Financial Derivatives

MBA(DISTANCE MODE)

DBA 1754

FINANCIAL DERIVATIVES

IV SEMESTER

COURSE MATERIAL

Centre for Distance EducationAnna University Chennai

Chennai – 600 025

Author

DrDrDrDrDr. J. J. J. J. J. Gopu. Gopu. Gopu. Gopu. GopuAssistant Professor

Department of Management StudiesBSA Crescent Engineering College

Chennai - 600 048

Reviewer

MsMsMsMsMs. Y. Y. Y. Y. Yasmeen Haiderasmeen Haiderasmeen Haiderasmeen Haiderasmeen HaiderSenior Lecturer

Department of Management StudiesBSA Crescent Engineering College

Chennai - 600 048

DrDrDrDrDr.T.T.T.T.T.V.V.V.V.V.Geetha.Geetha.Geetha.Geetha.GeethaProfessor

Department of Computer Science and EngineeringAnna University Chennai

Chennai - 600 025

DrDrDrDrDr.H.P.H.P.H.P.H.P.H.Peereereereereeru Mohamedu Mohamedu Mohamedu Mohamedu MohamedProfessor

Department of Management StudiesAnna University Chennai

Chennai - 600 025

DrDrDrDrDr.C.C.C.C.C. Chella. Chella. Chella. Chella. ChellappanppanppanppanppanProfessor


Chennai - 600 025

DrDrDrDrDr.A.K.A.K.A.K.A.K.A.KannanannanannanannanannanProfessor


Chennai - 600 025

Copyrights Reserved(For Private Circulation only)

Editorial Board

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ACKNOWLEDGEMENT

The author has drawn inputs from several sources for the preparation of this course material, to meet the

requirements of the syllabus. The author gratefully acknowledges the following sources:

• N.D.Vohra and B.R.Bagri, ‘Futures and Options’ – II Edition; Tata McGraw Hill Ltd.

• S.L.Gupta, Financial derivatives, theory, concepts and problems, Prentice Hall India, 2006.

• www.nseindia.com

• www.theponytail.com

• http://www.emecklai.com

• http://www.geocities.com

• www.indiainfoline.com

• http://sasmit.blogspot.com

Inspite of at most care taken to prepare the list of references any omission in the list is only accidental and not

purposeful.

Dr. J. Gopu

Author

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DBA 1754 FINANCIAL DERIVATIVES

UNIT I - INTRODUCTION

Financial derivatives – an introduction; Futures market and contracting; Forward market – pricing and trading

mechanism; Futures pricing – theories and characteristics.

UNIT II - REGULATIONS

Financial derivatives market in India; Regulation of financial derivatives in India.

UNIT III - STRATEGIES

Hedging strategy using futures; Stock index futures; Short-term interest rate futures; Long-term interest rate

futures; Foreign currency futures; Foreign currency forwards.

UNIT IV - OPTIONS

Options basics; Option pricing models; trading with options; Hedging with options; currency options; Financial

Swaps and Options; Swap markets.

UNIT V - ACCOUNTING

Accounting treatment of derivative transactions; Management of derivatives exposure; Advanced financial

derivatives; Credit derivatives.

REFERENCES

1. N.D.Vohra and B.R.Bagri, ‘Futures and Options’ – II Edition; Tata McGraw Hill Ltd.

2. S.L.Gupta, Financial derivatives, theory, concepts and problems, Prentice Hall India, 2006.

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CONTENTS

UNIT ICHAPTER I

FINANCIAL DERIVATIES AN INTRODUCTION

1.1 INTRODUCTION 11.2 THE SIGNIFICANCE OF DERIVATIVES 31.3 TYPES OF DERIVATIVES 3

1.3.1 Forward Contracts 31.3.2 Future Contracts 41.3.3 Options Contracts 41.3.4 Swap 4

1.4 FUTURES MARKET AND CONTRACTING 41.4.1 Contract Specifications 51.4.2 Trading Parameters 5

1.5 FORWARDS VS FUTURES 71.6 DIFFERENCES BETWEEN FORWARDS AND

FUTURES CONTRACTS 81.7 FUTURES PRICES AND FUTURE SPOT PRICES

UNIT IICHAPTER I

FINANCIAL DERIVATIVES MARKET IN INDIA

2.1.1 Introduction 112.1.2 Derivatives Market in India 112.1.3 Development of exchange-traded derivatives 162.1.4 The need for a derivatives market 16

CHAPTER IIREGULATIONS OF FINANCIAL DERIVATIVES IN INDIA

2.2.1 Introduction 182.2.2 Regulations by National Stock Exchange 182.2.3 Black-Scholes Option Price calculation model 262.2.4 Payment of Margins 272.2.5 Violations 272.2.6 Market Wide Position Limits for derivative contracts

on underlying stocks 282.2.7 Price Scan Range 29

2.2.8 Position Limits 292.2.9 Scheme for FIIs and MFs trading in Exchange traded derivatives 30

UNIT IIICHAPTER – I

HEDGING STRATEGIES USING INDEX FUTURES

3.1.1 Introduction 353.1.2 S&P CNX Nifty 353.1.3 Trading in Nifty 363.1.4 S&P CNX Nifty Futures 363.1.5 CNX Nifty Junior Futures 413.1.6 Cnxit Futures 433.1.7 CNX 100 Futures 443.1.8 BANK Nifty Futures 463.1.9 Nifty Midcap 50 Futures 483.1.10 Futures on Individual Securities 50

CHAPTER IIINTEREST RATE FUTURES

3.2.1 Introduction 543.2.2 Security descriptor 543.2.3 Underlying Instrument 543.2.4 Trading cycle 553.2.5 Expiry day 553.2.6 Product Characteristics 553.2.7 Trading Parameters 553.2.8 Clearing and Settlement 573.2.9 Interest Rate Derivatives - Risk Containment 59

CHAPTER IIICUURENCY FUTURES

3.3.1 Introduction 613.3.2 To Hedge or Not to Hedge? 613.3.3 Uncorrelated risks 613.3.4 Expected returns are zero 623.3.5 a) How long is the long-run? 623.3.5 b) Risk-return trade-off 623.3.6 Instruments for Hedging Currency Risk 623.3.7 Exchange-Traded Currency Futures 633.3.8 Accessible to All Market Participants 63

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3.3.9 Illustrating the Use of Currency Futures 643.3.10 Summary 65

UNIT IVCHAPTER I

OPTION MARKET4.1.1 Introduction 674.1.2 The main characteristics of a option contract 674.1.3 The market participants 684.1.4 Mini Option contracts on S&P CNX Nifty index 694.1.5 CNXIT Options 694.1.6 CNX 100 Options 734.1.7 BANKNIFTY OPTIONS 764.1.8 NIFTY MIDCAP 50 OPTIONS 794.1.9 Options on Individual Securities 82

CHAPTER IIFINANCIAL SWAPS MARKET

4.2.1 Introduction 964.2.2 There are Three Basic Motivations for Swaps: 964.2.3 Firms use Swaps to Reduce Financing Costs 964.2.4 Parallel Loans 964.2.5 Back-to-Back Loans 974.2.6 Drawbacks of parallel and back to back loans 974.2.7 Swap Banks 984.2.8 Types of Swaps 984.2.9 Swaptions, Caps, Floor and Collars 994.2.10 Motivation for Swaps 994.2.11 Closing Thoughts 994.2.12 Interest Rate Swaps 1004.2.13 Currency Swaps 1014.2.14 Flexibility 1024.2.15 Exposure 1054.2.16 Hedging Swaps 1034.2.17 Identifying the risk of the swaps portfolio 1044.2.18 Constructing the Hedge Portfolio 1044.2.19 Why will the Dealer only Partially Hedge the Swaps Portfolio? 1054.2.20 Floating Rate Cash Flow Management 105

4.2.21 Mismatches in the Timing of Short-Term Cash Flows. 1054.2.22 Mmismatches in the Type of Index used to Hedge. 1054.2.23 Interest Rate Swaps 1064.2.24 Valuation of swaps 1064.2.25 Equity Swaps 1074.2.26 Equity swaps make the index trading strategy even easier. 107

UNIT VCHAPTER I

ACCOUNTING TREATMENT FORDERIVATIVE TRANSACTIONS

5.1.1 Introduction 1115.1.2 Getting Ready 1115.1.3 Hedge Accounting 1125.1.4 Embedded Derivatives 1135.1.5 Recent Announcement 1135.1.6 Fair value hedges are accounted for as follows: 1145.1.7 Cash flow hedges are accounted for as follows: 1145.1.8 New Accounting Rules for Derivatives and Hedging Activity 1155.1.9 Fair Value Hedges 1155.1.10 Cash Flow Hedges 1165.1.11 Hedges for Net Investment in Foreign Operations 1165.1.12 Derivatives and Income Statement Volatility 1175.1.13 Increased Derivatives Disclosure 1175.1.14 Derivatives Management Systems 117

CHAPTER IICREDIT DERIVATIVES

5.2.1 Introduction 1225.2.2 Credit Swaps management. 1225.2.3 Credit Default Swaps 1235.2.4 Options on Credit Risky Bonds 124

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NOTES


UNIT I

INTRODUCTIONCHAPTER – I

FINANCIAL DERIVATIES – AN INTRODUCTION

1.1 INTRODUCTION

In finance, a security whose price is dependent upon or derived from one or moreunderlying assets. The derivative itself is merely a contract between two or more parties.Its value is determined by fluctuations in the underlying asset. The most common underlyingassets include stocks, bonds, commodities, currencies, interest rates and market indexes.Most derivatives are characterized by high leverage.

Futures contracts, forward contracts, options and swaps are the most common typesof derivatives. Because derivatives are just contracts, just about anything can be used asan underlying asset. There are even derivatives based on weather data, such as the amountof rain or the number of sunny days in a particular region.

Derivatives are generally used to hedge risk, but can also be used for speculativepurposes. For example, a European investor purchasing shares of an Americancompany off of an American exchange (using American dollars to do so) would be exposedto exchange-rate risk while holding that stock. To hedge this risk, the investor could purchasecurrency futures to lock in a specified exchange rate for the future stock sale and currencyconversion back into euros.

Derivative is any financial instrument, whose payoffs depend in a direct way on thevalue of an underlying variable at a time in the future. This underlying variable is also calledthe underlying asset, or just the underlying.

Usually, derivatives are contracts to buy or sell the underlying asset at a future time,with the price, quantity and other specifications defined today. Contracts can be bindingfor both parties or for one party only, with the other party reserving the option to exerciseor not. If the underlying asset is not traded, for example if the underlying is an index, somekind of cash settlement has to take place. Derivatives are traded in organized exchanges aswell as over the counter [OTC derivatives]. Examples of derivatives include forwards,futures, options, caps, floors, swaps, collars, and many others.

1 ANNA UNIVERSITY CHENNAI

DBA 1754

NOTES
Derivative contracts in general and options in particular are not novel securities. It hasbeen nearly 25 centuries since the above abstract appeared in Aristotle’s Politics, describingthe purchase of a call option on oil-presses. More recently, De La Vega (1688), in hisaccount of the operation of the Amsterdam Exchange, describes traded contracts thatexhibit striking similarities to the modern traded options.
Nevertheless, the modern treatment of derivative contracts has its roots in the inspiredwork of the Frenchman Louis Bachelier in 1900. This was the first attempt of a rigorousmathematical representation of an asset price evolution through time. Bachelier used theconcepts of random walk in order to model the fluctuations of the stock prices, and developeda mathematical model in order to evaluate the price of options on bond futures. Althoughthe above model was incomplete and based on assumptions that are virtually unacceptablein recent studies, its importance lies on the novelty of its ideas, both from an economist’sand a mathematician’s point of view. Unfortunately, this work was not developed further,despite the publication of the Einstein paper on Brownian motion in 1905, which wouldshed light on the properties of the model and perhaps highlight its misspecifications.

The above treatment of security prices was long forgotten until the 70s, when ProfessorSamuelson and his co-workers at MIT rediscovered Bachelier’s work and questioned itsunderlying assumptions. By construction, the payoff of a call option on the expiration daywill depend on the price of the underlying asset on that day, relative to the option’s exerciseprice. Common reasoning declares that therefore, the price of the call option today has todepend on the probability of the stock price exceeding the exercise price. One could thenargue that a mathematical model that can satisfactory explain the underlying asset’s price issufficient in order to price the call option today, just by constructing the probabilistic modelof the price on the expiration day. Professors Black, Merton and Scholes recognized thatthe above reasoning is incorrect: Since today’s price incorporates the probabilistic modelof the future behavior of the asset price, the option can (and has to) be priced relative totoday’s price alone. They realized that a levered position, using the stock and the risklessbond that replicates the payoff of the option is feasible, and therefore the option can bepriced using no-arbitrage restrictions. Equivalently, they observed that the true probabilitydistribution for the stock price return can be transformed into one which has an expectedvalue equal to the risk free rate, the so called risk adjusted or risk neutral distribution; thepricing of the derivative can be carried out using the risk neutral distribution whenexpectations are taken.

The classic papers produced by this work, namely Black and Scholes (1973) andMerton (1976), triggered an avalanche of papers on option pricing, and resulted in the1997 Nobel Prize in economics for the pioneers of contingent claims pricing. Even today,nearly thirty years after its publication, the original Black and Scholes paper is one of themost heavily cited in finance?


NOTES


1.2 THE SIGNIFICANCE OF DERIVATIVES

Every candidate underlying asset will have a value that is affected by a variety offactors, therefore inheriting risk. Derivative contracts, due to the leverage that they offermay seem to multiply the exposure to such risks. However, derivatives are rarely used inisolation. By forming portfolios utilizing a variety of derivatives and underlying assets, onecan substantially reduce her risk exposure, when an appropriate strategy is considered.

Derivative contracts provide an easy and straightforward way to both reduce risk -hedging, and to bear extra risk -speculating. As noted above, in any market conditionsevery security bears some risk. Using active derivative management involves isolating thefactors that serve as the sources of risk, and attacking them in turn. In general, derivativescan be used to

• hedge risks;

• reflect a view on the future behavior of the market, speculate;

• lock in an arbitrage profit;

• change the nature of a liability;

• change the nature of an investment;

1.3 TYPES OF DERIVATIVES

Derivative contracts have several variants. The most common variants are forwards,futures, options and swap.

1.3.1 Forward Contracts

A forward contract is an agreement between two parties – a buyer and a seller topurchase or sell something at a later date at a price agreed upon today. Forward contracts,sometimes called forward commitments, are very common in everyone life. For example,an apartment lease is a forward commitment. By signing a one-year lease, the tenant agreesto purchase the service – use of the apartment – each month for the next twelve months ata predetermined rate. Like-wise, the landlord agrees to provide the service each monthfor the next twelve months at the agreed-upon rate. Now suppose that six months later thetenant finds a better apartment and decides to move out. The forward commitment remainsin effect, and the only way the tenant can get out of the contract is to sublease the apartment.Because there is usually a market for subleases, the lease is even more like a futurescontract than a forward contract.

Any type of contractual agreement that calls for the future purchase of a good orservice at a price agreed upon today and without the right of cancellation is a forwardcontract.


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NOTES
1.3.2 Future Contracts
A futures contract is an agreement between two parties – a buyer and a seller – tobuy or sell something at a future date. The contact trades on a futures exchange and issubject to a daily settlement procedure. Future contracts evolved out of forward contractsand possess many of the same characteristics. In essence, they are like liquid forwardcontracts. Unlike forward contracts, however, futures contracts trade on organizedexchanges, called future markets. For example, the buyer of a future contact, who has theobligation to buy the good at the later date, can sell the contact in the future market, whichrelieves him or her of the obligation to purchase the good. Likewise, the seller of thefutures contract, who is obligated to sell the good at the later date, can buy the contactback in the future market, relieving him or her of the obligation to sell the good. Futurecontacts also differ from forward contacts in that they are subject to a daily settlementprocedure. In the daily settlement, investors who incur losses pay them every day to investorswho make profits.

1.3.3 Options Contracts

Options are of two types - calls and puts. Calls give the buyer the right but not theobligation to buy a given quantity of the underlying asset, at a given price on or before agiven future date. Puts give the buyer the right, but not the obligation to sell a given quantityof the underlying asset at a given price on or before a given date.

1.3.4 Swap

Swaps are private agreements between two parties to exchange cash flows in thefuture according to a prearranged formula. They can be regarded as portfolios of forwardcontracts. The two commonly used swaps are interest rate swaps and currency swaps.

Interest rate swaps: These involve swapping only the interest related cash flowsbetween the parties in the same currency.

Currency swaps: These entail swapping both principal and interest between theparties, with the cash flows in one direction being in a different currency than those in theopposite direction.

1.4 FUTURES MARKET AND CONTRACTING

This contract is an agreement to buy or sell an asset at a certain time in the future fora certain price. Futures are traded in exchanges and the delivery price is always such thattoday’s value of the contract is zero. Therefore in principle, one can always engage intofuture without the need of an initial capital: the speculators heaven

A futures contract is a forward contract, which is traded on an Exchange. NSEcommenced trading in index futures on June 12, 2000. The index futures contracts arebased on the popular market benchmark S & P CNX Nifty index.


NOTES


NSE defines the characteristics of the futures contract such as the underlying index,market lot, and the maturity date of the contract. The futures contracts are available fortrading from introduction to the expiry date.

1.4.1 Contract Specifications

Security descriptor

The security descriptor for the S&P CNX Nifty futures contracts is:

Market type : N

Instrument Type : UTIDX

Underlying : NIFTY

Expiry date : Date of contract expiry

Instrument type represents the instrument i.e. Futures on Index. Underlying symboldenotes the underlying index which is S&P CNX Nifty Expiry date identifies the date ofexpiry of the contract

Underlying Instrument

The underlying index is S&P CNX Nifty.

Trading cycle

S&P CNX Nifty futures contracts have a maximum of 3-month trading cycle - thenear month (one), the next month (two) and the far month (three). A new contract isintroduced on the trading day following the expiry of the near month contract. The newcontract will be introduced for a three month duration. This way, at any point in time, therewill be 3 contracts available for trading in the market i.e., one near month, one mid monthand one far month duration respectively.

Expiry day

S&P CNX Nifty futures contracts expire on the last Thursday of the expiry month. Ifthe last Thursday is a trading holiday, the contracts expire on the previous trading day.

1.4.2 Trading Parameters

Contract size

The value of the futures contracts on Nifty may not be less than Rs. 2 lakhs at the timeof introduction. The permitted lot size for futures contracts & options contracts shall be thesame for a given underlying or such lot size as may be stipulated by the Exchange from timeto time.

Price steps

The price step in respect of S&P CNX Nifty futures contracts is Re.0.05.


DBA 1754

NOTES
Base Prices
Base price of S&P CNX Nifty futures contracts on the first day of trading would betheoretical futures price.. The base price of the contracts on subsequent trading days wouldbe the daily settlement price of the futures contracts.

Price bands

There are no day minimum/maximum price ranges applicable for S&P CNX Niftyfutures contracts. However, in order to prevent erroneous order entry by trading members,operating ranges are kept at +/- 10 %. In respect of orders which have come under pricefreeze, members would be required to confirm to the Exchange that there is no inadvertenterror in the order entry and that the order is genuine. On such confirmation the Exchangemay approve such order.

Quantity freeze

Orders which may come to the exchange as Quantity freeze shall be such that have aquantity of more than 15000. In respect of orders which have come under quantity freeze,members would be required to confirm to the Exchange that there is no inadvertent errorin the order entry and that the order is genuine. On such confirmation, the Exchange mayapprove such order. However, in exceptional cases, the Exchange may, at its discretion,not allow the orders that have come under quantity freeze for execution for any reasonwhatsoever including non-availability of turnover / exposure limit. In all other cases, quantityfreeze orders shall be cancelled by the Exchange.

Order type/Order book/Order attribute

Regular lot order

• Stop loss order

• Immediate or cancel

• Spread order

• The forward contract

The forward contract is an over-the-counter [OTC] agreement between two parties,to buy or sell an asset at a certain time in the future for a certain price.

• The party that has agreed to buy has a long position.

• The party that has agreed to sell has a short position.

Usually, the delivery price is such that the initial value of the contract is zero. Thecontract is settled at maturity. For example, a long forward position with delivery price willK have the payoffs shown in figure


NOTES


Forward contract payoffs

1.5 FORWARDS VS FUTURES

It can be shown that when interest rates are constant and the same for all maturities,then the futures and forward prices are the same. If the interest rates are stochastic, thisrelationship does not hold. Whether the forward price is lower than the futures price orhigher will depend on the correlation of the underlying asset with the interest rates. Thissituation arises from the daily settlement procedure that takes place in the futures market.Remember that there is no secondary market for the forward contracts.

Suppose that the interest rates and the underlying asset are negatively correlated.That is to say that on average, when the interest rates fall the price of the underlying assetincreases, something that is true in the stock markets. Consider an investor that holds along futures position. When the asset price increases, because of the marking-the-marketprocedure, the investor is making an immediate gain —the basis increases. This extra gainwill be invested at an interest rate which is lower than average, due to the negativecorrelation. In a similar fashion, when the price of the underlying falls, the immediate losswill have to be financed at a rate which is above the average. Forwards are not subject todaily settlements, and therefore not affected by the spot-interest correlation. This makesforward contracts more attractive; in an efficient market when the spot-interest correlationis negative we expect forward prices to be higher than the futures ones.

Obviously the inverse will also hold, that is to say when the spot-interest correlation ispositive we expect forward prices to be lower than the futures ones.

These differences have only a theoretical value, in practice these differences are ignored.Usually the maturity of futures contracts is quite short, and the spot-interest correlation isnot that high in absolute terms to imply significant differences. Therefore handbooks andpractitioners make the assumption that futures and forwards have the same price, evenwhen interest rates are uncertain. Of course one has to be careful when dealing with longermaturity futures, since then the differences might become quite significant.


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NOTES
In the remaining of these notes we will use the same notation F(t, r) for both forwardsand futures, recognizing the pitfalls.
Although similar in nature, these two instruments exhibit some fundamental differencesin the organization and the contract characteristics.

1.6 DIFFERENCES BETWEEN FORWARDS AND FUTURESCONTRACTS

In the example a futures contract was not available for the investor to hedge againstthe interest rate risk. One can now see that she could alternative go to some investmentcompany seeking for a forward contract that would suit her needs.

1.7 FUTURES PRICES AND FUTURE SPOT PRICES

One very important question that one can ask is: Is the futures price an unbiasedestimator of the future spot price? The answer is no in general. Remember the relationbetween risk and return as stated by the CAPM: there are two types of risk in the economy,namely the systematic and the nonsystematic risk. The nonsystematic risk can be eliminatedby holding a well diversified portfolio, which is perfectly correlated with the market. Thesystematic risk cannot be eliminated, since it is the risk of the portfolio that is inherited fromthe market as a whole and it cannot be diversified away. The CAPM formula dictates that

rp – r = β β β β βp (r M – r)

We have already seen that a futures contract, when seen as a riskless investment willgrow in value with the risk free rate of return.

Example 10 (Futures risk) Suppose that an investor takes a long futures position.She puts the present value of the futures position into a risk free investment, to meet therequirements when the contract matures, in order to buy the asset on the delivery date.

Forwards Futures

Primary market Dealers Organized Exchange

Secondary market None the Primary market

Contracts Negotiated Standardized

Delivery Contracts expire Rare delivery

Collateral None Initial margin, mark-the-market

Credit risk Depends on parties None [Clearing House]

Market participants Large firms Wide variety


NOTES


The cash flows of the speculator are

.timeat)(S

and,ttimeate),t(F )t(r

τττ− −τ−

The present value of this investment is

)t(1rt

)t(r e)](S[Ee),t(F −τ−−τ− τ+τ−

where Et is the conditional expectations operator, and r

1 is the discount rate appropriate

for the investment —meaning the expected return required from investors in order tocompensate for the risks that are beard. The fact that the present value of all investmentopportunities is equal to zero will give

)t()1rr(t e)](S[E),t(F −τ−τ=τ .

It is straightforward to observe that the relationship of the futures with the expectedspot price will depend on the relationship between the two returns, which in turn dependson the correlation of the investment with the market due to the CAPM.

Example 11 (cont. Futures risk) Consider the case that ST is positively correlated

with the market —as is the usual case. Then, from the definition of )rm(var

)r,r(cov M1I =β it is

implied that βI is positive. The CAPM dictates that an investment with positive β will have

required return higher than the risk free rate. This in turn will give F(t,r) < Et [S(r)].The

inverse will also hold: If STis negatively correlated with the market, then F(t,r) > E

t [S(r)]..

What is the case where the futures price is an unbiased estimator of the future spot price?This happens only when the investment is not correlated with the market, or equivalentlywhen the investment does not exhibit systematic risk. If fact in this cases the above featureis more of an accident: it is not the case that the futures price became an unbiased estimator,it is more that the asset price happens to grow at the risk free rate of return.

Summary

Usually, derivatives are contracts to buy or sell the underlying asset at a future time,with the price, quantity and other specifications defined today. Contracts can be bindingfor both parties or for one party only, with the other party reserving the option to exerciseor not. If the underlying asset is not traded, for example if the underlying is an index, somekind of cash settlement has to take place. Derivatives are traded in organized exchanges aswell as over the counter [OTC derivatives]. Examples of derivatives include forwards,futures, options, caps, floors, swaps, collars, and many others.


