risk management of derivatives in Bombay Stock Exchange.docx

7/23/2019 risk management of derivatives in Bombay Stock Exchange.docx

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The risk management of derivatives in Bombay

Stock Exchange

Chapter 1

1.1

INTRODUCTION

A country is termed prosperous if its economy is doing well. There are a large

numer of influencing factors which determines the prosperity of the economy!

li"e #er$capita income of people! %D#! Imports & '(ports! )ore( Reser*es! etc.

In short it can e told that )inancial +ar"et is an important contriutor to the

economy. In this financial mar"et! capital mar"et plays a significant role. The

capital mar"et always replicates the power and aility of the in*estors and their

faith in the mar"et. 'arlier the capital mar"et was shy. ,ut mar"et deregulations!

growth in gloal trade and technological de*elopment ha*e re*olutioni-ed the

financial mar"et place. A y$product of this re*olution is increased mar"et

*olatility! which has led to a corresponding increase in ris" management

products. This demand is reflected in the growth of financial deri*ati*es and

deri*ati*es mar"et. ,ut! uestion arises! are these deri*ati*es ris" free/ As

world0s one of the greatest in*estor once said! Ris" is a part of %od0s game!

ali"e for man and nation2 Thus it can e said that these ris" management

instruments are not ris" free. This indicates the essence of ris" management of

deri*ati*es.


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1.3

RATIONA4'

In this world of uncertainty ris" management has an immense importance for

corporate. )inancial deri*ati*es which are introduced with a prime o5ecti*e of

hedging ris"! when used for speculati*e purposes resulted with increased ris".

Thus! ris" management of financial deri*ati*es is a ma5or area of concern. In

case of an e(change! as e(change plays the role of counterparty for oth uyer

and seller! it is more e(posed to counterparty ris" and all other ris" associated

with the financial deri*ati*es. This leads to the essence of ris" management of

deri*ati*es in e(changes.

The *arious tools used y the e(changes for ris" management includes margins!

position limits! and *arious rules and regulations laid down y the regulatory

authority for deri*ati*e trading. All these process of ris" management is done y

wholly computeri-ed process and with specific software. The inclusion of latest

technology has made the ris" management process more reliale. The ris"

management of deri*ati*es not only secures 6toc" '(changes! ut also creates

confidence in the minds of the in*estors. This enhances more in*estments in the

deri*ati*es mar"et! which leads to usiness prosperity. Thus the most of the

e(changes ha*e their ris" management procedure for ris" management of

deri*ati*es.


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1.7

O,8'CTI9'

On the ao*e outset! the following are the laid down as the o5ecti*e of this

study!

I. To study the ris" associated with deri*ati*e mar"et and deri*ati*e trading.

II. To study the ris" management tools used in ,omay 6toc" '(change limited

for mitigating these ris"s.

III. To study the margining system for deri*ati*es.

I9. To study the software used for margining system.

9. To do comparati*e analysis of the ris" management process of ,6' with that

Of N6'

9I. To gi*e suggestion and recommendations for impro*ement in ris"

management process of deri*ati*es in ,6'.


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1.:

R'6'ARC; +'T;ODO4O%. The secondary data consists of oo"s and 5ournals

pro*ided y ,6'! 6',I circulars and %uidelines. This also contains the data of

deri*ati*e segment of N6'! which was collected from the wesite of N6'.

1.:.:

TOO46 AND T'C;NI?U'6

The data so collected were classified and taulated for analysis and

interpretation. The tools and techniues used in this pro5ect are all computeri-ed

programming. The data are programmed in software li"e *isual asic!

+AT4A,! etc! to find the implied *olatility and price scan range. )inally all

these implied *olatility and price scan range are processed in #C @ 6#AN

=software for calculation of margin> to find out the margin reuirement of

different participants of the deri*ati*e mar"et. The turno*er of deri*ati*es

segment of ,6' and N6' is drawn in graphs to compare these two mar"ets.


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1.

4I+ITATION

6ome of the limitations that are faced during the pro5ect areB

1. The information collected is limited y the authenticity and accuracy of

information pro*ided y the inter*iewees. The data collected from the wesites

are limited. Certain information was not disclosed to maintain the secrecy of the

e(change.

3. The time predefined for this pro5ect was wee"s! which is *ery short for

co*ering such a ig pro5ect.


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1.

C;A#T'RI6ATION

This pro5ect is aout the ris" management of deri*ati*es in ,6'. 9arious

technicalities that are in*ol*ed in this process has een e(tensi*ely discussed

and dealt with this report. The report contains the following si( chapters! which

are summari-ed elow. Chapter one egins with the introduction to the pro5ect

report! stating the importance! o5ecti*es and research methodology adopted.

4imitations inherent to the pro5ect are also laid down.

Chapter two deals with the history and potentiality of ,omay 6toc" '(change4imited. !its mission and *ision are also laid down. +a5or e*ents that shaped the

securities mar"et in the country and helped ,6' to grow ha*e een mentioned.

The third chapter deals with the conceptual study of deri*ati*es and its

mechanism. A snapshot of international and Indian deri*ati*e mar"et was also

laid down. A rief idea aout euity deri*ati*es was also mentioned in this

chapter.

Chapter four contains the conceptual idea of ris" management process. This

chapter also throws light on the essence of ris" managementB ris" associated

with deri*ati*es trading and ris" management of deri*ati*es. The fifth chapter

comprises of analysis and interpretation part. Chapter si( contains the

summari-ed list of all important findings. And finally! the ultimate chapter aims


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trading 6ystem =,O4T>! which is a proprietary system of the e(change and is

,6 JJ$3$3FF3 certified. The 6ur*eillance and Clearing 6ettlement function of

the '(change are I6O JFF1K3FFF certified.

