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A Project Report
On
“Study of Risk Management in Stock Broking Firm”
For
“Pune Stock Exchange Securities Limited, Pune”
By
“Mr. Prasad Dipak Deshmukh”
Under the guidance of
“Dr. Yashwant Vaishampayan”
Submitted to
“University of Pune”In partial fulfillment of the requirement for the award of the degree of
Master of Business Administration (MBA) 2007-2009
Through
Vishwakarma Institute of ManagementPune-48.
1
ACKNOWLEDGEMENT
It gives me great pleasure to express my sincere gratitude towards all
the individuals who have directly or indirectly helped me in completing the project.
First of all I am extremely grateful to Mrs. Nihali Mitra, M.D. Pune Stock Exchange
Ltd. for providing me an opportunity to work with such an esteemed organization. I
feel immense pleasure to thank Mrs. Archana Gorhe, Officiating C.E.O., PSE
Securities Ltd. and Ms. Darshana Deshpande, Senior Manager, PSE Securities Ltd.
. I would also like to express my sincere thanks to Dr. Sharad L. Joshi,
Director, Vishwakarma Institute of Management, Prof. Shailesh Kasande, Executive
Director, Vishwakarma Institute of Management and my project guide Dr. Yashwant
Vaishampayan for providing valuable guidance and inputs which helped a lot for the
completion of project in a true sense.
I would also like to thank the whole staff of PSE Securities Ltd., my
parents and all my friends for their kind co-operation and support.
Prasad Dipak Deshmukh
2
CERTIFICATE
This is to certify that Mr. Prasad Dipak Deshmukh has completed the Summer
Project Titled “Study of Risk Management in Stock Broking Firm” to my
satisfaction and as per the requirements of the two year full-time MBA programme.
Project Guide Director
Date:
3
LIST OF ABBREVIATIONS
Following is the list of abbreviations used during the study.
BCFM – BSE’s Certification in Financial Markets
BSE – Bombay Stock Exchange
CDSL – Central Depository Services Limited
DP – Depository Participant
DRF – Dematerialization Request Form
FDR – Fixed Deposit Receipt
FII – Foreign Institutional Investors
ISIN – International Securities Identification Number
KYC – Know Your Client
MTM – Mark to Market
NCFM – NSE’s Certification in Financial Markets
NSCCL – National Securities Clearing Corporation Limited
NSDL – National Securities Depository Limited
NSE – National Stock Exchange
RRF – Rematerialization Request Form
RSE – Regional Stock Exchange
SEBI – Securities and Exchange Board of India
VaR – Value at Risk
4
INDEX
Sr. No. Title Page Number
I Executive Summary 1
II Company Profile 3
III Objectives of the Study 7
IV Research Methodology 8
V Data Analysis 9
VI Findings 60
VII Suggestions and Conclusion 62
VIII Limitations 65
IX Bibliography 66
5
EXECUTIVE SUMMARY
Title of the Project: Study of Risk Management in Stock Broking Firm.
Duration of the Project: 2nd June 2008 to 2nd August 2008.
The capital market in India is an emerging market with a great
potential. Indian capital market has got a strong foundation and therefore has gained a
confidence of Indian investors as well as Foreign Institutional Investors. In India there
are two Stock Exchanges (National Stock Exchange and Bombay Stock Exchange)
through which securities are traded. Stock exchange is a body formed for the purpose
of assisting, regulating or controlling the business of buying, selling or dealing in
securities.
An investor has to trade in stock market through a registered stock
broker. A stock broker is a member of a recognized stock exchange who is permitted
to do trades on the floor of the exchange. ‘Study of Risk Management in Stock
Broking Firm’ the title, shows that the project revolves around the risks managed by
Stock Brokers while handling their Sub brokers, branches, franchisees and investors.
The study was carried out in PSE Securities Ltd., Pune during the period of 2nd June
2008 to 2nd August 2008.
Risk can be defined as-
‘Risk is the possibility of happening uncertain events.’
6
Risk is the chance of happening of something that may affect the desired results.
Therefore, the concept of Risk Management comes into picture.
Risk Management can be defined as-
‘Risk Management is the structured approach towards managing the uncertainties.’
Risk Management involves risk identification and risk assessment. Further to avoid
the unpredictable outcomes arising out of risk, the risk can be avoided, reduced or
transferred. However, best possible solution has to be chosen to tackle the risk.
Risk can be broadly categorized as Systematic Risks and Unsystematic
Risks. Risk and uncertainty go together. However, risk and return have a direct
relationship, higher the risk, higher the chances of good return and vice versa. In stock
broking industry risks are high due to the volatility of the market. The risk may cause
due to its sub brokers, branches, investor clients etc. There are uncertainties about
payments from clients or from clients to sub brokers and then sub brokers to the
broker. The high volatility of the market may cause the clients or sub brokers not to
make payments in specified time. Thus brokers are always exposed to market risks,
financial risks, credit risks, liquidity risk and operational risks. To cope up with such
events brokers have to collect certain amount of margins and maintain the same with
the exchange.
To manage such risks Value at Risk margin, Mark to Market margin
and extreme loss margin is maintained. Also, the brokers are allowed intra day
turnover and gross exposure limits. Brokers have to maintain minimum base capital
and additional base capital with the exchange. Exchanges, SEBI and NSCCL have
7
taken steps like KYC, continuous surveillance, mandatory audit etc. Thus, every
broking firm has Risk Management department. In PSE Securities Ltd., there is a
surveillance department to deal with the risk management activities.
COMPANY PROFILE
PSE Securities Limited
History
Pune Stock Exchange Securities Ltd. is located at Shivleela Chambers,
752, Sadashiv Peth, R.B. Kumthekar Road, Pune-411030. It was founded in the year
1999 and is a subsidiary company of Pune Stock Exchange Ltd. PSE Securities Ltd. is
a leading Stock Broking Firm, member of NSE and BSE and also a Depository
Participant of CDSL. It commenced Live Trading in the BSE Cash Segment from
15th March 2004 and commenced depository operations with Central Depository
Services (I) LTD. from 16th Dec. 2003.
The company is also a CDSL Depository Participant and it witnessed
an increase in the handling of approximately 5600 Beneficiary accounts in the
previous year to 8400+ accounts this year.
PSE Securities Ltd. has the largest turnover in the cash market segment
in Pune. However the management still feels the need to generate more operational
income through Brokerage.
Founders and Promoters
8
The founders and promoters of PSE Securities Ltd. are the members of
Pune Stock Exchange Ltd. All the members of Pune Stock Exchange Ltd. came
together and formed PSE Securities Ltd. According to the Articles of Association of
company and SEBI, only the members of the Pune Stock Exchange Ltd. which is the
parent company can register as sub broker of PSE Securities Ltd. Hence all the
present sub brokers of PSE Securities Ltd. are the members of Pune Stock Exchange
Ltd. There are total 152 sub brokers of PSE Securities Ltd.
Board of Directors
Dr. Sharad L. Joshi - Chairman & PR Director
Mr. Mahesh Athavale - PR Director
Me. Shaukat Merchant - PR Director
Mr. Shailendra Shah - Broker/Member Director
Mr. Arvind R. Shah - Broker/Member Director
Mr. Rajendra Nahar - Nominee Director-Pune Stock Exchange Ltd.
Products
The main business of the company is to provide a platform for trading
in securities market with the help of Stock Broking and Depository Services. PSE
Securities Ltd. has cash segment membership of the Bombay Stock Exchange and
National Stock Exchange and also is a depository participant of Central Depository
Services Limited.
Competitors
9
Though the company deals in the cash segment only, it has to face
competition from following organizations.
Motilal Oswal
India Infoline
Sharekhan
Anand Rathi
Indiabulls
Religare
Angel Broking
Karvy Consultancy
Financial Data
The Authorized Capital of the company is Rs.7,80,00,000 divided into
390 equity shares or Rs. 2,00,000 each. The paid up capital is Rs.7,06,00,000 divided
into 353 equity shares or Rs. 2,00,000 each.
During the Financial Year 2007 – 2008, the total turnover of dealings
through BSE and NSE was Rs. 7451 Crores (Rs. 2885 Crores was delivery turnover
and Rs. 4556 was non delivery turnover).
The Profit before Taxes of PSE Securities Ltd. during the year was Rs.
494.80 Lacs of which Rs. 401.32 Lacs has been earned by way of Brokerage and Rs.
67.52 Lacs by way of interest on fixed deposits and short term deployment of funds.
The Net profit for the year was Rs. 367.04 Lacs.
10
Organization Chart
New Projects
This year the company proposes to issue 25 equity shares to persons
other than existing share holders thus increase the number of sub brokers from 152 to
177.
11
OBJECTIVES OF THE STUDY
Background
The stock prices in Indian capital market change very rapidly. It results
into high volatility in the market. Therefore, the brokers are always at a risk that
investors may not pay in the securities or funds due to increase or decrease in the
prices of shares. In the securities market the liquidity risks, financial risks and
operational risks also create hurdles in the smooth running of broking firm.
Need
Therefore, to tackle these situations need for risk management in stock
broking firm arises. To reduce such risks broking firms have risk management or
surveillance departments, which monitors the day to day activities of its sub brokers
and investors. Thus, this study is carried out to understand the measures taken to
reduce the risks at brokers’ end and the objectives of the study are as follows.