DBA 1754

NOTES
Derivative contracts in general and options in particular are not novel securities. It hasbeen nearly 25 centuries since the above abstract appeared in Aristotle’s Politics, describingthe purchase of a call option on oil-presses. More recently, De La Vega (1688), in hisaccount of the operation of the Amsterdam Exchange, describes traded contracts thatexhibit striking similarities to the modern traded options.
Nevertheless, the modern treatment of derivative contracts has its roots in the inspiredwork of the Frenchman Louis Bachelier in 1900. This was the first attempt of a rigorousmathematical representation of an asset price evolution through time. Bachelier used theconcepts of random walk in order to model the fluctuations of the stock prices, and developeda mathematical model in order to evaluate the price of options on bond futures. Althoughthe above model was incomplete and based on assumptions that are virtually unacceptablein recent studies, its importance lies on the novelty of its ideas, both from an economist’sand a mathematician’s point of view. Unfortunately, this work was not developed further,despite the publication of the Einstein paper on Brownian motion in 1905, which wouldshed light on the properties of the model and perhaps highlight its misspecifications.

Questions

1. What do you mean by Derivatives? Explain its importance

2. Discuss the various types of Derivatives

3. Explain the differences between Forwards and Futures contracts

4. Define Option contract

5. Is the futures price an unbiased estimator of the future spot price? Explain


NOTES


UNIT II

REGULATIONSCHAPTER - I

FINANCIAL DERIVATIVES MARKET IN INDIA

2.1.1 Introduction

Derivatives are financial contracts whose values are derived from the value of anunderlying primary financial instrument, commodity or index, such as: interest rates, exchangerates, commodities, and equities. Derivatives include a wide assortment of financial contracts,including forwards, futures, swaps, and options. The International Monetary Fund definesderivatives as “financial instruments that are linked to a specific financial instrument orindicator or commodity and through which specific financial risks can be traded in financialmarkets in their own right. The value of financial derivatives derives from the price of anunderlying item, such as asset or index. Unlike debt securities, no principal is advanced tobe repaid and no investment income accrues.” While some derivatives instruments mayhave very complex structures, all of them can be divided into basic building blocks ofoptions, forward contracts or some combination thereof. Derivatives allow financialinstitutions and other participants to identify, isolate and manage separately the marketrisks in financial instruments and commodities for the purpose of hedging, speculating,arbitraging price differences and adjusting portfolio risks.

2.1.2 Derivatives Market in India

Derivatives markets have had a slow start in India. The first step towards introductionof derivatives trading in India was the promulgation of the Securities Laws (Amendments)Ordinance, 1995, which withdrew the prohibition on options in securities. The market forderivatives, however, did not take off, as there was no regulatory framework to governtrading of derivatives. SEBI set up a 24-member committee under the Chairmanship ofDr. L.C. Gupta on 18th November 1996 to develop appropriate regulatory frameworkfor derivatives trading in India. The committee recommended that derivatives should bedeclared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’could also govern trading of securities. SEBI was given more powers and it starts regulatingthe stock exchanges in a professional manner by gradually introducing reforms in trading.


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NOTES
Derivatives trading commenced in India in June 2000 after SEBI granted the final approvalin May 2000. SEBI permitted the derivative segments of two stock exchanges, viz NSEand BSE, and their clearing house/corporation to commence trading and settlement inapproved derivative contracts.
Introduction of derivatives was made in a phase manner allowing investors and traderssufficient time to get used to the new financial instruments. Index futures on CNX Nifty andBSE Sensex were introduced during 2000. The trading in index options commenced inJune 2001 and trading in options on individual securities commenced in July 2001. Futurescontracts on individual stock were launched in November 2001. In June 2003, SEBI/RBIapproved the trading in interest rate derivatives instruments and NSE introduced trading infutures contract on June 24, 2003 on 91 day Notional T-bills. Derivatives contracts aretraded and settled in accordance with the rules, bylaws, and regulations of the respectiveexchanges and their clearing house/corporation duly approved by SEBI and notified in theofficial gazette.

The emergence of the market for derivatives products, most notable forwards, futures,options and swaps can be traced back to the willingness of risk-averse economic agentsto guard themselves against uncertainties arising out of fluctuations in asset prices. By theirvery nature, the financial markets can be subject to a very high degree of volatility. Throughthe use of derivative products, it is possible to partially or fully transfer price risks bylocking-in asset prices. As instruments of risk management, derivatives products generallydo not influence the fluctuations in the underlying asset prices. However, by locking-inasset prices, derivatives products minimize the impact of fluctuations in asset prices on theprofitability and cash flow situation of risk-averse investors.

Factors generally attributed as the major driving force behind growth of financialderivatives are:

i. Increased Volatility in asset prices in financial markets,

ii. Increased integration of national financial markets with the international markets,

iii. Marked improvement in communication facilities and sharp decline in their costs,

iv. Development of more sophisticated risk management tools, providing economicagents a wider choice of risk management strategies, and

v. Innovations in the derivatives markets, which optimally combine the risks andreturns over a large number of financial assets, leading to higher returns, reducedrisk as well as transaction costs as compared to individual financial assets

Financial markets are, by nature, extremely volatile and hence the risk factor is animportant concern for financial agents. To reduce this risk, the concept of derivatives comesinto the picture. Derivatives are products whose values are derived from one or morebasic variables called bases. These bases can be underlying assets (for example forex,


NOTES


equity, etc), bases or reference rates. For example, wheat farmers may wish to sell theirharvest at a future date to eliminate the risk of a change in prices by that date. The transactionin this case would be the derivative, while the spot price of wheat would be the underlyingasset. Development of exchange-traded derivatives has probably been around for as longas people have been trading with one another. Forward contracting dates back at least tothe 12th century, and may well have been around before then. Merchants entered intocontracts with one another for future delivery of specified amount of commodities at specifiedprice. A primary motivation for pre-arranging a buyer or seller for a stock of commoditiesin early forward contracts was to lessen the possibility that large swings would inhibitmarketing the commodity after a harvest. The need for a derivatives market. The derivativesmarket performs a number of economic functions:

i. They help in transferring risks from risk averse people to risk oriented people

ii. They help in the discovery of future as well as current prices

iii. They catalyze entrepreneurial activity

iv. They increase the volume traded in markets because of participation of risk aversepeople in greater numbers

v. They increase savings and investment in the long run The participants in a derivativesmarket

Hedgers use futures or options markets to reduce or eliminate the risk associatedwith price of an asset. Speculators use futures and options contracts to get extra leveragein betting on future movements in the price of an asset. They can increase both the potentialgains and potential losses by usage of derivatives in a speculative venture. Arbitrageurs arein business to take advantage of a discrepancy between prices in two different markets. If,for example, they see the futures price of an asset getting out of line with the cash price,they will take offsetting positions in the two markets to lock in a profit. Types of DerivativesForwards: A forward contract is a customized contract between two entities, wheresettlement takes place on a specific date in the future at today’s pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell anasset at a certain time in the future at a certain price. Futures contracts are special types offorward contracts in the sense that the former are standardized exchange-traded contractsOptions: Options are of two types - calls and puts. Calls give the buyer the right but not theobligation to buy a given quantity of the underlying asset, at a given price on or before agiven future date. Puts give the buyer the right, but not the obligation to sell a given quantityof the underlying asset at a given price on or before a given date. Warrants: Optionsgenerally have lives of upto one year, the majority of options traded on options exchangeshaving a maximum maturity of nine months. Longer-dated options are called warrants andare generally traded over-the-counter. LEAPS: The acronym LEAPS means Long-TermEquity Anticipation Securities. These are options having a maturity of upto three years.


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Baskets: Basket options are options on portfolios of underlying assets. The underlyingasset is usually a moving average or a basket of assets. Equity index options are a form ofbasket options. Swaps: Swaps are private agreements between two parties to exchangecash flows in the future according to a prearranged formula. They can be regarded asportfolios of forward contracts. The two commonly used swaps are : • Interest rate swaps:These entail swapping only the interest related cash flows between the parties in the samecurrency. • Currency swaps: These entail swapping both principal and interest betweenthe parties, with the cash flows in one direction being in a different currency than those inthe opposite direction
Swaptions: Swaptions are options to buy or sell a swap that will become operativeat the expiry of the options. Thus a swaption is an option on a forward swap. Rather thanhave calls and puts, the swaptions market has receiver swaptions and payer swaptions. Areceiver swaption is an option to receive fixed and pay floating. A payer swaption is anoption to pay fixed and receive floating.

Factors driving the growth of financial derivatives

a. Increased volatility in asset prices in financial markets,

b. Increased integration of national financial markets with the international markets,

c. Marked improvement in communication facilities and sharp decline in their costs,d. Development of more sophisticated risk management tools, providing economicagents a wider choice of risk management strategies, and

d. Innovations in the derivatives markets, which optimally combine the risks and returnsover a large number of financial assets leading to higher returns, reduced risk aswell as transactions costs as compared to individual financial assets.

Derivatives trading commenced in India in June 2000 after SEBI granted the finalapproval to this effect in May 2001. SEBI permitted the derivative segments of two stockexchanges, NSE and BSE, and their clearing house/corporation to commence trading andsettlement in approved derivatives contracts. To begin with, SEBI approved trading inindex futures contracts based on S&P CNX Nifty and BSE–30(Sensex) index. This wasfollowed by approval for trading in options based on these two indexes and options onindividual securities. The trading in BSE Sensex options commenced on June 4, 2001and the trading in options on individual securities commenced in July 2001. Futures contractson individual stocks were launched in November 2001. The derivatives trading on NSEcommenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in indexoptions commenced on June 4, 2001 and trading in options on individual securitiescommenced on July 2, 2001. Single stock futures were launched on Nov. 9, 2001. Theindex futures and options contract on NSE are based on S&P CNX Trading and settlementin derivative contracts is done in accordance with the rules, byelaws, and regulations of therespective exchanges and their clearing house/corporation duly approved by SEBI and


NOTES


notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade inall Exchange traded derivative products.

The following are some observations based on the trading statistics provided in theNSE report on the futures and options (F&O):

• Single-stock futures continue to account for a sizable proportion of the F&Osegment. It constituted 70 per cent of the total turnover during June 2002. Aprimary reason attributed to this phenomenon is that traders are comfortable withsingle-stock futures than equity options, as the former closely resembles the erstwhilebadla system.

• On relative terms, volumes in the index options segment continue to remain poor.This may be due to the low volatility of the spot index. Typically, options areconsidered more valuable when the volatility of the underlying (in this case, theindex) is high. A related issue is that brokers do not earn high commissions byrecommending index options to their clients, because low volatility leads to higherwaiting time for round-trips.

• Put volumes in the index options and equity options segment have increased sinceJanuary 2002. The call-put volumes in index options have decreased from 2.86 inJanuary 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that thetraders are increasingly becoming pessimistic on the market.

• Farther month futures contracts are still not actively traded. Trading in equity optionson most stocks for even the next month was non-existent.

Daily option price variations suggest that traders use the F&O segment as a less riskyalternative (read substitute) to generate profits from the stock price movements. The factthat the option premiums tail intra-day stock prices is evidence to this. Calls on Satyamfall, while puts rise when Satyam falls intra-day. If calls and puts are not looked as justsubstitutes for spot trading, the intra-day stock price variations should not have a one-to-one impact on the option premiums.

Commodity Derivatives Futures contracts in pepper, turmeric, gur (jaggery), hessian(jute fabric), jute sacking, castor seed, potato, coffee, cotton, and soybean and its derivativesare traded in 18 commodity exchanges located in various parts of the country. Futurestrading in other edible oils, oilseeds and oil cakes have been permitted. Trading in futuresin the new commodities, especially in edible oils, is expected to commence in the nearfuture. The sugar industry is exploring the merits of trading sugar futures contracts. Thepolicy initiatives and the modernisation programme include extensive training, structuring areliable clearinghouse, establishment of a system of warehouse receipts, and the thrusttowards the establishment of a national commodity exchange. The Government of Indiahas constituted a committee to explore and evaluate issues pertinent to the establishmentand funding of the proposed national commodity exchange for the nationwide trading ofcommodity futures contracts, and the other institutions and institutional processes such aswarehousing and clearinghouses. With commodity futures, delivery is best effected using


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warehouse receipts (which are like dematerialised securities). Warehousing functions haveenabled viable exchanges to augment their strengths in contract design and trading. Theviability of the national commodity exchange is predicated on the reliability of thewarehousing functions. The programme for establishing a system of warehouse receipts isin progress. The Coffee Futures Exchange India (COFEI) has operated a system ofwarehouse receipts since 1998 Exchange-traded vs. OTC (Over The Counter) derivativesmarkets The OTC derivatives markets have witnessed rather sharp growth over the lastfew years, which has accompanied the modernization of commercial and investment bankingand globalisation of financial activities. The recent developments in information technologyhave contributed to a great extent to these developments. While both exchange-tradedand OTC derivative contracts offer many benefits, the former have rigid structures comparedto the latter. It has been widely discussed that the highly leveraged institutions and theirOTC derivative positions were the main cause of turbulence in financial markets in 1998.These episodes of turbulence revealed the risks posed to market stability originating infeatures of OTC derivative instruments and markets. The OTC derivatives markets havethe following features compared to exchange-traded derivatives:
1. The management of counter-party (credit) risk is decentralized and located withinindividual institutions,

2. There are no formal centralized limits on individual positions, leverage, or margining,

3. There are no formal rules for risk and burden-sharing,

4. There are no formal rules or mechanisms for ensuring market stability and integrity,and for safeguarding the collective interests of market participants, and

5. The OTC contracts are generally not regulated by a regulatory authority and theexchange’s self-regulatory organization, although they are affected indirectly bynational legal systems, banking supervision and market surveillance.

2.1.3 Development of exchange-traded derivatives

Derivatives have probably been around for as long as people have been trading withone another. Forward contracting dates back at least to the 12th century, and May wellhave been around before then. Merchants entered into contracts with one another forfuture delivery of specified amount of commodities at specified price. A primary motivationfor pre-arranging a buyer or seller for a stock of commodities in early forward contractswas to lessen the possibility that large swings would inhibit marketing the commodity aftera harvest.

2.1.4 The need for a derivatives market

The derivatives market performs a number of economic functions:

• They help in transferring risks from risk adverse people to risk oriented people

• They help in the discovery of future as well as current prices


NOTES


• They catalyze entrepreneurial activity

• They increase the volume traded in markets because of participation of risk adversepeople in greater numbers

• They increase savings and investment in the long run

Summary

Derivatives are financial contracts whose values are derived from the value of anunderlying primary financial instrument, commodity or index, such as: interest rates, exchangerates, commodities, and equities

Derivatives markets have had a slow start in India. The first step towards introductionof derivatives trading in India was the promulgation of the Securities Laws (Amendments)Ordinance, 1995, which withdrew the prohibition on options in securities. The market forderivatives, however, did not take off, as there was no regulatory framework to governtrading of derivatives

Financial markets are, by nature, extremely volatile and hence the risk factor is animportant concern for financial agents. To reduce this risk, the concept of derivatives comesinto the picture. Derivatives are products whose values are derived from one or morebasic variables called bases. These bases can be underlying assets (for example forex,equity, etc), bases or reference rates. For example, wheat farmers may wish to sell theirharvest at a future date to eliminate the risk of a change in prices by that date. The transactionin this case would be the derivative, while the spot price of wheat would be the underlyingasset

Commodity Derivatives Futures contracts in pepper, turmeric, gur (jaggery), hessian(jute fabric), jute sacking, castor seed, potato, coffee, cotton, and soybean and its derivativesare traded in 18 commodity exchanges located in various parts of the country. Futurestrading in other edible oils, oilseeds and oil cakes have been permitted. Trading in futuresin the new commodities, especially in edible oils, is expected to commence in the nearfuture. The sugar industry is exploring the merits of trading sugar futures contracts. Thepolicy initiatives and the modernisation programme include extensive training, structuring areliable clearinghouse, establishment of a system of warehouse receipts, and the thrusttowards the establishment of a national commodity exchange.

Questions

• The derivatives market performs a number of economic functions”, Discuss

• What is the feature of OTC derivatives markets?

• Explain the development of Derivatives Market in India

• What are the factors generally attributed as the major driving force behind

• growth of financial derivatives in India?

• What do you understand by Swaps?


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CHAPTER – II
REGULATIONS OF FINANCIALDERIVATIVES IN INDIA

2.2.1 Introduction

The first step towards introduction of derivatives trading in India was the promulgationof the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition onoptions in securities. The market for derivatives, however, did not take off, as there was noregulatory framework to govern trading of derivatives. SEBI set up a 24–member committeeunder the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriateregulatory framework for derivatives trading in India. The committee submitted its reporton March 17, 1998 prescribing necessary pre–conditions for introduction of derivativestrading in India. The committee recommended that derivatives should be declared as‘securities’ so that regulatory framework applicable to trading of ‘securities’ could alsogovern trading of securities. SEBI also set up a group in June 1998 under the Chairmanshipof Prof.J.R.Varma, to recommend measures for risk containment in derivatives market inIndia. The report, which was submitted in October 1998, worked out the operationaldetails of margining system, methodology for charging initial margins, broker net worth,deposit requirement and real–time monitoring requirements. The Securities ContractRegulation Act (SCRA) was amended in December 1999 to include derivatives within theambit of ‘securities’ and the regulatory framework was developed for governing derivativestrading. The act also made it clear that derivatives shall be legal and valid only if suchcontracts are traded on a recognized stock exchange, thus precluding OTC derivatives.The government also rescinded in March 2000, the three–decade old notification, whichprohibited forward trading in securities.

2.2.2 Regulations by National Stock Exchange

2.2.2.1 Minimum Base Capital

A Clearing Member (CM) is required to meet with the Base Minimum Capital (BMC)requirements prescribed by NSCCL before activation. The CM has also to ensure thatBMC is maintained in accordance with the requirements of NSCCL at all points of time,after activation. Every CM is required to maintain BMC of Rs.50 lakhs with NSCCL inthe following manner:

1. Rs.25 lakhs in the form of cash.

2. Rs.25 lakhs in any one form or combination of the below forms:


NOTES


i. Cash

ii. Fixed Deposit Receipts (FDRs) issued by approved banks and deposited withapproved Custodians or NSCCL

iii. Bank Guarantee in favour of NSCCL from approved banks in the specified format.

iv. Approved securities in demat form deposited with approved Custodians.

In addition to the above MBC requirements, every CM is required to maintain BMCof Rs.10 lakhs, in respect of every trading member(TM) whose deals such CM undertakesto clear and settle, in the following manner:

1. Rs.2 lakhs in the form of cash.

2. Rs.8 lakhs in a one form or combination of the following:

• Cash

• Fixed Deposit Receipts (FDRs) issued by approved banks and depositedwith approved Custodians or NSCCL

• Bank Guarantee in favour of NSCCL from approved banks in the specified format.

• Approved securities in demat form deposited with approved Custodians.

Any failure on the part of a CM to meet with the BMC requirements at any point oftime, will be treated as a violation of the Rules, Bye-Laws and Regulations of NSCCL andwould attract disciplinary action inter-alia including, withdrawal of trading facility and/oreclearing facility, closing out of outstanding positions etc.

2.2.2.2 Additional Base Capital

Clearing members may provide additional margin/collateral deposit (additional basecapital) to NSCCL and/or may wish to retain deposits and/or such amounts which arereceivable from NSCCL, over and above their minimum deposit requirements, towardsinitial margin and/ or other obligations.

Clearing members may submit such deposits in any one form or combination of thefollowing forms:

• Cash

• Fixed Deposit Receipts (FDRs) issued by approved banks and deposited withapproved Custodians or NSCCL

• Bank Guarantee in favour of NSCCL from approved banks in the specified format.

• Approved securities in demat form deposited with approved custodians

2.2.2.3 Effective Deposits / Liquid Networth

Effective deposits

All collateral deposits made by CMs are segregated into cash component and non-cash component.


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For Additional Base Capital, cash component means cash, bank guarantee, fixeddeposit receipts, T-bills and dated government securities. Non-cash component shall meanall other forms of collateral deposits like deposit of approved demat securities.
At least 50% of the Effective Deposits should be in the form of cash.

2.2.2.4 Liquid Networth

Liquid Networth is computed by reducing the initial margin payable at any point intime from the effective deposits.

The Liquid Networth maintained by CMs at any point in time should not be less thanRs.50 lakhs (referred to as Minimum Liquid Net Worth).

2.2.2.5 Margins

NSCCL has developed a comprehensive risk containment mechanism for the Futures& Options segment. The most critical component of a risk containment mechanism forNSCCL is the online position monitoring and margining system. The actual margining andposition monitoring is done on-line, on an intra-day basis. NSCCL uses the SPAN(Standard Portfolio Analysis of Risk) system for the purpose of margining, which is aportfolio based system

2.2.2.6 Initial Margin

NSCCL collects initial margin up-front for all the open positions of a CM based onthe margins computed by NSCCL - SPAN. A CM is in turn required to collect the initialmargin from the TMs and his respective clients. Similarly, a TM should collect upfrontmargins from his clients.

Initial margin requirements are based on 99% value at risk over a one day time horizon.However, in the case of futures contracts (on index or individual securities), where it maynot be possible to collect mark to market settlement value, before the commencement oftrading on the next day, the initial margin may be computed over a two-day time horizon,applying the appropriate statistical formula. The methodology for computation of Value atRisk percentage is as per the recommendations of SEBI from time to time.

2.2.2.7 Initial margin requirement for a member

• For client positions - shall be netted at the level of individual client and grossedacross all clients, at the Trading/ Clearing Member level, without any setoffs betweenclients.

• For proprietary positions - shall be netted at Trading/ Clearing Member level withoutany setoffs between client and proprietary positions.

• For the purpose of SPAN Margin, various parameters are specified from time totime.


NOTES


In case a trading member wishes to take additional trading positions his CM is requiredto provide Additional Base Capital (ABC) to NSCCL. ABC can be provided by themembers in the form of Cash Bank Guarantee, Fixed Deposit Receipts and approvedsecurities.

2.2.2.8 Premium Margin

In addition to Initial Margin, Premium Margin would be charged to members. Thepremium margin is the client wise margin amount payable for the day and will be requiredto be paid by the buyer till the premium settlement is complete.

2.2.2.9 Assignment Margin

Assignment Margin is levied on a CM in addition to SPAN margin and PremiumMargin. It is required to be paid on assigned positions of CMs towards Interim and FinalExercise Settlement obligations for option contracts on individual securities, till suchobligations are fulfilled.

The margin is charged on the Net Exercise Settlement Value payable by a ClearingMember towards Interim and Final Exercise Settlement and is deductible from the effectivedeposits of the Clearing Member available towards margins. Assignment margin is releasedto the CMs for exercise settlement pay-in.

2.2.2.10 Margin Reports

The following margin reports are downloaded to members on a daily basis:

1. Margin Statement of Clearing Members : MG-09

2. Margin Statement of Trading Member/ Custodial Participant : MG-10

3. Margin Payable Statement of Clearing Member : MG-11

4. Detail Margin File of Clearing Members : MG - 12

5. Client Level Margin File of Trading Members : MG-13 Details of Margin Reports

2.2.2.11 NSCCL SPAN

The objective of SPAN is to identify overall risk in a portfolio of futures and optionscontracts for each member. The system treats futures and options contracts uniformly,while at the same time recognizing the unique exposures associated with options portfolioslike extremely deep out-of-the-money short positions, inter-month risk and inter-commodityrisk.

Because SPAN is used to determine performance bond requirements (marginrequirements), its overriding objective is to determine the largest loss that a portfolio mightreasonably be expected to suffer from one day to the next day.


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In standard pricing models, three factors most directly affect the value of an option ata given point in time:
1. Underlying market price

2. Volatility (variability) of underlying instrument

3. Time to expiration

As these factors change, so too will the value of futures and options maintained withina portfolio. SPAN constructs scenarios of probable changes in underlying prices andvolatilities in order to identify the largest loss a portfolio might suffer from one day to thenext. It then sets the margin requirement at a level sufficient to cover this one-day loss.

i. Mechanics of SPAN

ii. Risk Arrays

iii. Composite Delta

iv. Calendar spread or Intra – commodity or Inter – month Risk Charge

v. Short option Minimum Charge

vi. Net Buy Premium (only for option contracts)

vii. Computation of Initial Margin – Overall Portfolio Margin Requirement

viii. Black – Scholes Option Price calculation model.

2.2.2.12 Mechanics of SPAN

The complex calculations (e.g. the pricing of options) in SPAN are executed by theClearing Corporation. The results of these calculations are called Risk arrays. Risk arrays,and other necessary data inputs for margin calculation are then provided to members in afile called the SPAN Risk Parameter file. This file will be provided to members on a dailybasis.

Members can apply the data contained in the Risk parameter files, to their specificportfolios of futures and options contracts, to determine their SPAN margin requirements.

Hence members need not execute complex option pricing calculations, which wouldbe performed by NSCCL. SPAN has the ability to estimate risk for combined futures andoptions portfolios, and re-value the same under various scenarios of changing marketconditions.

2.2.2.13 Risk Arrays

The SPAN risk array represents how a specific derivative instrument (for example,an option on NIFTY index at a specific strike price) will gain or lose value, from thecurrent point in time to a specific point in time in the near future (typically it calculates riskover a one day period called the ‘look ahead time’), for a specific set of market conditionswhich may occur over this time duration.


NOTES


The specific set of market conditions evaluated, are called the risk scenarios, andthese are defined in terms of :

1. how much the price of the underlying instrument is expected to change over onetrading day, and

2. how much the volatility of that underlying price is expected to change over onetrading day.

The results of the calculation for each risk scenario – i.e. the amount by which thefutures and options contracts will gain or lose value over the look-ahead time under thatrisk scenario - is called the risk array value for that scenario. The set of risk array valuesfor each futures and options contract under the full set of risk scenarios, constitutes theRisk Array for that contract.