9I6ION

'merge as the premier Indian stoc" e(change y estalishing gloal

enchmar"2

3.3 ;I6TOR 6cheme! 3FF

notified y 6ecurities and '(change ,oard of India =6',I>. Then it is renamed

as the ,omay 6toc" '(change 4imited2.

3.7 #RO+IN'NT #O6ITION

The 5ourney of ,6' is as e*entful and interesting as the history of securities

mar"ets of India. India0s iggest ourse! in terms of listed companies and

mar"et capitali-ation! ,6' has played a pioneering role in Indian securities

mar"et. +uch efore the actual legislations were enacted! ,6' had formulated

comprehensi*e set of rules and regulations for Indian capital mar"ets. It also

laid down est practices adopted y Indian capital mar"et after India gained its

independence. #erhaps! there would not e any leading corporate in India!

which has not sourced ,6'0s ser*ices in resource moili-ation.

3.: A #ION''R

,6' as rand is synonymous with the capital mar"ets in India. The ,6'

6'N6'H is the enchmar" euity inde( that reflects the roustness of the

economy and finance. At par with international standards! ,6' has een a

pioneer in se*eral areas. It has a se*eral firsts to its credit!

)irst in India to introduce 'uity Deri*ati*es.

)irst in India to launch a )ree )loat Inde(.

)irst in India to launch U6G *ersion of ,6' 6'N6'H.

)irst in India to launch '(change 'nale Internet Trading #latform.


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)irst in India to otain I6O certification for 6ur*eillance! Clearing and 6ettle.

)irst to ha*e e(clusi*e facility for financial training.

L,6' On$4ine Trading 6ystem0 =,O4T> has awarded with the gloal recogni-ed

Information 6ecurity +anagement 6ystem 6tandard ,6JJ$3$3FF3. +o*ed

from Open Outcry to 'lectronic Trading within 5ust F days. An eual important

accomplishment of ,6' is the launch of a nationwide in*estor awareness

campaign @ 6afe In*esting in the 6toc" +ar"et @ under which nationwide

awareness campaigns and dissemination of information through print and

electronic medium was underta"en. ,6' also acti*ely promoted the securitiesmar"et awareness campaign of the 6ecurities and '(change ,oard of India

=6',I>.

3. AEARD6

,omay 6toc" '(change 4imited has many awards to its name for its

e(cellence in se*eral fields! these are

The Eorld Council of Corporate %o*ernance has awarded the %olden #eacoc"

%loal C6R Award for ,6'0s initiati*es in Corporate 6ocial Responsiility

=C6R>.

The Annual Reports and Accounts of ,6' for the year ended +arch 71! 3FF

and +arch 71! 3FF ha*e een awarded the ICAI Awards for e(cellence in

financial reporting.

The ;uman Resource +anagement at ,6' has won the Asia @ #acific ;R+

Award for its efforts in employer randing through talent management at wor"!

health management at wor" and e(cellence in ;R through technology.


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3. ,6' 6EOT

6TR'N%;6K ,6' has inherent ad*antagesK its history! larger scrip ase and a

stronger rand. The 6'N6'H =,6'0s 7F$share sensiti*e inde(> is one of the

most recogni-ed inde(es and trac"ed worldwide. Apart from lager ase of listed

companies! ,6' also has a historical perspecti*e. Its online trending system

=,O4T> has awarded with the gloal recogni-ed Information 6ecurity

+anagement 6ystem 6tandard ,6JJ$3$3FF3. It got the I6O certification forits sur*eillance and clearing and settlement.

E'AMN'66 K The ,6' 6'N6'H! which deli*ers inferior hedging

effecti*eness and higher impact cost. At present ,6' has fewer than 13 share

across the cash and deri*ati*e mar"et of euity mar"ets. At present! ,6' is

almost non$e(istence in deri*ati*es space. ,6' also lac"s in terms of pro*iding

etter ser*ices to its customers and is not proacti*e.

O##ORTUNITI'6 K Corporati-ation will impro*e internal management systems

and in*estor relations! and enefit companies that are listed on ,6'. Deri*ati*es

mar"et is growing at e(ponential rate and ,6' with its large infrastructure and

long presence in the capital mar"et has the capaility to e(pand its mar"et share

in this segment. If large a pri*ate sector an" pic"s up a strategic sta"e in ,6'!

it could gi*e the e(change access to a large distriution networ" and promote


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new products li"e deri*ati*es. 7F to :F percent of the income of e(change li"e

NA6DA? and N


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instruments which ha*e no independent *alue. Their *alue depends upon the

underlying asset. The underlying asset may e financial or non$financial.

The term deri*ati*e2 can e defined as a financial contract whose *alue is

deri*ed from the *alue of an underlying asset. 6ection 3=ac> of 6ecurities

Contract =Regulation> Act! =6CRA>! 1J defines deri*ati*es as!

a> a security deri*ed from a det instrument! share! loan whether secured or

unsecured! ris" instrument or a contract for difference or any other form of

securitiesB

> a contract which deri*es its *alue from the prices! or inde( of prices! of

underlying securities2. The underlying asset may e a stoc"! ond! a foreign

currency! commodity or e*en another deri*ati*e security. Deri*ati*e securities

can e used y indi*iduals! corporations! and financial institutions to hedge an

e(posure to ris".


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7.3 D'RI9ATI9' #RODUCT6

Deri*ati*e contracts ha*e se*eral *ariants. The most common *ariants are

forwards! futures! options and swaps. 9arious deri*ati*es contracts are

descried elow!