Introduction to Capital Market.
To get familiar with the working of broking firm.
To understand the concept and types of risk.
To find out the risks involved in stock broking firm.
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To study the measures to reduce the risk.
RESEARCH METHODOLOGY
During the project, the necessary inputs taken were primary as well as
secondary. The primary data collection and secondary data collection form an integral
part of the study. They are explained as below.
Primary Data
Primary data is the one which is collected specifically for the purpose
of the project, and can be obtained from various people working in the organization.
For this study the primary data was collected from following sources.
» Discussion with Surveillance department officers.
» Discussion with manager.
» Discussion with sub brokers.
» Discussion with employees of the organization.
Secondary Data
Secondary data is the one which is not specifically collected for a
certain work. It is a data collected by somebody else for their own purposes.
However, it plays a significant role in the project. For this study the secondary data
was collected from the following sources.
13
» Books related to risk management and capital market.
» Magazines related to the stock market.
» Websites related to risk management and stock market.
DATA ANALYSIS
Capital Markets
The capital markets deal in financial assets, which comprise shares,
debentures, mutual funds, insurance policies, bank accounts, pension funds, provident
funds and other securities. A capital market deals in financial assets, excluding coins
and currency. Capital market is a market for long-term debt and equity shares. In this
market, the capital funds comprising of both equity and debt are issued and traded.
Transfer of resources from those with idle resources to others who
have a productive need for them is perhaps most efficiently achieved through the
Capital Markets. They provide channels for reallocation of savings to investments and
entrepreneurship and thereby decouple these two activities. As a result, the savers and
investors are not constrained by their individual abilities, but by the economy’s
abilities to invest and save respectively, which inevitably enhances savings and
investment in the economy. It is not that the users and suppliers of funds meet each
other and exchange funds for securities. It is difficult to accomplish such double
coincidence of wants. The amount of funds supplied by the supplier may not be the
amount needed by the user. Thus, there are intermediaries who may act as agents to
match the needs of users and suppliers of funds for a commission. In this way, the
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Capital market moves the money of investors who have a surplus to the entrepreneurs
who needs it with the help of intermediaries.
The capital market in a country is very valuable indicator of its
soundness. Capital markets are evaluated while judging the performance of any
economy. Every decision or event related to economy of the country is reflected and
influenced by the capital market thus; it carries a huge weightage for the economic
development of any country.
Indian Capital Market – An Overview
Indian Stock Markets are one of the oldest in Asia. Its history dates
back to nearly 200 years ago. The East India Company was perhaps the most
dominant and powerful institution in those days and business in its loan securities
used to be transacted in an unorganized for at Bombay and Calcutta in early
Nineteenth century. Later on the business on corporate stocks and shares in bank and
cotton presses took place in Bombay and gradually the number of companies listed
increased from 1125 in 1946 to 8593 in 1995.
The tail of Twentieth Century made the Indian Capital Market change
drastically. During 1990’s with the introduction of computers, Indian Market started
prospering. On line trading, transparency, strict surveillance, depository system,
investor protection and regulations were some of the key activities which reflected the
growth of the Indian Capital Market. With the Dematerialization of shares and
introduction of SEBI (Securities and Exchange Board of India) Indian Capital market
provided protection to its investors.
15
With the liberal policy of India and investments of Foreign
Institutional Investors, the confidence of investors is increased to a great extent. In
January 2008 the BSE Sensex touched the 21000 points, which is the highest up till
now.
SEBI Act (Securities and Exchange Board of India Act), 1992
The Act had its origin during the war in 1943 when the objective was
to channel resources to support the war effort. It was retained with some changes as a
means of controlling the raising of capital by companies and to ensure that national
resources were channeled into proper lines, i.e., for desirable purposes to serve goals
and priorities of the government, and to protect the interests of investors. Under the
Act, any firm wishing to issue securities had to obtain approval from the Central
Government, which also determined the amount, type and price of the issue.
As a part of the liberalization process, the Act was repealed in May
1992 paving way for market determined allocation of resources. To ensure effective
regulation of the market, SEBI Act, 1992 was enacted in establish SEBI with statutory
powers for (a) protecting the interests of investors in securities, (b) promoting the
development of the securities market, and (c) regulating the securities market.
It can conduct enquiries, audits and inspection of all concerned and adjudicate
offences under the Act. It has powers to register and regulate all market intermediaries
and also to penalize them in case of violations of the provisions of the Act. SEBI has
full autonomy and authority to regulate and develop and orderly securities market.
16
Market Segments
A) Primary Market
The primary market provides the channel for sale of new securities.
Primary market provides opportunity to issuers of securities, Government as well as
corporates, to raise resources to meet their requirements of investment and/or
discharge some obligation. In this market the securities are offered for subscription
for the purpose of raising capital or fund. The investors and the company come into
direct contact in the primary market. The entrepreneurs or corporates as well as
Government may issue the securities at face value, or at as discount / premium and
these securities may take a variety of forms such as equity, debt etc. They may issue
the securities in domestic and/or international market.
(B) Secondary Market
Secondary Market refers to a market where securities are traded after
being initially offered to public in the primary market and/or listed on the Stock
Exchange. Majority of the trading is done in the secondary market. This market
comprises of equity markets and the debt markets.
For the general investor, the secondary market provides an efficient
platform for trading of securities. For the management of the company, secondary
equity markets serve as a monitoring and control conduit-by facilitating value-
enhancing control activities, enabling implementation of incentive-based management
contracts, and aggregating information (via price discovery) that guides management
decisions.
17
Stock Exchange
As seen earlier, securities are traded or exchanged in secondary
market. A Stock Exchange is an organized platform where securities are traded or
exchanged. Securities are defined as any monetary claims and include stock, shares,
debentures, bonds etc. Under the Securities Contract Regulation Act, 1956, securities
trading are regulated by the Central Govt. and such trading can take place only in
Stock Exchanges recognized by the Govt. under this Act. At present there are 23 such
recognized Stock Exchanges in India. Of these, major Stock Exchanges are Bombay,
Kolkata, Delhi, Chennai etc. As per the Act, trading in securities permitted to be
traded would be in normal trading hours (09:55 A.M. to 03:30 P.M on working days).
National Stock Exchange (NSE)
The National Stock Exchange (NSE) is India’s leading stock exchange
covering various cities and towns across the country. NSE was set up in November
1992 with an equity capital of Rs. 25 crores by leading institutions to provide a
modern, fully automated screen-based trading system with national reach. The
Exchange has brought about unparalleled transparency, speed & efficiency, safety and
market integrity and its index NIFTY has got worldwide recognition.
NSE has played a catalytic role in reforming the Indian securities
market in terms of microstructure, market practices and trading volumes. The market
today uses state-of-art information technology to provide an efficient and transparent
trading, clearing and settlement mechanism, and has witnessed several innovations in
products & services viz. demutualization of stock exchange governance, screen based
trading, professionalism of trading members, fine-tuned risk management systems,
emergence of clearing corporations to assume counter party risks, market of debt and
18
derivative instruments and intensive use of information technology. IDBI & other
financial institution with paid equity capital of Rs. 25 cores set up NSE. It started
operation in Wholesale debt market in June 1994 & in equity, in Nov 1994.
Bombay Stock Exchange (BSE)
Bombay Stock Exchange Limited is the oldest stock exchange in Asia
with a rich heritage. Popularly known as ‘BSE’, it was established as ‘The Native
Share & Stock Brokers Association’ in 1875. It is the first stock exchange in country
to obtain permanent recognition in 1956 from the Government of India under the
Securities Contracts (Regulation) Act, 1956. The Exchange’s pivotal and pre-eminent
role in the development of the Indian capital market is widely recognized and its
index, SENSEX, is tracked worldwide. The Exchange has a nation-wide reach with a
presence in 417 cities and towns of India. The systems and processes of the Exchange
are designed to safeguard market integrity and enhance transparency in operations.
The Exchange provides an efficient and transparent market for trading in equity, debt
instruments and derivatives. The BSE On Line Trading System (BOLT) is a
proprietary system of the Exchange and is BS 7799-2-2002 certified. The surveillance
and clearing and settlement functions of the Exchange are ISO 9001:2000 certified.
Regional Stock Exchanges (RSEs)
There are 23 stock exchanges in India. Among them two are national
level stock exchanges namely Bombay Stock Exchange (BSE) and National Stock
Exchange of India (NSE). The rest 21 are Regional Stock Exchanges (RSE). The
Regional Stock Exchanges started clustering from the year 1894, when the first RSE,
the Ahmedabad Stock Exchange (ASE) was established. In the year 1908, the second
in the series, Calcutta Stock Exchange (CSE) came into existence.
19
During the early sixties, there were only few recognized RSEs in India
namely Calcutta, Madras, Ahmedabad, Delhi, Hyderabad and Indore. The number
remained unchanged for the next two decades. 1980s was the turning point and many
RSEs were incorporated. The latest is Coimbatore Stock Exchange and Meerut Stock
Exchange.