In the Risk Array, losses are represented as positive values, and gains as negativevalues. Risk array values are typically represented in the currency (Indian Rupees) in whichthe futures or options contract is denominated.

SPAN further uses a standardized definition of the risk scenarios, defined in terms of

i. the underlying price scan range or probable price change over a one day period,

ii. and the underlying price volatility scan range or probable volatility change of theunderlying over a one day period.

These two values are often simply referred to as the price scan range and the volatilityscan range. There are sixteen risk scenarios in the standard definition. These scenarios arelisted as under:

a. Underlying unchanged; volatility up

b. Underlying unchanged; volatility down

c. Underlying up by 1/3 of price scanning range; volatility up

d. Underlying up by 1/3 of price scanning range; volatility down

e. Underlying down by 1/3 of price scanning range; volatility up

f. Underlying down by 1/3 of price scanning range; volatility down

g. Underlying up by 2/3 of price scanning range; volatility up

h. Underlying up by 2/3 of price scanning range; volatility down

i. Underlying down by 2/3 of price scanning range; volatility up

j. Underlying down by 2/3 of price scanning range; volatility down

k. Underlying up by 3/3 of price scanning range; volatility up

l. Underlying up by 3/3 of price scanning range; volatility down

m. Underlying down by 3/3 of price scanning range; volatility up

n. Underlying down by 3/3 of price scanning range; volatility down


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o. Underlying up extreme move, double the price scanning range (cover 35% ofloss)
p. Underlying down extreme move, double the price scanning range (cover 35% ofloss)

SPAN uses the risk arrays to scan probable underlying market price changes andprobable volatility changes for all contracts in a portfolio, in order to determine value gainsand losses at the portfolio level. This is the single most important calculation executed bythe system.

As shown above in the sixteen standard risk scenarios, SPAN starts at the last underlyingmarket settlement price and scans up and down three even intervals of price changes(price scan range).

At each price scan point, the program also scans up and down a range of probablevolatility from the underlying market’s current volatility (volatility scan range). SPANcalculates the probable premium value at each price scan point for volatility up and volatilitydown scenario. It then compares this probable premium value to the theoretical premiumvalue (based on last closing value of the underlying) to determine profit or loss.

Deep-out-of-the-money short options positions pose a special risk identificationproblem. As they move towards expiration, they may not be significantly exposed to normalprice moves in the underlying. However, unusually large underlying price changes maycause these options to move into-the-money, thus creating large losses to the holders ofshort option positions. In order to account for this possibility, two of the standard riskscenarios in the Risk Array (sr. no. 15 and 16) reflect an extreme underlying price movement,currently defined as double the maximum price scan range for a given underlying. However,because price changes of these magnitudes are rare, the system only covers 35% of theresulting losses.

After SPAN has scanned the 16 different scenarios of underlying market price andvolatility changes, it selects the largest loss from among these 16 observations. This “largestreasonable loss” is the ‘Scanning Risk Charge’ for the portfolio - in other words, for allfutures and options contracts.

2.2.2.14 Composite Delta

SPAN uses delta information to form spreads between futures and options contracts.Delta values measure the manner in which a future’s or option’s value will change in relationto changes in the value of the underlying instrument. Futures deltas are always 1.0; optionsdeltas range from -1.0 to +1.0. Moreover, options deltas are dynamic: a change in value ofthe underlying instrument will affect not only the option’s price, but also its delta.


NOTES


In the interest of simplicity, SPAN employs only one delta value per contract, calledthe “Composite Delta.” It is the weighted average of the deltas associated with eachunderlying ‘price scan point’. The weights associated with each ‘price scan point’ arebased upon the probability of the associated price movement, with more likely price changesreceiving higher weights and less likely price changes receiving lower weights. Please notethat Composite Delta for an options contract is an estimate of the contract’s delta after thelookahead - in other words, after one trading day has passed.

2.2.2.15 Calendar Spread or Intra-commodity or Inter-month Risk Charge

As SPAN scans futures prices within a single underlying instrument, it assumes thatprice moves correlate perfectly across contract months. Since price moves across contractmonths do not generally exhibit perfect correlation, SPAN adds an Calendar Spread Charge(also called the Inter-month Spread Charge) to the Scanning Risk Charge associated witheach futures and options contract. To put it in a different way, the Calendar Spread Chargecovers the calendar (inter-month etc.) basis risk that may exist for portfolios containingfutures and options with different expirations.

For each futures and options contract, SPAN identifies the delta associated eachfutures and option position, for a contract month. It then forms spreads using these deltasacross contract months. For each spread formed, SPAN assesses a specific charge perspread which constitutes the Calendar Spread Charge.

The margin for calendar spread shall be calculated on the basis of delta of the portfolioin each month. Thus a portfolio consisting of a near month option with a delta of 100 anda far month option with a delta of –100 would bear a spread charge equivalent to thecalendar spread charge for a portfolio which is long 100 near month futures contract andshort 100 far month futures contract.

A calendar spread would be treated as a naked position in the far month contractthree trading days before the near month contract expires.

2.2.2.16 Short Option Minimum Charge

Short options positions in extremely deep-out-of-the-money strikes may appear tohave little or no risk across the entire scanning range. However, in the event that underlyingmarket conditions change sufficiently, these options may move into-the-money, therebygenerating large losses for the short positions in these options. To cover the risks associatedwith deep-out-of-the-money short options positions, SPAN assesses a minimum marginfor each short option position in the portfolio called the Short Option Minimum charge,which is set by the NSCCL. The Short Option Minimum charge serves as a minimumcharge towards margin requirements for each short position in an option contract.


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For example, suppose that the Short Option Minimum charge is Rs. 50 per shortposition. A portfolio containing 20 short options will have a margin requirement of at leastRs. 1,000, even if the scanning risk charge plus the inter month spread charge on theposition is only Rs. 500.
2.2.2.17 Net Buy Premium (only for option contracts)

In the above scenario only sell positions are margined and offsetting benefits for buypositions are given to the extent of long positions in the portfolio by computing the netoption value.

To cover the one day risk on long option positions (for which premium shall be payableon T+1 day), net buy premium to the extent of the net long options position value isdeducted from the Liquid Networth of the member on a real time basis. This would beapplicable only for trades done on a given day. The Net Buy Premium margin shall bereleased towards the Liquid Networth of the member on T+1 day after the completion ofpay-in towards premium settlement.

2.2.2.18 Computation of Initial Margin - Overall Portfolio Margin Requirement

The total margin requirements for a member for a portfolio of futures and optionscontract would be computed as follows:

i. SPAN will add up the Scanning Risk Charges and the Intracommodity SpreadCharges.

ii. SPAN will compares this figure (as per i above) to the Short Option Minimumcharge

iii. It will select the larger of the two values between (i) and (ii)

iv. Total SPAN Margin requirement is equal to SPAN Risk Requirement (as perabove), less the ‘net option value’, which is mark to market value of difference inlong option positions and short option positions.

v. Initial Margin requirement = Total SPAN Margin Requirement + Net Buy Premium

2.2.3 Black-Scholes Option Price calculation model

The options price for a Call, computed as per the following Black Scholes formula:

C = S * N (d1) - X * e- rt * N (d

2)

and the price for a Put is : P = X * e- rt * N (-d2) - S * N (-d

1)

where :

d1 = [ln (S / X) + (r + ó2 / 2) * t] / ó * sqrt(t)


NOTES


d2 = [ln (S / X) + (r - ó2 / 2) * t] / ó * sqrt(t)

= d1 - ó * sqrt(t)

C = price of a call option

P = price of a put option

S price of the underlying asset

X = Strike price of the option

r = rate of interest

t = time to expiration

ó = volatility of the underlying

N represents a standard normal distribution with mean =0 and standard deviation = 1

ln represents the natural logarithm of a number. Natural logarithms are based on theconstant e (2.71828182845904).

Rate of interest may be the relevant MIBOR rate or such other rate as may be specified.

SPAN is a registered trademark of the Chicago Mercantile Exchange, used hereinunder License. The Chicago Mercantile Exchange assumes no liability in connection withthe use of SPAN by any person or entity.

2.2.4 Payment of Margins

The initial margin is payable upfront by Clearing Members. Initial margins can be paidby members in the form of Cash, Guarantee, Fixed Deposit Receipts and approved securities

Non-fulfillment of either the whole or part of the margin obligations will be treated asa violation of the Rules, Bye-Laws and Regulations of NSCCL and will attract penalcharges at 0.7 percent per day of the amount not paid throughout the period of non-payment. In addition NSCCL may at its discretion and without any further notice to theclearing member, initiate other disciplinary action, inter-alia including, withdrawal of tradingfacilities and/ or clearing facility, close out of outstanding positions, imposing penalties,collecting appropriate deposits, invoking bank guarantees/ fixed deposit receipts, etc.

2.2.5 Violations

PRISM (Parallel Risk Management System) is the real-time position monitoring andrisk management system for the Futures and Options market segment at NSCCL. Therisk of each trading and clearing member is monitored on a real-time basis and alerts/disablement messages are generated if the member crosses the set limits.


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NOTES
• Initial Margin Violation
• Exposure Limit Violation

• Trading Memberwise Position Limit Violation

• Client Level Position Limit Violation

• Market Wide Position Limit Violation

• Violation arising out of misutilisation of trading member/constituent collaterals and/or deposits

• Violation of Exercised Positions

Clearing members, who have violated any requirement and / or limits, may submit awritten request to NSCCL to either reduce their open position or, bring in additional cashdeposit by way of cash or bank guarantee or FDR or securities.

A penalty of Rs. 5000/- is levied for each violation and is debited to the clearingaccount of clearing member on the next business day. In respect of violation on more thanone occasion on the same day, penalty in case of second and subsequent violation duringthe day will be increased by Rs.5000/- for each such instance. (For example in case ofsecond violation for the day the penalty leviable will be Rs.10000/-, Rs.15000 for thirdinstance and so on). The penalty is charged to the clearing member irrespective of whetherthe clearing member brings in margin deposits subsequently.

Where the penalty levied on a clearing member/ trading member relates to a violationof Client-wise Position Limit, the clearing member/ trading member may in turn, recoversuch amount of penalty from the concerned clients who committed the violation

2.2.6 Market Wide Position Limits for derivative contracts on underlying stocks

At the end of each day the Exchange shall test whether the market wide open interestfor any scrip exceeds 95% of the market wide position limit for that scrip. If so, theExchange shall take note of open position of all client/ TMs as at the end of that day in thatscrip, and from next day onwards the client/ TMs shall trade only to decrease their positionsthrough offsetting positions till the normal trading in the scrip is resumed.

The normal trading in the scrip shall be resumed only after the open outstandingposition comes down to 80% or below of the market wide position limit.

A facility is available on the trading system to display an alert once the open interest inthe futures and options contract in a security exceeds 60% of the market wide positionlimits specified for such security. Such alerts are presently displayed at time intervals of 10minutes.


NOTES


At the end of each day during which the ban on fresh positions is in force for anyscrip, when any member or client has increased his existing positions or has created a newposition in that scrip the client/ TMs shall be subject to a penalty of 1% of the value ofincreased position subject to a minimum of Rs.5000 and maximum of Rs.1, 00,000. Thepositions, for this purpose, will be valued at the underlying close price.

The penalty shall be recovered from the clearing member affiliated with such tradingmembers/clients on a T+1 day basis along with pay-in. The amount of penalty shall beinformed to the clearing member at the end of the day.

2.2.7 Price Scan Range

To compute worst scenario loss on a portfolio, the price scan range for option onindividual securities and futures on individual securities would also be linked to liquidity,measured in terms of impact cost for an order size of Rs 5 lakh calculated on the basis oforder book snapshots in the previous six months. Accordingly if the mean value of theimpact cost exceeds 1%, the price scanning range would be scaled up by square root ofthree. This would be in addition to the requirement on account of look ahead period asmay be applicable.

The mean impact cost as stipulated by SEBI is calculated on the 15th of each monthon a rolling basis considering the order book snap shots of previous six months. If themean impact cost of a security moves from less than or equal to 1% to more than 1%, theprice scan range in such underlying shall be scaled by square root of three and scaling shallbe dropped when the impact cost drops to 1% or less. Such changes shall be applicableon all existing open position from the third working day from the 15th of each month. Thedetail of impact cost on the list of underlyings on which derivative contracts are availableand the methodology of computation of the same are available at our website.

2.2.8 Position Limits

Clearing Members are subject to the following exposure / position limits in addition toinitial margins requirements

i. Exposure Limits

ii. Trading Member wise Position Limit

iii. Client Level Position Limit

iv. Market Wide Position Limits (for Derivative Contracts on Underlying Stocks)

v. Collateral limit for Trading Members


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NOTES
2.2.9 Scheme for FIIs and MFs trading in Exchange traded derivatives
2.2.9.1 Position Limits

The position limits for FII, Mutual Funds , FII sub-accounts & MF schemes shall beas under:

2.2.9.2 At the level of the FII and MF

i. FII & MF Position limits in Index options contracts:

FII and MF position limit in all index options contracts on a particular underlyingindex shall be Rs.500 crores or 15 % of the total open interest of the market in indexoptions, whichever is higher. This limit would be applicable on open positions in all optionscontracts on a particular underlying index.

ii. FII & MF Position limits in Index futures contracts:

FII and MF position limit in all index futures contracts on a particular underlying indexshall be Rs.500 crores or 15 % of the total open interest of the market in index futures,whichever is higher. This limit would be applicable on open positions in all futures contractson a particular underlying index.

In addition to the above, FIIs & MF’s shall take exposure in equity index derivativessubject to the following limits:

• Short positions in index derivatives (short futures, short calls and long puts) notexceeding (in notional value) the FII’s / MF’s holding of stocks.

• Long positions in index derivatives (long futures, long calls and short puts) notexceeding (in notional value) the FII’s / MF’s holding of cash, government securities,T-Bills and similar instruments.

In this regard, if the open positions of an FII / MF exceeds the limits as stated in itemno a or b, such surplus would be deemed to comprise of short and long positions in thesame proportion of the total open positions individually. Such short and long positions inexcess of the said limits shall be compared with the FII’s / MF’s holding in stocks, cash etcas stated above.

iii. Stock Futures & Options

• For stocks having applicable market-wise position limit (MWPL) of Rs. 500 croresor more, the combined futures and options position limit shall be 20% of applicableMWPL or Rs. 300 crores, whichever is lower and within which stock futuresposition cannot exceed 10% of applicable MWPL or Rs. 150 crores, whicheveris lower.


NOTES


• For stocks having applicable market-wise position limit (MWPL) less than Rs.500 crores, the combined futures and options position limit would be 20% ofapplicable MWPL and futures position cannot exceed 20% of applicable MWPLor Rs. 50 crore which ever is lower.

2.2.9. 3 At the level of the sub-account a) Index Futures & Options

A disclosure is requirement from any person or persons acting in concert who togetherown 15% or more of the open interest of all futures and options contracts on a particularunderlying index on the Exchange. A failure to do so shall be treated as a violation and shallattract appropriate penal and disciplinary action in accordance with the Rules, Bye-Lawsand Regulations of NSE/NSCCL.

b) Stock Futures & Options

The gross open position across all futures and options contracts on a particularunderlying security, of a sub-account of an FII, should not exceed the higher of :

i. 1% of the free float market capitalisation (in terms of number of shares) or

ii. 5% of the open interest in the derivative contracts on a particular underlying stock (interms of number of contracts). These position limits shall be applicable on the combinedposition in all futures and options contracts on an underlying security on the Exchange.

c) Procedures

The Clearing Corporation would monitor the FII position limits at the end of eachtrading day. For this purpose, the following procedure is prescribed:

FIIs intending to trade in the F&O segment of the Exchange shall be required tonotify the following details of the Clearing Member/s, who shall clear and settle their tradesin the F&O segment, to Clearing Corporation.

1. Name of FII

2. SEBI Registration Number

3. Name of sub-account/s of FII (if any)

4. Name of the Clearing Member/s.

A unique code will be allotted by Clearing Corporation to each such FII prior tocommencement of trading by them. This will be utilized by Clearing Corporation for thepurpose of monitoring position limits at the level of the FII. For e.g. If the name of FII issay XYZ and it has 2 sub accounts viz. scheme 1 and 2, the FII code allotted by NSCCLmay be “XYZ” (comprising 12 characters).

Each FII/ sub-account of the FII, as the case may be, intending to trade in the F&Osegment of the Exchange, shall further be required to obtain a unique Custodial Participant(CP) code allotted from the Clearing Corporation, through their Clearing Member. CP


DBA 1754

NOTES
code normally comprises of 12 alphanumeric characters. Clearing Corporation will allotCP codes to each such FII/ sub-account of the FII. he Clearing Member/s of the FII/ sub-account of the FII, are required to furnish the following details to Clearing Corporation, toobtain CP codes:
a) Name of FII

b) Unique code allotted to the FII by NSCCL (as detailed in 2 above)

c) Name of sub-account/s of FII

d) CP code/s allotted to the FII/ sub account/s of the FII, in the Capital Marketsegment of Clearing Corporation

Eg. In the example given in 2 above the CP codes allotted by NSCCL may beABCDEFGH0001 and ABCDEFGH0002.

FIIs/ sub accounts of FIIs which have been allotted a unique CP code by ClearingCorporation shall only be permitted to trade on the Exchange.

The FII/ sub-account of FII shall ensure that all orders placed by them on the Exchangecarry the relevant CP code allotted by Clearing Corporation as specified in point 3 above,in the relevant field in NEATFO.

Clearing Member/s of the FII shall submit the details of all the trades confirmed byFII to Clearing Corporation, by the end of each trading day, as per the mechanism specified.

Clearing Corporation will monitor the open positions of the FII/ sub-account of theFII for each underlying security and index on which futures and option contracts are tradedon the Exchange, against the position limits specified at the level of FII/ sub-accounts ofFII respectively, at the end of each trading day.

The cumulative FII position may be disclosed to the market on a T + 1 basis, beforethe commencement of trading on the next day.

In the event of an FII breaching the position limits on any underlying, ClearingCorporation will advise the Exchange to withdraw the facility granted to such FII to takeany fresh positions in any derivative contracts. Such FII will be required to reduce theiropen position in such underlying, in accordance with the mechanism provided by ClearingCorporation from time to time. The facility withdrawn may be reinstated upon duecompliance of the position limits.

It shall also be obligatory on FIIs to report any breach of position limits by them / theirsub-account/s, to Clearing Corporation and ensure that such sub-account/s does not takeany fresh positions in any derivative contracts in such underlying. The sub-account of FIIshall be required to reduce open position in such underlying, in accordance with themechanism specified by Clearing Corporation. Only upon due compliance of the positionlimits, the sub-accounts may permitted to take further positions.


NOTES


d) Computation of Position Limits

The position limits would be computed on a gross basis at the level of a FII and on anet basis at the level of sub-accounts and proprietary positions.

The open position for all derivative contracts would be valued as the open interestmultiplied with the closing price of the respective underlying in the cash market.

E) Client Margin Reporting

Clearing Members (CMs) and Trading Members (TMs) are required to collect upfrontinitial margins from all their Trading Members/ Constituents.

CMs are required to compulsorily report, on a daily basis, details in respect of suchmargin amount due and collected, from the TMs/ Constituents clearing and settling throughthem, with respect to the trades executed/ open positions of the TMs/ Constituents, whichthe CMs have paid to NSCCL, for the purpose of meeting margin requirements.

Similarly, TMs are required to report on a daily basis details in respect of such marginamount due and collected from the constituents clearing and settling through them, withrespect to the trades executed/ open positions of the constituents, which the trading membershave paid to the CMs, and on which the CMs have allowed initial margin limit to the TMs.

f) Due date for Margin Reporting

The cut off day upto which a member may report client margin details to NSCCL isreferred to as the sign off date. It shall be 2 working days after the trade day.

g) Non submission of Client Margin Reporting Files

A penalty of Rs.200/- is charged to the members for each day of wrong reporting/partial reporting or non reporting of client margin in the prescribed format as specifiedabove, beyond 2 working days from the trade day.

h) Short reporting of margins in Client Margin Reporting Files

The following penalty shall be levied in case of short reporting by trading/clearingmember per instance. The amount of penalty shall vary as per the percentage of shortreporting done by members as indicated below :


Percentage of short reporting (In terms of Value)

Penalty per instance

< 1% Nil

> 1% but less than or equal to 20% Reprimand Letter

>20 Rs. 1000 or 0.10% of the shortage amount whichever is higher subject to a maximum of Rs. 1,00,000/-

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NOTES
Summary
The first step towards introduction of derivatives trading in India was the promulgationof the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition onoptions in securities. The market for derivatives, however, did not take off, as there was noregulatory framework to govern trading of derivatives. SEBI set up a 24–member committeeunder the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriateregulatory framework for derivatives trading in India. The committee submitted its reporton March 17, 1998 prescribing necessary pre–conditions for introduction of derivativestrading in India.

Clearing members may provide additional margin/collateral deposit (additional basecapital) to NSCCL and/or may wish to retain deposits and/or such amounts which arereceivable from NSCCL, over and above their minimum deposit requirements, towardsinitial margin and/ or other obligations.

NSCCL has developed a comprehensive risk containment mechanism for the Futures& Options segment. The most critical component of a risk containment mechanism forNSCCL is the online position monitoring and margining system. The actual margining andposition monitoring is done on-line, on an intra-day basis. NSCCL uses the SPAN(Standard Portfolio Analysis of Risk) system for the purpose of margining, which is aportfolio based system

The objective of SPAN is to identify overall risk in a portfolio of futures and optionscontracts for each member. The system treats futures and options contracts uniformly,while at the same time recognizing the unique exposures associated with options portfolioslike extremely deep out-of-the-money short positions, inter-month risk and inter-commodityrisk.

Because SPAN is used to determine performance bond requirements (marginrequirements), its overriding objective is to determine the largest loss that a portfolio mightreasonably be expected to suffer from one day to the next day

PRISM (Parallel Risk Management System) is the real-time position monitoring andrisk management system for the Futures and Options market segment at NSCCL. Therisk of each trading and clearing member is monitored on a real-time basis and alerts/disablement messages are generated if the member crosses the set limits.

Questions

(a) Explain the NSE Regulation over Minimum Base Capital of Clearing Member

(b) What is the initial margin of Members for Derivative Trading?

(c) Explain the Mechanics of SPAN

(d) What is meant by Price Scan Range?

(e) What do you mean by Client Margin Reporting?

(f) How does the Clearing Corporation monitor the FII position limits at the end ofeach trading day?


NOTES


UNIT III

STRATEGIES

CHAPTER – IHEDGING STRATEGIES USING INDEX FUTURES

3.1.1 Introduction

If a company knows that it has to sell a particular asset at a particular time in thefuture, it can hedge by taking a short position, therefore locking in the price of delivery.This is called a short hedge. Similarly, a company that knows that it will need an asset in thefuture can take a long hedge, thus locking in the price of purchase. It is very important tonote that hedging does not necessarily improve the financial outcome, it just reduces theuncertainty. In practice, hedging is not perfect, the basis risk arises due to a number ofreasons:

• The asset being hedged might be different that the one underlying the futures contract,i.e. using a 30y T-bill to hedge a 10y T-note;

• The hedger might be uncertain about the exact time that the delivery has to takeplace, i.e. a new oil ring that is expected to start extracting next summer, withoutknowing exactly when; and

3.1.2 S&P CNX Nifty

S&P CNX Nifty is a well diversified 50 stock index accounting for 21 sectors of theeconomy. It is used for a variety of purposes such as benchmarking fund portfolios, indexbased derivatives and index funds.

S&P CNX Nifty is owned and managed by India Index Services and Products Ltd.(IISL), hich is a joint venture between NSE and CRISIL. IISL is India’s first specialisedcompany focused upon the index as a core product. IISL has a Marketing and licensingagreement with Standard & Poor’s (S&P), who are world leaders in index services.

The traded value for the last six months of all Nifty stocks is approximately 48.15%of the traded value of all stocks on the NSE

Nifty stocks represent about 59.32% of the total market capitalization as on June 30,2008.


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NOTES
Impact cost f the S&P CNX Nifty for a portfolio size of Rs.2 crore is 0.14%
S&P CNX Nifty is professionally maintained and is ideal for derivatives trading

3.1.3 Trading in Nifty

The National Stock Exchange of India Limited (NSE) commenced trading in derivativeswith index futures on June 12, 2000. The futures contracts on NSE are based on S&PCNX Nifty. The Exchange later introduced trading on index options based on Nifty onJune 4, 2001.

The turnover in the derivatives segment has shown considerable growth in the lastyear, with NSE turnover accounting for 60% of the total turnover in the year 2000-2001.Further details on index based derivatives are available under the Derivatives (F&O) sectionof the website.

3.1.4 S&P CNX Nifty Futures

A futures contract is a forward contract, which is traded on an Exchange. NSEcommenced trading in index futures on June 12, 2000. The index futures contracts arebased on the popular market benchmark S&P CNX Nifty index. (Selection criteria forindices)


3.1.4.1 Eligibility Criteria for selection of Securities and Indices

The eligibility of a stock / index for trading in Derivatives segment is based upon thecriteria laid down by SEBI through various circulars issued from time to time.

A) Eligibility criteria of stocks

The stock shall be chosen from amongst the top 500 stocks in terms of average dailymarket capitalisation and average daily traded value in the previous six months on a rollingbasis.

The stock’s median quarter-sigma order size over the last six months shall be not lessthan Rs. 0.10 million (Rs. 1 lac). For this purpose, a stock’s quarter-sigma order size shallmean the order size (in value terms) required to cause a change in the stock price equal toone-quarter of a standard deviation.