7.3.1 )OREARD6

A forward contract is a customi-ed contract etween two entities! where

settlement ta"es place on a specific date in the future at today0s pre$agreed

price. A forward contract is an agreement etween two parties to uy or sell an

asset at a specific point of time in future and the price which is paid recei*ed y

the parties is decided at the time of entering the contract.

7.3.3 )UTUR'

A future contract is an agreement etween two parties to uy or sell an asset at a

certain time in the future at a certain price. )uture contracts are standardi-ed

forward contracts. )uture contracts are traded in e(changes and e(change sets


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the standardi-ed terms in term of uantity! uality! price uotation! date and

deli*ery date =in case of commodities>.

7.3.7 O#TION6

An option contract! as the name suggests! is in some sense an optional contract.

An option is the right! ut not the oligation! to uy or sell something at a stated

date at a stated price. Options are of two typesB

P CA44 O#TION6K A call option gi*es the uyer of the option the right! ut not

the oligation to uy a gi*en uantity of the underlying asset! at a gi*en price

and on or efore a gi*en date.

P #UT O#TIONK #ut options gi*e the uyer the right! ut the oligation to sell a

gi*en uantity of underlying asset at a gi*en price on efore a gi*en date.

Options can also e 'uropean options and American options. This classification

is ased on the e(ercise of the options. 'uropean options can e e(ercised at the

maturity date of the option. On the other hand! American options can e

e(ercised at any time up to and including the maturity date.

7.3.: EARRANT6

Options generally ha*e li*es of up$to one year. 4ong dated options are called as

warrants and generally traded o*er$the$counter.

7.3. 4'A#6

4ong$Term$'uity$Anticipated 6ecurities are options ha*ing a maturity of more

than three years or in other words options ha*ing a maturity of more than three

years are termed as 4'A#6.

7.3. ,A6M'T6


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,as"et options are options on portfolio of underlying assets. 'uity inde(

options are a form of as"et options

7.3. 6EA#6

A swap means a arter or e(change. Thus! a swap is an agreement etween two

parties to e(change stream of cash flows o*er a period of time in future. The

two commonly used swaps are!

i> INT'R'6T RAT' 6EA#6K 6waps which entail swapping only the interest

related cash flows etween the parties in the same currency.

ii> CURR'NC< 6EA#6K These entail swapping oth principal and interest

etween two parities! with cash flows in one direction eing in different

currency than those in the opposite direction.

7.7 #ARTICI#ANT6 IN D'RI9ATI9' +ARM'T

The reason for which deri*ati*es are so attracti*e is that they ha*e attracted

different types of in*estors and ha*e a great deal of liuidity. Ehen an in*estor

wants to ta"e one side of a contract! there is usually no prolem in finding

someone that is prepared to ta"e the other side. Three road "inds of

participants can e found in deri*ati*es mar"et! namely! hedgers! speculators

and aritrageurs.

1. ;edgersK They use deri*ati*es mar"ets to reduce or eliminate the ris"

associated with price of an asset. +a5ority of the participants in deri*ati*es

mar"et elongs to this category.

3. 6peculatorsK They transact futures and options contracts to get e(tra le*erage

in etting on future mo*ements in the price of an asset. They can increase oth

the potential gains and potential losses y usage of deri*ati*es in a speculati*e

*enture.


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The o*er$the$counter mar"et is an important deri*ati*e mar"et and has larger

*olume of trade than the e(change$traded mar"et. It is a telephone$ and

computer$ lin"ed networ" of dealers.

Traders are done o*er the phone and are usually etween two financial

institutions or etween a financial institution and one of its clients. Telephone

con*ersations in the OTC mar"et are usually taped. If there is a dispute aout

what was agreed! the tapes are replayed to resol*e the issue. A "ey ad*antage of

o*er$the$counter mar"et is that all the products are customi-ed. +ar"et

participants are free to negotiate any mutually alternati*e deal. A disad*antage

is that there is usually credit ris" in an o*er$the$counter trade. The o*er$the$

counter mar"et is not regulated y any regulatory ody and hence posses a huge

counterparty ris".

7. 'CONO+IC 6I%NI)ICANC' O) D'RI9ATI9'6

6ome of the significance of financial deri*ati*es can e enumerated as followsB

1> The most important function of deri*ati*es is ris" management. )inancial

deri*ati*es pro*ide a powerful tool for limiting ris"s that indi*iduals and

organi-ations face in ordinary conduct of their usiness.

3> The prices of deri*ati*es con*erge with the prices of underlying at the

e(piration of deri*ati*e contract. Thus! deri*ati*es help in disco*ering the

future as well as current prices.

7> As deri*ati*es are closely lin"ed with the underlying cash mar"et! with the

introduction of deri*ati*es! the underlying cash mar"ets witness higher trading


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*olumes. This is ecauseB more people participate in stoc" mar"et due to the

ris" transferring nature of deri*ati*es.

:> 6peculati*e trade shift to a more controlled en*ironment of deri*ati*e

mar"et. In the asence of an organi-ed deri*ati*es mar"et! speculators trade in

the cash mar"ets. +argining! monitoring and sur*eillance of *arious

participants ecome e(tremely difficult in these "inds of mi(ed mar"ets.

> Deri*ati*es trading acts as a catalyst for new entrepreneurial acti*ities. In a

nut shell! deri*ati*es mar"ets encourage in*estment in long run. Transfer of ris"

enales mar"et participants to e(pand their *olume of acti*ity.

