Risk Management of Derivatives in BSE

Risk Management of Derivatives

1 | P a g e B o m b a y S t o c k E x c h a n g e L i m i t e d .


in BSE

A Summer Project Report Submitted to Utkal University in the

Partial Fulfillment of Degree of Master of Finance & Control.

(2009 – 11)

Submitted bySubmitted bySubmitted bySubmitted by

Dillip Dillip Dillip Dillip KKKKhuntiahuntiahuntiahuntia Roll No. Roll No. Roll No. Roll No. –––– 1370V0910111370V0910111370V0910111370V091011

Under the Guidance ofUnder the Guidance ofUnder the Guidance ofUnder the Guidance of

Dr. Kshitibhusan DasDr. Kshitibhusan DasDr. Kshitibhusan DasDr. Kshitibhusan Das Mr.Mr.Mr.Mr. C. VasudevanC. VasudevanC. VasudevanC. Vasudevan

Reader,Reader,Reader,Reader, General General General General Manager,Manager,Manager,Manager,

P.G. Department of CommerceP.G. Department of CommerceP.G. Department of CommerceP.G. Department of Commerce BBBBSE Training InstituteSE Training InstituteSE Training InstituteSE Training Institute,,,,

Utkal UniversityUtkal UniversityUtkal UniversityUtkal University.... Bombay Stock ExchangeBombay Stock ExchangeBombay Stock ExchangeBombay Stock Exchange LimitedLimitedLimitedLimited....

MASTER OF FINANCE & CONTROL

P.G. DEPARTMENT OF COMMERCE,P.G. DEPARTMENT OF COMMERCE,P.G. DEPARTMENT OF COMMERCE,P.G. DEPARTMENT OF COMMERCE,

UTKAL UNIVERSITYUTKAL UNIVERSITYUTKAL UNIVERSITYUTKAL UNIVERSITY,,,,

BHUBANESWARBHUBANESWARBHUBANESWARBHUBANESWAR....



DECLARATION

I do hereby declare that the project entitled “Risk “Risk “Risk “Risk

Management of DerivativesManagement of DerivativesManagement of DerivativesManagement of Derivatives in BSEin BSEin BSEin BSE”””” is submitted to Utkal

University for the partial fulfillment of degree of Master of Master of Master of Master of

Finance and ControlFinance and ControlFinance and ControlFinance and Control, Utkal University. The project is an

authentic piece of work done by me under the guidance of

Dr. KshDr. KshDr. KshDr. Kshiiiitibhushan Dastibhushan Dastibhushan Dastibhushan Das, Reader, P.G. Department of

Commerce, Utkal University and it has neither been

submitted for award of any other degree to any other

University, Academy, Institution nor published in any

magazine or anywhere else in part or full to best of my

knowledge.

PLACE: BHUBANESWAR

DATE: (DILLIP KHUNTIA)



ACKNOWLEDGEMENT

The satisfaction that accompanies the successful completion of any task would

be incomplete without mentioning people who made it possible, whose encouragement

and consistent guidance crowned my efforts with success.

At the outset, I would like to extend my sincere gratitude and reverence to the

esteemed organization, Bombay Stock Exchange Limited and its management for

providing me with the opportunity to pursue my summer project.

I would like to thank Mr. C. Vasudevan, General Manager, Bombay Stock

Exchange Limited and Mr. Pulakesh Dutta, Deputy Manager, BTI, Bombay Stock

Exchange Limited, for allowing me to work on this project that not only interesting but

has also added to my knowledge.

I am also thankful to Product and Strategy department and Mr. Yogesh

Sundaram, Consultant and Analyst, Bombay Stock Exchange Limited, for enlightening

me with nuances of the risk management procedure followed by the Bombay Stock

Exchange Limited and acknowledge the support and help of employees of Product and

Strategy Department for their assistance in completion of this project.

I would like to express my heartfelt indebtedness and deep sense of gratitude to

my faculty guide Dr. KshDr. KshDr. KshDr. Kshiiiitibhushan Das tibhushan Das tibhushan Das tibhushan Das for sharing his knowledge and giving me

guidance and generous co-operation. I am also thankful to my other faculty members

and my friends for their continuous support and encouragement.

Last but not the least to MR. Madhusudan Sahu without whose help it was

difficult to take on an internship at BSE

PLACE: BHUBANESWAR

DATE: (DILLIP KHUNTIA)



Dr. Kshitibhushan Das

Reader, P.G. Department of Commerce

Utkal University

CertificateCertificateCertificateCertificate

This to certify that the project entitled “Risk

Management of Derivatives in BSE” is a record of bonafide

research work carried out by Dillip Khuntia under my

supervision and guidance. It embodies result of his original

contribution. The project has reached the standard of

fulfilling the requirements of the regulation relating to the

degree of Master of Finance and Control. No part of this

project has been submitted to any other institution for the

award of any other degree.

I wish him all success in his future endeavours.

PLACE: BHUBANESWAR

DATE: (Dr. Kshitibhushan Das)

P.G. Dept. of Commerce

Utkal University.



EXECUTIVE SUMMERY

In this project “Risk Management of Derivatives in BSE”, the major objective

was to find out the effectiveness and efficiency of the risk management process of BSE

for derivatives segment.

For achieving this objective a survey was conducted, wherein some of the

brokers are interviewed and the details of the risk management process of derivatives in

BSE was analyzed. SEBI guidelines and circulars are also followed for this purpose.

During the survey it was found that the risk management process of BSE is

efficient and can be compared with any of the major stock exchange of the world. The

SPAN margining system that BSE follows for margin calculation is an effective system

of risk management and most of the exchanges of the world follow this method for

margin calculation. The software PC SPAN®, used by BSE for SPAN margin calculation

is reliable and user friendly software. In case of risk management, BSE lags behind NSE

in one area i.e. monitoring. NSE has an integrated system (PRISM) for monitoring the

risk, whereas BSE does not have such facility

Thus the recommendation in accordance with this project would be that BSE

should take aggressive steps for expansion of its derivatives segment. This coupled with

a few with the risk management process such as providing real time information about

the parameters; especially the risk array and the trading information in tabular form

rather than graphical form, use of better monitoring system for risk management would

help BSE to improve its market position in derivatives.