The market wide position limit in the stock shall not be less than Rs. 500 million (Rs.50 crores). The market wide position limit (number of shares) shall be valued taking theclosing prices of stocks in the underlying cash market on the date of expiry of contract in


NOTES


the month. The market wide position limit of open position (in terms of the number ofunderlying stock) on futures and option contracts on a particular underlying stock shall be20% of the number of shares held by non-promoters in the relevant underlying security i.e.free-float holding.

B) Continued Eligibility

For an existing stock to become ineligible, the criteria for market wide position limitshall be relaxed upto 10% of the criteria applicable for the stock to become eligible forderivatives trading. To be dropped out of Derivatives segment, the stock will have to failthe relaxed criteria for 3 consecutive months.

If an existing security fails to meet the eligibility criteria for three months consecutively,then no fresh month contract shall be issued on that security.

However, the existing unexpired contracts may be permitted to trade till expiry andnew strikes may also be introduced in the existing contract months.

C) Re-introduction of dropped stocks

A stock which is dropped from derivatives trading may become eligible once again.In such instances, the stock is required to fulfill the eligibility criteria for three consecutivemonths to be re-introduced for derivatives trading.

D) Eligibility criteria of Indices

Futures & Options contracts on an index can be introduced only if 80% of the indexconstituents are individually eligible for derivatives trading. However, no single ineligiblestock in the index shall have a weightage of more than 5% in the index. The index on whichfutures and options contracts are permitted shall be required to comply with the eligibilitycriteria on a continuous basis.

SEBI has subsequently modified the above criteria, vide its clarification issued to theExchange “The Exchange may consider introducing derivative contracts on an index if thestocks contributing to 80% weightage of the index are individually eligible for derivativetrading. However, no single ineligible stocks in the index shall have a weightage of morethan 5% in the index.”

The above criteria is applied every month, if the index fails to meet the eligibilitycriteria for three months consecutively, then no fresh month contract shall be issued on thatindex, However, the existing unexpired contacts shall be permitted to trade till expiry andnew strikes may also be introduced in the existing contracts.


DBA 1754

NOTES
3.1.4.2 The following procedure is adopted for calculating the Quarter Sigma Order Size
a) The applicable VAR (Value at Risk) is calculated for each security based on theJ.R. Varma Committee guidelines. (The formula suggested by J. R. Varma forcomputation of VAR for margin calculation is statistically known as ‘Exponentiallyweighted moving average (EWMA)’ method. In comparison to the traditionalmethod, EWMA has the advantage of giving more weight to the recent pricemovements and less weight to the historical price movements.)

b) Such computed VAR is a value (like 0.03), which is also called standard deviationor Sigma. (The meaning of this figure is that the security has the probability tomove 3% to the lower side or 3% to the upper side on the next trading day fromthe current closing price of the security).

c) Such arrived at standard deviation (one sigma), is multiplied by 0.25 to arrive atthe quarter sigma.

(For example, if one sigma is 0.09, then quarter sigma is 0.09 * 0.25 = 0.0225)

a) From the order snapshots (taken four times a day from NSE’s Capital MarketSegment order book) the average of best buy price and best sell price is computedwhich is called the average price.

b) The quarter sigma is then multiplied with the average price to arrive at quartersigma price. The following example explains the same :

a) Based on the order snapshot, the value of the order (order size in Rs.), which willmove the price of the security by quarter sigma price in buy and sell side is computed.The value of such order size is called Quarter Sigma order size. (Based on theabove example, it will be required to compute the value of the order (Rs.) to movethe stock price to Rs. 306.00 in the buy side and Rs. 307.40 on the sell side. Thatis Buy side = average price – quarter sigma price and Sell side = average price +quarter sigma price). Such an exercise is carried out for four order snapshots perday for all stocks for the previous six months period

b) From the above determined quarter sigma order size (Rs.) for each order booksnap shot for each security, the median of the order sizes (Rs.) for buy side and sellside separately, are computed for all the order snapshots taken together for thelast six months.

c) The average of the median order sizes for buy and sell side are taken as the medianquarter sigma order size for the security.

d) The securities whose median quarter sigma order size is equal to or greater thanRs. 0.1 million (Rs. 1 Lac) qualify for inclusion in the F&O segment.

Futures & Options contracts may be introduced on new securities which meet theabove mentioned eligibility criteria, subject to approval by SEBI.


NOTES


New securities being introduced in the F&O segment are based on the eligibilitycriteria which take into consideration average daily market capitalization, average dailytraded value, the market wide position limit in the security, the quarter sigma values and asapproved by SEBI. The average daily market capitalisation and the average daily tradedvalue would be computed on the 15th of each month, on a rolling basis, to arrive at the listof top 500 securities. Similarly, the quarter sigma order size in a stock would also becalculated on the 15th of each month, on a rolling basis, considering the order booksnapshots of securities in the previous six months and the market wide position limit (numberof shares) shall be valued taking the closing prices of stocks in the underlying cash marketon the date of expiry of contract in the month.

The number of eligible securities may vary from month to month depending upon thechanges in quarter sigma order sizes, average daily market capitalisation & average dailytraded value calculated every month on a rolling basis for the past six months and themarket wide position limit in that security. Consequently, the procedure for introducing anddropping securities on which option and future contracts are traded will be as stipulated bySEBI.

3.1.4.3 Selection criteria for mini derivative contracts:

Mini derivative contracts (Futures and options) shall be made available for trading onsuch indices/securities as specified by SEBI from time to time.

3.1.4.4 Eligibility criteria for long term option contracts

SEBI has specifically permitted introduction of option contracts with longer tenure onS&P CNX Nifty index.

3.1.4.5 Selection criteria for unlisted companies

For unlisted companies coming out with initial public offering, if the net public offer isRs. 500 crs. or more, then the Exchange may consider introducing stock options andstock futures on such stocks at the time of its’ listing in the cash market.

3.1.4.6 Contract Specifications

Security descriptor The security descriptor for the S&P CNX Nifty futures contractsis: Market type : N Instrument Type : FUTIDX Underlying : NIFTY Expiry date : Date ofcontract expiry Instrument type represents the instrument i.e. Futures on Index. Underlyingsymbol denotes the underlying index which is S&P CNX Nifty Expiry date identifies thedate of expiry of the contract

3.1.4.7 Underlying Instrument

The underlying index is S&P CNX NIFTY.


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NOTES
3.1.4.8 Trading cycle
S&P CNX Nifty futures contracts have a maximum of 3-month trading cycle - thenear month (one), the next month (two) and the far month (three). A new contract isintroduced on the trading day following the expiry of the near month contract. The newcontract will be introduced for a three month duration. This way, at any point in time, therewill be 3 contracts available for trading in the market i.e., one near month, one mid monthand one far month duration respectively.

3.1.4.9 Expiry day

S&P CNX Nifty futures contracts expire on the last Thursday of the expiry month. Ifthe last Thursday is a trading holiday, the contracts expire on the previous trading day.

3.1.4.10 Trading Parameters

a) Contract size

The value of the futures contracts on Nifty may not be less than Rs. 2 lakhs at the timeof introduction. The permitted lot size for futures contracts & options contracts shall be thesame for a given underlying or such lot size as may be stipulated by the Exchange from timeto time.

b) Price steps

The price step in respect of S&P CNX Nifty futures contracts is Re.0.05.

c) Base Prices

Base price of S&P CNX Nifty futures contracts on the first day of trading would betheoretical futures price. The base price of the contracts on subsequent trading days wouldbe the daily settlement price of the futures contracts.

d) Price bands

There are no day minimum/maximum price ranges applicable for S&P CNX Niftyfutures contracts. However, in order to prevent erroneous order entry by trading members,operating ranges are kept at +/- 10 %. In respect of orders which have come under pricefreeze, members would be required to confirm to the Exchange that there is no inadvertenterror in the order entry and that the order is genuine. On such confirmation the Exchangemay approve such order.

e) Quantity freeze

Orders which may come to the exchange as quantity freeze shall be such that have aquantity of more than 15000. In respect of orders which have come under quantity freeze,members would be required to confirm to the Exchange that there is no inadvertent error


NOTES


in the order entry and that the order is genuine. On such confirmation, the Exchange mayapprove such order. However, in exceptional cases, the Exchange may, at its discretion,not allow the orders that have come under quantity freeze for execution for any reasonwhatsoever including non-availability of turnover / exposure limit. In all other cases, quantityfreeze orders shall be cancelled by the Exchange.

f) Order type/Order book/Order attribute

• Regular lot order

• Stop loss order


• Spread order

3.1.5 CNX Nifty Junior Futures

A futures contract is a forward contract, which is traded on an Exchange. JUNIORfutures contracts would be based on the CNX Nifty Junior index. (Selection criteria forindices)


3.1.5.1 Security descriptor

The security descriptor for the CNX Nifty Junior futures contracts is: Market type :N Instrument Type : FUTIDX Underlying : JUNIOR Expiry date : Date of contract expiryInstrument type represents the instrument i.e. Futures on Index. Underlying symbol denotesthe underlying index which is CNX Nifty Junior Expiry date identifies the date of expiry ofthe contract


The underlying index is CNX NIFTY JUNIOR


JUNIOR futures contracts have a maximum of 3-month trading cycle - the nearmonth (one), the next month (two) and the far month (three). A new contract is introducedon the trading day following the expiry of the near month contract. The new contract willbe introduced for a three month duration. This way, at any point in time, there will be 3contracts available for trading in the market i.e., one near month, one mid month and onefar month duration respectively.


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NOTES
3.1.5.4 Expiry day
JUNIOR futures contracts expire on the last Thursday of the expiry month. If the lastThursday is a trading holiday, the contracts expire on the previous trading day.


a) Contract size

The value of the futures contracts on JUNIOR may not be less than Rs. 2 lakhs at thetime of introduction. The permitted lot size for futures contracts & options contracts shallbe the same for a given underlying or such lot size as may be stipulated by the Exchangefrom time to time.

b) Price steps

The price step in respect of JUNIOR futures contracts is Re.0.05.

c) Base Prices

Base price of JUNIOR futures contracts on the first day of trading would be theoreticalfutures price.. The base price of the contracts on subsequent trading days would be thedaily settlement price of the futures contracts.

d) Price bands

Quantity freeze

Orders which may come to the exchange as quantity freeze shall be such that have aquantity of more than 15000. In respect of orders which have come under quantity freeze,members would be required to confirm to the Exchange that there is no inadvertent errorin the order entry and that the order is genuine. On such confirmation, the Exchange mayapprove such order. However, in exceptional cases, the Exchange may, at its discretion,not allow the orders that have come under quantity freeze for execution for any reasonwhatsoever including non-availability of turnover / exposure limit. In all other cases, quantityfreeze orders shall be cancelled by the Exchange.

e) Order type/Order book/Order attribute


• Stop loss order


• Spread order


NOTES


3.1.6 Cnxit Futures

A futures contract is a forward contract, which is traded on an Exchange. CNX ITFutures Contract would be based on the index CNX IT index. (Selection criteria forindices)


• Contract Specifications

• Trading Parameters


The security descriptor for the CNX IT futures contracts is: Market type : N InstrumentType : FUTIDX Underlying : CNXIT Expiry date : Date of contract xpiry Instrument typerepresents the instrument i.e. Futures on Index. Underlying ymbol denotes the underlyingindex which is CNXIT Expiry date identifies the ate of expiry of the contract


The underlying index is CNX IT.


CNX IT futures contracts have a maximum of 3-month trading cycle - the near month(one), the next month (two) and the far month (three). A new contract is introduced on thetrading day following the expiry of the near month contract. The new contract will beintroduced for a three month duration. This way, at any point in time, there will be 3contracts available for trading in the market i.e., one near month, one mid month and onefar month duration respectively.

3.1.6.4 Expiry day

CNX IT futures contracts expire on the last Thursday of the expiry month. If the lastThursday is a trading holiday, the contracts expire on the previous trading day.


a) Contract size

The value of the futures contracts on CNXIT may not be less than Rs. 2 lakhs at thetime of introduction. The permitted lot size for futures contracts & options contracts shallbe the same for a given underlying or such lot size as may be stipulated by the Exchangefrom time to time.


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b) Price steps
The price step in respect of CNX IT futures contracts is Re.0.05.

c) Base Prices

Base price of CNX IT futures Contracts on the first day of trading would be theoreticalfutures price.. The base price of the contracts on subsequent trading days would be thedaily settlement price of the futures contracts.

d) Price bands

There are no day minimum/maximum price ranges applicable for CNX IT futurescontracts. However, in order to prevent erroneous order entry by trading members,operating ranges are kept at +/- 10 %. In respect of orders which have come under pricefreeze, members would be required to confirm to the Exchange that there is no inadvertenterror in the order entry and that the order is genuine. On such confirmation the Exchangemay approve such order.

e) Quantity freeze




• Stop loss order


• Spread order

3.1.7 CNX 100 Futures

A futures contract is a forward contract, which is traded on an Exchange. CNX100futures contracts would be based on the CNX 100 index. (Selection criteria for indices)



NOTES





The security descriptor for the CNX 100 futures contracts is: Market type : NInstrument Type : FUTIDX Underlying : CNX100 Expiry date : Date of contract expiryInstrument type represents the instrument i.e. Futures on Index. Underlying symbol denotesthe underlying index which is CNX 100 Expiry date identifies the date of expiry of thecontract


The underlying index is CNX 100


CNX100 futures contracts have a maximum of 3-month trading cycle - the nearmonth (one), the next month (two) and the far month (three). A new contract is introducedon the trading day following the expiry of the near month contract. The new contract willbe introduced for a three month duration. This way, at any point in time, there will be 3contracts available for trading in the market i.e., one near month, one mid month and onefar month duration respectively.

3.1.7.4 Expiry day

CNX100 futures contracts expire on the last Thursday of the expiry month. If the lastThursday is a trading holiday, the contracts expire on the previous trading day.


a) Contract size

The value of the futures contracts on CNX100 may not be less than Rs. 2 lakhs at thetime of introduction. The permitted lot size for futures contracts & options contracts shallbe the same for a given underlying or such lot size as may be stipulated by the Exchangefrom time to time.

b) Price steps

The price step in respect of CNX100 futures contracts is Re.0.05.

c) Base Prices

Base price of CNX100 futures contracts on the first day of trading would be theoreticalfutures price.. The base price of the contracts on subsequent trading days would be thedaily settlement price of the futures contracts.


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d) Price bands
Quantity freeze


Order type/Order book/Order attribute


• Stop loss order


• Spread order

3.1.8 BANK Nifty Futures

A futures contract is a forward contract, which is traded on an Exchange. BANKNifty futures Contract would be based on the index CNX Bank index. (Selection criteriafor indices)

NSE defines the characteristics of the futures contract such as the underlying index, marketlot, and the maturity date of the contract. The futures contracts are available for tradingfrom introduction to the expiry date.




The security descriptor for the BANK Nifty futures contracts is:

Market type : N

Instrument Type : FUTIDX

Underlying : BANKNIFTY


Instrument type represents the instrument i.e. Futures on Index.

Underlying symbol denotes the underlying index which is BANK Nifty.

Expiry date identifies the date of expiry of the contract


NOTES



The underlying index is BANK NIFTY.


BANKNIFTY futures contracts have a maximum of 3-month trading cycle - the nearmonth (one), the next month (two) and the far month (three). A new contract is introducedon the trading day following the expiry of the near month contract. The new contract willbe introduced for three month duration. This way, at any point in time, there will be 3contracts available for trading in the market i.e., one near month, one mid month and onefar month duration respectively.

3.1.8.4 Expiry day

BANKNIFTY futures contracts expire on the last Thursday of the expiry month. Ifthe last Thursday is a trading holiday, the contracts expire on the previous trading day.


a) Contract size

The value of the futures contracts on BANKNIFTY may not be less than Rs. 2 lakhsat the time of introduction. The permitted lot size for futures contracts & options contractsshall be the same for a given underlying or such lot size as may be stipulated by the Exchangefrom time to time.

b) Price steps

The price step in respect of BANKNIFTY futures contracts is Re.0.05.

c) Base Prices

Base price of BANKNIFTY futures Contracts on the first day of trading would betheoretical futures price.. The base price of the contracts on subsequent trading days wouldbe the daily settlement price of the futures contracts.

d) Price bands

There are no day minimum/maximum price ranges applicable for BANKNIFTY futurescontracts. However, in order to prevent erroneous order entry by trading members,operating ranges are kept at +/- 10 %. In respect of orders which have come under pricefreeze, members would be required to confirm to the Exchange that there is no inadvertenterror in the order entry and that the order is genuine. On such confirmation the Exchangemay approve such order.


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e) Quantity freeze



• Stop loss order


• Spread order

3.1.9 Nifty Midcap 50 Futures

A futures contract is a forward contract, which is traded on an Exchange.NFTYMCAP50 futures contracts would be based on the Nifty Midcap 50 index.(Selectioncriteria for indices)





The security descriptor for the Nifty Midcap 50 futures contracts is:

Market type : N

Instrument Type : FUTIDX

Underlying : NFTYMCAP50



Underlying symbol denotes the underlying index which is Nifty Midcap 50



NOTES



The underlying index is NIFTY MIDCAP 50.


NFTYMCAP50 futures contracts have a maximum of 3-month trading cycle - thenear month (one), the next month (two) and the far month (three). A new contract isintroduced on the trading day following the expiry of the near month contract. The newcontract will be introduced for a three month duration. This way, at any point in time, therewill be 3 contracts available for trading in the market i.e., one near month, one mid monthand one far month duration respectively.

3.1.9.4 Expiry day

NFTYMCAP50 futures contracts expire on the last Thursday of the expiry month. Ifthe last Thursday is a trading holiday, the contracts expire on the previous trading day.


a) Contract size

The value of the futures contracts on NFTYMCAP50 may not be less than Rs. 2lakhs at the time of introduction. The permitted lot size for futures contracts & optionscontracts shall be the same for a given underlying or such lot size as may be stipulated bythe Exchange from time to time.

b) Price steps

The price step in respect of NFTYMCAP50 futures contracts is Re.0.05.

c) Base Prices

Base price of NFTYMCAP50 futures contracts on the first day of trading would betheoretical futures price. The base price of the contracts on subsequent trading days wouldbe the daily settlement price of the futures contracts.

d) Price bands

e) Quantity freeze

Orders which may come to the exchange as quantity freeze shall be such that have aquantity of more than 15000. In respect of orders which have come under quantity freeze,members would be required to confirm to the Exchange that there is no inadvertent errorin the order entry and that the order is genuine. On such confirmation, the Exchange mayapprove such order. However, in exceptional cases, the Exchange may, at its discretion,not allow the orders that have come under quantity freeze for execution for any reason


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whatsoever including non-availability of turnover / exposure limit. In all other cases, quantityfreeze orders shall be cancelled by the Exchange.


• Stop loss order


• Spread order

3.1.10 Futures on Individual Securities

A futures contract is a forward contract, which is traded on an Exchange. NSEcommenced trading in futures on individual securities on November 9, 2001. The futurescontracts are available on 267 securities stipulated by the Securities & Exchange Board ofIndia (SEBI). (Selection criteria for securities)

NSE defines the characteristics of the futures contract such as the underlying security,market lot, and the maturity date of the contract. The futures contracts are available fortrading from introduction to the expiry date.




The security descriptor for the futures contracts is:

Market type : N

Instrument Type : FUTSTK

Underlying : Symbol of underlying security



Underlying symbol denotes the underlying security in the Capital Market (equities) segmentof the Exchange



Futures contracts are available on 267 securities stipulated by the Securities &Exchange Board of India (SEBI). These securities are traded in the Capital Market segmentof the Exchange.


NOTES



Futures contracts have a maximum of 3-month trading cycle - the near month (one),the next month (two) and the far month (three). New contracts are introduced on thetrading day following the expiry of the near month contracts. The new contracts areintroduced for a three month duration. This way, at any point in time, there will be 3contracts available for trading in the market (for each security) i.e., one near month, onemid month and one far month duration respectively.

3.1.10.4 Expiry day

Futures contracts expire on the last Thursday of the expiry month. If the last Thursdayis a trading holiday, the contracts expire on the previous trading day.


a) Contract size

The value of the futures contracts on individual securities may not be less than Rs. 2lakhs at the time of introduction for the first time at any exchange. The permitted lot size forfutures contracts & options contracts shall be the same for a given underlying or such lotsize as may be stipulated by the Exchange from time to time.

b) Price steps

The price step in respect of futures contracts is Re.0.05.

c) Base Prices

Base price of futures contracts on the first day of trading (i.e. on introduction) wouldbe the theoretical futures price. The base price of the contracts on subsequent trading dayswould be the daily settlement price of the futures contracts.

d) Price bands

There are no day minimum/maximum price ranges applicable for futures contracts.However, in order to prevent erroneous order entry by trading members, operating rangesare kept at +/- 20 %. In respect of orders which have come under price freeze, memberswould be required to confirm to the Exchange that there is no inadvertent error in the orderentry and that the order is genuine. On such confirmation the Exchange may approve suchorder.

e) Quantity freeze

Orders which may come to the exchange as a quantity freeze shall be based on thenotional value of the contract of around Rs.5 crores. Quantity freeze is calculated for eachunderlying on the last trading day of each calendar month and is applicable through the


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next calendar month. In respect of orders which have come under quantity freeze, memberswould be required to confirm to the Exchange that there is no inadvertent error in the orderentry and that the order is genuine. On such confirmation, the Exchange may approve suchorder. However, in exceptional cases, the Exchange may, at its discretion, not allow theorders that have come under quantity freeze for execution for any reason whatsoeverincluding non-availability of turnover / exposure limits.


• Stop loss order


• Spread order

Summary

If a company knows that it has to sell a particular asset at a particular time in thefuture, it can hedge by taking a short position, therefore locking in the price of delivery.This is called a short hedge. Similarly, a company that knows that it will need an asset in thefuture can take a long hedge, thus locking in the price of purchase. It is very important tonote that hedging does not necessarily improve the financial outcome, it just reduces theuncertainty

S&P CNX Nifty is a well diversified 50 stock index accounting for 21 sectors of theeconomy. It is used for a variety of purposes such as benchmarking fund portfolios, indexbased derivatives and index funds.

A futures contract is a forward contract, which is traded on an Exchange. NSEcommenced trading in index futures on June 12, 2000. The index futures contracts arebased on the popular market benchmark S&P CNX Nifty index. (Selection criteria forindices)

The stock shall be chosen from amongst the top 500 stocks in terms of average dailymarket capitalisation and average daily traded value in the previous six months on a rollingbasis.

The stock’s median quarter-sigma order size over the last six months shall be not lessthan Rs. 0.10 million (Rs. 1 lac). For this purpose, a stock’s quarter-sigma order size shallmean the order size (in value terms) required to cause a change in the stock price equal toone-quarter of a standard deviation.

A futures contract is a forward contract, which is traded on an Exchange. JUNIORfutures contracts would be based on the CNX Nifty Junior index. (Selection criteria forindices)


NOTES



Questions

1. Explain the eligibility criteria for selection of securities and Indices for Futures?

2. Explain the CNX Nifty Junior Futures

3. What do you understand about Nifty Midcap 50 Futures?

4. What are the Trading Parameters for FUTIDX?

5. What are the Contract Specifications for NIFTY MIDCAP 50?


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CHAPTER II
INTEREST RATE FUTURES

3.2.1 Introduction

Interest Rate Futures Contracts are contracts based on the list of underlying as maybe specified by the Exchange and approved by SEBI from time to time. To begin with,interest rate futures contracts on the following underlyings shall be available for trading onthe F&O Segment of the Exchange :

• Notional T – Bills

• Notional 10 year bonds (coupon bearing and non-coupon bearing)

The list of securities on which Futures Contracts would be available and their symbolsfor trading are as under :

3.2.2 Security Descriptor

The security descriptor for the interest rate future contracts is:

Market type : N

Instrument Type : FUTINT

Underlying : Notional T- bills and Notional 10 year bond (coupon bearing and non-couponbearing)

Expiry Date : Last Thursday of the Expiry month.

Instrument type represents the instrument i.e. Interest Rate Future Contract.

Underlying symbol denotes the underlying.


3.2.3 Underlying Instrument

Interest rate futures contracts are available on Notional T- bills , Notional 10 yearzero coupon bond and Notional 10 year coupon bearing bond stipulated by the Securities& Exchange Board of India (SEBI).

S.No Symbol Description

1 NSETB91D Futures contract on National 91 days T bill

2 NSE10Y06 Futures contract on Notional 10 year coupon bearing bond

3 NSE10YZC Futures contract on Notional 10 year zero coupon bond


NOTES


3.2.4 Trading cycle

The interest rate future contract shall be for a period of maturity of one year with threemonths continuous contracts for the first three months and fixed quarterly contracts for theentire year. New contracts will be introduced on the trading day following the expiry of thenear month contract.

3.2.5 Expiry day

Interest rate future contracts shall expire on the last Thursday of the expiry month. Ifthe last Thursday is a trading holiday, the contracts shall expire on the previous trading day.

Further, where the last Thursday falls on the annual or half-yearly closing dates of thebank, the expiry and last trading day in respect of these derivatives contracts would bepre-poned to the previous trading day.

3.2.6 Product Characteristics

3.2.7 Trading Parameters3.2.7.1 Contract size

The permitted lot size for the interest rate futures contracts shall be 2000. The minimumvalue of a interest rate futures contract would be Rs. 2 lakhs at the time of introduction.