7. INT'RNATIONA4 D'RI9ATI9' +ARM'T

The financial deri*ati*es which were meant to address the needs of farmers and

merchants ha*e now a ma5or share in the financial mar"et place. 6tarted with he

estalishment of Chicago ,oard of Trade =C,OT>! deri*ati*es are now traded in

almost all ma5or stoc" e(changes of the world. ,oosted with the rea"down of

,rettonwoods system! the deri*ati*es got the recognition of ris" management

instruments and are used y all in*estors starting from indi*idual in*estor to

institutional in*estor.

Thus! the gloal deri*ati*e mar"et is now a wide spread mar"et with a potential

of further growth. In last two decades deri*ati*es has shown a tremendousgrowth and also continuing to grow in future.


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+a5or stoc" e(changes of deri*ati*es trading are Chicago +ercantile '(change

=C+'>! 'ure(! ;ong"ong )utures '(change! The 4ondon International

)inancial )utures and Options '(change =4I))'>! 6ingapore '(change! 6ydney

)utures '(change etc. Apart from these stoc" e(changes other stoc" e(changes

of *arious countries has shown a huge growth in deri*ati*es trading.

7. INDIAN D'RI9ATI9' +ARM'T

Deri*ati*es mar"ets in India ha*e een in e(istence in one form or the other for

a long time. In the area of commodities! the ,omay Cotton Trade Association

started futures trading way ac" in 1. In 1J3! the %o*ernment of Indiaanned cash settlement and options trading. Deri*ati*es trading shifted to

informal forwards mar"ets. In recent years! go*ernment policy has shifted in

fa*our of an increased role of mar"et$ased pricing and less suspicious

deri*ati*es trading. The first step towards introduction of financial deri*ati*es

trading in India was the promulgation of the 6ecurities 4aws =Amendment>

Ordinance! 1JJ. It pro*ided for withdrawal of prohiition on options insecurities. The last decade! eginning the year 3FFF! saw lifting of an on

futures trading in many commodities. Around the same period! national

electronic commodity e(changes were also set up.

Deri*ati*es trading commenced in India in 8une 3FFF after 6',I granted the

final appro*al to this effect in +ay 3FF1 on the recommendation of 4. C %upta

committee. 6ecurities and '(change ,oard of India =6',I> permitted the

deri*ati*e segments of two stoc" e(changes! N6' and ,6'! and their clearing

housecorporation to commence trading and settlement in appro*ed deri*ati*es

contracts. Initially! 6',I appro*ed trading in inde( futures contracts ased on

*arious stoc" mar"et indices such as! 6 CNH! Nifty and 6'N6'H.

6useuently! inde($ased trading was permitted in options as well as

indi*idual securities.


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The trading in ,6' 6'N6'H options commenced on 8une :! 3FF1 and the

trading in options on indi*idual securities commenced in 8uly 3FF1. )utures

contracts on indi*idual stoc"s were launched in No*emer 3FF1. The

deri*ati*es trading on N6' commenced with 6 CNH Nifty Inde( futures on

8une 13! 3FFF. The trading in inde( options commenced on 8une :! 3FF1 and

trading in options on indi*idual securities commenced on 8uly 3! 3FF1. 6ingle

stoc" futures were launched on No*emer J! 3FF1. The inde( futures and

options contract on N6' are ased on 6 CNH. In 8une 3FF7! N6' introduced

Interest Rate )utures which were suseuently anned due to pricing issue.

6ince the scope of this pro5ect is limited to euity deri*ati*es only! so the

further discussion will e confined to euity deri*ati*es only.

'uity deri*ati*es mar"et in India has registered an Qe(plosi*e growthQ and is

e(pected to continue the same in the years to come. Introduced in 3FFF!

financial deri*ati*es mar"et in India has shown a remar"ale growth oth in

terms of *olumes and numers of traded contracts. N6' alone accounts for JJ

percent of the deri*ati*es trading in Indian mar"ets. The introduction of

deri*ati*es has een well recei*ed y stoc" mar"et players. Trading in

deri*ati*es gained popularity soon after its introduction. In due course! the

turno*er of the N6' deri*ati*es mar"et e(ceeded the turno*er of the N6' cash

mar"et. )or e(ample! in 3FF! the *alue of the N6' deri*ati*es mar"ets was Rs.

17F! JF!:. Cr. whereas the *alue of the N6' cash mar"ets was only Rs.

7!1!F7 Crore. If I compare the trading figures of N6' and ,6'! performance

of ,6' is not encouraging oth in terms of *olumes and numers of contracts

traded in all product categories.

N6'06 D'RI9ATI9' 6'%+'NT

The National 6toc" '(change accounts almost JJ of the Indian deri*ati*es

mar"et in terms of turno*er! *olume etc. Its euity deri*ati*es mar"et is most


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oosted one and in turno*er it is a ma5or stoc" e(change. All products in euity

deri*ati*e segment i.e. Inde( )utures and Options and 6toc" )utures and

Options ha*e mar"ed a tremendous growth o*er the last decade. The graph

elow shows the a*erage yearly turno*er in each euity deri*ati*e products and

a*erage daily turno*er of deri*ati*e segment of N6'.

C;A#T'R )OUR

RI6M AND RI6M +ANA%'+'NT

:.1 RI6M

O*er the past two decades and so! the mar"ets ha*e seen deacle after another!each of which has rought its lessons @ from some of which the mar"ets ha*e

learned and from many of which mar"ets still need to learn. The %reat

Depression of 1J7F0s has rought remainder to all financial mar"ets or the

economies as a whole. The 1J crash taught mar"ets the dangers of automated

trading models and the second and third$order effects of credit crisis. In 1JJF!