CONTENTS Declaration…………………………………………………………………………………………………………………………………. i

Acknowledgement………………………………………………………………………………………………………………………. ii

Certificates………………………………………………………………………………………………………………………………… iii

Executive Summery…………………………………………………………………………………………………………………… iv

CHAPTER 1: INTRODUCTION

1.1 Introduction……………………………………………………………………………………………… 2

1.2 Rationale…………………………………………………………………………………………………… 2

1.3 Objective…………………………………………………………………………………………………… 3

1.4 Research Methodology…………………………………………………………………………….. 3

1.5 Limitation………………………………………………………………………………………………….. 4

1.6 Chapterisation………………………………………………………………………………………….. 4

CHAPTER 2: COMPANY PROFILE

2.1 Company Profile ………………………………………………………………………………………. 7

2.2 History ……………………………………………………………………………………………………. 8

2.3 Prominent Position …………………………………………………………………………………. 8

2.4 A Pioneer ………………………………………………………………………………………………… 9

2.5 Awards ……………………………………………………………………………………………………. 9

2.6 BSE SWOT ………………………………………………………………………………………………. 10

CHAPTER 3: INTRODUCTION TO DERIVATIVES

3.1 Derivatives …………………………………………………………………………………………….. 13

3.2 Derivatives products …………………………………………………………………………….. 14

3.3 Participants of Derivatives Market ………………………………………………………. 16

3.4 Classification of Derivatives …………………………………………………………………. 16

3.5 Economic Significance of Derivatives …………………………………………………… 18

3.6 History of Derivatives ……………………………………………………………………………. 18

3.7 International Derivative Market ……………………………………………………………. 20

3.8 Indian Derivative Market ………………………………………………………………………. 20

3.9 NSE’s Derivative Segment ……………………………………………………………………. 22

CHAPTER 4: RISK AND RISK MANAGEMENT

4.1 Risk ………………………………………………………………………………………………………... 25

4.2 Risk Management Process ……………………………………………………………………. 26



4.3 Risk Associated with Derivatives …………………………………………………………. 27

4.4 Risk Management of Derivatives ………………………………………………………….. 30

CHAPTER 5: ANALYSIS AND INTEPRETATION

5.1 The SPAN Margining System ………………………………………………………………… 33

5.2 Working of SPAN Margining System …………………………………………………….. 36

5.3 Margin …………………………………………………………………………………………………… 36

5.4 Mark-to-Market of Margin ……………………………………………………………………. 37

5.5 Exposure Limits ……………………………………………………………………………………. 37

5.6 Position Limits ……………………………………………………………………………………… 38

5.7 Final Settlement …………………………………………………………………………………… 39

CHAPTER 6: SUMMERY AND CONCLUSION

6.1 Major Findings ………………………………………………………………………………………. 41

6.2 Suggestions …………………………………………………………………………………………. 42

6.3 Conclusion …………………………………………………………………………………………… 43

6.4 Bibliography …………………………………………………………………………………………. 45

LIST OF FIGURES 3.1 Classification of Derivatives ………………………………………………………………………………………….… 17

3.2 Business Growth of Derivative in India …………………………………………………………………………... 22

3.3 Equity Derivative Market of India ………….………………………………………………………………………… 23

3.4 Average Daily Turnover of India’s Derivative Market ….………………………………………………… 23



CCCCHHHHAAAAPTER ONEPTER ONEPTER ONEPTER ONE

INTRODUCTIONINTRODUCTIONINTRODUCTIONINTRODUCTION



1.1 INTRODUCTION

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

number of influencing factors which determines the prosperity of the economy, like

Per-capita income of people, GDP, Imports & Exports, Forex Reserves, etc. In short it

can be told that Financial Market is an important contributor to the economy. In this

financial market, capital market plays a significant role. The capital market always

replicates the power and ability of the investors and their faith in the market. Earlier

the capital market was shy. But market deregulations, growth in global trade and

technological development have revolutionized the financial market place. A by-

product of this revolution is increased market volatility, which has led to a

corresponding increase in risk management products. This demand is reflected in the

growth of financial derivatives and derivatives market. But, question arises, are these

derivatives risk free? As world’s one of the greatest investor once said,

“Risk is a part of God’s game, alike for man and nation”

Thus it can be said that these risk management instruments are not risk free.

This indicates the essence of risk management of derivatives.

1.2 RATIONALE

In this world of uncertainty risk management has an immense importance for

corporate. Financial derivatives which are introduced with a prime objective of

hedging risk, when used for speculative purposes resulted with increased risk. Thus,

risk management of financial derivatives is a major area of concern. In case of an

exchange, as exchange plays the role of counterparty for both buyer and seller, it is

more exposed to counterparty risk and all other risk associated with the financial

derivatives. This leads to the essence of risk management of derivatives in exchanges.

The various tools used by the exchanges for risk management includes margins,

position limits, and various rules and regulations laid down by the regulatory authority

for derivative trading. All these process of risk management is done by wholly

computerized process and with specific software. The inclusion of latest technology

has made the risk management process more reliable. The risk management of



derivatives not only secures Stock Exchanges, but also creates confidence in the

minds of the investors. This enhances more investments in the derivatives market,

which leads to business prosperity. Thus the most of the exchanges have their risk

management procedure for risk management of derivatives.

1.3 OBJECTIVE

On the above outset, the following are the laid down as the objective of this study,

I. To study the risk associated with derivative market and derivative trading.

II. To study the risk management tools used in Bombay Stock Exchange Limited

for mitigating these risks.

III. To study the margining system for derivatives.

IV. To study the software used for margining system.

V. To do comparative analysis of the risk management process of BSE with that

of NSE

VI. To give suggestion and recommendations for improvement in risk management

process of derivatives in BSE.

1.4 RESEARCH METHODOLOGY

1.4.1 SCOPE

The scope of this project is confined to the study of risk management of

derivatives in BSE, about the margining system. The software used for this purpose,

details about the process and tools of risk management and various problems faced by

them.

1.4.2 TIME FRAME

The project has been undertaken on the basis of information provided by BSE’s

derivatives segment which consists of the daily prices and volatility of derivative

segment of BSE for the last ten years. This data consist of details about the daily

prices of derivatives products and proportion of investment in each and every

derivatives instrument.

1.4.3 SOURCES OF DATA



The data has been collected from both primary and secondary sources. The

primary data are collected by interviewing brokers and some officials of BSE. Some

data are collected from personnel of the various departments in BSE, like Product and

Strategy Department, Bank of India Shareholding Limited. (Clearinghouse of BSE).

The secondary data consists of books and journals provided by BSE, SEBI circulars

and Guidelines. This also contains the data of derivative segment of NSE, which was

collected from the website of NSE.

1.4.4 TOOLS AND TECHNIQUES

The data so collected were classified and tabulated for analysis and

interpretation. The tools and techniques used in this project are all computerized

programming. The data are programmed in software like visual basic, MATLAB, etc,

to find the implied volatility and price scan range. Finally all these implied volatility

and price scan range are processed in PC – SPAN (software for calculation of margin)

to find out the margin requirement of different participants of the derivative market.

The turnover of derivatives segment of BSE and NSE is drawn in graphs to compare

these two markets.

1.5 LIMITATION

Some of the limitations that are faced during the project are;

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

information provided by the interviewees. The data collected from the websites

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

the exchange.

2. The time predefined for this project was 8 weeks, which is very short for

covering such a big project.

1.6 CHAPTERISATION



This project is about the risk management of derivatives in BSE. Various

technicalities that are involved in this process has been extensively discussed and dealt

with this report. The report contains the following six chapters, which are summarized

below.

Chapter one begins with the introduction to the project report, stating the

importance, objectives and research methodology adopted. Limitations inherent to the

project are also laid down. Chapter two deals with the history and potentiality of

Bombay Stock Exchange Limited. ,its mission and vision are also laid down. Major

events that shaped the securities market in the country and helped BSE to grow have

been mentioned. The third chapter deals with the conceptual study of derivatives and

its mechanism. A snapshot of international and Indian derivative market was also laid

down. A brief idea about equity derivatives was also mentioned in this chapter.