Stock Broker
The Stock Broker is a member of a recognized stock exchange, who is
permitted to do trades on the floor of the exchange. A broker is an intermediary who
arranges to buy and sell securities on behalf of clients (the buyer and the seller).
According to Rule 2 (e) of SEBI (Stock Brokers and Sub brokers) Rules, 1992, a
stock broker means a member of a recognized stock exchange. No stockbroker is
allowed to buy, sell or deal in securities, unless he or she holds a certificate of
registration granted by SEBI.
No investor can invest in the stock market directly, they have to
register themselves with a registered broker of recognized stock exchange. The broker
then trades in securities on behalf of its investors.
Sub broker
A Sub broker is a person who intermediates between investors and
stock brokers. He acts on behalf of a stock broker as an agent or otherwise for
assisting the investors for buying, selling or dealing in securities through such stock
broker. No sub broker is allowed to buy, sell or deal in securities, unless he or she
holds a certificate of registration granted by SEBI. A sub broker may take the form of
20
a sole proprietorship, a partnership firm or a company. Stock brokers of the
recognized stock exchange are permitted to transact with sub brokers.
Depository
A depository is an organization which holds securities of investor in
electronic form at the request of the investor through a registered Depository
Participant. It also provides services related to transactions in securities. Depository
transfers securities between accounts on the instructions given by the account holder.
The fear of loosing of securities is removed through depository as it facilitates
safekeeping of shares. It transfers the ownership of the securities without having to
handle the securities.
Depositories in India
There are two depositories in India.
1. National Securities Depository Limited (NSDL)
2. Central Depository Services Limited (CDSL)
Depository Participant
A Depository Participant (DP) is an agent of the depository through
which it interfaces with the investor. A DP can offer depository services only after it
gets proper registration from SEBI. A Depository can be compared with a bank, like
wise a DP may be compared with a branch of a bank. Presently there are
approximately 390 DPs are registered with SEBI. To avail the services of a depository
an investor has to open an account with any of the depository participant of any
depository.
Dematerialization
21
Dematerialization is the process by which physical certificates of an
investor are converted to an equivalent number of securities in electronic form and
credited to the investor’s account with his Depository Participant (DP).
Working of Stock Broking Firm
Stock Broker
As seen earlier, According to Rule 2 (e) of SEBI (Stock Brokers and
Sub brokers) Rules, 1992, a Stock Broker means a registered member of a recognized
stock exchange. A broker is an intermediary who arranges to buy and sell securities
on behalf of clients (the buyer and the seller). No stockbroker is allowed to buy, sell
or deal in securities, unless he or she holds a certificate of registration granted by
SEBI. The constitution of a broking firm may be a Proprietary Concern, a Partnership
firm or a Corporate.
Departments in Stock Broking Firm
(A) Central Depository Services Ltd (CDSL) Department
CDSL Department
Demat Account Dematerialization & Transmission Settlement
Opening Rematerialization & Nomination of Trade
22
The CDSL department performs the above stated functions. An
investor has to first open an account with the DP in order to hold the securities in a
dematerialized form. An investor can open an account with any DP of CDSL or
NSDL. The CDSL department also converts the physical shares into demat form and
also shares in demat form into physical share certificate. The activities like
transmission and nomination and trade settlement are also done at CDSL department.
Importance of Demat Account
Demat account is a safe and convenient way to hold the securities as compared
to holding them in physical form.
No stamp duty is levied on transfer of securities held in demat form.
Change of name, address, registration of power of attorney, deletion of
deceased name etc. can be effected across companies by one single instruction
to the DP.
It eliminates thefts, deface, delays, and subsequent misuse of the certificates.
Any number of securities can be transferred and delivered with one delivery
order. Therefore heavy paperwork and headache of signing multiple transfer
forms is eliminated.
(1) Demat Account Opening
The CDSL department performs the basic function of demat account
opening. To hold the securities an investor has to open the demat account with any of
the DP of either Central Depository Services Ltd. or National Securities Depository
Limited. It is mandatory of open a demat account with any of the DP in order to hold
the securities in an electronic form.
23
To open a demat account client has to submit identity proof, address
proof, PAN Card, statement of bank account, cheque and two latest photographs.
Absence of any of the above document create hurdles in the procedure of demat
account opening.
(2) Dematerialization and Rematerialization
(a) Dematerialization
Dematerialization is the process in which the physical form of holding
securities is replaced with electronic (book-entry) form of holding. Shares in demat
form do not bear any distinguishable feature like distinctive number, certificate
number. Each security is identified in depository system by ISIN (International
Securities Identification number).
To convert the physical shares certificates in the dematerialized form,
an investor has to submit the DRF (Dematerialization Request Form) along with the
shares certificate. DP enters the DRF in its system and dispatches the Physical
certificates along with the DRF to the R&T agent. R&T agent, on receiving the
physical documents and the electronic request verifies them. Once the R&T agent is
satisfied, dematerialization of the concerned securities is electronically confirmed to
the Depository. Depository credits the dematerialized securities to the beneficiary
account of the investor and intimates the DP electronically. The DP issues a statement
of transaction to the client.
(b) Rematerialization
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Rematerialization is exactly opposite of dematerialization. It refers to
the process of converting the shares held in electronic form with a DP into the
physical shares certificate. Under this process the depository account of a beneficial
owner is debited for the securities sought to be rematerialized and physical share
certificates for the equivalent number of securities issued.
To convert the shares in dematerialized form into physical form, a
client has to submit the RRF (Rematerialization Request Form) with its DP. DP
checks all the details of RRF and also verifies that client has a sufficient balance of
shares in his account. RRF is then entered in the system. DP sends it to the R & T
agent for further procedure. R & T agent scrutinizes of shares and after being satisfied
a certificate is issued to respective DP which is later passed on to the client.
(3) Transmission and Nomination
(a) Transmission
The Companies Act 1956 distinguishes Transmission of shares from
transfer of shares. Transfer of shares relates to a voluntary act of the shareholder
while Transmission is brought about by the operation of law. The word
“Transmission” means devolution of title to shares. Such kind of transmission takes
place due to devolution by death, succession, inheritance, bankruptcy, and marriage
etc. The person on whom the shares devolve has to prove his entitlement by
submitting appropriate documents and seek transmission. If the securities are held in
the depository system, documents have to be submitted to the DP. If the securities are
held in physical form, the documents have to be sent to the company for effective
transmission of shares.
25
(b) Nomination
The Companies (Amendment) Act 1999 has introduced provisions for
nomination in respect of shares, Debentures, Fixed Deposits etc. Under the provision
the security holder can nominate a person in whom the shares, debentures, bonds or
deposits would vest, in the event of original investor’s death.
If the shares are held jointly, all the joint holders are required to sign
the nomination form. A holder can even nominate a minor, represented by one of the
parents or guardian. However, Trusts, Societies, Body Corporate, Partnership Firms,
Kartas’ of Hindu Undivided Family, or Power of Attorney holder cannot be appointed
as nominee.
(4) Settlement of Trade
One of the basic services provided by the Depository is to facilitate
transfer of securities from one account to another on the instruction of the account
holder. Transfer of securities from one account to another may be done for any of the
following purposes.
Transfer due to a transaction done on a person-to-person basis.
Transfer arising out of transaction done on a stock exchange.
Transfer arising out of transmission and account closure.
(B) Compliance Department
Compliance Department
26
Reg. Of Client Reg. of Sub Broker
Individual Non-individual
Joint Stock Co. Partnership firm Sole Proprietor
The main function of the compliance department is to open a trading
account of clients and registration of sub brokers and franchisees. As a client has to
open demat account to hold the securities, a trading account is opened to trade into
securities. Such account enables the client to trade in the securities held in the demat
account. Such account is opened with the registered member broker.
The compliance department has to comply with the rules and
regulations of SEBI while opening account of clients and registering the sub brokers.
An individual client has to submit identity proof, address proof, PAN card, broker
client agreement on stamp paper along with application form. In case of non
individuals Joint Stock Company, Partnership Firm or Sole Proprietor the documents
required are application form, broker client agreement, certified copy of Articles and
Memorandum of Association, certified copy of resolution to open account, bank
certifying letter whichever is applicable.
While registering for sub broker compliance department has to comply
with the criteria laid down by the SEBI. The applicant should not be less than 21
years of age, he should have at least passed HSC exam, he should not be convicted to
any offence involving fraud or dishonesty etc. An application for the grant of
certificate shall be made in form B, application shall be accompanied by a
27
recommendation letter from a stock broker of recognized stock exchange with whom
he is affiliated to along with two references including one from his banker. The stock
exchange on receipt of application shall verify the information contained and then
shall also certify that the applicant is eligible for registration.
(C) Dealing Department
Dealing Department
Buying Securities Selling Securities
Entering Order Order Order
Orders Modification Cancellation Matching
The most basic and important function of stock broking firm i.e.
buying and selling of securities on behalf of its clients is performed by the Dealing
Department. The employees who carry out this function are known as dealers. Dealer
is the person who performs the function of buying and selling of securities of
securities for clients. The clients have to inform the dealer to buy or sell securities
who then enters the order in the system. Generally, the ODIN software is used for
such purposes. The functions carried out at dealing department are explained below in
detail.