Eall 6treet learned the horrors of holding huge illiuid in*estments. In 1JJ:0s

spectacular ond mar"et collapse! financial e(ecuti*es saw for the first time


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how correlated gloal mar"ets had ecome as the fallout from )ederal Reser*e

,oard rate hi"es swept from the U6 through 'urope! efore de*astating +e(ico

and other emerging mar"ets. The Russian meltdown in August 1JJ was

widespread and mounting. ,an"s and ro"erage firms too" turns announcing

trading losses from emerging mar"ets! high yield! euities! or dealings with

hedge funds. +ost recently! the %loal )inancial +eltdown! which was started

with the U6 su$prime mortgage crisis! has captured almost all economies of

the world. +any an"s ecome an"rupt! many loss their 5o! increased

udgetary deficits are the result of this crisis. Thus! it can e said that! the

financial mar"et is full of ris" and uncertainties. )inance has ne*er een so

competiti*e! so far$flung! and so uantitati*e. Information flow has ne*er een

so fast. ,ut with the passage of time! financial mar"ets are ecoming more

sophisticated in pricing! isolating! repac"aging! and transferring ris"s. Tools

such as deri*ati*es and securiti-ation contriute to this process! ut they pose

their own ris"s. The failure of accounting and regulation to "eep areast of

de*elopments includes yet more ris"s! with occasionally spectacularconseuences. #ractical applications @ including ris" limits! trader performance$

ased compensation! portfolio optimi-ation! and capital calculations @ all

depend on the measurement of ris". In the asence of a definition of ris"! it is

unclear what! e(actly! such measurements reflect.

Charles Tschampion! the +D of the GF n %+ #ension fund! once said @

In*estment management is not an art! not science! it is engineering. Ee are in

the usiness of managing and engineering financial in*estment ris"2B the

challenge is to first not ta"e more ris" than we need to generate the returns that

is offered2. It is a profound statement that well captures the philosophical and

mathematical connotation of LRis"0.

The terms ris" and uncertainty are often used interchangealy though there is a

clear distinction etween them. Certainty is a state of eing completely


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confident! ha*ing no douts of whate*er eing e(pected. Uncertainty is 5ust

opposite of that. Ris" is situation where there are a numer of specific! proale

outcomes! ut it is not certain as to which one of them will actually happen. In

that conte(t ris" is not an astract concept. It is a *ariale! which can e

calirated! measured and compared. 6o to define ris"! ris" entails two essential

componentsB e(posure and uncertainty. Thus! ris" is the e(posure to uncertainty.

:.3 RI6M +ANA%'+'NT #ROC'66

+ar"et integration! lierali-ation! gloali-ation and technical ad*ancement has

resulted with an increased competition in the mar"et and the corporate are hencee(posed to ris". Thus a proper and uniased assessment of ris" is a prereuisite

for a sound management process. +oreo*er! with the ad*ancement of

communication system and technology! the mar"ets o*er the world are getting

interconnected. Thus ma"ing an effecti*e ris" management system is the need

of the hour. Ris" management is the process in which ris" is minimi-ed with the

application of certain tools. The ris" management process essentially comprisesof certain steps! such as! identification! assessment! prioriti-ation! followed y

coordinated and economical application of resources to minimi-e! monitor and

control it. These steps are descried elow!

:.3.1 ID'NTI)ICATION

The ris" management process starts with the identification of the factors which

are e(posed to ris". It is always of primary concerns to identify the factors

which are more *ulnerale and wea" points in the system.

:.3.3 A66'66+'NT

After identifying the ris" e(posure points! it then to e assessed! i.e. to what

e(tent it is susceptile to that particular ris" that has to e measured.


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Assessment of ris" helps in "nowing the e(tent of *ulneraility of a particular

factor which is ris" e(posed.

:.3.7 #RIORITIATION

The ne(t step of ris" management process is the prioriti-ation of factors which

are more *ulnerale. The assessment of ris" results in identifying the factors

which are more ris" e(posed and then these factors are prioriti-ed from ris"

management point of *iew.

:.3.: A##4ICATION O) R'6OURC'6 TO +INI+I' RI6M

After identifying the most *ulnerale factor! the management team applies

economic resources to minimi-ing the ris". This is the most important stage of

ris" management as any wrong step can result a more susceptile situation.

:.3.: +ONITOR

The final step of ris" management is monitoring the ris" management process.

6imply applying the resources to minimi-e the ris" is not the last step of ris"

management! as it is needed to analy-e the success of the ris" management

process. )or this reason the entire process is monitored and if anything goes

wrong! it is rectified.

:.7 RI6M A66OCIAT'D EIT; D'RI9ATI9'6 TRADIN%

The continuing discussion of ris"s and its management in deri*ati*e mar"ets

illustrates that there is little agreement on what the ris"s are and how to control

it. One source of confusion is the sheer profusion of names descriing the ris"s

arising from deri*ati*es. ,esides the price ris"2 of losses on deri*ati*es from

change in underlying asset *alues! there is default ris"2! settlement ris"2! and

operational ris"2. 4ast! ut certainly not the least! is the specter of systemic


27/44

ris"2 that has captured so much congressional and regulatory attention. All these

ris"s associated with deri*ati*es mar"et are descried elow!

:.7.1 #RIC' RI6M

#rice arises for the simple reason that the price of the underlying and price of

the deri*ati*es are correlated. If the prices of the underlying increases! the

impact is seen in corresponding prices of deri*ati*es products i.e. their prices

also increase. )or an in*estor who is short in a futures contract or long in a put

option or short in a call option! there are potential losses. Thus! he or she may

default in the oligation of the deri*ati*e contract. This is price ris" associatedwith the deri*ati*es. Default due to #rice ris" is mitigated y imposing some

ris" management tools in e(change$traded deri*ati*es! ut in case of o*er$the$

counter mar"et! since it is largely unregulated! default is more due to price ris".

