until settlement.

    Primary form of risk management is margin payment and daily mark-to-market settlement.

    Larger markets in currencies and metals.

    Larger markets in fixed income, equities and agricultural commodities.

     

  • 8. What is the structure in the derivatives market?
    • At the top of the hierarchy, is the Clearing House (NSE Clear), which is a wholly owned subsidiary of the NSE.
    • The Clearing House novates all transactions and is therefore the legal counterparty to both parties.
    • Clearing Members are under the Clearing House. They are either banks or financial institutions that are responsible for clearing, settlement and risk monitoring of Trading Members.
    • Clients open accounts with Trading Members who then execute orders on their behalf i.e. buy and sell derivative contracts for them.

     

  • 9. What is NSE Clear?
    • NSE Clear is the institution that novates or guarantees the settlement of trades on NEXT. It is set up with its own equity capital and governance structure independent from the governance of the NSE.
    • NSE Clear is the buyer to every seller and the seller to every buyer. Depending on the settlement terms of the contract, NSE Clear either delivers the asset to the buyer and pays the proceeds to the seller, or settles with both the buyer and seller in cash.
  • 10. How does NEXT manage risks associated with these contracts?
    • Investors require Initial Margin to enter into any futures position. This is a minimum (good faith) deposit required from an investor for the duration of an open contract. The investor is also required to deposit Variation Margin. These margin requirements apply to both the buyer and seller.
    • Daily profits or losses on an investor’s position are either taken out of or added to the investor’s Variation Margin deposits.
    • The regular administration of margins prevents participants from accumulating large unpaid losses which could impact the financial positions of other market users (systemic risk).
    • All contracts traded on NEXT are traded against NSE Clear. This drastically reduces the counterparty risk compared to traditional OTC transactions.
  • 11. What is Variation Margin?
    • Unlike the cash market where profit or loss is only realised when the instrument is sold, trading on NEXT means that investors receive or pay profit or loss on a daily basis.
    • This payment is known as the Variation Margin and is equal to the difference in the value of the investor’s position from day to day.
  • 12. How does one invest on NEXT?
    • NEXT contracts can be bought and sold through the Trading Members of the NSE.
    • First, the investor opens an account with one of the Trading Members and completes the required documents. These documents include member-client agreements, Know-Your-client (KYC) and risk disclosure documentation.
    • After completing the documents, the Trading Member will give the investor a unique client identification number.
    • To begin trading, you must deposit cash and/or other collateral with your Trading Member as stipulated by the Trading Member.
  • 13. What are the benefits of trading derivatives on NEXT?
    • Derivatives are more flexible than the underlying instruments while the value is still based on the price of the underlying assets.
    • Derivatives contracts can be leveraged.
    • Derivatives are used to insure against adverse price movements and therefore facilitate the hedging of risks.
    • Derivatives are cheaper to transact.
    • Derivatives are quicker to complete than a number of individual transactions.
  • 14. How are these contracts closed out?
    • All NEXT futures contracts have closeout dates on which the contract expires. The futures contracts are named according to their expiry month for example, December futures expire in December.
    • NEXT Equity Index Futures and NEXT Single Stock Futures expire on the third Thursday of the relevant expiry month. If that day is a holiday, then expiry is on the previous business day.
  • 15. How is clearing and settlement done on NEXT?
    • The Clearing House (NSE Clear), through its appointed Clearing Members, computes the obligations of investors who have traded through Trading Members. These obligations detail the amounts an investor needs to pay or receive in terms of margins. The computation of these obligations is the “clearing” process. The actual flow of cash to satisfy the obligations is the “settlement” process. The clearing and settlement process is performed daily for all trades executed on NEXT.
    • Settlement is done on a T + 1 basis. This means that parties to a trade satisfy the obligations arising from the transaction one day after the trade is executed. All futures contracts on NEXT are settled in cash on a daily basis.