28
Entering Order
The trading member can enter orders in the normal market during the
trading hours. When an order enters the trading system it is an active order, it tries to
find out on the other side of the books if it finds the match, trade is generated. If it
does not find a match, the order becomes passive order and appears in the order book.
Order Modification
All orders can be modified in the system till the time they do not get executed and
only during the market hours. Once an order is modified, the branch order values limit
for the branch and get adjusted automatically.
Order Cancellation
Order cancellation functionality can be performed only for orders
which have not been fully or partially executed (for the unexecuted part of partially
traded orders only) and only during the market hours.
Order Matching
The buy and sell orders are matched on book type, symbol, series,
quantity and price. The best sell order is the order with lowest price and best buy
order is the order with highest price. The unmatched orders are queued in the system
by the following priority.
(D) Settlement Department
Settlement Department
29
Pay In Of Pay Out Of Pay In Pay Out
Securities Securities Of Funds Of Funds
Settlement department performs the back office function i.e. settling of
trades that takes place every day. This settling is done under ‘T+2’ rolling settlement
system. NSE/BSE provides a platform for trading to its trading members; the National
Securities Clearing Corporation LTD (NSCCL) determines the funds/securities
obligation of the trading members and ensures that trading members meet their
obligations. The clearing banks and depositories provide the necessary interface
between the custodians and clearing members (who clear for trading members or their
own transactions) for settlement of funds/securities obligation of trading members.
Rolling Settlement
Under Rolling settlement all the trades executed on a trading day are
settled X days later this is called ‘T+X’ rolling settlement where ‘T’ is the trade date
and ‘X’ is the number of working days after trade date in which settlement takes
place. The rolling settlement has started in T+5 bases in India, now it is T+2.
Pay In Of Securities and Funds
The members bring in their securities/funds to the NSCCL; they make
available required securities in designated accounts with the depositories by the
prescribed pay in time. If they fail to do so the securities go for auction.
Pay Out Of Securities and Funds
NSCCL sends electronic instructions to the depositories/clearing banks
to release pay out of securities/funds. These securities/funds reach to the respective
members account. This settlement is based on rolling system which is T+2 days.
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(E) Risk Management Department / Surveillance Department
Risk Management Department
Capital On Line Off Line Margin Circuit
Adequacy Monitoring Monitoring Requirements Filters
A sound risk management system is integral to an efficient clearing
and settlement system. The NSCCL ensures that trading members’ obligations are
commensurate with their net worth. It monitors the track record and performance of
members and their net worth, undertakes on-line monitoring of members’ positions
and exposure with the market collects margins from members and automatically
disables members if the limits are breached. Thus, in order to keep a continuous check
on market risk management department performs the following functions.
Capital Adequacy
The stock exchanges mention their own capital adequacy requirements.
The members have to pay Base Minimum Capital and Additional Base Capital. Base
minimum capital of the member is taken to determine the member’s intra-day trading
limit and/or gross exposure limit only whereas the amount provided as additional
capital is allowed to be utilized towards margin payment if not used up for taking
exposure/turnover.
On-line Monitoring
NSCCL has put in place an online monitoring and surveillance system
whereby exposure of the members is monitored on a real time basis. A system of
alerts has been built in so that both the member and NSCCL are alerted as per pre-set
levels (reaching 70%, 85%, 90%, and 100%) when the members approach their
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allowable limits. It enables to further check the micro-details of members’ positions,
if required and take pro-active action.
Off-line Monitoring
Off-Line surveillance activity Consists of inspection and investigations
as per regulatory requirement a minimum of 10% of the active trading members are to
be inspected every year to verify the level of compliance with various rules, bye laws
and regulations of the exchange. Generally, inspection of more members than the
regulatory requirement is undertaken every year. It also verifies if investor interests
are being compromised in the conduct of business by the members.
Margin Requirements
As per SEBI directive, in T+2 rolling settlement, all stock exchanges
have imposed stringent margin requirements as a part of their risk containment
measures. The daily margin in rolling settlement comprises of Value at Risk - based
Margin (VaR Margin) and Mark to Market margin (MTM Margin). Margins are
computed at client level. A member entering an order needs to enter the client code.
Based on this information margin is computed at the client level which will be
payable by the trading member on T+1 basis.
Circuit Filters
An index based market wide circuit breakers system applies at three
stages of the index movement either way at 10%, 15%, and 20%. These circuit
breakers bring about a coordinated trading halt in all equity derivatives market
nationwide. These breakers are triggered by movement of either S&P CNX Nifty or
Sensex whichever is breached earlier. As an additional measure of safety, individual
scrip – wise price bands of 20% for all scrips and 10% for scrips for which derivative
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products are available or those included in indices on which derivative are available,
have been imposed.
Risk
Risk has been known to man ever since he first faced adversity. It is an
integral part of the evolution of man. Risk has been encountered primarily in his
physical environment, later on in his social environment. With time, risk has evolved
along with man. The main risk man faced was an attack by animals. This risk was
mitigated by the discovery of fire. Here also risk is mitigated not eliminated. From
that time to the twenty first century man has faced n number of risks. Whether it is
walking on the road or flying in the plane, buying the video game or a bunglow every
person is exposed to the risk involved in the situation.
Risk can be defined as-
‘Risk is the possibility of happening uncertain events.’
Risk is the chance of happening of something that may affect the desired results.
Risk exists if there is something you don’t want to happen – having a
chance to happen. The risk can also be explained as a probability that some event will
cause an undesirable outcome on the financial health of your business and/or other
business/family goals. In the same way risk is involved in the investments also. All
investments are risky, whether in stock, capital market, banking, financial sector, real
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estate, bullion, gold etc. The degree of risk however varies on the basis of the features
of the assets, investments instrument, the mode of investment, time frame or the issuer
of the security etc. However, the risk and return goes hand in hand. Higher the risk,
higher is the possibility of better returns and vice versa. Thus, the degree of risk plays
a vital role in any kind of investment.
Types of Risk
Risks are broadly divided into 2 categories.
Risk
Systematic Risk Unsystematic Risk
(1) Systematic Risk
Systematic risks are out of external and uncontrollable factors, arising
out of the market, nature of the industry and the state of the economy and a host of
other factors. The examples of systematic risk are as follows.
(a) Market Risk
This arises out of changes in demand and supply pressures in the
markets, following the changing flow of information or expectations. The market
risks also arise due to ups and downs in the prices of securities. The economic
changes affect the prices of securities to go up or down, and make the market more
volatile. The totality of investor perception and subjective factors influence the events
in the market which are unpredictable and give rise to risk, which is not controllable.
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(b) Interest Rate Risk
The return on an investment depends on the interest rate promised on it
and changes in market rates of interest from time to time. The cost of funds borrowed
by companies or stockbrokers depends on interest rates. These interest rates depend
on nature of instruments, stocks, bonds, loans etc., maturity of the periods and the
creditworthiness of the issuer of securities.
(c) Purchasing Power Risk
Inflation or rise in prices lead to rise in costs of production, lower
margins, wage rises and profit squeezing etc. The return expected by investors will
change due to change in real value of return. The element of purchasing power risk is
inherent in all investments and cannot be controlled.
(2) Unsystematic Risk
Unsystematic risks emerge out of the known and controllable factors,
internal to the issuer of the securities or companies. The examples of unsystematic
risk are as follows.
(a) Business Risk
Business risk relates to the variability of the business, sales, income,
profits etc., while in turn depend on the market conditions for the product mix, input
supplies, and strength of competitors. It is sometimes external to company due to
changes in Govt. policy or strategies of competitors etc. It may internal due to labour
problems, raw material problems, fall in production etc.
(b) Financial Risk
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Financial risk relates to the method of financing, adopted by the
company, high leverage leading to larger debt servicing problems or short-term
liquidity problems due to bad debts, delayed receivables and fall in current assets or
rise in current liabilities. Proper financial planning and other financial adjustments can
be used to correct this risk and as such it is controllable.
(c) Default or Insolvency Risk
The borrower or issuer of securities may become insolvent or may
default, or delay the payments due, such as interest installments or principal
repayments. The borrower, in extreme cases, may get bankrupt in short span of time,
may be due to mistakes of management. In such cases, the investor may get no return
or negative returns.
Risk vs. Return
The risk and return go hand in hand. They have a direct relationship.
Higher the risk, higher is the possibility of better returns and lower the risk, lower is
the possibility of better returns. Investors’ personality, lifestyle, and their financial
position play a big role on how much risk they can comfortably bear. The risk/return
tradeoff is the balance, an investor must decide on between the desires for the lowest
possible risk for the highest possible returns. It is important to keep in mind that low
levels of uncertainty (low risks) are associated with low potential return and high
levels of uncertainty (high risks) are associated with high potential returns.
The diagram given below explains the relationship between the risk
and return. As the risk increases the probability of getting higher returns also
increases and vice versa.
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RISK/ RETURN TRADEOFF
Returns Low Risk Higher Risk
Low Return High Return
Risk
Different securities have different degrees of risk. Insurance is the
safest mode of investment, whereas there is very high risk in equity. The below
diagram shows the degree of risk contained in various investments.