:.7.3 D')AU4T RI6M

This may the most popular and ha-ardous ris" associated with the deri*ati*es.

As deri*ati*es are contracts or agreements! they need the oligations to e

performed. If any party default from the contract! then the contract is

meaningless. The ris" that arises from the default of any party in deri*ati*es is

called as default ris". This is common ris" that is found in o*er$the$counter

deri*ati*e mar"et! ut in e(change$traded mar"et! this type of ris" is minimi-ed

y regulating the transactions. Default ris" is the ris" that losses will e incurred

due to default y the counterparty. As noted ao*e! part of the confusion in the

current deate aout deri*ati*es stems from the profusion of names associated

with the default ris". Terms such as credit ris"2 and counterparty ris"2 are

essentially synonyms for default ris". 4egal ris"2 refers to the enforceaility of

the contract. Terms such as 6ettlement ris"2 and ;erstatt ris"2 refer to

defaults that occur at a specific point in the life of the contractK date of

settlement. These terms do not represent independent ris"sB they 5ust descrie


28/44

different occasions or causes of default. Default ris" has two componentsK the

e(pected e(posure and the proaility that default will occur. The e(pected

e(posure measures how much capital is li"ely to e at ris" should the

counterparty defaults. The proaility of default is the measure of the possiility

that the counterparty will default.

:.7.7 6


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Therefore! a tempore disturance would primarily affect contracts with reuired

settlements during this period. If the shoc" were permanent! it would affect the

deri*ati*es in a much ha-ardous way.

:.: RI6M +ANA%'+'NT O) D'RI9ATI9'6

Deri*ati*es! which come to light as a hedging instrument against *olatility of

mar"et and mar"et related ris"! created ris" when there is a default. This ga*e

rise to the essence of ris" management of deri*ati*es and deri*ati*es trading. In

case of OTC deri*ati*es! as it is not regulated! it is more ris"y and there is no

ris" management at all. ,ut in case of e(change traded deri*ati*es! se*eral ris"management tools are applied to ensure the integrity of the mar"et. The tools

used for ris" management of deri*ati*es are descried elowB

:.:.1 +AR%IN6

+argins are upfront payment y the participants of the deri*ati*es mar"et to the

e(changes. This upfront payment is collected to ensure that none will default in

future in oliging his oligation. If someone defaults then the clearinghouse

settles the contract from this margin account. '(change0s clearinghouse collects

the margin from the clearing memer! the clearing memer collects the margin

from the trading memer or the ro"ers and it is the responsiility of the trading

memers to collect the same from its clients.

:.:.3 +ARM$TO$+ARM'T +AR%IN

In case of futures contracts! the margin is mar"$to$mar"et on daily asis i.e. the

gain or loss of a day is settled to the margin account on a daily asis. If the long

position gains! then the amount he gained will e transferred to his account in

the end of the day. 6imilarly! if the in*estor losses! the amount that he lost is

withdrawn from his account.

:.:.7 'H#O6UR' 4I+IT6


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If an in*estor holds uite a large position than his capacity! then the proaility

that he will default is more. )or this reason! the regulatory ody of the

deri*ati*e mar"et put an e(posure limit for the participants eyond which one

cannot ta"e position in the mar"et. This will ensure the integrity in term that

noody will default.

:.:.: #O6I6TION 4I+IT6

#osition limit is more applicale for the high net worth indi*iduals! the )IIs and

the mutual funds. This is ecause! these people ha*e huge in*estile cash and

they can direct the mar"et as their wish. This will harm the mar"et and otherparticipants of the mar"et. Thus a position limit is introduced for this type of

ris" y the regulators for the sound running of the mar"et.

:.:. )INA4 6'TT4'+'NT

)inal settlement is the last part of ris" management in case of deri*ati*es. The

settlement is done y the clearing house of the e(change. On e(ercise the

settlement is done on the closing price of the deri*ati*e product and final

settlement ta"es place on TS1 asis. If the long position e(ercises his right! then

the settlement is done y randomly assigning the oligation on a short position

at the end of the day. )ran"ly spea"ing ris" management of deri*ati*es

comprises of two things i.e. margining reuirement and the regulatory

reuirement. Thus ris" management of deri*ati*es is nothing ut! complying the

rules and regulation laid down y the regulator and satisfying the margin

reuirement.


31/44

C;A#T'R )I9'

INT'R#R'TATION AND ANA4


32/44

positions in all deri*ati*es contract traded on deri*ati*e segment. The 6#AN

=6tandard #ortfolio Analysis of Ris" 6ystem> is a portfolio ased margining

system de*eloped y Chicago +ercantile '(change and it is eing used y

almost all stoc" e(changes now. )or setting the margin the e(change has a

margin committee! which decides aout *arious factors to e considered while

calculating the margin reuirements.

.1 T;' 6#AN +AR%ININ% 6


33/44

The implied *olatility scan range is the largest mo*ement in implied *olatility

that margin committee chooses. The margin committee sets input scan ranges

after analy-ing histograms of asolute *alue of day$to$day changes in the

implied *olatility of traded futures$option contracts. The underlying a*erage

implied *olatility estimate that is analy-ed is a simple a*erage of eight contracts

implied *olatility on a gi*en maturityK the first is in$the$money and first three

out$of$the$money implied *olatility estimates for oth calls and puts.

.1.7 T;' +INI+U+ 6;ORT O#TION C;AR%'K

The minimum short option charge or minimum margin on an option contract isset at 3. of the clearing memer0s futures price scan range.

