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
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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
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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.
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C;A#T'R )I9'
INT'R#R'TATION AND ANA4
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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
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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
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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
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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
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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$worth of the
memer! i.e. of the notional *alue of gross short open position in single
stoc" options or 1. of notional *alue of gross short open position in single
stoc" options whiche*er is higher.
o In case of inde( products! the notional *alue of gross open positions at ant
time would not e(ceed 77 17 times of the a*ailale liuide networth of the
memer. for inde( products! 7 of the notional *alue of gross open position
would e collected from the liuide networth of a memer on a real time asis.
. #O6ITION 4I+IT6
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o A mar"et wide limit on the open position on stoc" options and futures
contracts of a particular underlying stoc" is 3F of the numer of shares held
y non$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".
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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
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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
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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
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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
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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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