Chapter four contains the conceptual idea of risk management process. This chapter

also throws light on the essence of risk management; risk associated with derivatives

trading and risk management of derivatives. The fifth chapter comprises of analysis

and interpretation part. Chapter six contains the summarized list of all important

findings. And finally, the ultimate chapter aims at providing some relevant

suggestions and recommendations to improve the present market position of BSE.



CHAPTER TWO

COMPANY PROFILE



2.1 COMPANY PROFILE

Bombay Stock Exchange Limited is the oldest stock exchange of Asia and one

of the oldest in World with a rich heritage. As the first stock exchange in India, the

Bombay Stock Exchange Limited is considered to have played a very important role

in the development of county’s capital market. The BSE is the largest stock exchange

of 24 exchanges in India, with over 6000 listed companies. It is also the fifth largest

exchange in the world with a market capitalization of $466 billion.

The Bombay Stock Exchange Limited uses BSE SENSEX, an index of 30

large, developed BSE stocks. This index gives a measure of overall performance of

BSE and is tracked worldwide.

In addition to individual stocks the Bombay Stock Exchange Limited also a

market for derivatives, which was first introduced in India. Listed derivatives on the

exchange include stock futures and options, Index futures and options and weekly

options. The Bombay Stock exchange is also actively involved with the development

of retail debt market.

The Exchange has a nationwide reach with its presence in 417 cities and towns

of India. The systems and processes of the exchange are designed to safeguard market

integrity and enhance transparency in the operations. The Exchange provides an

efficient and transparent market for trading in equity, debt and derivative instruments.

The BSE provides online trading with the BSE’s Online trading System (BOLT),

which is a proprietary system of the exchange and is BS 7799-2-2002 certified. The

Surveillance and Clearing Settlement function of the Exchange are ISO 9001:2000

certified.

VISION

“Emerge as the premier Indian stock exchange by establishing global

benchmark”



2.2 HISTORY

One of the oldest stock exchanges of the world and the first in the country to be

granted permanent recognition under the Securities Contract (Regulation) Act, 1956,

Bombay Stock Exchange Limited has had an interesting rise to prominence over the

past 133 years.

The Bombay Stock Exchange Limited traces its history to the 1850s, when four

Gujarati and one Parsi stock broker would gather under the banyan tree in front of the

Town Hall, where the Horniman Circle is now situated. A decade later, the brokers

moved their venue to another set of foliage, this time under banyan trees at the

junction of Meadows Street and Mahatma Gandhi Road. As the number of brokers

increased, they had to shift from place to place and wherever they went, through sheer

habit, they overflowed to the streets. At last, in 1874, found a permanent place. The

new place was, aptly, called Dalal Street.

This group of brokers in 1875 formed an official organization known as “The

Native Share and Stock Brokers Association”. In 1956, BSE became the first stock

exchange to be recognized by the Indian Government under the Securities Contract

(Regulation) Act, 1956. In 1979, BSE introduced its Index SENSEX and from that

time it achieved many milestones in the capital market. In 2002, the name “The

Exchange, Mumbai” was changed to Bombay Stock Exchange. Subsequently on

August 5, 2005, the exchange turned into a corporate entity from an Association of

Persons (AOP), under the provision of Companies Act, 1956, pursuant To BSE

(Corporatization and Demutualization) Scheme, 2005 notified by Securities and

Exchange Board of India (SEBI). Then it is renamed as the “Bombay Stock Exchange

Limited”.

2.3 PROMINENT POSITION

The journey of BSE is as eventful and interesting as the history of securities

markets of India. India’s biggest bourse, in terms of listed companies and market

capitalization, BSE has played a pioneering role in Indian securities market. Much

before the actual legislations were enacted, BSE had formulated comprehensive set of



rules and regulations for Indian capital markets. It also laid down best practices

adopted by Indian capital market after India gained its independence. Perhaps, there

would not be any leading corporate in India, which has not sourced BSE’s services in

resource mobilization.

2.4 A PIONEER

BSE as brand is synonymous with the capital markets in India. The BSE

SENSEX is the benchmark equity index that reflects the robustness of the economy

and finance. At par with international standards, BSE has been a pioneer in several

areas. It has a several firsts to its credit,

First in India to introduce Equity Derivatives.

First in India to launch a Free Float Index.

First in India to launch US$ version of BSE SENSEX.

First in India to launch Exchange Enable Internet Trading Platform.

First in India to obtain ISO certification for Surveillance, Clearing and Settle.

First to have exclusive facility for financial training.

‘BSE On-Line Trading System’ (BOLT) has awarded with the global

recognized Information Security Management System Standard BS7799-2-

2002.

Moved from Open Outcry to Electronic Trading within just 50 days.

An equal important accomplishment of BSE is the launch of a nationwide

investor awareness campaign – Safe Investing in the Stock Market – under which

nationwide awareness campaigns and dissemination of information through print and

electronic medium was undertaken. BSE also actively promoted the securities market

awareness campaign of the Securities and Exchange Board of India (SEBI).

2.5 AWARDS

Bombay Stock Exchange Limited has many awards to its name for its

excellence in several fields, these are



� The World Council of Corporate Governance has awarded the Golden Peacock

Global CSR Award for BSE’s initiatives in Corporate Social Responsibility

(CSR).

� The Annual Reports and Accounts of BSE for the year ended March 31, 2006

and March 31, 2007 have been awarded the ICAI Awards for excellence in

financial reporting.

� The Human Resource Management at BSE has won the Asia – Pacific HRM

Award for its efforts in employer branding through talent management at work,

health management at work and excellence in HR through technology.

2.6 BSE SWOT

STRENGHS:

� BSE has inherent advantages: its history, larger scrip base and a stronger brand.

� The SENSEX (BSE’s 30-share sensitive index) is one of the most recognized

indexes and tracked worldwide.

� Apart from lager base of listed companies, BSE also has a historical

perspective.

� Its online trending system (BOLT) has awarded with the global recognized

Information Security Management System Standard BS7799-2-2002.

� It got the ISO certification for its surveillance and clearing and settlement.

WEAKNESS

� The BSE SENSEX, which delivers inferior hedging effectiveness and higher

impact cost.

� At present BSE has fewer than 12% share across the cash and derivative

market of equity markets.

� At present, BSE is almost non-existence in derivatives space.

� BSE also lacks in terms of providing better services to its customers and is not

proactive.



OPPORTUNITIES

� Corporatization will improve internal management systems and investor

relations, and benefit companies that are listed on BSE.

� Derivatives market is growing at exponential rate and BSE with its large

infrastructure and long presence in the capital market has the capability to

expand its market share in this segment.

� If large a private sector bank picks up a strategic stake in BSE, it could give the

exchange access to a large distribution network and promote new products like

derivatives. The strategic investor could also be a market maker (providing buy

and sell quotes at any given time).

� 30 to 40 percent of the income of exchange like NASDAQ and NYSE is from

vending data. For BSE, it’s measly 4 percent. The potential for growth then, is

immense.

THREATS

� Aggressive competitor like NSE poses major threat to BSE’s future.