* Equity
* Mutual Funds
Rewards * Debentures
* Fixed Deposits
* Post Office Certificates
* Bank Deposits
* Insurance Schemes
Risk Taken By Investor
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Risks involved in a Stock Broking Firm
A stock broker has to deal with various risks while dealing with its sub
brokers, clients etc. Due to the high volatility of the market broker is always exposed
to the risks. The various risks borne by a broker can be classified as under.
Risks in broking firms
Market Financial Credit Liquidity Operational
Risks Risks Risks Risks Risks
(1) Market Risks
Market risks are the risks which cause due to the high volatility of
market and value of scrips. These risks arise due to adverse market rate movements
i.e. foreign exchange rate, interest rates, commodity prices and equity prices. The
value of investments may decline over a given time period simply because of
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economic changes or other events that impact large portions of the market. Proper
asset allocation and diversification can protect against market risk.
(2) Financial Risks
Financial risk is the risk that a company will not have adequate cash
flow to meet the financial obligations. Financial risk means fear of loss of money,
which is the biggest risk faced by a broking firm. Financial risk in respect of broking
firm can be of two types firstly loss of income i.e. brokerage secondly loss of capital.
It has a risk that it will go out of funds because of non payment by the clients, sub
brokers etc.
(3) Credit Risks
Credit risk is the risk that the counter party of financial transaction will
fail to perform according to the terms and conditions of the contract, thus causing the
other party to suffer a financial loss. Credit risk is the risk of loss due to a debtor's
non-payment of a loan or non fulfillment of terms and conditions of contract. Credit
risk is often due to bankruptcy or insolvency of the counter party which results in non
payment of dues.
(4) Liquidity Risk
Liquidity risk is a risk which arises from the difficulty of selling an
asset and realizing the money of it. Market liquidity is the risk that a financial
instrument cannot be sold quickly at a price, which equates to their market value.
An investment may sometimes need to be sold quickly. Unfortunately, an insufficient
secondary market may prevent the liquidation or limit the funds that can be generated
from the asset. Some assets are highly liquid and have low liquidity risk (such as
stock of a publicly traded company), while other assets are highly illiquid and have
high liquidity risk (such as a house).
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(5) Operational Risks
Operational risks are explained as Risk of loss arising due to procedure
errors, omission or failure of internal control system. These risks are defined as ‘The
risk of loss resulting from inadequate or failed internal processes, people and systems
or from external events.’ An operational risk is a risk arising from execution of a
company's business functions. As such, it is a very broad concept including fraud
risks, legal risks, physical or environmental risks, etc. Operational risks are very
common risks, which are found almost in every organization. All the organizations
face the risks that their activities and processes may be disrupted unexpectedly or fail
and this will stop the functioning of organization. Such events may cause an
organization certain problems like-
Direct financial losses, which arise from failing to meet an obligation (e.g.
penalty interest payments or restitution loss).
Direct financial losses, attributable to an absence of income (e.g. loss of sales,
transaction fees, direct fees or commission)
Statutory or regulatory penalties resulting to revocation of licenses.
Opportunity costs, arising from adverse publicity, being unable to trade or
because of processing delays, backlogs, and poor customer service delivery or
poor product or service quality.
In stock broking firms the operational risks are found at various levels
of departments. They are as follows.
Operational Risks
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CDSL Compliance Dealing Settlement Risk Management
Department Department Department Department Department
(a) CDSL Department
Following are the risks involved in CDSL department.
Failure in receipt of transaction slip.
Wrong entry of DRF and RRF.
Punching error.
Networking problem with the exchange.
Failures in maintaining records for demat and remat account.
Effects
CDSL department directly deals with the clients. If services are not
provided properly to the clients, it may mar the reputation of the broker. If transaction
slip is not received, it will result in the problems with recording the transaction. The
errors in entering the details of DRF and RRF will cause problems to security holder.
Errors in CDSL department will directly affect the clients and this may cause a bad
client broker relationship.
(b) Compliance Department
Following are the risks involved in compliance department.
Non-eligibility of the applicant.
Non-compliance of various agreements and forms.
Absence of bank certification.
Absence of identity proof.
Absence of reference letter from chartered accountant.
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Absence of undertaking from sub broker that he/she has not been involved in
any criminal offence and no trail is pending against him/her.
Effects
Compliance department is responsible for the acceptance to the new
clients and sub brokers. Therefore compliance department must verify all the
documents while opening the trading accounts of investors and approving to new sub
brokers. On the event of non compliance of documents a broker can be penalized or
terminated. This will result in the bad publicity and loss of clients. Also the
compliance department has to verify all the details about person applying for the sub
broker ship. If a wrong person is appointed as sub broker it may mar the reputation of
the broker.
(c) Dealing Department
Following are the risks involved in dealing department.
Placing of wrong order i.e. instead of buy order sell order is given.
Placing of wrong quantity.
Trading done from wrong account i.e. buying and selling from wrong clients
account.
Trading in wrong scrip i.e. instead of trading in L & T, trading is done in ABB
Effects
In all the above cases mentioned a broker has to face financial loss. If
the trading is done from wrong client account i.e. if buy order is put from Mr. A in
place of Mr. B and Mr. B does not give a cheque a broker has to face the loss from is
own pocket. Thus, such kinds of events result in loss of money as well as loss of
reputation for a broker. If such things happen on regular basis the client may change
the broker and it will create problems for broker in the long term.
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(d) Settlement Department
Following are the risks involved in settlement department.
Failure of client in Pay in of shares or funds.
Payout of shares to wrong account.
Failure in deciding brokerage slab for a client.
Wrong preparation of statement of funds.
Failure in sending confirmation of account opening to the client.
Failure in sending contracts.
Failure in preparing bills.
Failures in preparing pay in and pay out slips.
Effects
The work of settlement department is of utmost importance and full of
responsibility. All the good work done by different departments can be nullified by an
incompetent or casual work of settlement department. Wrong payout of shares, wrong
payout of funds, failure in preparing bills in time, failure in preparing pay in and pay
out of slips can not only create chaos in a broking firm, it can result in huge financial
losses to the broker and a bad image in the minds of clients.
(e) Risk Management Department
Following are the risks involved in risk management department.
Failure in calculating the limits and margins.
Giving wrong limits to the client.
Failure in collecting margins.
Failure in sending daily reports to franchisee and sub broker.
Failure in sending daily reports to management.
Effects
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The risk management department directly comes into contact with sub
brokers and franchisees. If risk management department does not give enough limits
where it is due and is required it can result in loss to investor or a sub broker leading
to dispute and financial loss. On the contrary giving wrong limits have the same
effect. Failure in collecting margins attracts two types of risks regulatory and
financial. If the margins are not collected according to SEBI guidelines it can result in
financial penalty, suspension or termination of broker ship.
Risk Management
Risk management is a structured approach to managing uncertainty
related to a threat, a sequence of human activities including: risk assessment,
strategies development to manage it, and mitigation of risk using managerial
resources. The complexity of our modern lives and the numerous decisions we are
able to take are only made possible by our ability to manage risks - the risk of house
fire; the risk of losing a job; the risk to the entrepreneur who invests in a business; the
risk to the farmer who plants a crop that will have an uncertain yield and be sold at an
uncertain price in several months time; the risk to the investor in the stock market;
and so on.
Ways to deal with Risk
Ways to deal with Risk
Avoid Retain Reduce Transfer
(a) Avoid the Risk
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Avoidance of risk Includes not performing an activity that could carry
risk. Avoidance may seem the answer to all risks, but avoiding risks also means losing
out on the potential gain that accepting the risk may have allowed. Not entering a
business to avoid the risk of loss also avoids the possibility of earning profits.
(b) Retain the Risk
Retention of risk involves accepting the loss when it occurs. Risk
retention is a viable strategy for small risks where the cost of insuring against the risk
would be greater over time than the total losses sustained. All risks that are not
avoided or transferred are retained by default. This includes risks that are so large that
they either cannot be insured against or the premiums would be infeasible.
(c) Reduce the Risk
Reduction in risk involves methods that reduce the severity of the loss
or the likelihood of the loss from occurring. Outsourcing could be an example of risk
reduction. For example, a company may outsource its manufacturing of hard goods to
another company, while handling the business management itself. This way, the
company can concentrate more on business development without worrying much
about the manufacturing process.
(d) Transfer the Risk
Risk transference causes another party to accept the risk, typically by
contract or hedging. Insurance is one type of risk transfer which uses contracts.
Liability among construction or other contractors is very often transferred this way.
Such transference of risk may include certain cost like insurance premium.
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Process of Risk Management
Identify the areas of risk
Search for and locate the areas where there can be risk before they
become the actual problems for the organization.
Analyze the risk
Transform the risks data into decision-making information. Evaluate
impact, probability and time frame of it and classify the risks, and prioritize them.
Plan
On the basis of the data evaluated, plan for the management of risk
Planning is done according to whether the risk is to be avoided, retained, reduced
or transferred.
Control
Find out any deviations or variance and correct for the same during the
execution of risk mitigation plan.
Communicate
Communicate the internal and external information and feedback to
the project on the risk activities, current risks, and emerging risks.