3.2.7.2 Price steps

The price steps in respect of all interest rate future contracts admitted to dealings onthe Exchange is Re.0.01.

Contract underlying

Notional 10 year bond (6 % coupon )

Notional 10 year zero coupon bond

Notional 91 day T-Bill

Contract descriptor

N FUTINT NSE10Y06 26JUN2003

N FUTINT NSE10YZC 26JUN2003

N FUTINT NSETB91D 26JUN2003

Contract Value

Rs.2,00,000

Lot size 2000 Tick size Re.0.01 Expiry date

Last Thursday of the month

Contract months

The contracts shall be for a period of a maturity of one year with three months continuous contracts for the first three months and fixed quarterly contracts for the entire year.

Price limits

Not applicable

Settlement Price

As may be stipulated by NSCCL in this regard from time to time.


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The Futures contracts having face value of Rs 100 on notional ten year coupon bearingbond and notional ten year zero coupon bond would be based on price quotation andFutures contracts having face value of Rs. 100 on notional 91 days treasury bill would bebased on Rs. 100 minus (-) yield.
3.2.7.3 Base Price & operating ranges

Base price of the Interest rate future contracts on introduction of new contracts shallbe theoretical futures price computed based on previous days’ closing price of the notionalunderlying security. The base price of the contracts on subsequent trading days will be theclosing price of the futures contracts. However, on such of those days when the contractswere not traded, the base price will be the daily settlement price of futures contracts.

There will be no day minimum/maximum price ranges applicable for the futurescontracts. However, in order to prevent / take care of erroneous order entry, the operatingranges for interest rate future contracts shall be kept at +/- 2% of the base price. In respectof orders which have come under price freeze, the members would be required to confirmto the Exchange that the order is genuine. On such confirmation, the Exchange at its discretionmay approve such order. If such a confirmation is not given by any member, such ordershall not be processed and as such shall lapse.

3.2.7.4 Quantity freeze

Orders which may come to the Exchange as a quantity freeze shall be 2500 contractsamounting to 50,00,000 which works out on the day of introduction to approximately Rs50 crores.

In respect of such orders which have come under quantity freeze, the member shallbe required to confirm to the Exchange that the order is genuine. On such confirmation, theExchange at its discretion may approve such order subject to availability of turnover/exposure limits, etc. If such a confirmation is not given by any member, such order shall notbe processed and as such shall lapse.

3.2.7.5 Order type/Order book/Order attribute


• Stop loss order


• Good till day

• Good till cancelled*

• Good till date

• Spread order


• 2L and 3L orders

NOTES


* Good till cancelled (GTC) orders shall be cancelled at the end of the period of 7calendar days from the date of entering an order.

3.2.8 Clearing and Settlement

3.2.8.1 Settlement Procedure & Settlement Price

Daily Mark to Market Settlement and Final settlement for Interest Rate FuturesContract

• Daily Mark to Market settlement and Final Mark to Market settlement in respectof admitted deals in Interest Rate Futures Contracts shall be cash settled by debiting/crediting of the clearing accounts of Clearing Members with the respective ClearingBank.

• All positions (brought forward, created during the day, closed out during the day)of a F&O Clearing Member in Futures Contracts, at the close of trading hours ona day, shall be marked to market at the Daily Settlement Price (for Daily Mark toMarket Settlement) and settled.

• All positions (brought forward, created during the day, closed out during the day)of a F&O Clearing Member in Futures Contracts, at the close of trading hours onthe last trading day, shall be marked to market at Final Settlement Price (for FinalSettlement) and settled.

• Daily Settlement Price shall be the closing price of the relevant Futures contractfor the Trading day.

• Final settlement price for an Interest rate Futures Contract shall be based on thevalue of the notional bond determined using the zero coupon yield curve computedby National Stock Exchange or by any other agency as may be nominated in thisregard.

• Open positions in a Futures contract shall cease to exist after its expiration day.

3.2.8.2 Daily Settlement Price

Daily settlement price for an Interest Rate Futures Contract shall be the closing priceof such Interest Rate Futures Contract on the trading day. The closing price for an interestrate futures contract shall be calculated on the basis of the last half an hour weightedaverage price of such interest rate futures contract. In absence of trading in the last half anhour, the theoretical price would be taken or such other price as may be decided by therelevant authority from time to time. Theoretical daily settlement price for unexpiredfutures contracts, shall be the futures prices computed using the (price of the notionalbond) spot prices arrived at from the applicable ZCYC Curve. The ZCYC shall be computedby the Exchange or by any other agency as may be nominated in this regard from theprices of Government securities traded on the Exchange or reported on the NegotiatedDealing System of RBI or both taking trades of same day settlement(i.e. t = 0).


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In respect of zero coupon notional bond, the price of the bond shall be the presentvalue of the principal payment discounted using discrete discounting for the specified periodat the respective zero coupon yield. In respect of the notional T-bill, the settlement priceshall be 100 minus the annualized yield for the specified period computed using the zerocoupon yield curve. In respect of coupon bearing notional bond, the present value shall beobtained as the sum of present value of the principal payment discounted at the relevantzero coupon yield and the present values of the coupons obtained by discounting eachnotional coupon payment at the relevant zero coupon yield for that maturity. For this purposethe notional coupon payment date shall be half yearly and commencing from the date ofexpiry of the relevant futures contract.
For computation of futures prices from the price of the notional bond (spot prices)thus arrived, the rate of interest may be the relevant MIBOR rate or such other rate as maybe specified from time to time.

3.2.8.3 Final Settlement Price for mark to market settlement of interest rate futurescontracts

Final settlement price for an Interest rate Futures Contract on zero coupon notionalbond and coupon bearing bond shall be based on the price of the notional bond determinedusing the zero coupon yield curve computed as explained above. In respect of notional T-bill it shall be 100 minus the annualised yield for the specified period computed using thezero coupon yield curve.

3.2.8.4 Settlement value in respect of notional T-bill

Since the T-bills are priced at 100 minus the relevant annualised yield, the settlementvalue shall be arrived at using the relevant multiplier factor. Currently it shall be 91/365

3.2.8.5 Settlement Schedule


NOTES


3.2.9 Interest Rate Derivatives - Risk Containment

3.2.9.1 Margins

• Initial Margins

• Computation of Initial Margin

• Exposure Limits (2nd line of defense)

• Trading Member wise/ Custodial Participant wise Position Limit

3.2.9.2 Initial Margins

Initial margin shall be payable on all open positions of Clearing Members, upto clientlevel, at any point of time, and shall be payable upfront by Clearing Members in accordancewith the margin computation mechanism and/ or system as may be adopted by ClearingCorporation from time to time. Presently, the initial margins would be based on the zerocoupon yield curve computed at the end of the day as explained above with trades of sameday settlement (t =0). However, in case of large deviation between the yields generatedusing only t = 0 trades and all trades, initial margins revised accordingly may be computedand collected by the Clearing corporation from the members at its discretion.

Initial Margin shall include SPAN margins and such other additional margins, thatmay be specified by Clearing Corporation from time to time.

3.2.9.3 Computation of Initial Margin

Clearing Corporation will adopt SPAN (Standard Portfolio Analysis of Risk) system orany other system for the purpose of real time initial margin computation.

Initial margin requirements shall be based on 99% value at risk over a one day timehorizon. Provided, however, in the case of futures contracts, where it may not be possibleto collect mark to market settlement value, before the commencement of trading on thenext day, the initial margin may be computed over a two day time horizon, applying theappropriate statistical formula.

The methodology for computation of Value at Risk percentage will be as per therecommendations of SEBI from time to time.

3.2.9.4 Initial margin requirement for a member:

a) For client positions - shall be netted at the level of individual client and grossedacross all clients, at the Trading/ Clearing Member level, without any setoffs betweenclients.

b) For proprietary positions - shall be netted at Trading/ Clearing Member level withoutany set offs between client and proprietary positions.


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For this purpose, various parameters shall be as specified hereunder or such otherparameters as may be specified by the relevant authority from time to time:
(a) Price scan range

In the case of Notional Bond Futures, the price scan range shall be 3.5 StandardDeviation (3.5 sigma) and in no case the initial margin shall be less than 2% of the notionalvalue of the Futures Contracts, which shall be scaled up by look ahead period as may bespecified from time to time. For Notional T-Bill Futures, the price scan range shall be 3.5Standard Deviation (3.5 sigma) and in no case the initial margin shall be less than 0.2% ofthe notional value of the futures contract, which shall be scaled up by look ahead period asmay be specified from time to time.

(b) Calendar Spread Charge

The margin on calendar spread shall be calculated at a flat rate of 0.125% per monthof spread on the far month contract subject to a minimum margin of 0.25% and a maximummargin of 0.75% on the far side of the spread with legs upto 1 year apart.

A Calendar spread positions will be treated as non-spread (naked) positions in thefar month contract, 3 trading days prior to expiration of the near month contract.

3.2.9.5 Exposure Limits (2nd line of defense)

Clearing Members shall be subject to Exposure limits in addition to initial margins.Exposure Limit shall be 100 times the liquid net worth i.e. 1% of the notional value of thegross open positions in Notional 10 year bond futures (both coupon bearing and zero


coupons) and shall be 1000 times the liquid net worth i.e. 0.1% of the gross open positionsin notional 91 day T-Bill futures.

Exposure limit for calendar spreads: the Calendar spread shall be regarded as anopen position of one third of the mark to market value of the far month contract. As thenear month contract approaches expiry, the spread shall be treated as a naked position inthe far month contract three days prior to the expiry of the near month contract

3.2.9.6 Trading Member wise/ Custodial Participant wise Position Limit

Each Trading Member/ Custodial Participant shall ensure that his clients do not exceedthe specified position limit. The position limits shall be at the client level and for near monthcontracts and shall be 15% of the open interest or Rs. 100 crores, whichever is higher.

For futures contracts open interest shall be equivalent to the open positions in thatfutures contract multiplied by its last available closing price.

NOTES


CHAPTER III

CUURENCY FUTURES

3.3.1 Introduction

A key difference between investing in domestic and foreign assets is that the latterexposes the investor to a currency risk. Over the years, most investors have not beencareful in characterizing this risk to returns from unhedged portfolios. One simplistic viewwas to measure the return in domestic currency terms and compare it with returns in localcurrency terms, and characterize the difference as the “currency effect.” The reasoningwas that if the exchange rate remains constant from the time of purchase of the foreignasset to its sale, then the currency risk has had zero impact. On the other hand, if thedomestic currency has weakened (strengthened) against the foreign currency, the exposurewould result in a gain (loss). In August 1998, the Association for Investment ManagementResearch (AIMR) argued that the use of changes in spot exchange rates (over the investmentperiod) as a measure of the influence of currency risk on foreign asset returns was misleading.AIMR preferred an alternate approach, one that involved splitting the currency effect intocomponents: expected or known effect captured by forward premium or discount; andunexpected or surprise effect.

In other words, currency surprise can be interpreted as “the unexpected movementof the foreign currency relative to its forward rate or market predicted rate.” The assumptionhere is that the forward premium or discount (expected currency effect) will be embeddedin the return from a fully hedged portfolio. This implies that Unhedged foreign asset return(US$) = Currency surprise + Hedged foreign asset return (US$) Currency surprise isessentially noise. So every investor in foreign assets must make an explicit decision onwhether or not he wants to take on exposure to this noise factor.

3.3.2 To Hedge or Not to Hedge?

Over the years, there has been considerable controversy on this question. As mightbe expected, there are multiple view points regarding the relative merits of hedging awaycurrency risks. Here are a couple of classic arguments in favor of not hedging.

3.3.3 Uncorrelated risks

On a historical basis, changes in exchange rates (and hence currency returns) havehad very low correlations with foreign equity and bond returns. The belief is that this lackof any systematic relationship could in theory lower portfolio risk.


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3.3.4 Expected returns are zero
Viewed over a long investment horizon, currency movements cancel out each other –the mean-reversion argument. In other words, exchange rates have an expected return ofzero. So why bother hedging against currency surprise.

The arguments in favor of hedging are as follows:

3.3.5 a) How long is the long-run?

Financial planners advice their clients to pursue buy-and-hold strategies. If one tradeswith the attitude of “investing for the long-run”, ignoring short-term dynamics of currencyreturns could be a perfectly valid strategy. Folks who invest other peoples’ money, fundmanagers, though tend to be compensated on their quarterly performances relative tobenchmark indices. In addition, there is sufficient evidence on the high turnover rates ofactively managed fund portfolios. In such instances, it behooves the fund manager to takeinto account the impact of currency movements on the risk-return characteristics of his orher portfolio. Realized versus expected returns Currency returns tend to be episodic. Inother words, there can be sufficient movement in exchange rates in the short run that intheory could be exploited to generate positive returns. More important, these movementsalso tend to exhibit some degree of persistence.

3.3.5 b) Risk-return trade-off

A study by Bob Doyen compares risk and return from hedged and unhedged equityportfolios. It specifically looks at the MSCI EAFE Index for the period January 1980 toJune 1999. (Morgan Stanley Capital International Europe, Australia, Far East Index is themost commonly cited international equity index.) Jan 1980 to Jun 1999 Annualized returnVolatility Unhedged EAFE return in US$ 13.48% 17.52% Hedged (US$) EAFE return13.51% 15.29% It vividly illustrates the zero impact of currency movements on assetreturns over the long run. But it also presents sufficient evidence that hedging reduces thevolatility of the return. From an efficient portfolio perspective, hedging does seem to be anattractive strategy. To conclude, whether foreign assets are being held for the short- or thelong-run, it is apparent that hedging can help improve a fund manager’s performance andthus deliver value to investors.

3.3.6 Instruments for Hedging Currency Risk

Foreign currency markets are deep, highly liquid, and relatively inexpensive. Fundmanagers seeking to manage their currency exposures can pursue one or more strategies:trade over-the-counter (OTC) market currency forwards and options, exchange-tradedfutures and options on futures, or hire the services of an overlay manager. Overlay managersare essentially specialist currency trading firms that will actively manage a currency hedgemandate, and in addition, attempt to generate a positive excess return. These firms too relyon currency futures, forwards and options contracts.


NOTES


3.3.7 Exchange-Traded Currency Futures

Exchange-traded currency products offer at least three major advantages vis-àvis theinter-bank over-the-counter (OTC) market:

1. Price transparency and efficiency,

2. Elimination of counterparty credit risk, and

3. Accessibility for all

Types of market participants. Price Transparency and Efficiency Futures and optionsexchanges bring together in one place divergent categories of buyers and sellers to determineforeign exchange prices. This efficient price discovery process is further enhanced bytransparent trading arrangements. Whether the trading venue is open outcry or electronic,the prices for exchangetraded foreign currency products are disseminated worldwide viamajor quote vendors such as Reuters, Bloomberg, and others. Electronic trading oncomputerized trading systems (e.g., GLOBEX® at Chicago Mercantile Exchange (CME)Inc.) takes place on a nearly 24-hour basis. Elimination of Counterparty Credit RiskExchange-traded currency contracts have the exchange clearing house as the counterpartyto every trade. For example, the CME Clearing House is the buyer to every seller and theseller to every buyer of all its currency products. Market participants then need not evaluatethe credit worthiness of multiple counterparties. The CME Clearing House is theircounterparty. All clearing members of the CME Clearing House stand behind trades at theexchange. Importantly, there has never been a single default in the 104-year history of theexchange. The OTC inter-bank market operates on the basis of credit limits for everypotential counterparty. BIS requires banks to maintain adequate levels of capital to coverforward-maturity currency transaction risk. These requirements are waived for foreignexchange transactions booked on exchanges, where performance bonds are required anddaily mark to market of open positions is done.

3.3.8 Accessible to All Market Participants

The advent of financial futures began in the early 1970’s because some inventive andpersistent commodity traders at Chicago Mercantile Exchange did not have access to theinter-bank foreign exchange markets when they believed significant moves were about totake place in currency prices. They established the International Monetary Market (now adivision of CME), which launched trading in seven currency futures contracts on May 16,1972—creating the world’s first financial futures. No longer was the arena of foreignexchange trading limited to large commercial banks and their big corporate customers.Individuals, small and medium-sized banks and corporations, investment funds andgovernments can buy and sell currencies for future delivery or cash settlement. Universalaccess to its markets is an important defining characteristic of exchange-traded foreigncurrency futures and options.


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NOTES
3.3.9 Illustrating the Use of Currency Futures
Example 1: Hedging Mexican Peso Foreign Currency Risk

A U.S. hedge fund continues to find Mexican Treasury bill (CETES) yields attractiveand decides to rollover an investment in CETES, whose principal plus interest at maturityin five months will be 850 million Mexican pesos (MP). Knowing that its all-in return issubject to U.S. dollar versus Mexican peso exchange rate risk, the U.S. hedge fund wantedto hedge its exposure of converting the CETES investment back into U.S. dollars. Afterassessing the available alternatives, the U.S. hedge fund chose to hedge with exchange-traded Mexican peso futures contracts. The trading unit of the Mexican peso futures is500,000 MP. Therefore, on May 1st, the U.S. hedge fund sells 1,700 September 2003Mexican peso futures at $0.08950 per MP (equivalent to 850 million MP). Over thecourse of the next five months the U.S. dollar exchange rate for the Mexican peso falls to$0.08600 per MP. As the Mexican peso futures price falls, the hedge fund’s trading accountat its clearing member firm is credited the gains on the position by the exchange clearinghouse. The price move from US$0.08950 to US$0.08600 per Mexican peso on the shortMexican peso futures position represents a gain of US$0.00350 per Mexican peso. Thisis equal to a profit of US$1,750 per contract times 1,700 contracts for a net position gainof US$2,975,000. (For the purpose of these examples, calculations do not includebrokerage or clearing fees that may be associated with exchange transactions.) This U.S.dollar profit when added to the U.S. dollars resulting from conversion of the Mexicanpesodenominated CETES principal and interest into U.S. dollars at the lower dollar / pesoexchange rate (of US$0.08600 per Mexican peso), results in an effective rate equivalentto the Mexican peso futures price at the start of the hedge.

Example 2: Hedging equity portfolio risk using CME$INDEX futures contracts In recentmonths, CME has introduced a new dollar index futures contract. The CME$INDEX is ageometric index of seven foreign currencies, weighted to reflect the relative competitivenessof U.S. goods in foreign markets. It is designed to provide investors with a new instrumentfor currency market participation and risk management. Here is an example illustrating theuse of CME$INDEX futures to hedge international equity portfolio risk. During the periodJanuary to February of 2003, a large U.S. pension fund invested in various overseasequity markets. Though the fund manager was comfortable with the near-term market riskof these individual countries, given the recent weakness in the US dollar, plus the impendingwar in Iraq, he sought to reduce portfolio risk by hedging a portion of the currency risk.The foreign investment portfolio was valued at approximately $100 million, and the managerbelieved that the U.S. dollar would not remain weak for an extended period of time. OnMarch 11, 2003, the June CME$INDEX futures contract traded at 103.45. At this price,the notional value of each contract was $103,450. Since the fund manager wanted tohedge half of his currency exposure, he bought 483 dollar index contracts, a number whichhe derived by dividing $50 million by $103,450. In purchasing CME$INDEX futures


NOTES


contracts, the fund manager took on a position that was long the U.S. dollar and short abasket of seven currencies, thereby hedging his exposure to the underlying currency risk.

Scenario A

Suppose that during mid-May 2003, the US dollar begins to reverse its course. Byearly June, the U.S. dollar is up 3.5% on average, and the pension fund has cut back on itsexposure to overseas equity markets by 25%. The CME$INDEX June futures contract isnow trading at 107.20 and if he so desires, the fund manager can sell 121 contracts at thisprice, or 25% of his 483 contract holdings, in order to book a gain of $453,750 on hiscurrency hedge. In this instance, the unhedged portion of the portfolio would result in aloss due to the strengthening of the U.S. dollar. The remaining 362 ME$INDEX futurescontracts could then be rolled over to the next quarterly contract.

Scenario B

Referencing Scenario A above, assume that the U.S. dollar instead remains weak andis down by 2% by early June. The fund manager can take physical delivery on 121 contracts,whereby he would receive US dollars and would pay the appropriate amount of each ofthe seven currencies in the index. (In a simple scenario, he would be using the foreigncurrency proceeds from the sale of various stocks to make these payments.) This hedgehas simply reduced the potential gain from the US dollar weakness.

During periods of intense market risk, issues related to hedging different risk factorsbecome critical. This paper has focused on currency risks. We started with a completedefinition of currency effect on foreign portfolio returns, and argued in favor of protectingagainst this risk. The main benefit of a full hedge would be in the form of a reduction inportfolio volatility. Fund managers can choose from a range of instruments to hedge theircurrency risks. The paper argues that exchange-traded futures contracts have certainadvantages that make them suitable for managing single currency as well as multiple currencyexposures, providing examples of hedging U.S. dollars versus Mexican pesos and hedgingequity portfolio risk using the new CME$INDEX.

3.3.10 Summary

A key difference between investing in domestic and foreign assets is that the latterexposes the investor to a currency risk. Over the years, most investors have not beencareful in characterizing this risk to returns from unhedged portfolios. One simplistic viewwas to measure the return in domestic currency terms and compare it with returns in localcurrency terms, and characterize the difference as the “currency effect.” The reasoningwas that if the exchange rate remains constant from the time of purchase of the foreignasset to its sale, then the currency risk has had zero impact. On the other hand, if thedomestic currency has weakened (strengthened) against the foreign currency, the exposurewould result in a gain (loss).


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NOTES
Over the years, there has been considerable controversy on this question. As
-might be expected, there are multiple view points regarding the relative merits of hedgingaway currency risks. Here are a couple of classic arguments in favor of not hedging.

Financial planners advice their clients to pursue buy-and-hold strategies. If one tradeswith the attitude of “investing for the long-run”, ignoring short-term dynamics of currencyreturns could be a perfectly valid strategy. Folks who invest other peoples’ money, fundmanagers, though tend to be compensated on their quarterly performances relative tobenchmark indices. In addition, there is sufficient evidence on the high turnover rates ofactively managed fund portfolios. In such instances, it behooves the fund manager to takeinto account the impact of currency movements on the risk-return characteristics of his orher portfolio

Questions

1 What do you understand by Currency Futures?

2 What is the need for Currency Futures?

3 Illustrate the use of Currency Futures

4 What do you understand by Exchange-Traded Currency Futures? State itsadvantages

5 What is meant by Risk-return trade-off?


NOTES


UNIT IV

OPTIONSCHAPTER I

OPTION MARKET4.1.1 Introduction

Futures and Forwards share a very important characteristic: when the delivery datearrives, the delivery must take place. The agreement is binding for both parties: the partywith the short position has to deliver the goods, and the party with the long position has topay the agreed price. Options give the party with the long position one extra degree offreedom: she can exercise the contracts if she wants to do so; whereas the short party haveto meet the delivery if they are asked to do so. This makes options a very attractive way ofhedging an investment, since they can be used as to enforce lower bounds on the financiallosses. In addition, options offer a very high degree of gearing or leverage, which makesthem attractive for speculative purposes too.

4.1.2 The Main Characteristics of a Option Contract

a) The maturity : The time in the future, up to which the contract is valid;

b) The strike or exercise price : The delivery price. Remember that the long partywill assess whether or not this price is better than the current market price. If so,then the option will be exercised. If not the option will be left to expire worthless;

c) Call or put: The call option gives the long party the right to buy the underlyingsecurity at the strike price from the short party. The put option gives the long partythe right to sell the underlying security at the strike price to the short party. Theshort party has to obey the long party’s will;

d) American or European: The American option gives the right to the long party toexercise the contract at any time they wish, up to the maturity date. If the option isEuropean, it can be exercised on the maturity date only; and

e) Details concerning the delivery.

Apart from the plain vanilla contracts which are American or European, a lot of otherexotic options have appeared recently, mostly as OTC contracts. These include Asianoptions, digital options, lookback options, etc. Traders have been rather imaginative whenit comes to designing new derivative securities.


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NOTES
Unlike the forward or futures contracts, and because of the payoff asymmetries, theinitial value of an option, say, is not equal to zero. Apart from the above characteristics, theoption price is generally affected by:
a) The volatility [or uncertainty] of the underlying asset, from today up to the maturitydate. In fact, it is common in the literature for option markets to be described asmarkets where volatility is traded;

b) The level of the interest rates, in fact the whole term structure, and the stochasticbehavior of them if they are unknown;

c) The dividends, coupon payments, costs of storage, and other cash flows that arepossible before the maturity date; and

d) Commissions and the way the margin is marked.

As an example of the payoff asymmetries, the profits from a long European call optionposition look typically like the ones given in figure. A great deal of time will be dedicateddiscussing how option contracts are priced.

European call option payoffs

4.1.3 The market participants

Three kinds of dealers engage in market activities: hedgers, speculators andarbitrageurs. Each type of dealer has a different set of objectives, as discussed below.

a) Hedgers: Hedging includes all acts aimed to reduce uncertainty about future[unknown] price movements in a commodity, financial security or foreign currency.This can be done by undertaking forward or futures sales or purchases of thecommodity security or currency in the OTC forward or the organized futures market.Alternatively, the hedger can take out an option which limits the holder’s exposureto price fluctuations.

b) Speculators: Speculation involves betting on the movements of the market andtry to take advantage of the high gearing that derivative contracts offer, thus makingwindfall profits. In general, speculation is common in markets that exhibit substantial


fluctuations over time. Normally, a speculator would take a “bullish” or “bearish”

NOTES


view on the market and engage in derivatives that will profit her if this viewmaterializes. Since in order to buy, say, a European call option one has to pay aminute fraction of the possible payoffs, speculators can attempt to materializeextensive profits.

c) Arbitrageurs: They lock riskless profits by taking positions in two or moremarkets. They do not hedge nor speculate, since they are not exposed to any risksin the very first place. For example if the price of the same product is different intwo markets, the arbitrageur will simultaneously buy in the lower priced marketand sell in the higher priced one. In other situations, more complicated arbitrageopportunities might exist. Although hedging and [mainly] speculating are the reasonsthat have made derivatives [im]famous, the analysis of pricing them fairly dependssolely on the actions of the arbitrageurs, since they ensure that price differencesbetween markets are eliminated, and that products are priced in a consisted way.