.1.:T;' CA4'NDAR 6#R'AD C;AR%'K

The calendar spread charge is put into the 6#AN is a parameter that sets the

amount of margin collateral! the clearinghouse collects against calendar spread

asis ris" in portfolios. The calendar spread asis is the difference etween

prices of contracts with different maturities. The asis etween nearest uarterly

and ne(t uarterly futures contract is calculated. ;istograms of the asolute

*alue changes in asis series are constructed for different windows periods! and

the histograms are considered y the margin committee while calculating

margin.

.1. T;' INT'R$CO++ODIT< 6#R'AD C;AR%'K

The inter$commodity spread charge is an input that sets the collateral

reuirement that must e posted to protect against correlation ris" in inter$

commodity spread positions.

In 6#AN! futures and futures options changes are estimate under alternati*e

scenario that are determined y the *alues chosen for the price and implied

*olatility scan range inputs. In the simulation analysis! the *alue of each option


34/44

contract is estimated for following day using ,lac" Option #ricing +odel. The

ne(t$day contract prices are determined under alternati*e scenarios in which

underlying futures contract0s price and implied *olatility mo*e y

predetermined function of their scan range. The futures price and implied

*olatility scan inputs are translated into 1 different scenarios that represent

alternati*e cominations of futures price and implied *olatility changes. )or

each scenario simulated! the contract0s *alue is reported as an element called

6#AN ris" array2. This a*erage implied *olatility is then shoc"ed2 y the

implied *olatility scan range in the 6#AN simulations. The ne(t day simulated

contract prices are compared with the prior day0s theoretical settlement price

and contract gains and losses are calculated as the difference in these prices. In

e(treme price mo*e scenarios! the C+'0s margin committee has decided to

margin 7 of the simulated price mo*e gain or loss is the *alue reported in

these e(treme price mo*e 6#AN array entries. The 6#AN ris" array is gi*en

elow!

1. Underlying unchangedB *olatility up

3. Underlying downB *olatility down

7. Underlying up y 17 of price scan rangeB *olatility up

:. Underlying down y 17 of price scan rangeB *olatility down

. Underlying down y 17 of price scan rangeB *olatility up

. Underlying up y 17 of price scan rangeB *olatility down

. Underlying up y 37 of price scan rangeB *olatility up

. Underlying down y 37 of price scan rangeB *olatility down


35/44

J. Underlying down y 37 of price scan rangeB *olatility up

1F. Underlying up y 37 of price scan rangeB *olatility down

11. Underlying up y 1 of the price scan rangeB *olatility up

13. Underlying down y 1 of the price scan rangeB *olatility down

17. Underlying down y 1of price scan rangeB *olatility up

1:. Underlying up y 1 of price scan rangeB *olatility down

1. Underlying up e(treme mo*e! doule the price scanning range

1. Underlying down e(treme mo*e! doule the price scanning range

.3 EORMIN% O) 6#AN +AR%IN 6


36/44

margin reuirement is the product of the numer of written options times the

minimum short option charge.

.: +ARM$TO$+ARM'T O) +AR%IN

o )or all stoc" futures and inde( futures contract! the client0s position is

mar"ed$to$mar"et on a daily asis at portfolio le*el. The mar"$to$mar"et margin

is paid inout in TS1 day in cash. )or determining the mar"$to$mar"et margin!

the closing price is ta"en into consideration.

. 'H#O6UR' 4I+IT6

The e(posure limit for different euity deri*ati*es products are gi*en elowB

o In case of stoc" futures contracts! the notional *alue of gross open positions at

any point in time should not e(ceed 3F times the a*ailale liuid net$worth of a

memer! i.e. 1F of the notional *alue of gross open position in single stoc"

futures or 1. of the notional *alue of gross open position in single stoc"

futures! whiche*er is higher. ;owe*er ,6' charges e(posure margin for etter

ris" management.

o )or stoc" options contracts! the notional *alue of gross short open position at

any time would not e(ceed 3F times of the a*ailale liuid net$worth of the

memer! i.e. of the notional *alue of gross short open position in single

stoc" options or 1. of notional *alue of gross short open position in single

stoc" options whiche*er is higher.

o In case of inde( products! the notional *alue of gross open positions at ant

time would not e(ceed 77 17 times of the a*ailale liuide networth of the

memer. for inde( products! 7 of the notional *alue of gross open position

would e collected from the liuide networth of a memer on a real time asis.

. #O6ITION 4I+IT6


37/44

o A mar"et wide limit on the open position on stoc" options and futures

contracts of a particular underlying stoc" is 3F of the numer of shares held

y non$promoters i.e. 3F of the free float! in terms of numer of shares of a

company.

o In case of stoc" futures and options! the stoc" ha*ing applicale mar"et wide

position limit =+E#4> of Rs. FF crores or more! the comined futures and

options position limits shall e 3F of mar"et wide position limit or Rs. 7FF

crores! whiche*er is lower and within which shoc" futures position cannot

e(ceed 1F of applicale mar"et wide position limit or Rs. 1F crores!

whiche*er is lower. This is the position limit for trading memers! )II and

mutual funds.

o )or stoc"s ha*ing applicale mar"et wide position limit less than Rs. FF

crores! the comined futures and options position limit would e 3F of

applicale mar"et wide position limit or Rs. F crore whiche*er is lower. This is

applicale for trading memers! )II and mutual funds.

o )or futures and options contracts! the trading memers! )II and mutual funds

position limits shall e higher ofB Rs. FF crores or 1 of total open interest in

the mar"et in euity inde( futures contracts or euity inde( options contract

respecti*ely.

o The gross open position of clients! su$accounts! NRI le*el and for each

scheme of mutual funds across all deri*ati*es contracts on a particular

underlying shall not e(ceed higher ofB 1 of the free float mar"et capitali-ation

or of the open interest in underlying stoc".