� NSE’s top 100 stocks alone account for nearly 80 percent of its cash segment’s

turnover, indicating that NSE is clearly the preferred destination for trading in

the top stocks.



CHAPTER THREE

INTRODUCTION TO DERIVATIVES



3.1 DERIVATIVES

Risk is a characteristic feature of all commodity and capital markets. Over

time, variations in the prices of agricultural and non-agricultural commodities occur as

a result of interaction of demand and supply forces. The last two decades have

witnessed a many-fold increase in the volume of international trade and business due

to the ever growing wave of globalization and liberalization sweeping across the

world. As a result, financial markets have experienced rapid variations in interest and

exchange rates, stock market prices thus exposing the corporate world to a state of

growing financial risk.

Increased financial risk causes losses to an otherwise profitable organization.

This underlines the importance of risk management to hedge against uncertainty.

Derivatives provide an effective solution to the problem of risk caused by uncertainty

and volatility in underlying asset. Derivatives are risk management tools that help an

organization to effectively transfer risk. Derivatives are instruments which have no

independent value. Their value depends upon the underlying asset. The underlying

asset may be financial or non-financial.

The term “derivative” can be defined as a financial contract whose value is

derived from the value of an underlying asset. Section 2(ac) of Securities Contract

(Regulation) Act, (SCRA), 1956 defines derivatives as,

a) “a security derived from a debt instrument, share, loan whether secured or

unsecured, risk instrument or a contract for difference or any other form of

securities;

b) “a contract which derives its value from the prices, or index of prices, of

underlying securities”.

The underlying asset may be a stock, bond, a foreign currency, commodity or

even another derivative security. Derivative securities can be used by individuals,

corporations, and financial institutions to hedge an exposure to risk.



3.2 DERIVATIVE PRODUCTS

Derivative contracts have several variants. The most common variants are

forwards, futures, options and swaps. Various derivatives contracts are described

below,

3.2.1 FORWARDS

A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at today’s pre-agreed price. A

forward contract is an agreement between two parties to buy or sell an asset at a

specific point of time in future and the price which is paid /received by the parties is

decided at the time of entering the contract.

3.2.2 FUTURE

A future contract is an agreement between two parties to buy or sell an asset at

a certain time in the future at a certain price. Future contracts are standardized forward

contracts. Future contracts are traded in exchanges and exchange sets the standardized

terms in term of quantity, quality, price quotation, date and delivery date (in case of

commodities).

3.2.3 OPTIONS

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

An option is the right, but not the obligation, to buy or sell something at a stated date

at a stated price. Options are of two types;

• CALL OPTIONS: A call option gives the buyer of the option the right, but not

the obligation to buy a given quantity of the underlying asset, at a given price

and on or before a given date.

• PUT OPTION: Put options give the buyer the right, but the obligation to sell a

given quantity of underlying asset at a given price on before a given date.



Options can also be European options and American options. This

classification is based on the exercise of the options. European options can be

exercised at the maturity date of the option. On the other hand, American options can

be exercised at any time up to and including the maturity date.

3.2.4 WARRANTS

Options generally have lives of up-to one year. Long dated options are called as

warrants and generally traded over-the-counter.

3.2.5 LEAPS

Long-Term-Equity-Anticipated Securities are options having a maturity of

more than three years or in other words options having a maturity of more than three

years are termed as LEAPS.

3.2.6 BASKETS

Basket options are options on portfolio of underlying assets. Equity index

options are a form of basket options

3.2.7 SWAPS

A swap means a barter or exchange. Thus, a swap is an agreement between two

parties to exchange stream of cash flows over a period of time in future. The two

commonly used swaps are,

i) INTEREST RATE SWAPS: Swaps which entail swapping only the interest related

cash flows between the parties in the same currency.

ii) CURRENCY SWAPS: These entail swapping both principal and interest between

two parities, with cash flows in one direction being in different currency than those in

the opposite direction.

3.3 PARTICIPANTS IN DERIVATIVE MARKET



The reason for which derivatives are so attractive is that they have attracted

different types of investors and have a great deal of liquidity. When an investor wants

to take one side of a contract, there is usually no problem in finding someone that is

prepared to take the other side. Three broad kinds of participants can be found in

derivatives market, namely, hedgers, speculators and arbitrageurs.

1. Hedgers: They use derivatives markets to reduce or eliminate the risk associated

with price of an asset. Majority of the participants in derivatives market belongs to

this category.

2. Speculators: They transact futures and options contracts to get extra leverage in

betting on future movements in the price of an asset. They can increase both the

potential gains and potential losses by usage of derivatives in a speculative venture.

3. Arbitrageurs: Their behaviour is guided by the desire to take advantage of a

discrepancy between prices of more or less the same assets or competing assets in

different markets. If, for example, they see the futures price of an asset getting out of

line with the cash price, they will take offsetting positions in the two markets to lock

in a profit.

3.4 CLASSIFICATION OF DERIVATIVES

Broadly derivatives can be classified into two categories, commodity

derivatives and financial derivatives. In case of commodity derivatives, the underlying

asset can be commodities like wheat, gold, silver etc; whereas in case of financial

derivatives the underlying assets are stocks, currencies, bonds and other interest

bearing securities etc. A figure below shows the classification of derivatives,

Figure – 3.1

Classification of Derivatives



Basing on the type of market, derivative market is of two types, exchange-

traded derivatives market and over-the-counter derivative market. In the exchange-

traded derivatives, the derivatives which are standardized in nature are traded. The

trading of the derivatives is well regulated by the exchanges. The over-the-counter

market is an important derivative market and has larger volume of trade than the

exchange-traded market. It is a telephone- and computer- linked network of dealers.

Traders are done over the phone and are usually between two financial institutions or

between a financial institution and one of its clients. Telephone conversations in the

OTC market are usually taped. If there is a dispute about what was agreed, the tapes

are replayed to resolve the issue. A key advantage of over-the-counter market is that

all the products are customized. Market participants are free to negotiate any mutually

alternative deal. A disadvantage is that there is usually credit risk in an over-the-

counter trade. The over-the-counter market is not regulated by any regulatory body

and hence posses a huge counterparty risk.

3.5 ECONOMIC SIGNIFICANCE OF DERIVATIVES

Some of the significance of financial derivatives can be enumerated as follows;



1) The most important function of derivatives is risk management. Financial

derivatives provide a powerful tool for limiting risks that individuals and

organizations face in ordinary conduct of their business.

2) The prices of derivatives converge with the prices of underlying at the

expiration of derivative contract. Thus, derivatives help in discovering the

future as well as current prices.

3) As derivatives are closely linked with the underlying cash market, with the

introduction of derivatives, the underlying cash markets witness higher trading

volumes. This is because; more people participate in stock market due to the

risk transferring nature of derivatives.

4) Speculative trade shift to a more controlled environment of derivative market.

In the absence of an organized derivatives market, speculators trade in the cash

markets. Margining, monitoring and surveillance of various participants

become extremely difficult in these kinds of mixed markets.

5) Derivatives trading acts as a catalyst for new entrepreneurial activities.