4.1.4 Mini Option contracts on S&P CNX Nifty index

A mini derivative option contract is similar to any other existing option contract exceptfor the minimum contract size. Currently SEBI has prescribed a minimum contract value ofnot less than Rs 1 lac for mini derivative contracts as compared to Rs 2 lacs for normalderivative contracts. MINIFTY option contracts would be based on the S&P CNX Niftyindex. (Selection criteria for mini derivative contracts)

NSE defines the characteristics of the mini derivative option contracts such as theunderlying index, market lot, and the maturity date of the contract. The option contractsare available for trading from introduction to the expiry date. The mini option contracts areEuropean style and cash settled.


The contract specifications for Mini Option contracts on S&P CNX Nifty index areexactly as applicable to the underlying S&P CNX Nifty index. The trading symbol forthese contracts is MINIFTY.


The trading specifications for Mini Option contracts on S&P CNX Nifty index areexactly as applicable to the underlying S&P CNX Nifty index. The value of the optioncontracts on MINIFTY may not be less than Rs. 1 lakhs at the time of introduction. Thepermitted lot size for future & option contracts shall be the same for a given underlying orsuch lot size as may be stipulated by the Exchange from time to time.

4.1.5 CNXIT OPTIONS

An option gives a person the right but not the obligation to buy or sell something. Anoption is a contract between two parties wherein the buyer receives a privilege for which


DBA 1754

NOTES
he pays a fee (premium) and the seller accepts an obligation for which he receives a fee.The premium is the price negotiated and set when the option is bought or sold. A personwho buys an option is said to be long in the option. A person who sells (or writes) anoption is said to be short in the option.
The options contracts are European style and cash settled and are based on theCNX IT index. (Selection criteria for indices)




Security descriptor

The security descriptor for the CNX IT options contracts is:

Market type : N

Instrument Type : OPTIDX

Underlying : CNXIT


Option Type : CE/ PE

Strike Price: Strike price for the contract

Instrument type represents the instrument i.e. Options on Index.


Underlying symbol denotes the underlying index, which is CNXIT


Option type identifies whether it is a call or a put option., CE - Call European, PE

Put European.


The underlying index is CNXIT.


CNX IT options contracts have a maximum of 3-month trading cycle - the nearmonth (one), the next month (two) and the far month (three). On expiry of the near monthcontract, new contracts are introduced at new strike prices for both call and put options,on the trading day following the expiry of the near month contract. The new contracts areintroduced for three month duration.

NOTES


4.1.5.4 Expiry day

CNX IT options contracts expire on the last Thursday of the expiry month. If the lastThursday is a trading holiday, the contracts expire on the previous trading day.

4.1.5.5 Strike Price Intervals

The number of contracts provided in options on the index is related to the range inwhich previous day’s closing value of the index falls as per the following table:

New contracts with new strike prices for existing expiration date are introduced fortrading on the next working day based on the previous day’s index close values, as andwhen required. In order to decide upon the at-the-money strike price, the index closingvalue is rounded off to the nearest applicable strike interval.

The in-the-money strike price and the out-of-the-money strike price are based onthe at-the-money strike price.


a) Contract size

The value of the option contracts on Nifty may not be less than Rs. 2 lakhs at the timeof introduction. The permitted lot size for futures contracts & options contracts shall be thesame for a given underlying or such lot size as may be stipulated by the Exchange from timeto time.

b) Price steps

The price step in respect of CNX IT options contracts is Re.0.05.

c) Base Prices

Base price of the options contracts, on introduction of new contracts, would be thetheoretical value of the options contract arrived at based on Black-Scholes model ofcalculation of options premiums.

Index Level Strike Interval Scheme of strikes to be introduced (ITM-ATM-OTM)

upto 2000 25 4-1-4 >2001 upto 4000 50 4-1-4 >4001 upto 6000 50 5-1-5 >6000 50 6-1-6


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NOTES
C = S * N (d1) - X * e- rt * N (d

2)


1)where :

d1 = [ln (S / X) + (r + ó2 / 2) * t] / ó * sqrt(t)

d2 = [ln (S / X) + (r - ó2 / 2) * t] / ó * sqrt(t)

= d1 - ó * sqrt(t)



S = price of the underlying asset





N represents a standard normal distribution with mean = 0 and standard deviation = 1



The base price of the contracts on subsequent trading days, will be the daily closeprice of the options contracts. The closing price shall be calculated as follows:

• If the contract is traded in the last half an hour, the closing price shall be the last halfan hour weighted average price.

• If the contract is not traded in the last half an hour, but traded during any time of theday, then the closing price will be the last traded price (LTP) of the contract.

If the contract is not traded for the day, the base price of the contract for the nexttrading day shall be the theoretical price of the options contract arrived at based on Black-Scholes model of calculation of options premiums.

d) Price bands

Quantity freeze

Orders which may come to the exchange as quantity freeze shall be such that have aquantity of more than 15000. In respect of orders which have come under quantity freeze,members would be required to confirm to the Exchange that there is no inadvertent errorin the order entry and that the order is genuine. On such confirmation, the Exchange mayapprove such order. However, in exceptional cases, the Exchange may, at its discretion,


NOTES


not allow the orders that have come under quantity freeze for execution for any reasonwhatsoever including non-availability of turnover / exposure limit. In all other cases, quantityfreeze orders shall be cancelled by the Exchange.

e) Order type/Order book/Order attributes


• Stop loss order


• Spread order

4.1.6 CNX 100 Options

An option gives a person the right but not the obligation to buy or sell something. Anoption is a contract between two parties wherein the buyer receives a privilege for whichhe pays a fee (premium) and the seller accepts an obligation for which he receives a fee.The premium is the price negotiated and set when the option is bought or sold. A personwho buys an option is said to be long in the option. A person who sells (or writes) anoption is said to be short in the option. The options contracts are European style and cashsettled and are based on the popular market CNX 100 index.


Security descriptor

The security descriptor for the CNX Nifty Junior options contracts is:

Market type : N


Underlying : CNX 100





Underlying symbol denotes the underlying index, which is CNX 100


Option type identifies whether it is a call or a put option., CE - Call European, PE

Put European.


The underlying index is CNX 100


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NOTES
CNX100 options contracts have a maximum of 3-month trading cycle - the nearmonth (one), the next month (two) and the far month (three). On expiry of the near monthcontract, new contracts are introduced at new strike prices for both call and put options,on the trading day following the expiry of the near month contract. The new contracts areintroduced for three month duration.

4.1.6.4 Expiry day

CNX100 options contracts expire on the last Thursday of the expiry month. If the lastThursday is a trading holiday, the contracts expire on the previous trading day.






a) Contract size

The value of the option contracts on CNX100 may not be less than Rs. 2 lakhs at thetime of introduction. The permitted lot size for futures contracts & options contracts shallbe the same for a given underlying or such lot size as may be stipulated by the Exchangefrom time to time.

b) Price steps

The price step in respect of CNX 100 options contracts is Re.0.05.

Index Level Strike Interval

Scheme of strikes to be introduced (ITM-ATM-

OTM) upto 2000 25 4-1-4 >2001 upto 4000 50 4-1-4 >4001 upto 6000 50 5-1-5 >6000 50 6-1-6


NOTES


c) Base Prices



C = S * N (d1) - X * e- rt * N (d

2)


1)

where :

d1 = [ln (S / X) + (r + ó2 / 2) * t] / ó * sqrt(t)

d2 = [ln (S / X) + (r - ó2 / 2) * t] / ó * sqrt(t)

= d1 - ó * sqrt(t)








N represents a standard normal distribution with mean = 0 and standard deviation lnrepresents the natural logarithm of a number. Natural logarithms are based on the constante (2.71828182845904).







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NOTES
d) Price bands
Quantity freeze




• Stop loss order


• Spread order

4.1.7 BANKNIFTY OPTIONS

• An option gives a person the right but not the obligation to buy or sell something.An option is a contract between two parties wherein the buyer receives a privilegefor which he pays a fee (premium) and the seller accepts an obligation for whichhe receives a fee. The premium is the price negotiated and set when the option isbought or sold. A person who buys an option is said to be long in the option. Aperson who sells (or writes) an option is said to be short in the option.

The options contracts are European style and cash settled and are based on theBANK NIFTY index.


Security descriptor

The security descriptor for the BANKNIFTY options contracts is:

Market type : N

Instrument Type : OPTIDXUnderlying : BANKNIFTY





Underlying symbol denotes the underlying index, which is BANKNIFTY


NOTES



Option type identifies whether it is a call or a put option., CE - Call European, PE PutEuropean.


The underlying index is BANK NIFTY.


BANKNIFTY options contracts have a maximum of 3-month trading cycle - thenear month (one), the next month (two) and the far month (three). On expiry of the nearmonth contract, new contracts are introduced at new strike prices for both call and putoptions, on the trading day following the expiry of the near month contract. The newcontracts are introduced for three month duration.

4.1.7.4 Expiry day

BANKNIFTY options contracts expire on the last Thursday of the expiry month. Ifthe last Thursday is a trading holiday, the contracts expire on the previous trading day.






a) Contract size

The value of the option contracts on Nifty may not be less than Rs. 2 lakhs at the timeof introduction. The permitted lot size for futures contracts & options contracts shall be thesame for a given underlying or such lot size as may be stipulated by the Exchange from timeto time.

Index Level Strike Interval Scheme of strikes to be introduced (ITM-ATM-OTM)

upto 2000 25 4-1-4 >2001 upto 4000 50 4-1-4 >4001 upto 6000 50 5-1-5 >6000 50 6-1-6


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NOTES
b) Price steps
The price step in respect of BANK Nifty options contracts is Re.0.05.

c) Base Prices



C = S * N (d1) - X * e- rt * N (d

2)


1)

where :

d1 = [ln (S / X) + (r + ó2 / 2) * t] / ó * sqrt(t)

d2 = [ln (S / X) + (r - ó2 / 2) * t] / ó * sqrt(t)

= d1 - ó * sqrt(t)















NOTES



d) Price bands

Quantity freeze




• Stop loss order


• Spread order

4.1.8 NIFTY MIDCAP 50 OPTIONS

• An option gives a person the right but not the obligation to buy or sell something.An option is a contract between two parties wherein the buyer receives a privilegefor which he pays a fee (premium) and the seller accepts an obligation for which hereceives a fee. The premium is the price negotiated and set when the option isbought or sold. A person who buys an option is said to be long in the option. Aperson who sells (or writes) an option is said to be short in the option.

• The options contracts are European style and cash settled and are based on thepopular market Nifty Midcap 50 index.


Security descriptor

The security descriptor for the Nifty Midcap 50 options contracts is:

Market type : N


Underlying : NFTYMCAP50




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NOTES

Underlying symbol denotes the underlying index, which is Nifty Midcap 50


Option type identifies whether it is a call or a put option., CE - Call European, PE PutEuropean.


The underlying index is NIFTY MIDCAP 50


NFTYMCAP50 options contracts have a maximum of 3-month trading cycle - thenear month (one), the next month (two) and the far month (three). On expiry of the nearmonth contract, new contracts are introduced at new strike prices for both call and putoptions, on the trading day following the expiry of the near month contract. The newcontracts are introduced for three month duration.

4.1.8.4 Expiry day

NFTYMCAP50 options contracts expire on the last Thursday of the expiry month.If the last Thursday is a trading holiday, the contracts expire on the previous trading day.


The number of contracts provided in options on the index is related to the range in


which previous day’s closing value of the index falls as per the following table:



Index Level Strike Interval

Scheme of strikes to be introduced (ITM-

ATM-OTM) upto 2000 25 4-1-4 >2001 upto 4000 50 4-1-4 >4001 upto 6000 50 5-1-5 >6000 50 6-1-6

NOTES



a) Contract size

The value of the option contracts on NFTYMCAP50 may not be less than Rs.2lakhs at the time of introduction. The permitted lot size for futures contracts & optionscontracts shall be the same for a given underlying or such lot size as may be stipulated bythe Exchange from time to time.

b) Price steps

The price step in respect of NFTYMCAP50 options contracts is Re.0.05.

c) Base Prices



C = S * N (d1) - X * e- rt * N (d

2)


1)

where :

d1 = [ln (S / X) + (r + ó2 / 2) * t] / ó * sqrt(t)

d2 = [ln (S / X) + (r - ó2 / 2) * t] / ó * sqrt(t)

= d1 - ó * sqrt(t)













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NOTES


d) Price bands

Quantity freeze




• Stop loss order


• Spread order

4.1.9 Options on Individual Securities

• An option gives a person the right but not the obligation to buy or sell something.An option is a contract between two parties wherein the buyer receives a privilegefor which he pays a fee (premium) and the seller accepts an obligation for whichhe receives a fee. The premium is the price negotiated and set when the option isbought or sold. A person who buys an option is said to be long in the option. Aperson who sells (or writes) an option is said to be short in the option.

NSE became the first exchange to launch trading in options on individual securities.Trading in options on individual securities commenced from July 2, 2001. Option contractsare American style and cash settled and are available on 267 securities stipulated by theSecurities & Exchange Board of India (SEBI).


NOTES



Security descriptor

The security descriptor for the options contracts is:

Market type : N

Instrument Type : OPTSTK

Underlying : Symbol of underlying security


Option Type : CA / PA


Instrument type represents the instrument i.e. Options on individual securities.

Underlying symbol denotes the underlying security in the Capital Market (equities)segment of the Exchange

Expiry date identifies the date of expiry of the contract Option type identifies whetherit is a call or a put option., CA - Call American, PA - Put American.


Option contracts are available on 267 securities stipulated by the Securities & ExchangeBoard of India (SEBI). These securities are traded in the Capital Market segment of theExchange.


Options contracts have a maximum of 3-month trading cycle - the near month (one),the next month (two) and the far month (three). On expiry of the near month contract, newcontracts are introduced at new strike prices for both call and put options, on the tradingday following the expiry of the near month contract. The new contracts are introduced forthree month duration.

4.1.9.4 Expiry day

Options contracts expire on the last Thursday of the expiry month. If the last Thursdayis a trading holiday, the contracts expire on the previous trading day.


The Exchange provides a minimum of seven strike prices for every option type (i.eCall & Put) during the trading month. At any time, there are three contracts in-the-money(ITM), three contracts out-of-the-money (OTM) and one contract at-the-money (ATM).


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NOTES
4.1.9.6 The Strike Price Interval
Price of Underlying Strike Price interval (Rs.)

Less than or equal to Rs. 50 2.50

> Rs.50 to less than or equal to Rs. 250 5




> Rs.2500 50

New contracts with new strike prices for existing expiration date are introduced fortrading on the next working day based on the previous day’s underlying close values, asand when required. In order to decide upon the at-the-money strike price, the underlyingclosing value is rounded off to the nearest strike price interval.

The in-the-money strike price and the out-of-the-money strike price are based onthe at-the-money strike price interval.


a) Contract size

The value of the option contracts on individual securities may not be less than Rs. 2lakhs at the time of introduction for the first time at any exchange. The permitted lot size orfutures contracts & options contracts shall be the same for a given underlying or such lotsize as may be stipulated by the Exchange from time to time.

b) Price steps

The price step in respect of the options contracts is Re.0.05.

c) Base Prices



C = S * N (d1) - X * e- rt * N (d

2)


1)

where :

d1 = [ln (S / X) + (r + ó2 / 2) * t] / ó * sqrt(t)

d2 = [ln (S / X) + (r - ó2 / 2) * t] / ó * sqrt(t)


= d1 - ó * sqrt(t)

NOTES











Rate of interest may be the relevant MIBOR rate or such other rate as may bespecified.





d) Price bands

Quantity freeze

Orders which may come to the exchange as a quantity freeze shall be based on thenotional value of the contract of around Rs.5 crores. Quantity freeze is calculated for eachunderlying on the last trading day of each calendar month and is applicable through thenext calendar month. In respect of orders which have come under quantity freeze, memberswould be required to confirm to the Exchange that there is no inadvertent error in the orderentry and that the order is genuine. On such confirmation, the Exchange may approve suchorder. However, in exceptional cases, the Exchange may, at its discretion, not allow theorders that have come under quantity freeze for execution for any reason whatsoeverincluding non-availability of turnover / exposure limits.


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• Stop loss order


• Spread order

OPTION Permitted lot size

Underlying Symbol Market Lot BANK Nifty BANKNIFTY 25 CNX 100 CNX100 50 CNX IT CNXIT 50 CNX Nifty Junior JUNIOR 25 Nifty Midcap 50 NFTYMCAP50 75 S&P CNX Nifty NIFTY 50 S&P CNX Nifty MINIFTY 20 Derivatives on Individual Securities Symbol Market Lot 3I Infotech Ltd. 3IINFOTECH 2700 Aban Offshore Ltd. ABAN 50 Abb Ltd. ABB 250 Aditya Birla Nuvo Limited ABIRLANUVO 200 Adlabs Films Ltd ADLABSFILM 225 Aia Engineering Limited AIAENG 200 Allahabad Bank ALBK 2450 Alok Industries Ltd. ALOKTEXT 3350 Alstom Projects India Ltd APIL 200 Ambuja Cements Ltd. AMBUJACEM 2062 Amtek Auto Ltd. AMTEKAUTO 600 Andhra Bank ANDHRABANK 2300 Ansal Prop & Infra Ltd ANSALINFRA 1300 Aptech Limited APTECHT 650 Arvind Limited ARVIND 4300 Ashok Leyland Ltd ASHOKLEY 4775 Associated Cement Co. Ltd. ACC 188


NOTES


Underlying Symbol Market LotAurobindo Pharma Ltd. AUROPHARMA 700 Axis Bank Ltd. AXISBANK 225 Bajaj Auto Limited BAJAJ-AUTO 200 Bajaj Hindustan Ltd. BAJAJHIND 950 Bajaj Holdings & Investment Ltd. BAJAJHLDNG 250 Ballarpur Industries Limited BALLARPUR 7300 Balrampur Chini Mills Ltd. BALRAMCHIN 2400 Bank Of Baroda BANKBARODA 700 Bank Of India BANKINDIA 950 Bata India Ltd. BATAINDIA 1050 Bharat Earth Movers Ltd. BEML 125 Bharat Electronics Ltd. BEL 138 Bharat Forge Co Ltd BHARATFORG 1000 Bharat Heavy Electricals Ltd. BHEL 75 Bharat Petroleum Corporation Ltd. BPCL 550 Bharti Airtel Ltd BHARTIARTL 250 Bhushan Steel & Strips Lt BHUSANSTL 250 Biocon Limited. BIOCON 450 Birla Corporation Ltd BIRLACORPN 850 Bombay Dyeing & Mfg. Co Ltd. BOMDYEING 300 Bombay Rayon Fashions Ltd BRFL 1150 Bongaigaon Refinery Ltd. BONGAIREFN 2250 Brigade Enterprises Ltd. BRIGADE 550 Cairn India Limited CAIRN 1250 Canara Bank CANBK 800 Central Bank Of India CENTRALBK 2000 Century Textiles Ltd CENTURYTEX 212 Cesc Ltd. CESC 550 Chambal Fertilizers Ltd. CHAMBLFERT 3450 Chennai Petroleum Corporation Ltd. CHENNPETRO 900 Cipla Ltd. CIPLA 1250 Cmc Ltd. CMC 200


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Underlying Symbol Market Lot Colgate Palmolive Ltd COLPAL 550 Corporation Bank CORPBANK 600 Crompton Greaves Ltd. CROMPGREAV 500 Cummins India Ltd CUMMINSIND 475 Dabur India Ltd. DABUR 2700 Deccan Aviation Limited AIRDECCAN 850 Dena Bank DENABANK 2625 Develop Credit Bank Ltd DCB 1400 Divi'S Laboratories Ltd. DIVISLAB 155 Dlf Limited DLF 400 Dr. Reddy'S Laboratories Ltd. DRREDDY 400 Edelweiss Capital Ltd EDELWEISS 250 Educomp Solutions Ltd EDUCOMP 75 Escorts India Ltd. ESCORTS 2400 Essar Oil Ltd. ESSAROIL 1412 Everest Kanto Cylinder Ltd EKC 1000 Federal Bank Ltd. FEDERALBNK 851 Financial Technologies (I) Ltd FINANTECH 150 Gail (India) Ltd. GAIL 750 Gateway Distriparks Ltd. GDL 2500 Gitanjali Gems Limited GITANJALI 500 Glaxosmithkline Pharma Ltd. GLAXO 300 Gmr Infrastructure Ltd. GMRINFRA 1250 Grasim Industries Ltd. GRASIM 88 Great Offshore Ltd GTOFFSHORE 250 Gtl Ltd. GTL 750 Gujarat Alkalies & Chem GUJALKALI 1400 Gujarat Narmada Fertilizer Co. Ltd. GNFC 1475 Havells India Limited HAVELLS 400 Hcl Technologies Ltd. HCLTECH 650 Hdfc Bank Ltd. HDFCBANK 200 Hero Honda Motors Ltd. HEROHONDA 400


NOTES


Underlying Symbol Market Lo

Hindalco Industries Ltd. HINDALCO 1759

Hinduja Ventures Ltd. HINDUJAVEN 500

Hindustan Construction Co HCC 1400

Hindustan Oil Exploration HINDOILEXP 1600

Hindustan Petroleum Corporation Ltd. HINDPETRO 1300

Hindustan Unilever Ltd HINDUNILVR 1000

Hindustan Zinc Limited HINDZINC 250

Hotel Leela Ventures Ltd HOTELEELA 3750

Housing Development And

Infrastructure Ltd. HDIL 516

Housing Development Finance

Corporation Ltd. HDFC 75

ibn18 Broadcast Limited IBN18 1250

Icici Bank Ltd. ICICIBANK 175

Idea Cellular Ltd. IDEA 2700

Ifci Ltd. IFCI 1970

I-Flex Solutions Ltd. I-FLEX 150

India Cements Ltd. INDIACEM 725

India Infoline Limited INDIAINFO 1250

Indian Bank INDIANB 1100

Indian Hotels Co. Ltd. INDHOTEL 1899

Indian Oil Corporation Ltd. IOC 600

Indian Overseas Bank IOB 1475

Indusind Bank Ltd. INDUSINDBK 1925

Industrial Development Bank Of India

Ltd. IDBI 1200

Info Edge (I) Ltd NAUKRI 150

Infosys Technologies Ltd. INFOSYSTCH 200

Infrastructure Development Finance

Company Ltd. IDFC 1475


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NOTES



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NOTES



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NOTES


Summary

Futures and forwards share a very important characteristic: when the delivery datearrives, the delivery must take place. The agreement is binding for both parties: the partywith the short position has to deliver the goods, and the party with the long position has topay the agreed price.

A mini derivative option contract is similar to any other existing option contract exceptfor the minimum contract size.

An option gives a person the right but not the obligation to buy or sell something. Anoption is a contract between two parties wherein the buyer receives a privilege for whichhe pays a fee (premium) and the seller accepts an obligation for which he receives a fee.

Options contracts have a maximum of 3-month trading cycle - the near month (one),the next month (two) and the far month (three). On expiry of the near month contract, newcontracts are introduced at new strike prices for both call and put options, on the tradingday following the expiry of the near month contract.

An option gives a person the right but not the obligation to buy or sell something. Anoption is a contract between two parties wherein the buyer receives a privilege for whichhe pays a fee (premium) and the seller accepts an obligation for which he receives a fee.

Orders which may come to the exchange as a quantity freeze shall be based on thenotional value of the contract of around Rs.5 crores. Quantity freeze is calculated for eachunderlying on the last trading day of each calendar month and is applicable through thenext calendar month. In respect of orders which have come under quantity freeze, memberswould be required to confirm to the Exchange that there is no inadvertent error in the orderentry and that the order is genuine.

Questions

1. What are the main characteristics of Option Contract? Explain

2. Who are the Market Participants in Option Market?

3. Explain the Mini Option contracts on S&P CNX Nifty index

4. What do you understand by Strike Price Intervals?

5. Explain the Options on Individual Securities


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CHAPTER II
FINANCIAL SWAPS MARKET

4.2.1 Introduction

A Swap is an agreement between two parties, called Counterparties, who exchangecash flows over a period of time in the future. When exchange rate and Interest ratesfluctuate, risks of forward and money market positions are so great that the forward market& money market may not function properly. Currency futures and options are inflexibleand available only for selected currencies. In such cases, MNC’s & governments may useswap arrangements to protect the value of export sales, import orders and outstandingloans dominated in foreign currencies.

4.2.2 There are Three Basic Motivations for Swaps:

Firms use swaps to provide protection against future changes in exchange rates andinterest rates.

Firms use swaps to eliminate interest-rate risks arising from normal commercialoperations

4.2.3 Firms use Swaps to Reduce Financing Costs

Financial swaps are now used by Multinational companies, commercial banks, worldorganizations and sovereign governments to minimize currency and interest-rate risks. Thusswaps have become another risk management tool along with currency forwards, futuresand options.