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Measures to reduce the risk
Stock broking firm is highly exposed to the financial risks. Since it
poses maximum risk in the financial markets, risk management in stock broking firms
was felt most essential by the exchanges and its regulatory bodies. National Stock
Exchange introduced for the first time in India, risk containment measures that were
common internationally but were absent from the Indian Securities Market. NSCCL
has also put in place a comprehensive risk management system, which is constantly
upgraded to pre-empt market failures. These measures were taken to reduce the risks
at brokers’ end. SEBI has also suggested certain measures to manage the risks borne
by the brokers.
Margins
There is a lot of uncertainty in the movement of share prices. This
uncertainty leading to risk is sought to be addressed by margining systems by stock
markets.
Suppose an investor, purchases 1000 shares of ‘ABC’ company at
Rs.100 on July 1, 2008. Investor has to give the purchase amount of Rs.1,00,000
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(1000 x 100) to his broker on or before July 2, 2008. Broker, in turn, has to give this
money to stock exchange on July 3, 2008. There is always a small chance that the
investor may not be able to bring the required money by required date. As an advance
for buying the shares, investor is required to pay a certain portion (margin) of the total
amount of Rs.1,00,000 to the broker at the time of placing the buy order. Stock
exchange in turn collects similar amount from the broker upon execution of the order.
This initial token payment is called margin.
For every buyer there is a seller and if the buyer does not bring the
money, seller may not get the money. Margin is levied on the seller also to ensure that
he gives the shares sold to the broker who in turn gives it to the stock exchange.
Volatility
Volatility essentially refers to uncertainty arising out of price changes
of shares. It is important to understand the meaning of volatility a little more closely
because it has a major bearing on how margins are computed. Volatility has different
definitions and therefore different people compute it differently. For the margin
purposes, let us compute volatility based on close prices of a share over last 6 months.
Since it is based on historical data let us call it ‘historical volatility’.
The historical volatility can be easily calculated using an excel sheet.
First put down close prices of a share for the last six months in a column of the excel
sheet. Calculate the daily returns, that is, use ‘LN’ (natural log) function in excel. Use
the formula LN (today’s close price / yesterday’s close price) in the next column for
calculating daily returns for all the days. Go to the end of the second column (after the
last value) and use the excel function ‘STDEV’ (available under statistical formulas)
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to calculate the Standard Deviation of returns computed as above. The calculated
standard deviation expressed as percentage is the ‘historical volatility’ of the share for
the six months period.
Higher volatility means the price of the security may change dramatically over a short time
period in either direction. Lower volatility means that a security’s value may not change as dramatically.
Date
Closing price of shares of X
DailyLN returns
Closing price of shares of Y
Daily LN Returns
Closing price of share of Z
Daily LN Returns
1-July-08 2800 2420 2510
2-July-08 2850 1.77% 2480 2.45% 2515 0.20%
3-July-08 2700 -5.41% 2515 1.40% 2520 0.20%
4-July-08 2750 1.83% 2550 1.38% 2512 -0.32%
5-July-08 2900 5.31% 2565 0.59% 2508 -0.16%
6- July-08 2800 -3.51% 2592 1.05% 2514 0.24%
7-July-08 2650 -5.51% 2614 0.85% 2523 0.36%
8- July-08 2700 1.87% 2635 0.80% 2510 -0.52%
9-July-08 2750 1.83% 2667 1.21% 2505 -0.20%
10-July-08 2650 -3.70% 2686 0.71% 2515 0.40%
11-July-08 2640 -0.38% 2708 0.82% 2502 -0.52%
12-July-08 2520 -4.65% 2725 0.63% 2510 0.32%
13-July-08 2670 5.78% 2742 0.62% 2515 0.20%
14-July-08 2720 1.86% 2758 0.58% 2511 -0.16%
15-July-08 2790 2.54% 2825 2.40% 2514 0.12%
Volatility 3.85% 0.62% 0.32%
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Value at Risk Margin (VaR Margin)
The most popular and traditional measure of uncertainty/risk is
Volatility, while historical volatility tells us how the security price moved in the past,
VaR answers the question, ‘How much is it likely to move over next one day?’ VaR is
computed using exponentially weighted moving average (EWMA) methodology.
Based on statistical analysis, 94% weight is given to volatility on ‘T-1’ day and 6%
weight is given to ‘T’ day returns.
To compute, volatility for Trading Day (T), first we need to compute
day’s return for T by using LN (close price on T / close price on T-1).
Following formula is used to calculate volatility T.
Square root of [0.94*(T-1 volatility)*(T-1 volatility) + 0.06*(T LN return)*(T LN
return)]
To arrive at VaR margin rate, companies are divided into 3 categories
based on how regularly their shares trade and on the basis of liquidity (that is, by how
much a large buy or sell order changes the price of the scrip, what is technically called
as impact cost. Group I consists of shares that are regularly traded (that is, on more
than 80% of the trading days in the previous six months) and have high liquidity (that
is, impact cost less than 1%). Group II consists of shares that are regularly traded
(again, more than 80% of the trading days in the previous six months) but with higher
impact cost (that is, more than 1 %). All other shares are classified under Group III.
For Group I shares, the VaR margin rate would be higher of
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3.5 times volatility or
7.5% of value
For Group II shares, the VaR margin rate would be higher of
3.5 times volatility or
3.0 times volatility of index
The volatility of index is taken as the higher of the daily Index
volatility based on S&P CNX NIFTY or BSE SENSEX. At any point in time,
minimum value of volatility of index is taken as 5%.
For Group II shares, the number arrived at as above, is multiplied by 1.732051 (that
is, square root of 3). The number so obtained is the VaR margin rate.
For Group III securities VaR margin rate would be 5.0 times volatility of the Index
multiplied by 1.732051 (that is, square root of 3).
Mark to Market Margin (MTM Margin)
Mark to Market margin is calculated at the end of the day on all open
positions by comparing transaction price with the closing price of the share for the
day. In the above example a buyer purchased 1000 shares @ Rs.100 at 11 am on July
1, 2008. If close price of the shares on that day happens to be Rs.75, then the buyer
faces a notional loss of Rs.25,000 on his buy position. In technical terms this loss is
called as MTM loss and is payable by July 2, 2008 (that is next day of the trade). In
case price of the share falls further by the end of July 2, 2008 to Rs. 70, then buy
position would show a further loss of Rs.5,000. This MTM loss is payable.
In case, on a given day, buy and sell quantity in a share are equal, that is net quantity
position is zero, but there could still be a notional loss / gain (due to difference
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between the buy and sell values), such notional loss also is considered for calculating
the MTM payable.
MTM Profit/Loss = [(Total Buy Qty X Close price) - Total Buy Value] - [Total Sale
Value - (Total Sale Qty X Close price)]
Extreme Loss Margin
The extreme loss margin aims at covering the losses that could occur
outside the coverage of VaR margins. The Extreme loss margin for any stock is
higher of 1.5 times the standard deviation of daily LN returns of the stock price in the
last six months or 5% of the value of the position. This margin rate is fixed at the
beginning of every month, by taking the price data on a rolling basis for the past six
months.
According to the example mentioned above, the VaR margin rate for
shares of ABC Ltd. was 13%. Suppose the 1.5 times standard deviation of daily LN
returns is 3.1%. Then 5% (which is higher than 3.1%) will be taken as the Extreme
Loss margin rate. Therefore, the total margin on the security would be 18% (13%
VaR Margin + 5% Extreme Loss Margin). As such, total margin payable (VaR
margin + extreme loss margin) on a trade of Rs.10 lakhs would be Rs. 1,80,000.
Upfront Margin Co llection
Members are required to ensure collection of upfront margin from their
clients at rates mentioned below and deposit the same in a separate clients account, in
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respect of trades in normal market in which would result in a margin of Rs 50,000
more, after applying the margin percentages as given below.
Groups (Securities Covered) Upfront Margin Rate
Group I 15%
Group II 30%
Group III 45%
Failure to pay margins
Non-payment of either the whole or part of the margin amount due will
be treated as a violation of the Bye Laws of the Clearing Corporation and will attract
penal charges @ 0.09% per day of the amount not paid throughout the period of non-
payment. In case a member has a margin shortage of Rs. 10 lacs or above for more
than 10 occasions in the past 4 weeks, the gross exposure multiple of the member will
be reduced to one level lower at the time of re-activation of their trading terminals as
giver. Under
Slab Multiple
Full Exposure
1st level
2nd level
3rd level
4th level
8.50 times
7.00 times
5.00 times
3.00 times
2.00 times
If there is no margin shortage for the next I week of Rs. 10 lacs or
more, the exposure limits shall be restored to the previous levels. In addition, NSCCL
may, within such time as it may deem fit, advice the exchange to withdraw any or all
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of the membership rights of the member including the withdrawal of 'trading facilities
without any notice. In the event of withdrawal of trading facilities, the outstanding
positions of the member may be closed out, to the extent possible, forthwith or any
time thereafter by NSCCL, at its discretion by placing at the Exchange, counter orders
in respect of the outstanding position of the member, without any notice to the
member, and such action shall be final and binding on the member.
Margins based on turnover & Exposure limits (Initial margins)
Intra-day turnover limit
Members are subject to the intra-day trading limits. Gross turnover
(buy + sell) intra-day of the member should not exceed the thirty three and one-third
(33 1/3) times the base capital (cash deposit and other deposits in the form of
securities or bank guarantees with NSCCL and NSE).