In a nut shell, derivatives markets encourage investment in long run. Transfer of risk

enables market participants to expand their volume of activity.

3.6 HISTORY OF DERIVATIVES

The history of derivatives is quite colorful and surprisingly a lot longer than

most people think. The origin of derivatives can be traced in Bible. In Genesis Chapter

29, believed to be about the years 1700 B.C., Jacob purchased an option costing him

seven years labour that granted him the right to marry Laban’s daughter Rachel.

Around 580 B.C., Thales the Milesian purchased option on Olive presses and made a

fortunate off of a bumper crop in Olives. So, derivatives were before the time of

Christ.

The first exchange for trading derivatives appeared to be Royal Exchange in

London, which permitted forward contracting on tulip bulbs at around 1637. The first

“futures” contracts are generally traced to the Yodaya rice market in Osaka, Japan

around 1650. These were evidently standardized contracts, which made them much



like today’s futures, although it is not known whether the contracts are marked to

market daily, and/or had credit guarantee.

Probably the next major event, and the most significant as far as the history of

derivatives markets, was the creation of Chicago Board of Trade in 1848. Due to its

prime location, Chicago was developing as a major centre for the storage, sale, and

distribution of Midwestern grain. Due to seasonality of grain, however Chicago’s

storage facilities were unable to accommodate the enormous increase in supply that

occurred following the harvest. Similarly, its facilities were underutilized in spring.

Chicago’s spot prices rose and fall drastically. To resolve this problem a group of

grain traders created “to-arrive” contracts which permitted the farmers to lock in the

price and deliver the grains in future. These to-arrive contracts are called as forward

contracts. The forward contracts proved as a useful device for hedging the price risk.

However, “credit risk” remained as serious problem. To deal with this problem, a

group of Chicago businessmen formed the Chicago Board of Trade (CBOT), in 1848.

The primary intention of CBOT was to provide a centralize location for buyers and

sellers to negotiate forward contracts. In 1865, CBOT went one step further and listed

the first “exchange traded” derivatives in US, which are termed as “Futures

Contracts”. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, got approval

for futures trading. Its name was changed to Chicago Mercantile Exchange (CME). In

1925, the first clearing house for derivatives trading was established.

Since then, derivatives are traded in many exchanges, although their trading

was banned by Government of different countries from time to time. But, the modern

derivative market has originated in 1970’s. This is due to the unprecedented volatility

in the international financial environment, starting with the breakdown of Bretton-

woods systems on 15 August 1971 and ending with the well-known Saturday night

massacre of Federal Reserve on 6th October 1979. The breakdown of Brettonwoods

system resulted in inflation, volatility in the market place and currency turmoil. This

state of affairs heralded the emergence of financial derivatives.



The next major fillip for development of derivatives was provided in October

1979, when the US Federal Reserve started its policy of interest rate deregulation and

anti-inflationary monetary policy. This resulted in increased interest rates. This

marked the emergence of interest rate derivatives to hedge interest rate risk.

The history of financial derivatives is concurrent with the history of various

risks in the financial world. The fascination with risk and its components started

during the early 1970’s has grown substantially since then, resulting in the expansion

of financial derivatives market.

3.7 INTERNATIONAL DERIVATIVE MARKET

The financial derivatives which were meant to address the needs of farmers and

merchants have now a major share in the financial market place. Started with the

establishment of Chicago Board of Trade (CBOT), derivatives are now traded in

almost all major stock exchanges of the world. Boosted with the breakdown of

Brettonwoods system, the derivatives got the recognition of risk management

instruments and are used by all investors starting from individual investor to

institutional investor.

Thus, the global derivative market is now a wide spread market with a potential

of further growth. In last two decades derivatives has shown a tremendous growth and

also continuing to grow in future. Major stock exchanges of derivatives trading are

Chicago Mercantile Exchange (CME), Eurex, Hongkong Futures Exchange, The

London International Financial Futures and Options Exchange (LIFFE), Singapore

Exchange, Sydney Futures Exchange etc. Apart from these stock exchanges other

stock exchanges of various countries has shown a huge growth in derivatives trading.

3.8 INDIAN DERIVATIVE MARKET

Derivatives markets in India have been in existence in one form or the other for

a long time. In the area of commodities, the Bombay Cotton Trade Association started

futures trading way back in 1875. In 1952, the Government of India banned cash

settlement and options trading. Derivatives trading shifted to informal forwards

markets. In recent years, government policy has shifted in favour of an increased role



of market-based pricing and less suspicious derivatives trading. The first step towards

introduction of financial derivatives trading in India was the promulgation of the

Securities Laws (Amendment) Ordinance, 1995. It provided for withdrawal of

prohibition on options in securities. The last decade, beginning the year 2000, saw

lifting of ban on futures trading in many commodities. Around the same period,

national electronic commodity exchanges were also set up.

Derivatives trading commenced in India in June 2000 after SEBI granted the

final approval to this effect in May 2001 on the recommendation of L. C Gupta

committee. Securities and Exchange Board of India (SEBI) permitted the derivative

segments of two stock exchanges, NSE and BSE, and their clearing house/corporation

to commence trading and settlement in approved derivatives contracts. Initially, SEBI

approved trading in index futures contracts based on various stock market indices such

as, S&P CNX, Nifty and SENSEX. Subsequently, index-based trading was permitted

in options as well as individual securities.

The trading in BSE SENSEX options commenced on June 4, 2001 and the

trading in options on individual securities commenced in July 2001. Futures contracts

on individual stocks were launched in November 2001. The derivatives trading on

NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in

index options commenced on June 4, 2001 and trading in options on individual

securities commenced on July 2, 2001. Single stock futures were launched on

November 9, 2001. The index futures and options contract on NSE are based on S&P

CNX. In June 2003, NSE introduced Interest Rate Futures which were subsequently

banned due to pricing issue. Since the scope of this project is limited to equity

derivatives only, so the further discussion will be confined to equity derivatives only.

Equity derivatives market in India has registered an "explosive growth" and is

expected to continue the same in the years to come. Introduced in 2000, financial

derivatives market in India has shown a remarkable growth both in terms of volumes

and numbers of traded contracts. NSE alone accounts for 99 percent of the derivatives

trading in Indian markets. The introduction of derivatives has been well received by



stock market players. Trading in derivatives gained popularity soon after its

introduction. In due course, the turnover of the NSE derivatives market exceeded the

turnover of the NSE cash market. For example, in 2008, the value of the NSE

derivatives markets was Rs. 130, 90,477.75 Cr. whereas the value of the NSE cash

markets was only Rs. 3,551,038 Crore. If I compare the trading figures of NSE and

BSE, performance of BSE is not encouraging both in terms of volumes and numbers

of contracts traded in all product categories.

Figure 3.2

Business Growth of Derivatives in India from 2000- 2011(May)

NSE’S DERIVATIVE SEGMENT

The National Stock Exchange accounts almost 99% of the Indian derivatives market in terms of turnover, volume etc. Its equity derivatives market is most boosted one and in turnover it is a major stock exchange. All products in equity derivative segment i.e. Index Futures and Options and Stock Futures and Options have marked a tremendous growth over the last decade. The graph below shows the average yearly turnover in each equity derivative products and average daily turnover of derivative segment of NSE.