The origins of swap market can be traced back to 1970’s when traders developedcurrency swaps to evade British controls on movement of foreign currency. The markethas grown rapidly ever since and in year 2002 about $44 trillion was traded via swaps

4.2.4 Parallel Loans

A Parallel Loan refers to a loan which involves an exchange of currencies between 4parties, with a promise to re-exchange the currencies at a predetermined exchange rate ona specified future date. Typically, the parties consist of two pairs of affiliated companies.Parallel loans are commonly arranged by two multinational parent companies in two differentcountries.

The structure of a typical parallel loan is illustrated in the following example.


NOTES


IBM in USA with a subsidiary in Italy wants to obtain a one year Lira loan for itssubsidiary.

Olivetti in Italy wishes to invest in US via a loan to its US subsidiary. With a Parallelloan, these loans can be arranged without currency crossing the national border. IBMlends $10M to Olivetti’s US subsidiary at US interest rates. Olivetti in return lends $10Min Lira to IBM’s Italian subsidiary.

4.2.5 Back-to-Back Loans

Bank to back loan involves an exchange of currencies between two parties, with apromise to re-exchange the currencies at a specified rate on a specified future date. Backto back loans involve two companies domiciled in two different countries. For example,IBM borrows money in US dollars and lends the borrowed funds to Olivetti in Italy, whichin return borrows funds in Italy and lends those funds to IBM in the United States. By thissimple arrangement, each firm has access to capital markets in foreign country and makesuse of their comparative advantage of borrowing in different capital markets.

4.2.6 Drawbacks of parallel and back to back loans

The difficulty in finding counterparties with matching needs. Firms must find firms withmirror-image financing needs. Financing requirements include principals, types of interestpayments, frequency of interest payments, and length of the loan period. The search costfor finding such counterparty is quite considerable.

One is still obligated to comply with the loan terms even when the other defaults. In theabove example, IBM is still liable for the loan even if Olivetti defaults. To avoid defaultrisks, a separate agreement defining the right of offset must be drafted.

The loans are carried on the accounting books of both the firms. This limits additionalborrowing and hence limits the leverage of these firms.

Swaps on the other hand overcome the above drawbacks by:


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Making it easier to find counterparties via swap brokers.
Defining an offset agreement as a part of the swap.

Principal amounts in a swap do not appear on the accounting books. These off booktransactions help banks avoid increases in their capital requirements under applicableregulations

As a result, Swaps are very popular financial instruments. In 2000, the size of worldswap market was greater than $25 billion

4.2.7 Swap Banks

Financial institutions which assist in the completion of a swap is called “Swap Bank”.The swap bank makes profits from the bid-ask spread it imposes on the swap coupon. ASwap broker is a swap bank who acts strictly as an agent without taking any financialposition in the swap transaction, i.e., mearly matches counterparties and does not assumeany risk of a swap. A Swap Dealer is a swap bank who actually transacts for its ownaccount to help complete the swap. In this capacity, the swap dealer assumes a position inthe swap and thus assumes certain risks.

4.2.8 Types of Swaps

4.2.8.1 Plain Vanilla Swaps

It is the simplest kind of swaps. Here two counterparties agree to make payments toeach other on the basis of some underlying assets. These payments include interest payments,commissions and other service payments. The swap agreement contains specifications ofthe assets to be exchanged, the rate of interest applicable to each, the timetable by whichthe payments are to be made and other provisions.

The two parties may or may not exchange the underlying assets, which are calledNotional Principals, in order to distinguish them from physical exchanges in the cash markets.

4.2.8.2 Interest Rate Swaps

An interest rate swap is a swap in which counterparties exchange cash flows of afloating rate for cash flows of a fixed rate or vice-versa. No notional principal changeshands, but it is a reference amount against which interest is calculated. Interest swaps canbe international or purely domestic.

4.2.8.3 The Most Common Motive for Interest Rate Swaps are:

Changes in financial markets may cause interest rates to change

Borrowers may have different credit ratings in different countries


NOTES


Borrowers have different preferences for debt service payment schedule

Interest rate swaps are normally arranged by an international bank which serves as a swapbroker or a swap dealer. Through interest rate swaps, borrowers obtain a lower cost ofdebt service payments and lenders obtain profit guarantees.

4.2.8.4 Currency Swaps

A Currency swap is a swap in which one party provides a certain principal in one currencyto its counterparty in exchange for an equivalent amount in a different currency. For example,An US firm wants to exchange its Dollars for Italian Lira while an Italian firm want toexchange Lira to US dollars. Given these two needs, the two may engage in a swap deal.

Currency swap is similar to parallel loans, but swaps are better due to:

Ease of finding counterparties

The right to offset the loan payments

Off books transactions.

4.2.9 Swaptions, Caps, Floor and Collars

A swaption is an option to enter into a plain vanilla swap. A Call swaption gives theholder the right to receive fixed-interst payments. A put swaption gives the holder the rightto make fixed interest payments. Call swaptions are attractive when interest rates areexpected to fall. Put swaptions are attractive when interest rates are expected to rise.Banks & investment firms usually act as dealers rather than as brokers.

An interest rate cap sets the maximum rate of interest on floating rate interest payments;An interest rate floor set the minimum rate of interest on a floating rate interest payments;and an interest rate collar combines a cap with a floor.

A buyer of these instruments pays a one time premium, which is a small percentage ofthe notional capital.

4.2.10 Motivation for Swaps

There are three basic motivations for swaps. First, companies use swaps to provideprotection against future changes in exchange rates. Second, Companies use swaps toeliminate interest rate risks arising from normal commercial operations. Third, companiesuse swaps to reduce financing costs.

4.2.11 Closing Thoughts


Swap market has emerged largely because financial swaps escape many of thelimitations inherent in currency futures and options markets. Swaps are custom tailored tothe needs of two parties; swap agreements are more likely to meet the specific needs of

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the counterparties than currency futures and options. Swap market is done via financialinstitutions and offers privacy when compared to foreign exchange markets. Lastly swapsare not as highly regulated as options and futures markets
4.2.12 Interest Rate Swaps

One of the largest components of the global derivatives markets and a natural adjunctto the fixed income markets is the interest rate swaps market. Understanding the over-the-counter swaps market can give a deeper insight into the capital flows that drive the bondmarkets, the way in which the companies whose stock investor manage their exposure tofluctuations in interest rates and the way banks and financial institutions make a great dealof their income.

Simply put, it is the exchange of one set of cash flows for another. A pre-set index, notionalamount and set of dates of exchange determine each set of cash flows. The most commontype of interest rate swap is the exchange of fixed rate flows for floating rate flows.

Differences in the credit quality between entities borrowing money motivate the interestrate swap market. Specifically, some agents may have a better borrowing profile in theshort maturities than they do in the long maturities. Other agents (with more creditworthystatus) have a comparative advantage raising money in the longer maturities.

A counter-party’s creditworthiness is an assessment of their ability to repay moneylent to them over time. If a company has a good credit rating, they are more likely to beable to pay back a loan over time than a company with a poor credit rating. This effect ismagnified with time. By making it easier for less creditworthy agents to borrow in the shortterm than in the long term, lenders make sure that they are less exposed to this risk.

Therefore, we would expect that in fixed-floating interest rate swaps, the entity payingfixed and receiving floating is usually the less creditworthy of the two counterparties.

The interest rate swap gives the less creditworthy entity a way of borrowing fixed ratefunds for a longer term at a cheaper rate than they could raise such funds in the capitalmarkets by taking advantage of the entity’s relative advantage in raising funds in the shortermaturity buckets.

As we shall see in a later article, this arbitrage opportunity is expanded when weconsider agents who can borrow money in a number of different currencies. In that case,we can think of a matrix of currency and maturity to describe an entity’s relative arbitrateopportunities. This can be addressed using currency swaps.

Of course, fixed-floating interest rate swaps are not the only kinds of interest rateswaps we can construct. Any kind of interest rate swap is possible, as long as the twocounter-parties can come up with differing indices. We could imagine a swap in which


there are two different kinds of floating indices or another in which there are two differentkinds of fixed indices.

NOTES


In subsequent articles, we shall also see how swaps can be constructed using equityindices and commodity indices and the rationale for using these structures instead of outrightpurchases of the underlying equities and commodities.

How do we value swaps? There are several steps:

a) Identify the cash flows. To simplify things, many people draw diagrams with inflowsand outflows of funds over time.

b) Construct the swap curve, obtained from the government yield curve and the swapspread curve.

c) Construct a zero-coupon curve from the swap curve. (See the Fixed Incomesection).

d) Present value the cash flows using the zero-coupon rates.

The swap spread is obtained from market makers. It is the market-determinedadditional yield that compensates counter-parties who receive fixed payments in a swapfor the credit risk involved in the swap. The swap spread will differ with the creditworthinessof the counter-party.

Just like an option, a swap can be at-the-money, in-the-money or out-of-the-money.Most swaps are priced to be at-the-money at inception meaning that the value of thefloating rate cash flows is exactly the same as the value of the fixed rate cash flows at theinception of the deal. Naturally, as interest rates change, the relative value may shift. Receivingthe fixed rate flow will become more valuable than receiving the floating rate flow if interestrates drop or if credit spreads tighten.

Investment banks and commercial banks are the market makers for most of theseswaps. Most of them warehouse the risk in portfolios, managing the residual interest raterisk of the cash flows. As you can imagine, the management of these risks can be verycomplex with swaps maturing on a daily basis and the difficulties of managing a variety ofsimilar but not identically matched products.

4.2.13 Currency Swaps

In the case of a currency swap, principal exchange is not redundant. The exchange ofprincipal on the notional amounts is done at market rates, often using the same rate for thetransfer at inception as is employed at maturity.

For example, consider the US-based company (“Acme Tool & Die”) that has raisedmoney by issuing a Swiss Franc-denominated Eurobond with fixed semi-annual couponpayments of 6% on 100 million Swiss Francs. Upfront, the company receives 100 millionSwiss Francs from the proceeds of the Eurobond issue (ignoring any transaction fees,etc.). They are using the Swiss Francs to fund their US operations.


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Why issue bonds in Swiss Francs? The only rationale for doing this is because thereare investors with Swiss Franc funds who are looking to diversify their portfolios with UScredits such as Acme’s. They are willing to buy Acme’s Eurobonds at a lower yield thanAcme can issue bonds in the US. A Eurobond is any bond issued outside of the country inwhose currency the bond is denominated.
Because this issue is funding US-based operations, we know two things straightaway.Acme is going to have to convert the 100 million Swiss Francs into US dollars. And Acmewould prefer to pay its liability for the coupon payments in US dollars every six months.

Acme can convert this Swiss Franc-denominated debt into a US dollar-like debt byentering into a currency swap with the First London Bank.

Acme agrees to exchange the 100 million Swiss Francs at inception into US dollars,receive the Swiss Franc coupon payments on the same dates as the coupon payments aredue to Acme’s Eurobond investors, pay US dollar coupon payments tied to a pre-setindex and re-exchange the US dollar notional into Swiss Francs at maturity.

Acme’s US operations generate US dollar cash flows that pay the US-dollar indexpayments.

Currency swaps are used to hedge or lock-in the value-added of issuing Eurobonds.They are often negotiated as part of the whole issuance package with the main issuingfinancial institution.

4.2.14 Flexibility

Currency swaps give companies extra flexibility to exploit their comparative advantagein their respective borrowing markets.

Interest rate swaps allow companies to focus on their comparative advantage inborrowing in a single currency in the short end of the maturity spectrum vs. the long-end ofthe maturity spectrum.

Currency swaps allow companies to exploit advantages across a matrix of currenciesand maturities.

The success of the currency swap market and the success of the Eurobond marketare explicitly linked.

4.2.15 Exposure

Because of the exchange and re-exchange of notional principal amounts, the currencyswap generates a larger credit exposure than the interest rate swap.


NOTES


Companies have to come up with the funds to deliver the notional at the end of thecontract. They are obliged to exchange one currency’s notional against the other currency’snotional at a fixed rate. The more actual market rates have deviated from this contractedrate, the greater the potential loss or gain.

This potential exposure is magnified with time. Volatility increases with time. Thelonger the contract, the more room for the currency to move to one side or other of theagreed upon contracted rate of principal exchange.

This explains why currency swaps tie up greater credit lines than regular interest rateswaps.

Currency swaps allow companies to exploit the global capital markets more efficiently.They are an integral arbitrage link between the interest rates of different developed countries.

The future of banking lies in the securitization and diversification of loan portfolios.The global currency swap market will play an integral role in this transformation. Bankswill come to resemble credit funds more than anything else, holding diversified portfolios ofglobal credit and global credit equivalents with derivative overlays used to manage thevariety of currency and interest rate risk.

4.2.16 Hedging Swaps

Dealers at commercial banks do most of the market making that is done in the interestrate swap and currency swap markets. In addition to making markets to their customers,these traders will also make prices to other financial institutions in the wholesale or interbankmarket, often in transactions facilitated by interbank brokers. In any given day, the dealerat the bank may engage in several transactions or several dozen transactions, all of whichare added to his general position. The combination of all of the different swaps and bondtrades and futures trades that the dealer has conducted constitutes a portfolio.

While it may be easier for us to understand intuitively the way in which the dealermanages the risk of an individual swap transaction, in practice this is prohibitively difficultand it does not take advantage of the natural hedges within the portfolio. Therefore, theswaps dealer will manage the risks of his position using portfolio management techniquesthat are similar to but more sophisticated than the portfolio management techniques usedfor a simple cash position in fixed income or equities.


In portfolio hedging, the dealer’s objective is to construct a portfolio of hedges usingswaps, forward rate agreements (FRAs), futures and bonds the changes in value of whichoffsets the change in value of the underlying swap portfolio for a given set of fluctuations ininterest rates, currency rates or basis between the futures and the bonds.

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4.2.17 Identifying the risk of the swaps portfolio
The first necessary step in hedging the swaps portfolio is to measure the risk of theswaps portfolio. Namely, the dealer must answer a series of questions. How much will theportfolio lose on a mark-to-market basis if interest rates move up in a parallel fashion (i.e.all interest rates increase by the same amount) by 50 basis points? How much will theportfolio lose on a mark-to-market basis if interest rates fall in a parallel fashion by 50basis points? How much will the portfolio lose if the spread between the 30-year governmentbond and the 2-year government note increases by 25 basis points? How will the position’ssensitivity to interest rates change if the level of interest rates change?

Cash flows are grouped in maturity buckets (or intervals of consecutive maturity).One example might be all of the cash flows from 1 year to 1 year and 3 months. Anotherexample might be all of the cash flows from 29 years to maturity to 30 years to maturity.These grouped cash flows are then valued at market rates. Doing so enables the dealer toget a true picture of the cash flow’s local sensitivity to market rates. The sensitivity of theportfolio maturity bucket may be dependent on the level of interest rates because of theconvexity of fixed income flows.

One way of looking at the delta is just the fixed income instrument with a term tomaturity equal to the average maturity for the interval in question that is as sensitive in profitand loss terms to small changes in the interest rate for that bucket as the swaps portfolio isfor that bucket.

Similarly, the gamma is an expression of the changes in the position size (i.e. thechanges in the delta) for changes in the level of interest rates.

Vega is the sensitivity of the portfolio to changes in implied volatilities for at-the-money options associated with the maturity bucket in question. This may be important, forexample, if the portfolio contains swaptions.

In categorizing the risk of the swaps portfolio, the dealer must look at different typesof yield curve risk including parallel shifts in the yield curve, non-parallel shifts in the yieldcurve and changes in swap spreads. Sophisticated dealers may incorporate someassumptions about the correlation between swap spreads and interest rates in doing theirscenario analysis. It may be reasonable to believe that swap spreads will widen out ifinterest rates back up because of degrading credit conditions, for example.

4.2.18 Constructing the Hedge Portfolio

The dealer will then take this analysis of the behavioural characteristics of the swapportfolio and he will construct a hedging portfolio using one or more financial instruments inorder to offset those aspects of the risk that he is unhappy carrying. Note that the dealerwill not close out all of the aspects of the risk.


NOTES


4.2.19 Why will the Dealer only Partially Hedge the Swaps Portfolio?

Hedging costs money. The main benefit of hedging activity is to reduce the risk of theportfolio. This benefit must be compared to the hedging cost. If the marginal benefit ofreducing the risk with an individual transaction is less than its marginal cost, it is not worthwhileto hedge that risk.

Another reason for not completely hedging the swaps portfolio is the fact that thedealer may carry a proprietary position in one or more aspects of the risk. If, for example,he thinks that interest rates are going to fall in the 2-year to 3-year bucket, he may behappy to continue received fixed interest payments for that period. If he is correct, he willmake money on a mark-to-market basis that he can realize by hedging the position at apreferable level.

4.2.20 Floating Rate Cash Flow Management

One of the more difficult aspects of managing a swap portfolio is managing the short-term cash flows or the floating rate cash flows. There are two problems that confront thedealer.

4.2.21 Mismatches in the Timing of Short-Term Cash Flows.

Consider a hedge that was entered into two years ago to hedge a two year fixed-floating plain vanilla interest rate swap where the hedge transaction took place a weekafter the initial customer transaction. Unless the dealer matched the dates precisely at thetime he conducted the hedge transaction, there will be a one-week mismatch of flows.Matching the dates may have cost extra money in terms of the market prices at the time oftransaction making it too expensive to match the timing of the cash flows. Some peoplemight argue that one week is not very much of a difference. That is no way to run abusiness. To paraphrase an old saying, ten grand here and one hundred grand there andpretty soon you’re talking about some real money.

4.2.22 Mmismatches in the Type of Index used to Hedge.

Consider a swap in which the floating rate index is the 3-month US Bankers’Acceptance rate. If the best swap available at the time is the 3-month US LIBOR (LondonInterbank Offered Rate for US dollars), then there is an index mismatch risk. If thecorrelation between these two indices changes (and correlation between financial indicesis rarely stable), then the swap portfolio is exposed to refunding risk.

One way for the commercial bank to hedge its floating rate cash flows is to establisha separate book dedicated to hedging such risks, one which participates actively in thefutures markets such as the IMM Eurodollar market and one which takes aggressivepositions in short-term interest rates.


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An alternative might be to pay the hedging costs necessary for closing out themismatches. This can get expensive. With the increased commoditization of global derivativesmarkets, dealers are losing much of their pricing edge, a phenomenon that makes payingfor outside hedging more difficult.
By giving an appreciation for the way swaps dealers manage their combined portfoliorisk, this article has identified some of the key types of risk in interest rate swaps andinterest rate products, generally.

4.2.23 Interest Rate Swaps

One of the largest components of the global derivatives markets and a natural adjunctto the fixed income markets is the interest rate swaps market. Understanding the over-the-counter swaps market can give you a deeper insight into the capital flows that drive thebond markets, the way in which the companies whose stock investor own manage theirexposure to fluctuations in interest rates and the way banks and financial institutions makea great deal of their income.

What is an interest rate swap? Simply put, it is the exchange of one set of cash flowsfor another. A pre-set index, notional amount and set of dates of exchange determine eachset of cash flows. The most common type of interest rate swap is the exchange of fixedrate flows for floating rate flows.

The interest rate swap gives the less creditworthy entity a way of borrowing fixed ratefunds for a longer term at a cheaper rate than they could raise such funds in the capitalmarkets by taking advantage of the entity’s relative advantage in raising funds in the shortermaturity buckets.

4.2.24 Valuation of swaps

a) Identify the cash flows. To simplify things, many people draw diagrams with inflowsand outflows of funds over time.

b) Construct the swap curve, obtained from the government yield curve and the swapspread curve.

c) Construct a zero-coupon curve from the swap curve. (See the Fixed Incomesection).

d) Present value the cash flows using the zero-coupon rates.

The swap spread is obtained from market makers. It is the market-determinedadditional yield that compensates counter-parties who receive fixed payments in a swapfor the credit risk involved in the swap. The swap spread will differ with the creditworthinessof the counter-party.

Just like an option, a swap can be at-the-money, in-the-money or out-of-the-money.Most swaps are priced to be at-the-money at inception meaning that the value of thefloating rate cash flows is exactly the same as the value of the fixed rate cash flows at the


NOTES


inception of the deal. Naturally, as interest rates change, the relative value may shift. Receivingthe fixed rate flow will become more valuable than receiving the floating rate flow if interestrates drop or if credit spreads tighten.

Investment banks and commercial banks are the market makers for most of theseswaps. Most of them warehouse the risk in portfolios, managing the residual interest raterisk of the cash flows.

4.2.25 Equity Swaps

Having discussed interest rate swaps and their cross-currency extension to currencyswaps as exchanges of cash flows predicated on pre-set indices, it is natural for us to thinkof structuring swaps involving non-interest indices. Equity swaps are exchanges of cashflows in which at least one of the indices is an equity index. An equity index is a measure ofthe performance of an individual stock or a basket of stocks. Common equity indices withwhich the general investor is probably familiar include the Standard & Poor’s 500 Index,the Dow Jones Industrial Average or the Toronto Stock Exchange Index.

The outstanding performance of equity markets in the 1980s and the 1990s,technological innovations that have made widespread participation in the equity marketmore feasible and more marketable and the demographic imperative of baby-boomersaving has generated significant interest in equity derivatives. In addition to the listed equityoptions on individual stocks and individual indices, a burgeoning over-the-counter(OTC) market has evolved in the distribution and utilization of equity swaps.

There are many reasons to use equity swaps, some of which come from the motivationbehind index trading.

This passive investing strategy is gaining ground in the fund management community.Instead of trying to buy individual stocks that are deemed to be undervalued by somemethod of fundamental analysis, the index trading mechanism chooses a basket of stocksthat is selected for its ability to represent the general market or one particular sector of thestock market. The fees associated with funds that engage in index trading are much lowerbecause the investment management is mechanically deterministic. It is prescribed by theindex that the investors have chosen. The investment manager is not paid for his discretionaryexpertise.

4.2.26 Equity swaps make the index trading strategy even easier.

Consider the Bulldog S&P 500 Mutual Fund that is a fund promising to deliver thereturn of the S&P 500 (less administrative and managerial costs). How do they do it?


One way would be to buy the 500 stocks that comprise the index in their exactproportions. However, the execution of this would be cumbersome, particularly if the level

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of funds in the Bulldog S&P 500 Mutual Fund were to fluctuate as people put more moneyto work or as they withdraw from the fund.
Another way would be to participate in the S&P 500 through the futures market byusing the mutual fund’s money to purchase S&P 500 Futures. The Futures contract wouldhave to be rolled on a quarterly basis. There would be complex administration with theFutures Exchange.

There is a third alternative: the equity swap. The investment manager at Bulldog callsup First Derivatives bank and asks for an S&P 500 swap in which the fund pays FirstDerivatives some money market return in exchange for receiving the return on the S&P500 index for a period of five years with monthly payments. The return on the S&P 500index consists of capital gains as well as income distributions.

The structure is easy for the passive investment manager to implement administratively.And it fully accomplishes the goal with very little costs. Index trading funds typically havemuch lower costs associated with them.

Summary

A Swap is an agreement between two parties, called Counterparties, who exchangecash flows over a period of time in the future. When exchange rate and Interest ratesfluctuate, risks of forward and money market positions are so great that the forward market& money market may not function properly.

A Parallel Loan refers to a loan which involves an exchange of currencies between 4parties, with a promise to re-exchange the currencies at a predetermined exchange rate ona specified future date.

Financial swaps are now used by Multinational companies, commercial banks, worldorganizations and sovereign governments to minimize currency and interest-rate risks.

The difficulty in finding counterparties with matching needs. Firms must find firms withmirror-image financing needs. Financing requirements include principals, types of interestpayments, frequency of interest payments, and length of the loan period. The search costfor finding such counterparty is quite considerable.

One of the largest components of the global derivatives markets and a natural adjunctto the fixed income markets is the interest rate swaps market. Understanding the over-the-counter swaps market can give you a deeper insight into the capital flows that drive thebond markets, the way in which the companies whose stock investor own manage theirexposure to fluctuations in interest rates and the way banks and financial institutions makea great deal of their income.


NOTES


Equity swaps are powerful tools in the hand of the passive investment manager, theinvestor looking to tailor the timing of his tax events, investment managers looking foropportunities abroad and the average investor looking to enhance his return despite theletter of government provisos.

Questions

1 What do you mean by Interest Rate Swap? Briefly Explain

2 What are the Types of Swaps? Explain

3 Explain about the Floating Rate Cash flow Management

4 What are the drawbacks of Parallel and Back to back loans?

5 Why will the dealer only partially hedge the swaps portfolio?

6 “Equity swaps make the index trading strategy even easier”. Explain


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NOTES


UNIT V

ACCOUNTINGCHAPTER I

ACCOUNTING TREATMENT FOR DERIVATIVETRANSACTIONS

5.1.1 Introduction

The accounting of financial instruments is based on whether those are used for hedgingor not. Where they are not used for hedging they could fall under any of the four categories:(i) Financial asset/liability at fair value through profit and loss account (ii) Held-to-maturityinvestments (iii) Loans and receivables and (iv) Available for sale.

Financial asset/liability at fair value through profit and loss account would generallycover trading items and those that management voluntarily wishes to classify under thiscategory. All the fair value changes in the financial asset/liability are taken to the incomestatement and consequently the income statement would become highly volatile.

Derivatives would fall under this category, unless they are used for hedging purposesin which case hedge accounting would apply.

Held-to-maturity financial assets are those investments where there is positive intentionto hold those assets till the maturity period. They do not include derivatives since they areincluded in the first category. A financial asset that fulfills the definition of loans and receivablesare also not included.

Besides an investment which is otherwise held-to-maturity may be classified voluntarilyby the management in the fair value category or available for sale category.