Members violating the intra-day gross turnover limit at any time on
any trading day are not being permitted to trade forthwith. Member’s trading facility
is restored from the next trading day with a reduced intraday turnover limit of 20
times the base capital till deposits in the form of additional deposits (additional base
capital) is deposited with NSCCL. Members are given a maximum of 15 days time
from the date of the violation to bring in the additional capital. Upon members failing
to deposit the additional capital within the stipulated time, the reduced turnover limit
of 20 times the base capital would be applicable for a period of one month from the
last date for providing the margin deposits.
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Upon the member violating the reduced intra-day turnover limit, the
above-mentioned provisions apply and the intra-day turnover limit will be further
reduced to 15 times. Upon subsequent violations, the intra-day turnover limit will be
further reduced from 15 times to 10 times and then from 10 times to 5 times the base
capital. Members are not permitted to trade if any subsequent violation occurs till the
required additional deposit is brought in.
Gross Exposure Limits
Members are also subject to gross exposure limits. Gross exposure for
a member, across all the securities in rolling settlements, is computed as the absolute
(buy value - sell value), i.e. ignoring +ve and -ve signs, across all open settlements.
Open settlements would be all those settlements for which trading has commenced
and for which settlement pay in is not yet completed. The total gross exposure for a
member on any given day would be the sum total of the gross exposure computed
across all the securities in which the member has an open position.
Gross exposure limit would be:
Total Base Capital Gross Exposure Limit
Up to Rs. 1 crore
> Rs. 1 crore
8.5 times the total base capital
8.5 crores +
10 times the total base capital in excess of Rs 1 crore
Or any such lower limits as applicable to the members.
The total base capital being the base minimum capital (cash deposit and security
deposit) and additional deposits, not used towards margins, in the nature of securities,
bank guarantee, FDR or cash with NSCCL and NSE.
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Security-wise Differential Exposure Limits
In case of securities that are traded in the Rolling settlement (Type 'N'
and security series 'EQ'), the GE multiple for each security are as under:
Groups (Securities Covered) Covered Multiple
Group I
Group II
Group III
1 time
2 times
5 times
All new securities to be traded on the Exchange shall be subject to
exposure multiple of 2 times. It is clarified that while computing the gross exposure at
any time for a particular trading day, for the purpose of the above limits, members are
required to add the net outstanding positions of the previous settlement period to the
cumulative net outstanding positions as of that particular trading day until the
securities pay in day for the previous settlement period. Members exceeding the gross
exposure limit are not permitted to trade with immediate effect and are not permitted
to do so until the cumulative gross exposure is reduced to below the gross exposure
limits (as defined above or any such lower limits as applicable to the members) or
they increase their limit by providing additional base capital.
Members who desire to reduce their gross exposure may submit their
order entry requirements as per the prescribed format and if members desire to
increase their limits additional deposits by way of bank guarantee or Fixed Deposit
Receipt (FDR) have to be submitted to NSCCL. Additional deposits by way of
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securities in electronic form (demat securities) may be deposited as per procedures.
The additional deposits of the member are used first for adjustment against gross
exposure of the member. After such adjustments, the surplus additional deposits, if
any, excluding deposits in the form of securities is utilized for meeting the margin
requirements.
Violation Charges
Members exceeding the gross exposure limit are not permitted to trade
with immediate effect (trading terminals are disabled automatically. A penalty of
Rs.5,000 is levied for each violation of gross exposure limit and Intra Day Turnover
limits, which shall be paid by next day. The penalty is debited to the clearing account
of the member. Non-payment of penalty in time will attract penal interest of 15 basis
points per day till the date of payment. In respect of violation of stipulated limits on
more than one occasion on the same day, each violation would be treated as a separate
instance for purpose of calculation of penalty. The penalty as indicated above would
be charged to the members irrespective of whether the member brings in additional
capital subsequently.
Additional Base Capital
Members may provide additional margin/collateral deposit (additional
base capital) to NSCCL, over and above their minimum deposit requirements (base
capital), towards margins and/ or exposure / turnover limits. Members may submit
such deposits in any one form or combination of the following forms:
Cash
Fixed Deposit Receipts (FDRs) issued by approved banks and deposited with
Approved Custodians or NSCCL
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Bank Guarantee in favour of NSCCL from approved banks in the specified
format.
Approved securities in demat form deposited with approved Custodians.
All Additional Base Capital (ABC) given in the form of cash / FDR
(hereinafter referred to as 'Cash Component) should be at least 30% of the total ABC
and cash margins in respect of every trading member. Incase where non - cash
component is more than 70 % of the total additional base capital, the excess non-cash
component is ignored for the purpose of exposure limits requirements and / or
margins requirements.
Exemption for institutional deals
Deals executed on behalf of the following entities are considered as
institutional deals:
Financial Institutions
SEBI registered FII’s
Banks
SEBI registered Mutual Funds
While computing margins, institutional deals are excluded. Deals are
identified by the use of the participant code in the trades reported. Deals entered into
on behalf of custodial participants i.e. carrying custodial participant code are
considered as institutional deals unless not confirmed by the respective custodians in
which case the deals shall attract margins.
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Non-Custodial Institutional Deals are identified by the use of the
participant code `NCIT'. The NCIT' deals will be exempted for margin purposes
(However, VaR based margin which is charged on institutional trades on the net
outstanding sale position, in securities shall be applicable in this case also) and the
settlement obligation will remain with TM clearing member. Non Custodial
Institutional deals, which are not marked as 'NCIT' at the time of order entry, will not
be exempted. All TM clearing members are required to provide details of the contract
notes for all Non-Custodial Institutional Trades through a file upload as per the
procedure.
Exemption upon delivery of securities
If members deliver the securities prior to the securities pay in day, then
the margin payable by the member will be recomputed after considering the above
pay in of securities. The margin benefit on account of early pay in of securities shall
be given to the extent of the net delivery position across all clients of the member.
The early pay in would be allocated to clients having net deliverable position, on a
random basis, till such time that the system is developed to provide the early pay in
benefit on a client basis. However, members are required to ensure to pass on
appropriate early pay in benefit of margin/exposure to the relevant client, until the
above system is in place.
The value of the advance pay in made is reduced from the cumulative
net outstanding sale position of the member for the purpose of gross exposure limits.
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Members may note that early pay in of securities only up to the
working day prior to the scheduled settlement pay in day shall be considered for the
purpose of early pay in benefits. In case any member makes early pay in on the
scheduled day of pay in for the settlement, no benefit will accrue to the member. Such
early pay in shall not be adjusted against the settlement pay in obligation and it would
be treated as short delivery. Members are therefore alerted to ensure that no early pay
in is made on the scheduled day of settlement pay in.
Pay in of funds and securities prior to scheduled pay in day
The relevant authority may require members to pay in funds and
securities prior to the scheduled pay in day for funds and securities. The relevant
authority would determine from time to time, the members who would be required to
pay in funds and securities prior to the pay in day. The relevant authority would also
determine securities and funds which would be required to be paid in and the date by
which such pay in shall be made by the respective members.
The value of such prior pay in of funds and securities will not be
reduced from the cumulative net position of the member for the purpose of gross
exposure reduction. There will be no margin exemption available for such pay in of
funds and securities.
Measures taken by BSE for risk management
Certain steps or measures are taken by BSE towards the reduction of
risks of stock brokers.
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Know your client (KYC)
According to know your client scheme the member brokers of the
exchange are required to obtain detailed information of clients prior to
commencement of any transactions with new clients. A similar procedure is also to be
followed for existing clients. This information is to be made available to the exchange
authorities whenever called for. In case the member broker fails to furnish the same, it
may result in penalties to the member brokers.
Surveillance / Inspection
Surveillance / Inspection department carries out inspection of the
member brokers records and keep a regular check on the activities of member brokers
as well as sub brokers as regards the compliance of the risk management procedures.
Insurance
The exchange presently has in place insurance policies to protect itself
in the event of losses on account of fire, damage to computer systems and a
comprehensive policy that covers risks faced by the exchange, its member brokers
and the clearing houses.
The risks covered under the basic cover of the policy are detailed as below.
» Loss of member on account of fake / forged / stolen shares being
introduced by the clients.
» Loss to members on account of fraud by employees.
» Direct financial losses suffered by the member broker on account of
physical loss, destruction, theft or damage to securities and cash.
» Loss on account of securities lost in transit.
» Loss suffered on account of incomplete transaction.
» Loss on account of errors and omission.
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Verification of shares members’ office
The exchange has outlined the process i.e. in case the transaction in a
script with one particular client in a settlement exceeds Rs. 10 lacs then the member
has to send the photocopies of the transfer deeds and the share certificates to the
company / registrar for verification of the material particulars. The basic idea behind
the introduction of this procedure is to prevent the fake / forged / stolen shares from
being introduced in the market.
Measures taken by SEBI
The Securities and Exchange Board of India (SEBI) along with
Government have been stressing upon the need for strict regulation of secondary
market and bringing the transparency on the floor of stock exchanges. The steps taken
by the SEBI and Government in order to regulate and control the activities of stock
exchanges and reduce the risk of investors and sock brokers are as follows.