Figure – 3.3

Equity Derivative Market of India

0

2000000

4000000

6000000

8000000

10000000

12000000

14000000

16000000

18000000

20000000

2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11

Indian Derivatives Market

Indian Derivatives Market



Average Daily Turnover of

0

1000000

2000000

3000000

4000000

5000000

6000000

7000000

8000000

9000000

2000-01 2001-02 2002

Index Futures

0

10000

20000

30000

40000

50000

60000

70000

80000

90000

100000

2000-01 2001-02 2002

Management of Derivatives

B o m b a y S t o c k E x c h a n g e L i m i t e d .

Figure – 3.4

Average Daily Turnover of India’s Derivatives Market

2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008

Index Options Stock Futures

2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008

Average Daily Turnover

Average Daily Turnover

B o m b a y S t o c k E x c h a n g e L i m i t e d .

India’s Derivatives Market

2008-09 2009-10 2010-11

Stock Options

2008-09 2009-10 2010-11



CHAPTER FOUR

RISK AND RISK MANAGEMENT



4.1 RISK

Over the past two decades and so, the markets have seen debacle after another,

each of which has brought its lessons – from some of which the markets have learned

and from many of which markets still need to learn. The Great Depression of 1930’s

has brought remainder to all financial markets or the economies as a whole. The 1987

crash taught markets the dangers of automated trading models and the second and

third-order effects of credit crisis. In 1990, Wall Street learned the horrors of holding

huge illiquid investments. In 1994’s spectacular bond market collapse, financial

executives saw for the first time how correlated global markets had become as the

fallout from Federal Reserve Board rate hikes swept from the US through Europe,

before devastating Mexico and other emerging markets. The Russian meltdown in

August 1998 was widespread and mounting. Banks and brokerage firms took turns

announcing trading losses from emerging markets, high yield, equities, or dealings

with hedge funds. Most recently, the Global Financial Meltdown, which was started

with the US sub-prime mortgage crisis, has captured almost all economies of the

world. Many banks become bankrupt, many loss their job, increased budgetary

deficits are the result of this crisis. Thus, it can be said that, the financial market is full

of risk and uncertainties.

Finance has never been so competitive, so far-flung, and so quantitative.

Information flow has never been so fast. But with the passage of time, financial

markets are becoming more sophisticated in pricing, isolating, repackaging, and

transferring risks. Tools such as derivatives and securitization contribute to this

process, but they pose their own risks. The failure of accounting and regulation to

keep abreast of developments includes yet more risks, with occasionally spectacular

consequences. Practical applications – including risk limits, trader performance-based

compensation, portfolio optimization, and capital calculations – all depend on the

measurement of risk. In the absence of a definition of risk, it is unclear what, exactly,

such measurements reflect.

Charles Tschampion, the MD of the $50 bn GM Pension fund, once said –

“Investment management is not an art, not science, it is engineering. We are in the



business of managing and engineering financial investment risk”; the challenge “is to

first not take more risk than we need to generate the returns that is offered”. It is a

profound statement that well captures the philosophical and mathematical connotation

of ‘Risk’.

The terms risk and uncertainty are often used interchangeably though there is a

clear distinction between them. Certainty is a state of being completely confident,

having no doubts of whatever being expected. Uncertainty is just opposite of that.

Risk is situation where there are a number of specific, probable outcomes, but it is not

certain as to which one of them will actually happen. In that context risk is not an

abstract concept. It is a variable, which can be calibrated, measured and compared. So

to define risk, risk entails two essential components; exposure and uncertainty. Thus,

risk is the exposure to uncertainty.

4.2 RISK MANAGEMENT PROCESS

Market integration, liberalization, globalization and technical advancement has

resulted with an increased competition in the market and the corporate are hence

exposed to risk. Thus a proper and unbiased assessment of risk is a prerequisite for a

sound management process. Moreover, with the advancement of communication

system and technology, the markets over the world are getting interconnected. Thus

making an effective risk management system is the need of the hour.

Risk management is the process in which risk is minimized with the application

of certain tools. The risk management process essentially comprises of certain steps,

such as, identification, assessment, prioritization, followed by coordinated and

economical application of resources to minimize, monitor and control it. These steps

are described below,

4.2.1 IDENTIFICATION



The risk management process starts with the identification of the factors which

are exposed to risk. It is always of primary concerns to identify the factors which are

more vulnerable and weak points in the system.

4.2.2 ASSESSMENT

After identifying the risk exposure points, it then to be assessed, i.e. to what

extent it is susceptible to that particular risk that has to be measured. Assessment of

risk helps in knowing the extent of vulnerability of a particular factor which is risk

exposed.

4.2.3 PRIORITIZATION

The next step of risk management process is the prioritization of factors which

are more vulnerable. The assessment of risk results in identifying the factors which are

more risk exposed and then these factors are prioritized from risk management point

of view.

4.2.4 APPLICATION OF RESOURCES TO MINIMIZE RISK

After identifying the most vulnerable factor, the management team applies

economic resources to minimizing the risk. This is the most important stage of risk

management as any wrong step can result a more susceptible situation.

4.2.4 MONITOR

The final step of risk management is monitoring the risk management process.

Simply applying the resources to minimize the risk is not the last step of risk

management, as it is needed to analyze the success of the risk management process.

For this reason the entire process is monitored and if anything goes wrong, it is

rectified.

4.3 RISK ASSOCIATED WITH DERIVATIVES TRADING

The continuing discussion of risks and its management in derivative markets

illustrates that there is little agreement on what the risks are and how to control it. One



source of confusion is the sheer profusion of names describing the risks arising from

derivatives. Besides the “price risk” of losses on derivatives from change in

underlying asset values, there is “default risk”, “settlement risk”, and “operational

risk”. Last, but certainly not the least, is the specter of “systemic risk” that has

captured so much congressional and regulatory attention. All these risks associated

with derivatives market are described below,

4.3.1 PRICE RISK

Price arises for the simple reason that the price of the underlying and price of

the derivatives are correlated. If the prices of the underlying increases, the impact is

seen in corresponding prices of derivatives products i.e. their prices also increase. For

an investor 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 obligation of the

derivative contract. This is price risk associated with the derivatives. Default due to

Price risk is mitigated by imposing some risk management tools in exchange-traded

derivatives, but in case of over-the-counter market, since it is largely unregulated,

default is more due to price risk.

4.3.2 DEFAULT RISK

This may the most popular and hazardous risk associated with the derivatives.

As derivatives are contracts or agreements, they need the obligations to be performed.

If any party default from the contract, then the contract is meaningless. The risk that

arises from the default of any party in derivatives is called as default risk. This is

common risk that is found in over-the-counter derivative market, but in exchange-

traded market, this type of risk is minimized by regulating the transactions.

Default risk is the risk that losses will be incurred due to default by the

counterparty. As noted above, part of the confusion in the current debate about

derivatives stems from the profusion of names associated with the default risk. Terms

such as “credit risk” and “counterparty risk” are essentially synonyms for default risk.