Held-to-maturity investments are accounted for through the effective interest ratemethod and the consequent gains and losses are recognised in the income statement.

5.1.2 Getting Ready

The markets for derivatives have been remarkable and continued growth over thepast decade. This reflects the increasing use of such instruments by business, either for


speculation or hedging purposes. Accordingly, the accounting treatment for derivativesand hedging activities has taken on a high degree of importance.

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Hedge accounting does not sit well with the standard setters’ desired goal for financialinstrument accounting, i.e. a full fair value model. Further, hedge accounting relies onmanagement intent to link for accounting purposes what the standard setters see as two ormore separate transactions. It also overrides accounting requirements that would otherwiseapply to those transactions when viewed separately.
Standard setters believe that separate accounting is the best way to “tell it as it is”, inother words, to apply the full fair value model. However, the wider financial reportingcommunity could not be persuaded to accept the abolition of hedge accounting. AccountingStandard AS-30 on Financial Instruments-Recognition and Measurement has been issuedby the institute as published in January 2008 journal.

This Accounting Standard will become mandatory in respect of accounting periodcommencing on or after April 1, 2011, for all commercial, industrial and business entitiesexcept to a small and medium size entity.

Correspondingly, a limited revision has also been made to AS-11 so as to withdrawthe requirements concerning forward exchange contracts from that Standard. ICAI is alsoin process of formulating a separate Accounting Standard AS-32 on Financial Instruments-Disclosures. As such AS-30 deals with Recognition and Measurement, and AS-32 dealswith exclusively on Disclosure.

5.1.3 Hedge Accounting

As required by the standard, on the date of this standard becoming mandatory, anentity should; measure all derivatives at fair value; and eliminate all deferred losses andgains, if any, arising on derivatives that under the previous accounting policy of the entitywere reported as assets or liabilities.

Any resulting gain or loss (as adjusted by any related tax expense/benefit) should beadjusted against opening balance of revenue reserves and surplus.

On the date of this standard becoming mandatory, an entity should not reflect in itsfinancial statements a hedging relationship of a type that does not qualify for hedge accountingunder this standard (for example, hedging relationships where the hedging instrument is acash instrument or written option; where the hedged item is a net position; or where thehedge covers interest risk in a held-to-maturity investment). However, if an entity designateda net position as a hedged item under its previous accounting policy, it may designate anindividual item within that net position as a hedged item under Accounting Standards,provided that it does so on the date of this standard becoming mandatory.

It, before the date of this standard becoming mandatory, an entity had designated a


transaction as a hedge but the hedge does not meet the conditions for hedge accounting inthis standard, the entity should apply paragraphs 102 and 112 to discontinue hedge

NOTES


accounting. Transactions entered into before the date of this standard becoming mandatoryshould not be retrospectively designated as hedges.

5.1.4 Embedded Derivatives

As entity that applies this standard for the first time should assess whether an embeddedderivative is required to be separated from the host contract and accounted for as a derivativeon the basis of the conditions that existed on the date it first became a party to the contractor on the date on which a reassessment is required by appendix A paragraph A56, whicheveris the later date.

5.1.5 Recent Announcement

Notwithstanding the applicability of AS-30, it is very important to understand theimpact and effect of this announcement. The announcement on accounting for derivativesissued by ICAI on March 29, 2008, clarifies the best practice treatment to be followed forall derivatives is as follows:

i. All derivatives except forward contracts covered by AS 11, can be accounted for onthe basis of the requirements prescribed in AS 30, Financial Instruments: Recognitionand Measurement.

ii. In case an entity does not follow AS 30, keeping in view the principle of prudence asenunciated in AS 1, ‘Disclosure of Accounting Policies’, the entity is required to providefor losses in respect of all outstanding derivative contracts at the balance sheet dateby marking them to market.

The effect of the above announcement is as follows:

i. In case an entity does not follow AS 30, the losses in respective of derivative contractsat the balance sheet date have to be provided for and disclosed.

ii. In case an entity follows AS 30, then the effect will be broadly as follows:

In case the derivatives do not meet the hedge accounting criteria as laid down in AS30, the gains or losses in respect thereof will have to be recognised in the statement ofprofit and loss. The derivatives will have to be shown as financial assets or financial liabilitieson the balance sheet, as the case may be, as per the requirements of the accounting standard.

In case the hedge accounting criteria, e.g., hedge effectiveness, qualifying hedges,documentation etc, as laid down in AS 30 are met, the entity will have to consider, keepingin view the requirements of AS 30, whether the hedge is a fair value hedge or cash flowhedge.

‘Fair value hedge’ and ‘cash flow hedge’ have been explained in AS 30 as follows:


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a) Fair value hedge: A hedge of the exposure to changes in fair value of a recognisedasset or liability or an unrecognised firm commitment, or an identified portion ofsuch an asset, liability or firm commitment, that is attributable to a particular riskand could affect profit or loss.
b) Cash flow hedge: A hedge of the exposure to variability in cash flows that (i) isattributable to a particular risk associated with a recognised asset or liability (suchas all or some future interest payments on variable rate debt) or a highly probableforecast transaction and (ii) could affect profit or loss.

As per the standard, a hedge of the foreign currency risk of a firm commitment maybe accounted for as a fair value hedge or a cash flow hedge.

5.1.6 Fair value hedges are accounted for as follows:

The gain or loss for re-measuring the derivative hedge instruments at fair value shouldbe recognised in the statement of profit and loss, and The gain or loss on the hedged items(the underlying) should adjust the carrying amount of the said items and be recognised inthe statement of profit and loss.

5.1.7 Cash flow hedges are accounted for as follows:

i. In case of effective cash flow hedges, the gain or loss on the hedging derivative isrecognised directly in an appropriate equity account, say, hedge reserve account (theineffective hedge portion is recognised in the statement of profit and loss account).

ii. If a hedge of a forecast transaction subsequently results in the recognition of a financialasset or a financial liability, the associated gains or losses that were recognised directlyin the appropriate equity account in accordance should be reclassified into, i.e.,recognised in the statement of profit and loss in the same period or periods duringwhich the asset acquired or liability assumed affects profit or loss (such as in theperiods that interest income or interest expense is recognised).

iii. If a hedge of a forecast transaction, subsequently results in the recognition of a non-financial asset or a non-financial liability, or a forecast transaction for a non-financialasset or non-financial liability becomes a firm commitment for which fair value hedgeaccounting is applied, then the entity should adopt (a) or (b) below:

a) It reclassifies, i.e., recognises, the associated gains and losses that were recogniseddirectly in the appropriate equity account into the statement of profit and loss in thesame period or periods during which the asset acquired or liability assumed affectsprofit or loss (such as in the periods that depreciation expense or cost of sales isrecognised).

b) It removes the associated gains and losses that were recognised directly in the equityaccount, and includes them in the initial cost or other carrying amount of the asset orliability.


NOTES


An entity should adopt either (a) or (b) as its accounting policy and should apply itconsistently to all hedges to which

iv. above relates.

v. For cash flow hedges, other than those covered by paragraphs (ii) and (iii) above,amounts that had been recognised directly in the equity account should be reclassifiedinto, i.e., recognised in the statement of profit and loss in the same period or periodsduring which the hedged forecast transaction affects profit or loss (for example, whena forecast sale occurs).

5.1.8 New Accounting Rules for Derivatives and Hedging Activity

For the last six years, the Financial Accounting Standards Board (FASB) has beenconsidering the way derivative instruments are reported in corporations’ financial statements.The Board concluded that current accounting rules for derivatives are incomplete,inconsistent, difficult to apply and not transparent in financial statements, and thereforeproposed a new standard.

Four fundamental principals underlie the new accounting rules:

a) Derivatives are assets and liabilities, and should be reported in financial statementsas such;

b) Fair value is the only relevant measure for derivative instruments;

c) Gains or losses on derivatives cannot be deferred; however,

d) Special accounting is permitted for items which qualify as hedges.

Of importance is that the new rules provide no circumstance for which a companycan retain off-balance sheet accounting treatment for derivatives. Any derivative instrumentmust be reflected in the balance sheet at its fair value.

Derivatives that meet the criteria for an effective hedge qualify for special hedgeaccounting treatment. Three types of hedges are recognized: fair value hedges, cash flowhedges and hedges of corporations’ net investments in foreign operations.

5.1.9 Fair Value Hedges

Derivatives can be used to hedge changes in the fair value (market value) of financialassets or liabilities like debt securities. For instance, a fixed rate bond’s market valuechanges when interest rates go up or down. Hedging the bond’s price risk with a derivativewould be considered a fair value hedge.

Changes in the fair value of the derivative flow directly to the income statement, butare offset by changes in the fair value of the hedged item which are recognized in theincome statement at the same time.


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Fair Value Hedge Accounting
5.1.10 Cash Flow Hedges

Derivatives can also be used to hedge changes in future cash flows arising from existingassets or liabilities, or from forecasted transactions. For example, interest payments on acompany’s variable rate debt expose a company to interest rate risk. Hedging this exposureusing an interest rate swap (to convert the debt from floating rate to fixed interest rate)would be considered a cash flow hedge under the new rules.

In a cash flow hedge, changes in the fair value of the interest rate swap wouldaccumulate first in the statement of comprehensive income. (This is similar to how foreignexchange translation gains and losses are accumulated as a separate component of equityunder existing accounting rules.) A portion of these gains or losses would be transferredout of comprehensive income to the income statement whenever interest is paid on thehedged debt. The net result will be a fixed rate of interest expense.

Cash Flow Hedge Accounting

5.1.11 Hedges for Net Investment in Foreign Operations

The new rules still permit companies to hedge foreign currency exposure related to aninvestment in a foreign operation. The new accounting is similar to current rules except that

Example Company issues fixed rate debt, then swaps debt to floating rate.

Accounting for swap: Swap is marked to market and changes in value are recognized in current earnings.

Accounting for debt: Change in value of debt related to change in market interest rates is recognized in earnings.

Combination of swap change in value plus debt change in value is offset in earnings.

Example: Company issues floating rate debt, then swaps to fixed rate. Accounting for swap:

Swap is marked to market and changes in value are recognized first in statement of comprehensive income and then in earnings as interest payments on hedged debt are made. At maturity, swap's value reduces to zero. Swap's carrying value is adjusted each period to reflect actual swap payments or receipts.

Accounting for floating rate debt:

Variable interest rate expense is recognized in earnings as incurred.

Combination of swap change in value plus debt change in value is offset in earnings.


NOTES


the translation gains or losses on the investment and the hedge are reported in the statementof comprehensive income instead of equity.

5.1.12 Derivatives and Income Statement Volatility

Income statements of companies that utilize derivatives as hedges will be largelyunaffected by the accounting changes. Under the new rules, effective hedges (hedges whichhave a high correlation to the asset or liability being hedged) should not introduce incomestatement volatility.

So as long as the hedge works effectively, changes in the fair value of the derivativeshould be opposite to and offset changes in the fair value/cash flow of the hedged item.

5.1.13 Increased Derivatives Disclosure

One of the benefits of the new rules is that more information about a company’shedging program will be revealed to investors. In addition to the more detailed informationprovided in financial statements, a company must also provide an expanded description ofits risk management philosophy and strategy. From this, investors and analysts will bebetter able to determine whether or not a company is hedging critical financial exposures.This increases the likelihood that companies with prudent hedging programs will be rewardedby the market.

5.1.14 Derivatives Management Systems

5.1.14.1 Derivatives Systems

A critical but often overlooked aspect of a competent derivatives trading operationare the computer systems used to manage the risk, account for the positions on a mark-to-market basis, track derivatives-related events (such as expiries and rollovers) and measureValue-at-Risk. Once you have read some of the articles in the Derivatives section of theFinancial Pipeline, you will realize how quickly a portfolio of transactions can becomecomplicated. In the section on hedging swaps, we discussed some of these complicationsincluding the problems associated with mismatched short term cash flows and maturitybucket grouping. Options produce their own problems because of the convexity of theseproducts. Taking snapshots of delta, gamma and vega at an instantaneous specification ofprices is insufficient (although necessary) for competent financial risk management.

One must also have an appreciation of how these risks change with the progress oftime and the evolution of prices. In the first edition of Risk Professional magazine publishedby the Global Association of Risk Professionals (see http://www.garp.com), Geoff Katesestablishes a framework for evaluating a financial risk management system and he uses thisframework to assess some of the more common off-the-shelf products on the market.


This article will discuss those criteria and it will explain the importance.

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5.1.14.2 Integration
At the beginning of the global derivatives market’s development, almost every bankpursued derivatives in a stand-alone asset-class-by-asset-class fashion. That is to say, onegroup managed interest rate derivatives, another group managed equity derivatives and athird group managed foreign exchange derivatives. For many banks, this is still the case.

However, an increasing number of financial institutions are turning to a more integratedapproach, stripping the derivatives desks from each asset class’ cash group and combiningthem into a more efficient cross-marketing machine. Once you understand interest ratederivatives, it is straightforward to understand equity derivatives or foreign exchangederivatives. Conversely, it is not necessarily the case that a manager who has spent hisentire career overseeing spot foreign exchange salespeople will be able to understand theway in which a derivatives book works. It is not something you’re likely to learn from abook or a classroom. You have to have experience.

5.1.14.3 To Buy or to Build

The next question the bank’s senior management must ask itself is whether or not thebank should buy an off-the-shelf system or build one using its own internal IT resources.

Buying a system is convenient, particularly if it is one that is in widespread use. Popularsystems have been tested and have had all of the kinks worked out. The more popular thesystem, the less likely that it is vulnerable to internal control irregularities. That is, the morepopular the system, the less likely it is possible for individuals to manipulate the bank’sofficial records for fraudulent purposes. Systems are typically very expensive, with chargesfor both a site license and individual annual user permits. Many of the companies that sellthese systems make it easy for the user to customize reports, batch files, pricing modules,etc.

However, many financial institutions are reticent to relinquish the responsibility forrisk management computer systems to a third party. The managers of these institutionswould prefer to have their own internal risk management personnel design the system thatis then implemented by the bank’s IT staff. Not only is this more expensive than buying anoff-the-shelf system in terms of up-front dollar cost and delays in implementation but thesystem is vulnerable to the expertise of a handful of individuals. Let’s say you are the headof trading at ABC Bank and you commission your risk management department, all ofthree people (Larry, Curly and Moe) to design and implement your interest rate riskmanagement system. If Larry, Curly and Moe leave to go as a team to DEF Bank, you willhave lost all of your core knowledge base and you will have to start from scratch. There isalso the possibility that Larry, Curly or Moe designed secret entrances into the system forthemselves so that they could manipulate tickets and positions and profit and loss statements.


NOTES


5.1.14.4 Speed

In order to be effective, risk management information must be at least as fast as themarkets to which it refers. On the face of it, for most people using applications designedfor home use, this is not problematic. However, for financial institutions with portfoliosconsisting of thousands of different instruments, some of which use very complicatedformulae, and arrays of parameters to revalue, this is a serious database design problem.

5.1.14.5 Interface

One of the key aspects of a well-designed system is its flexibility. A good riskmanagement system will have a user interface that is customizable. Many of them arebeginning to use the Internet as their interface platform. The interface is also the mechanismin which reports are designed. For an example of the kinds of reports dealers and riskmanagers require, see our earlier article entitled “How Do Options Traders Look At TheirPortfolios”

5.1.14.6 Asset Class Coverage

Further to our discussion of the integration of asset classes in the management ofderivatives sales and trading operations at leading financial institutions, a good riskmanagement system will provide the senior management with the ability to immediatelyaccess information on all of the derivatives activities in which the financial institution isengaged, across all asset classes.

It is not uncommon for banks to have systems in place that enable their managementto take a snapshot of the firm’s financial price risk with the simple click of a button at anypoint during the trading day, in real-time.

Covering all of the asset classes also allows for greater overall risk-taking because itallows for the portfolio effects of diversification of risk across the different asset classes.

5.1.14.7 Pricing Model Flexibility

Model risk refers to the problems associated with discrepancies between the theoreticalpricing of a financial instrument and the way in which it actually trades in the market. Thedifference in price, for a given set of input parameters, is a result of the assumptions thatare necessary for solution of the mathematical model of the price of the financial product inquestion.

For some financial products, particularly the more exotic or novel ones, the choice ofpricing model is a controversial one. A good risk management system will allow managementto pick and choose the pricing model it prefers for a particular instrument and it will alsoallow management to compare the model risk in different market environments associatedwith individual pricing models.


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5.1.14.8 Ability to Link to Other Systems
The derivatives risk management system is only one of a handful of systems withwhich the dealer at a financial institution must be familiar. Other systems include ticketingsystems for cash instruments, accounting systems, credit risk management systems and,possibly, spreadsheets tracking customer portfolios.

A dealer’s life is made much easier when the primary system he uses on a daily basis, therisk management system, can communicate its information to the other relevant systemsautomatically. Otherwise, the dealer (or more likely his assistant) will have to input multipletickets for a single transaction. This is not just a question of personal effort. It is an operationalrisk issue, as well. Every time the dealer inputs a ticket, there is room for an error. Toomany errors and the bank begins to lose customers as well as money.

5.1.14.9 The key point here is that technological sophistication leads to better management.

These are just some of the criteria that a financial institution risk manager may chooseto apply to the selection of a financial risk management computer system. In the next waveof development, risk management platforms will be entirely web-based. Already, GoldmanSachs and other leading American investment banks are offering web-based riskmanagement systems, including pricing models, to their clients. Helping their clientsunderstand the financial price risk they face makes it easier for the client to understand theefficacy of financial products (products which they hopefully transact with Goldman Sachs).

Summary

Financial asset/liability at fair value through profit and loss account would generallycover trading items and those that management voluntarily wishes to classify under thiscategory. All the fair value changes in the financial asset/liability are taken to the incomestatement and consequently the income statement would become highly volatile.

The markets for derivatives have been remarkable and continued growth over thepast decade. This reflects the increasing use of such instruments by business, either forspeculation or hedging purposes. Accordingly, the accounting treatment for derivativesand hedging activities has taken on a high degree of importance.

However, if an entity designated a net position as a hedged item under its previousaccounting policy, it may designate an individual item within that net position as a hedgeditem under Accounting Standards, provided that it does so on the date of this standardbecoming mandatory.

Derivatives can be used to hedge changes in the fair value (market value) of financialassets or liabilities like debt securities.


NOTES


At the beginning of the global derivatives market’s development, almost every bankpursued derivatives in a stand-alone asset-class-by-asset-class fashion. That is to say, onegroup managed interest rate derivatives, another group managed equity derivatives and athird group managed foreign exchange derivatives. For many banks, this is still the case.

Accounting standards groups around the world have been watching the FASB’sprogress as it tackles the issue of accounting for derivative instruments. The InternationalAccounting Standards Committee continues to review the new US standard and is expectedto make a decision shortly about whether it will follow the US lead. As well, the CanadianInstitute of Chartered Accountants may adopt FASB’s standards so Canadian companieswould be required to adhere to these new rules in the not-too-distant future.

Questions

1. Explain the Accounting Treatment For Derivative Transactions

2. What do you understand by Hedge Accounting?

3. What do you mean by Embedded Derivatives?

4. How are the Fair value hedges accounted?

5. What do you understand by Hedges for Net Investment in Foreign Operations?

6. Explain the Derivatives Management Systems


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CHAPTER II
CREDIT DERIVATIVES

5.2.1 Introduction

A credit derivative is a financial instrument used to mitigate or to assume specificforms of credit risk by hedgers and speculators. These new products are particularly usefulfor institutions with widespread credit exposures. Some observers suggest that creditderivatives may herald a new form of international banking in which banks resemble portfoliosof globally diversified credit risk more than purely domestic lenders.

Local banks can take advantage of their informational edge in terms of assessing thedefault risk and recovery rates in their regional market. They make loans based upon thiscredit assessment and then use credit derivatives to swap these cash flows for moreinternationally diverse cash flows. Imagine a US regional bank that lends money in Carolinato a local hotel. They take this credit risk and add it to their overall portfolio of credit risk.Deciding to reduce their local exposure, they exchange the cash flows from a portfolio oftheir mid-grade Carolina debt for cash flows of highly rated Northern Italian corporatedebt. This is just one example.

5.2.2 Credit Swaps

Corporate bonds trade at a premium to the risk-free yield curve in the same currency.US Corporate Bonds trade at a premium (called a credit spread) to the US Treasurycurve. The credit spread is volatile in and of itself and it may be correlated with the level ofinterest rates. For example, in a declining, low interest rate environment combined withstrong domestic growth, we might expect corporate bond spreads to be smaller than theirhistorical average. The corporate who has issued the bond will find it easier to service thecash flows of the corporate bond and investors will be hungry for any kind of premiumthey can add to the risk-free rate.

Imagine the fund manager who specializes in corporate bonds who has a view on thedirection of credit spreads on which he would like to act without taking a specific positionin an individual corporate bond or a corporate bond index.

One way for the fund manager to take advantage of this view is to enter into a creditswap.

Let’s say that the fund manager believes that credit spreads are going to tighten andthat interest rates are going to continue to decline.


NOTES


He would then want to enter into a swap in which he paid the corporate yield at six-month intervals against receiving a fixed yield equal to the inception Treasury yield plus thecorporate credit spread. That is to say, at the six-month reset for the tenor of the swap, thefund manager agrees to pay a cash flow determined to be equal to the current annual yieldon some benchmark corporate bond or corporate bond index in consideration for receivinga fixed cash flow.

This is an off-balance sheet transaction and the swap will typically have zero value atinception.

If corporate yields continue to fall (i.e. through a combination of a lower risk-free rateand a lower corporate credit spread than the one he locked in with the swap), he will make


money. If corporate yields rise, he will lose money.

1998 was a dynamic year for corporate bond spreads with the backup in interestrates in the aftermath of the Russian devaluation-inspired liquidity crisis concentrated mainlyin corporate yields. The volatility of these spreads was extreme when compared to theirhistorical movement. Credit swaps would have been an excellent way to play this spreadvolatility.

Moreover, credit swaps (particularly ones based on a spread index) are cleanstructures without the messy difficulty of finding individual corporate bond supply, etc.

Another example of a credit swap might be the exchange of fixed flows (determinedby the yield on a corporate bond at inception) against paying floating rate flows tied to therisk-free Treasury rate for the corresponding maturity.

Naturally, swaps are flexible in their design. If you can imagine a cash flow exchange, youcan structure the swap. There might be a cost associated with it but you can certainly putit on the books.

5.2.3 Credit Default Swaps

A credit default swap is a swap in which one counterparty receives a premium at pre-set intervals in consideration for guaranteeing to make a specific payment should a negativecredit event take place.

One possible type of credit event for a credit default swap is a downgrade in thecredit status of some preset entity.

Consider two banks: First Chilliwack Bank and Banque de Bas.

Chilliwack has made extensive loans in its corporate credit portfolio to a propertydeveloper called Churchill Developments. It is looking for some kind of insurance againsta downgrade of Churchill by the major ratings agency, a real possibility since the main

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project Churchill has taken on is running into unforeseen delays. Chilliwack approachesBanque de Bas with the concept of a credit default swap. They pay Banque de Bas apremium every six months for the next five years in exchange for which de Bas agrees tomake payments to Chilliwack of a pre-set amount should Churchill be downgraded.
De Bas now has exposure to Churchill, a position they could not take directly becausethey are not part of Churchill’s lending syndicate.

Chilliwack has some degree of protection against a Churchill credit downgrade. Thisreduction in their overall credit profile means that they do not need to hold as much capitalin reserve, freeing Chilliwack up to take other business opportunities as they presentthemselves.

5.2.4 Options on Credit Risky Bonds

Finally, our fund manager from the first example could use an options position to takeadvantage of his view on the level of the corporate yield.

If he believed that corporate yields were set to fall through some combination oflower risk-free interest rates and tighter corporate bond spreads, then he could just buy acall on a corporate bond of the appropriate maturity.

These are just a few of the examples of credit derivatives. Institutional investors oftenuse credit derivatives when positioning themselves in emerging markets for the ease oftransaction in the same way that they might use equity swaps. Fund managers can usecredit derivatives to hedge themselves against adverse movements in credit spreads.Corporates can use credit swaps to hedge near-term issues of corporate bonds. Banksand other financial institutions can use credit derivatives to optimize the employment oftheir capital by diversifying their portfolio-wide credit risk.

Summary

Local banks can take advantage of their informational edge in terms of assessing thedefault risk and recovery rates in their regional market. They make loans based upon thiscredit assessment and then use credit derivatives to swap these cash flows for moreinternationally diverse cash flows. Imagine a US regional bank that lends money in Carolinato a local hotel. They take this credit risk and add it to their overall portfolio of credit risk.Deciding to reduce their local exposure, they exchange the cash flows from a portfolio oftheir mid-grade Carolina debt for cash flows of highly rated Northern Italian corporatedebt. This is just one example.

Corporate bonds trade at a premium to the risk-free yield curve in the same currency.US Corporate Bonds trade at a premium (called a credit spread) to the US Treasurycurve. The credit spread is volatile in and of itself and it may be correlated with the level ofinterest rates


NOTES


A credit default swap is a swap in which one counterparty receives a premium at pre-set intervals in consideration for guaranteeing to make a specific payment should a negativecredit event take place.

If he believed that corporate yields were set to fall through some combination oflower risk-free interest rates and tighter corporate bond spreads, then he could just buy acall on a corporate bond of the appropriate maturity.

Questions

1. What do you mean by Credit Derivatives?

2. Explain the Credit Swaps

3. What do you understand by Options on Credit Risky Bonds?

4. What is meant by Credit Default Swaps?


DBA 1754

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DBA 1754

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Financial Derivatives

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