38/44


39/44

settlement price is the closing price of the stoc" or inde( in the cash segment.

On e(ercise of options! the assignment ta"es place on a random asis at client

le*el. At present there would not e any e(ercise limit for trading in options! ut

the e(change can specify the limit as per its con*enience.

C;A#T'R 6IH

.1 +A8OR )INDIN%6

On course of study of the ris" management process of deri*ati*es in ,6'! the

following oser*ations are pointed out. 6ince the study is focused on euity

deri*ati*es only! the findings are concerned only aout euity deri*ati*es.

.1.1 6#AN +AR%ININ% 6


40/44

The 6#AN =6tandard #ortfolio Analysis of Ris"> is a portfolio ased margining

approach for calculation of margin reuirement of deri*ati*es. This is an

integrated system of margining that reduces margining reuirement on

deri*ati*es than any other system of margining. The 6#AN margining system in

,6' is an efficient system of margin calculation. The procedure in which the

6#AN is calculated in ,6' can e compared to any ma5or e(change of the

world and co*ers almost JJ of ris" e(posure of the e(change.

.1.7 RI6M +ANA%'+'NT

o The ris" management process for deri*ati*es used y ,6' is efficient andeffecti*e system.

o It co*ers aout JJ 9ary at any time.

o This also helps in protecting the mar"et and helps in increasing the mar"et

integration.

o On comparing the ris" management process of ,6' with that of N6'! it is

found that it is almost same. ,ut N6' has an added ad*antage for the

information related ser*ices that it pro*ides.

o ,6' pro*ides its data on a graphical format! whereas N6' pro*ides the same

on a taular format! which is easy to understand.

o The N6' uses #RI6+ =#arallel Ris" +anagement 6ystem>! which monitors

the deri*ati*es segment of N6' on a real time asis. ,ut ,6' do not ha*e! this

system.

.3 6U%%'6TION6

,ased on the interaction with different ro"ing firms! it is oser*ed that ,6' is

comparale to N6' in technical terms. ;owe*er! ,6' lac"s in pro*iding etter


41/44

ser*ices and information to the in*estors! which leads to poor mar"et position in

deri*ati*es.

o During our interaction with the ro"ers we come to "now that! the ser*ices

pro*ided y N6' are more reliale than that of ,6'. 6o ,6' should try to

pro*ide integrated ser*ices to its memers to impro*e its deri*ati*es segment.

o Regarding the ris" management procedure! as there is no difference etween

N6' and ,6'! it can e said that! ,6' should continue with this process.

o ,6' should impro*e its monitoring system for etter ris" management of the

e(change.

o Another ma5or cause for ,6'0s lost mar"et share is the failure in pro*iding

data. ,6' can focus on this part in particular. It should also pro*ide data in

taular format rather than graphical format! so that it can e easily understood

y the in*estors.

o To impro*e its deri*ati*es segment! ,6' has to constantly inno*ate in terms

of ser*ices! products and technology! otherwise it cannot compete with N6'.

o ,6' charges more margins for etter ris" management! which in terms harms

its mar"et position. Thus! a reasonale margin should e charged on the

memers for de*elopment of deri*ati*es mar"et and etter ris" management.

.7 CONC4U6ION

,6' with its distincti*e feature has a long! colorful and cheuered history. It

en5oys a pre$eminent position y ha*ing a permanent recognition from the

6ecurities Contract =Regulation> Act! 1J. It can e considered as an essential

concomitant of the Indian economy. It is performing all the important functions

of an ideal stoc" e(change y pro*iding a ready and continuous mar"et with


42/44

negotiaility and safety to in*estment of in*estorsB redressing their grie*ance!

minimi-ing ris"! and pro*iding a forum to ensure liuidity and attracting capital

from the in*estors! etc.

Despite the efficiency and transparency! ,6' still lags ehind N6' and faces a

stiff competition from it. #articularly! N6' holds aout JJ of the deri*ati*es

mar"et of India! whereas ,6'0s position is negligile. This can e attriuted to

the following reasons.

)irstly! lac" of detail and timely information of deri*ati*e segment and its ris"

management is one of the main reasons for the falling mar"et share of the ,6'0sderi*ati*es segment.

6econdly! the data files for margin calculation are not precious as N6' has. This

is also one of the "ey ostacles in the de*elopment of deri*ati*e segment of

,6'.

Ehen ,6' losses N6' gains.

Thirdly! the lac" of monitoring system for ris" management is another prolem

with ,6'. N6' has #RI6+ as the monitoring system which enales it for etter

ris" management of deri*ati*es. Coming to ris" management of deri*ati*es in

,6'! ,6' has an efficient and effecti*e ris" management system! which can e

compared with any of the e(change of the world. The 6#AN margining system

followed y ,6' for margin calculation is one of the most efficient systems ofmargining. Along with this the regulatory reuirement of ,6' ma"es the ris"

management system stronger and effecti*e. Though the margin with which ,6'

lags ehind N6' is too much for deri*ati*es mar"et! ut a committed effort can

help ,6' to gain supremacy in this segment. This can e done y ma"ing itself

more informati*e! monitoring the ris" management process and ta"ing some

aggressi*e steps for the impro*ement of the deri*ati*es segment. All it needs to


43/44

do is to ta"e uic" and timely decisions for the impro*ement of the deri*ati*es

segment.

,I,4IO%RA#;

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