“Legal risk” refers to the enforceability of the contract. Terms such as “Settlement

risk” and “Herstatt risk” refer to defaults that occur at a specific point in the life of the



contract: date of settlement. These terms do not represent independent risks; they just

describe different occasions or causes of default.

Default risk has two components: the expected exposure and the probability

that default will occur. The expected exposure measures how much capital is likely to

be at risk should the counterparty defaults. The probability of default is the measure of

the possibility that the counterparty will default.

4.3.3 SYSTEMATIC RISK

One of the prominent concerns of regulators is “systematic risk” arising from

derivatives. Although this risk is rarely defined and almost never quantified, the

systemic risk associated with the derivative contracts is often envisioned as a potential

domino effect in which default in one derivative contract spreads to other contracts

and markets, ultimately threatening the entire financial system.

For the purpose of this paper, systemic risk can be defined as widespread

default in any set of financial contracts associated with default in derivatives. If

derivative contracts are to cause widespread default in other markets, there first must

be large defaults in derivative markets. In other words, significant derivative defaults

are a necessary condition for systematic problems.

It is argued that widespread corporate risk management with derivatives

increases the correlation of default among financial contracts. What this argument

fails to recognize, is that the adverse effects of stocks on individual firms should be

smaller precisely because the same shocks are spread more widely. Moe important, to

the extent firms use derivatives to hedge their existing exposures, much of impact of

stocks is being transferred from corporations and investors less able to bear them to

counterparties better able to absorb them.

It is conceivable that financial markets could be hit by a large disturbance. The

effect of such disturbances depends, in particular, on the duration of the disturbances

and whether firms suffer common or independent shocks. If the disturbance were

large but temporary many outstanding derivatives would be essentially unaffected



because they specify only relative infrequent payment. Therefore, a tempore

disturbance would primarily affect contracts with required settlements during this

period. If the shock were permanent, it would affect the derivatives in a much

hazardous way.

4.4 RISK MANAGEMENT OF DERIVATIVES

Derivatives, which come to light as a hedging instrument against volatility of

market and market related risk, created risk when there is a default. This gave rise to

the essence of risk management of derivatives and derivatives trading. In case of OTC

derivatives, as it is not regulated, it is more risky and there is no risk management at

all. But in case of exchange traded derivatives, several risk management tools are

applied to ensure the integrity of the market. The tools used for risk management of

derivatives are described below;

4.4.1 MARGINS

Margins are upfront payment by the participants of the derivatives market to

the exchanges. This upfront payment is collected to ensure that none will default in

future in obliging his obligation. If someone defaults then the clearinghouse settles the

contract from this margin account. Exchange’s clearinghouse collects the margin from

the clearing member, the clearing member collects the margin from the trading

member or the brokers and it is the responsibility of the trading members to collect the

same from its clients.

4.4.2 MARK-TO-MARKET MARGIN

In case of futures contracts, the margin is mark-to-market on daily basis i.e. the

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

position gains, then the amount he gained will be transferred to his account in the end

of the day. Similarly, if the investor losses, the amount that he lost is withdrawn from

his account.

4.4.3 EXPOSURE LIMITS



If an investor holds quite a large position than his capacity, then the probability

that he will default is more. For this reason, the regulatory body of the derivative

market put an exposure limit for the participants beyond which one cannot take

position in the market. This will ensure the integrity in term that nobody will default.

4.4.4 POSISTION LIMITS

Position limit is more applicable for the high net worth individuals, the FIIs and

the mutual funds. This is because, these people have huge investible cash and they can

direct the market as their wish. This will harm the market and other participants of the

market. Thus a position limit is introduced for this type of risk by the regulators for

the sound running of the market.

4.4.5 FINAL SETTLEMENT

Final settlement is the last part of risk management in case of derivatives. The

settlement is done by the clearing house of the exchange. On exercise the settlement is

done on the closing price of the derivative product and final settlement takes place on

T+1 basis. If the long position exercises his right, then the settlement is done by

randomly assigning the obligation on a short position at the end of the day.

Frankly speaking risk management of derivatives comprises of two things i.e.

margining requirement and the regulatory requirement. Thus risk management of

derivatives is nothing but, complying the rules and regulation laid down by the

regulator and satisfying the margin requirement.



CHAPTER FIVE

INTERPRETATION AND ANALYSIS



In the course of study of the risk management process used in BSE for

derivative segment, the following things are observed.

The risk management of derivatives in BSE has two parts; one is the margining

system and the regulatory requirement. The details of these are explained below,

For margining the BSE is following portfolio based margining system and the

margin calculation is done by software known as PC SPAN. The portfolio based

margining model adopted by the exchange takes an integrated view of the risk

involved in the portfolio of each and every individual client comprising of his

positions in all derivatives contract traded on derivative segment. The SPAN

(Standard Portfolio Analysis of Risk System) is a portfolio based margining system

developed by Chicago Mercantile Exchange and it is being used by almost all stock

exchanges now. For setting the margin the exchange has a margin committee, which

decides about various factors to be considered while calculating the margin

requirements.

5.1 THE SPAN MARGINING SYSTEM

The SPAN margins are estimates of changes in futures and futures-options

contract prices that would occur under various next-day realizations of futures prices

and implied volatility. The inputs into SPAN are; the futures price scan range, the

implied volatility scan range, the minimum short option charge, the calendar spread

charge, the inter-commodity spread charge. These are described below;

5.1.1 THE FUTURE’S PRICE SCAN RANGE:

The price scan range inputs sets the maximum underlying price movement that

the margin committee chooses to consider in setting margin collateral requirements.

The future’s price scan range is the clearinghouse margin requirement on a naked

future position and controlling input into the option pricing model simulation that

ultimately determines the margin requirements. The future scan range is set by the

margin committee after examining historical price movements and applying subjective

judgments.



5.1.2 THE IMPLIED VOLATILITY SCAN RANGE:

The implied volatility scan range is the largest movement in implied volatility

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

analyzing histograms of absolute value of day-to-day changes in the implied volatility

of traded futures-option contracts. The underlying average implied volatility estimate

that is analyzed is a simple average of eight contracts implied volatility on a given

maturity: the first is in-the-money and first three out-of-the-money implied volatility

estimates for both calls and puts.

5.1.3 THE MINIMUM SHORT OPTION CHARGE:

The minimum short option charge or minimum margin on an option contract is

set at 2.5% of the clearing member’s futures price scan range.

5.1.4THE CALENDAR SPREAD CHARGE:

The calendar spread charge is put into the SPAN is a parameter that sets the

amount of margin collateral, the clearinghouse collects against calendar spread basis

risk in portfolios. The calendar spread basis is the difference between prices of

contracts with different maturities. The basis between nearest quarterly and next

quarterly futures contract is calculated. Histograms of the absolute value changes in

basis series are constructed for different windows periods, and the histograms are

considered by the margin committee while calculating margin.

5.1.5 THE INTER-COMMODITY SPREAD CHARGE:

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

requirement that must be posted to protect against correlation risk in inter-commodity

spread positions.

