Settlement,

Clearing &
Risk Management
 Settlement (liquidation of contract)
Methods for settlements:
• Closing out (offsetting)
• Physical delivery
• Cash settlement,
• Exchange of futures for physical

Closing out:
Trader holding a long position can offfset his
position by selling an identical future contract
(same commodity & delivery month) to bring the
net position to zero.
Physical delivery:
Delivery of underlying involves several factors as
per contract like quantity, quality, delivery
location, time etc.
It is very difficult to fulfill all conditions above,
hence Exchange allows three types of
contracts
a) Contract with seller option: seller decides if to
give or not to give delivery to buyer & buyer
has to accept the seller’s choice
b) Contract with compulsory delivery:
Where in all contract are settled by actual delivery
of underlying
c) Contract with intension matching:
Where actual delivery takes place to the extent to
the delivery intensions if sellers & buyers as per
their wish & match balance outstanding contarcts
are cash settlement
 Smooth physical settlement
NCDEX has worked successfully to network
acredited warehouse & enable the holding of
commodity balances in electronic form &
dematerialized warehouse receipt (in
partnership with NSDL & CDSL) to facilitate
smooth physical settlement. NCDEX was the
1st to facilitate holding of commodity balance
in an electronic form like cash in saving
bank account & securities in electronic
custodial account.
Cash settlement:
The buyers or sellers has to make cash payment
at the expiration of contract to settle the loss or
gain.
The settlement price on last trading day is set
equal to closing spot price of underlying asset.

Final settlement price:

It is the last polled price ( 4 pm ) on the date of
expiry of contract

Daily settlement price:

Same as mark to market
Exchange of futures for physical
It is the transaction generally used by 2 hedgers
who want to exchange futures for cash positions.

A trader hold long position in a month & intends to

take delivery
Other trader is known to 1st trader, holds short
position in same month
Both of them agree on a price for a physical
commodity & purpose to cancel the their positions
on future exchange. Exchange notes positions &
cancels their futures obligations. It is also referred
as “Ex-pit” transaction.
 Clearing
All settlement functions I.e. Closing out (offsetting)
Physical delivery, Cash settlement, are looked
after by exchange called as clearing house.

Clearing house: It main task of the clearing house

is to keep track of all the transactions that takes
place during the day, so that net position of each
of its members can be calculated.

It guarantees the performance of the contracts by

parties to each transaction.
Clearing house is responsible for
• Effecting timely settlement
• Trade registration & follow up
• Controls of open interest
• Financial clearing of the payment flow
• Physical or financial settlement of contracts
• Administration of financial guarantees
demanded by participants.
Clearing margins calculations:
Clearing house for the purpose of clearing
margins calculates the number of outstanding
contract on either a gross or net basis
Gross basis adds total of all long positions by
clients to the total short positions by the clients.
Net basis allows this two to be offset against each
other.
 Warehousing
Warehouse receipt is a document of the title to
the goods deposited in the warehouse & title is
transferable by endorsement & delivery.
In case of physical delivery of commodities, the
clearing house will receive warehouse receipts
from the seller instead of actual commodities &
pass on the receipt to buyer.
Buyer will surrender the receipt & take delivery of
commodity from warehouse.
 Risk management
Risks for clearing house:
1.Replacement cost risk:
If clearing member defaults, still clearing house
must fulfill the obligation on the other side of the
contract identical to those onwhich default has
occurred. Cost of replacing such contract will
fluctuate with market.
2 Liquidity risk:
When a clearing member defaults, defaulter’s
non-cash assets have to be sold or pledged,
which might be difficult within the time frame
available for honouring commitment of the other
parties
3.Physical (delivery) risks:
If contract provide for the delivery & delivery –
verses payment mechanism is not used.
Operational risk:
Since replacement cost exposures increase with
the passage of time, any operational problem that
delays the settlement or prevents the clearing
house from resolving the a default could increase
counter party exposures.
In addition, a brake-down in operations due to
technical & other reasons might prevent a
clearing house from monitoring its exposures.
Risk control methods:
1) Clearing member are subject to minimum
financial & capital requirements.
2) Periodic monitoring their risk management
policies
3) Clearing house imposes margining regime
(initial margin) so that obligations are
collateralized.
4) Mark to market
5) Customers assets are segregated.
The objective being to enhance the confidence in
financial market
If default occurs in a clearing member’s customer
account, then clearing house has rights to make
good this short fall from other, non-defaulting
clearing member.
6) Recovery procedures:
Emergency procedure & financial back-up
arrangements once default by a clearing member
has occurred.
Action taken in this case is immediate close out
of defaulting member’s proprietary positions.
Where defaulter clearing member’s margin is
insufficient to satisfy member’s obligations, then
principle of loss spreading is applies which may
involve reliance of security deposits paid in by
clearing member in the form of settlement
guarantee fund & back-up insurance
arrangements,when losses exceeds all other
available financial resources.
National securities clearing corporation limited
(NSCCL)
Wholly owned subsidiary of NSE incorporated in
August 1995
1st clearing corporation in the country & also 1st
clearing corporation in the country to introduce
settlement guarantee.
Carries out clearing & settlement of trades
executed in equity & derivative segments of NSE.
It operates well defined settlement cycle so that
there is no deviation in settlement cycle.
Risk management at NCDEX:
Initial margin:
It is the margin requirements are based on of
worst scenario loss to recover 99.9 % daily (VaR=
value at risk)
Position monitoring:
Total deposit placed by menber is bifurcated into
initial margin & liquid net worth.
As soon as menber reaches 70% of initial margin
limit or exposure limit then message ”70% limit
being reached”is flashed on terminal.
Once member reaches to 100% of limit & does
not bring additional funds to increase base capital,
his terminal is disabled.(this is function of
NCDEX)
Parallel risk management system(PRMS)
Parallel risk management system is real time
position monitoring & risk management system for
futures & options market segment at NSCCL.
Risk of each clearing member is computed on real
time basis for each trade. The initial margin
amount is reduced from the deposit of clearing
member (CM).
Novation process:
Commodity futures being exchange traded
instruments the contract obligation is not
between the buyer & the seller. Even
though the contract at the time of initiation is
between two parties, each contract is
substituted by 2 contracts in such a way that
clearing house becomes a buyer to every
seller & a seller to every buyer.This is a
called the novation process, in which the
clearing house plays the role of central
counter party.
The mechanism effectively removes counter pary
risk from future transaction which now assumed by
clearing house instead of individuals. The risk
carried by the clearing house becomes to high & it
becomes necessary to minimize the credit risk.
In novation, all transactions between counter
parities are assigned to a central counter party
(clearing house), which permits multilateral letting
of all transactions which by it self reduce the credit
exposure (net market value of transaction at the
time of default) & probability of counter party
default.
 Fundamental
analysis
price discovery
method
Price discovery
Success in trading commodity derivatives,
depends upon the price discovery.