Uniform Trading hours at all the stock exchanges in the country to check the
arbitrage.
Registration of all market players such as brokers, sub brokers, registrars to
issues, merchant bankers, portfolio managers, underwriters, debenture trustees,
custodians etc so as to have access/inspection of their books, records and
verification of transactions.
Regulation on insider trading with the object to curb it completely and punish
the guilty.
Compulsory audit of accounts of all member brokers and registered
intermediaries by practicing chartered accountants.
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Indirect supervision through stock exchanges in day-to-day business by fixing
margins, imposing curbs, penalties and fines etc.
Systematization and computerization in order to reduce the paper work and
ensure transparency in transactions.
Mentioning of brokerage separately in broker contract notes.
Brokers have to notify all transaction to the stock exchanges including off the
floor trades.
Uniform good/bad delivery norms.
Capital adequacy norms prescribed for brokers.
Brokers have to keep the clients money in a separate bank account.
Forward trading being banned on stock exchanges.
Derivative trading in index based futures of 1, 2 or 3 months.
Dematerialization of almost all the securities.
Total transparency and automation of stock exchanges.
Effective margin system for smooth settlement.
Circuit breaker system to check volatility of particular scrip and the exchange.
Introduction of Internet and online trading.
Recent steps taken by SEBI
Compliance Officer
Each company is required to appoint the compliance officer who
would be able to verify the rumors and information floating in the market about the
company and inform the same to the stock exchanges. This will help reduce the
encouragement to rumors about companies, which aids in price control and stability.
Streamlining Investor protection fund
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The committee set up by SEBI to review the sources and utilization of
investor protection fund of stock exchanges has made following recommendations
» Funds should be on trust structure and set upon under Indian Trust Act,
1882 with independent trustees.
» Regular contributions from active member brokers and stock
exchanges.
» Fund to be utilized only for investor claims and not for broker claims.
» Trustees to ensure that fund is not deployed in risky instruments or for
the benefit of any member but only in prescribed avenues.
» Time schedule to be specified while setting investor claims.
Appointment of administrators
To get rid of bad deliveries, SEBI has decided to appoint administrator
to implement the signature guarantee and certificate authentication programs. The
administrators appointed by SEBI act on behalf regulator in resolving problems
arising out of signature mismatch.
Service centers for investors
SEBI has directed all stock exchanges to constitute service centers for
investors to enable the investors to have a form for recording and counseling of their
grievances as well as access financial and other information of companies on
government norms, policies, rules, regulations, etc.
Investor Education
SEBI has taken steps to educate the investors through various
awareness programmes, and publications etc.
Corporate Governance
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SEBI has prescribed the corporate governance norms for all listed
companies to ensure transparency and better disclosure practices.
FINDINGS
The study of risk management in stock broking firm was really an
interesting and informative project. Though the concept of risk management in stock
broking firm is a new concept in India, it is emerging as an utmost important practice.
Due to high volatility of market brokers are always exposed to the risk and they have
to suffer heavy financial losses. The findings drawn during the project are as follows.
Risk is the possibility of happening uncertain events. It is the chance of
happening of something that may affect the desired results. Risk may hamper
the pre determined outcomes and result into losses.
To cope up with the situation and reduce the evil effects of it such risks can be
avoided, retained, reduced or transferred.
The Indian capital market is very volatile and because of this brokers are
always at a risk of non receipt of payments from clients and sub brokers.
Stock broking firms face the market risks, financial risks, credit risks, liquidity
risks and operational risks.
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To tackle such risks Value at Risk (VaR) Margin, Mark to Market (MTM)
Margin, Extreme Loss Margin are collected from clients and maintained at the
exchange.
Non payment of margins is treated as violation of the bye laws of NSCCL and
attracts penalties. In extreme cases NSCCL may withdraw the membership
rights of member broker.
Intra day turnover limit and gross exposure limit are allowed to member
brokers against the minimum base capital and additional base capital. The
members violating the limits are penalized and not permitted to trade
forthwith. Member’s trading facility is restored from the next trading day with
a reduced intra day and gross exposure limit.
If member delivers the securities prior to the scheduled securities pay in day,
the margin payable by broker is then recomputed and margin is released to the
extent of early pay in.
NSE, BSE, SEBI and NSCCL have taken various steps like KYC, circuit
filters, surveillance, inspection, compulsory audit of accounts etc. to ensure the
minimum risk.
The technological advancements and infrastructural development have helped
broking firms to keep a regular check on its clients and sub brokers. It has also
enabled the exchanges to monitor on line where the correct and immediate
position of members is monitored on real time basis.
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SUGGESTIONS AND CONCLUSION
Inspite of strict surveillance and stringent policies towards reducing the
risk, brokers have to suffer financial losses. Many times strict adherence to the
provisions laid down by the exchanges and SEBI is neglected and it results in to
losses. The one important reason behind this can be lack of proper implementation of
the rules and regulations. Therefore following are the suggestions which would help
reduce the risk and losses at exchanges and member brokers.
Every stock broking firm must have a Risk Management or Surveillance
Department to keep a strict watch on market and the activities of its sub
brokers, franchisees and investors etc.
There has to be minimum qualification criteria for the member broker, sub
broker and franchisee and employees especially dealers. The criteria can be
various modules of NCFM or BCFM (e.g. a dealer must pass the NCFM or
BCFM Dealer’s module.)
67
Such qualified staff would help in reducing the mistakes and errors as they
have a proper understanding of the procedure.
While providing acceptance to the limits it must be scrutinized that broker or
sub broker has a required amount of credit in his bank account.
Also while giving refunds to the broker or sub broker it must be checked that
he has maintained a minimum required balance (Minimum Base Capital).
In both the cases of acceptance to the limit and refund of capital the margins
must be recomputed and increased or decreased immediately.
The member brokers and sub brokers must strictly adhere to the limits and
gross exposure provided to them and in case of need a specified amount must
be deposited first with the exchange.
The clients should be asked to call dealers on the phones only on which the
conversation can be recorded. Thus, clients’ calls on personal phones should
be avoided. It helps to reduce the miscommunication and conflicts between
client and broker.
All the documents along with applications for client and sub broker must be
verified thoroughly and all the requirements (e.g. Letter from bank, copy of
passbook, signature, letter of landlord in case of tenant etc) must be fulfilled.
The senior officers of broker must visit periodically to its sub brokers and
franchisees to keep a check and understand their problems.
Risk Management or Surveillance Department should generate a report
containing the position, limits, gross exposure, acceptance, refund etc. The
report should be send to senior management for verification.
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CONCLUSION
Working with PSE Securities Ltd. for study of risk management in stock
broking firm was a great experience. The activities of risk management or
surveillance are the heart of the broking industry and they should be taken care of.
Prices of shares in Indian stock market change very swiftly, they are
very volatile and unpredictable too. The brokers are always at a risk that investors
may not pay in the securities or funds due to increase or decrease in prices of shares.
Therefore, broking firm is a very risky business and chance of financial losses lies in
almost each and every activity of the business. However, with the margin system and
use of advanced technology the transparency of market is growing.
Therefore to conclude it can be noted that though the business of stock
broking is always exposed to the risk of non receipt of payments or loss of money but
such risks can be managed and reduced through strict adherence to the rules and
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regulation mentioned by exchanges, SEBI and NSCCL. This will not only reduce the
risk but also help organization run smoothly and grow further.
LIMITATIONS
During the study certain limitations were faced, in the absence of
which the study could have been better. Those limitations are as follows.
The time period of 2 months was a very short span to complete the study.
The study was conducted in Pune city only, which restricted the scope of
study.
It was not possible to study certain confidential data.
The PSE Securities Ltd. deals in the cash segment only and not in the
derivatives segment, that put restrictions on the study.
The data provided by persons cannot be held 100% true.
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BIBLIOGRAPHY
Books
» V.K. Bhalla, (2002), Portfolio Analysis and Management, S. Chand
and Co. Ltd., New Delhi, pp1-24
» National Stock Exchange, (Oct. 2007), Capital Market (Basic) Module
Work Book NSE, Mumbai, pp 151-159
» V.A Avadhani, (2006), Securities Analysis and Portfolio Management,
Himilaya Publishing House, Mumbai, pp46-54.
» National Stock Exchange, (Oct. 2007), Capital Market (Dealers)
Module Work Book NSE, Mumbai, pp 84-95.
Journals or Magazines
» Jointly Published by NSE and BSE; Understanding Margins, pp 3-10
Internet sites
» <http://en.wikipedia.org/wiki/Risk_Management>
Assessed on 15th June 2008, 10 a.m.
» <http://www.nseindia.com/home/NSCCL/RiskManagement/
equities.htm> Assessed on 29th June 2008, 4 p.m.
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» <http://bseindia.com/mktlive/market_summ/margin.asp>
Assessed on 29th June 2008, 4:30 p.m.
» <http://punestockexchange.com/psescompanyprofile.html>
Assessed on 6th July 2008, 5:30 p.m.
» <http://www.investopedia.com/search/searchresults.aspx?q=risk>
Assessed on 12th July 2008, 6 p.m.
» <http://www.investopedia.com/terms/v/var.asp>
Assessed on 12th July 2008, 6:30 p.m.
72