There are various factors affecting the commodity

price behaviour,at particular time period.

Success lies in identifying the factors &

understanding correlation between them.

Two techniques
1) Fundamental analysis
2) Technical analysis
Fundamental analysis:
• Economic indicators
• Frequency of data
• Timing
1)Economic indicators:
It is simply economic statistic, i.e. unemployment
rate, GDP(Gross domestic product), inflation rate
which indicate how well the economy is doing &
how well the economy is going to so in time to
come
Relation to the business cycle/economy
Procyclic: It moves in the same direction of
economy. If economy is doing well this number
usually increases. Or in case of recession this
indicator decreases. For example GDP
Countercyclical: It moves in the opposite direction
of economy. For example unemployment
Acyclic: It no relation with the health of economy.
& is no much use.
Frequency of data:
GDP data release every quaterly
Unemployment data release monthly
Indices change every minute on workingdays of
market.
This information can be used to analyze the data
at that time interval.

Timing:
Leading: Indicators changes before economy
changes. For example, Stock market returns.
Market changes the trend before economy gets
slowed down/recovery
Lagged timing indicator:
Changes the direction after few quarters of actual
change in economy.for example: unemployment
Coincident timing indicator:
It simply moves in line with the economy. For
example, GDP
Timing indicator falls into 7 broad catagories
1) Total output, income & spending
2) Employment, unemployment & wedges
3) Production & business activity
4) Prices
5) Money, credit & security market
6) Federal finance
7) International statistics
Total output, income & spending
It is most broad measures of economic
performance & includes

1) GDP- quarterly
2) Real GDP – quarterly
3) Implicit price deflator for GDP- quarterly
4) Business output – quarterly
5) National income –quarterly
6) Consumption expenditure –quarterly
7) Corporate profits –quarterly
8) Real gross private domestic investment
-quarterly
Employment, Unemployment & wedges
This give information about the strength of labour
market.
1) Unemployment rate –Monthly
2) Level of civilian employment measures number
of people working -Monthly
3) Average weekly working hours, hourly earning
& weekly earnings –Monthly
4) Labour productivity – quarterly
Production & business activity
This covers how much businesses are producing &
level of new construction in the economy

1) Industrial production & capacity utilization

2) New construction
3) New private housing
4) Business sales & inventories
5) Manufacturer’s shipment, inventories & orders
Prices
Includes the prices that consumers pay as well as
prices businesses pay for raw materials

1) Producers prices
2) Consumer prices
3) Prices received & paid by farmers
Money, credit & security market:
Measures the amount of money in the economy
As well as interest rates and consist of

1) Money stock
2) Bank credits at all commercial banks
3) Consumer credit
4) Interest rates & bond yield
5) Stock prices & yields
Federal finance
It is measures of government spending &
government deficit
1) Federal receipts ( income)
2) Federal outlays (expenses)
3) Federal debt
International trade:
These measures how much the country is
exporting & Importing
1) Industrial production & Consumer prices of
major industrial countries
2) US international trades of goods & services
3) US international transactions