In SPAN, futures and futures options changes are estimate under alternative

scenario that are determined by the values chosen for the price and implied volatility

scan range inputs. In the simulation analysis, the value of each option contract is

estimated for following day using Black Option Pricing Model. The next-day contract



prices are determined under alternative scenarios in which underlying futures

contract’s price and implied volatility move by predetermined function of their scan

range. The futures price and implied volatility scan inputs are translated into 16

different scenarios that represent alternative combinations of futures price and implied

volatility changes. For each scenario simulated, the contract’s value is reported as an

element called “SPAN risk array”. This average implied volatility is then “shocked”

by the implied volatility scan range in the SPAN simulations. The next day simulated

contract prices are compared with the prior day’s theoretical settlement price and

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

price move scenarios, the CME’s margin committee has decided to margin 35% of the

simulated price move gain or loss is the value reported in these extreme price move

SPAN array entries. The SPAN risk array is given below,

1. Underlying unchanged; volatility up

2. Underlying down; volatility down

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

4. Underlying down by 1/3 of price scan range; volatility down

5. Underlying down by 1/3 of price scan range; volatility up

6. Underlying up by 1/3 of price scan range; volatility down

7. Underlying up by 2/3 of price scan range; volatility up

8. Underlying down by 2/3 of price scan range; volatility down

9. Underlying down by 2/3 of price scan range; volatility up

10. Underlying up by 2/3 of price scan range; volatility down

11. Underlying up by 1 of the price scan range; volatility up

12. Underlying down by 1 of the price scan range; volatility down

13. Underlying down by 1of price scan range; volatility up

14. Underlying up by 1 of price scan range; volatility down

15. Underlying up extreme move, double the price scanning range

16. Underlying down extreme move, double the price scanning range

5.2 WORKING OF SPAN MARGIN SYSTEM



The clearinghouse of the exchange electronically distributes a SPAN risk array

for every derivative product that it clears and settles. Clearing members firms receive

these arrays and use them to calculate their margin requirements for their customers

account. The maximum loss across the 16 scenarios becomes the “Preliminary” SPAN

margin for that account. The final margin requirements may differ from this

preliminary margin owing to additional margin requirements that resulted from

margin requirement on calendar spreads and minimum margin requirement for written

options contracts. Inter-commodity spread charges also enter into the final margin

calculation. Each written option contract is subjected to minimum margin

requirement. For a portfolio, this margin requirement is the product of the number of

written options times the minimum short option charge.

5.3 MARGINS

The BSE collects margin collateral in advance to minimize its risk exposure.

The margin required for different equity derivatives are explained below;

o The initial margin requirements on all derivative products are based on worst-

case loss of portfolio at client level to cover 99% Vary over one day horizon.

The initial margin requirement is net at client level and shall be on gross at the

trading and clearing member level.

o For this purpose, the price scan range of index products and stock products is

taken as 3σ and 3.5σ respectively. The price scan range of options and futures

on individual securities is also linked to liquidity. This is measured in terms of

impact cost for an order size of Rs. 5 laky calculated on the basis of order book

snapshots in the previous six months. If the impact cost exceeds by 1%, the

price scan range is increased by square root of three.

o For stock futures and short stock options contracts a minimum initial margin

equal to 7.5% of the notional value of the contract based on the last available

price of futures and option contract respectively is collected. For index futures

a minimum margin equal t 5% of the notional value of the contract is collected.

For index options a minimum of 3% is charged as the minimum margin.



o The margin on calendar spread is calculated on the basis of delta of the

portfolio consisting of futures and options contracts in each month. The spread

charge is specified as 0.5% per month for the difference between the two legs

of the spread subjected to minimum of 1% and maximum of 3%.

5.4 MARK-TO-MARKET OF MARGIN

o For all stock futures and index futures contract, the client’s position is marked-

to-market on a daily basis at portfolio level. The mark-to-market margin is paid

in/out in T+1 day in cash. For determining the mark-to-market margin, the

closing price is taken into consideration.

5.5 EXPOSURE LIMITS

The exposure limit for different equity derivatives products are given below;

o In case of stock futures contracts, the notional value of gross open positions at

any point in time should not exceed 20 times the available liquid net-worth of a

member, i.e. 10% of the notional value of gross open position in single stock

futures or 1.5σ of the notional value of gross open position in single stock

futures, whichever is higher. However BSE charges exposure margin for better

risk management.

o For stock options contracts, the notional value of gross short open position at

any time would not exceed 20 times of the available liquid net-worth of the

member, i.e. 5% of the notional value of gross short open position in single

stock options or 1.5σ of notional value of gross short open position in single

stock options whichever is higher.

o In case of index products, the notional value of gross open positions at ant time

would not exceed 33 1/3 times of the available liquide networth of the member.

for index products, 3% of the notional value of gross open position would be

collected from the liquide networth of a member on a real time basis.

5.6 POSITION LIMITS



o A market wide limit on the open position on stock options and futures contracts

of a particular underlying stock is 20% of the number of shares held by non-

promoters i.e. 20% of the free float, in terms of number of shares of a

company.

o In case of stock futures and options, the stock having applicable market wide

position limit (MWPL) of Rs. 500 crores or more, the combined futures and

options position limits shall be 20% of market wide position limit or Rs. 300

crores, whichever is lower and within which shock futures position cannot

exceed 10% of applicable market wide position limit or Rs. 150 crores,

whichever is lower. This is the position limit for trading members, FII and

mutual funds.

o For stocks having applicable market wide position limit less than Rs. 500

crores, the combined futures and options position limit would be 20% of

applicable market wide position limit or Rs. 50 crore whichever is lower. This

is applicable for trading members, FII and mutual funds.

o For futures and options contracts, the trading members, FII and mutual funds

position limits shall be higher of; Rs. 500 crores or 15% of total open interest in

the market in equity index futures contracts or equity index options contract

respectively.

o The gross open position of clients, sub-accounts, NRI level and for each

scheme of mutual funds across all derivatives contracts on a particular

underlying shall not exceed higher of; 1% of the free float market capitalization

or 5% of the open interest in underlying stock.

o Any person who holds 15% or more of the open interest in all derivatives

contracts on the index shall be required to disclose the fact to the exchange and

failure of which will attract a penalty.

5.7 FINAL SETTLEMENT



o On expiry of a stock futures or index futures contract, the contract is settled in

cash at the final settlement price. The final settlement price is the closing price

of the underlying stock or the index respectively. The profit or loss is paid in or

out in T+1 day.

o On exercise or assignment of options, the settlement takes place on T+1 basis

and in cash. On expiry, if the options are not exercised or closed out, all in-the-

money options are settled by the exchange at the settlement price. The

settlement price is the closing price of the stock or index in the cash segment.

On exercise of options, the assignment takes place on a random basis at client

level. At present there would not be any exercise limit for trading in options,

but the exchange can specify the limit as per its convenience.



CHAPTER SIXCHAPTER SIXCHAPTER SIXCHAPTER SIX

SUMMERY AND CONCLUSIONSUMMERY AND CONCLUSIONSUMMERY AND CONCLUSIONSUMMERY AND CONCLUSION



6.1 MAJOR FINDINGS

On course of study of the risk management process of derivatives in BSE, the

following observations are pointed out. Since the study is focused on equity

derivatives only, the findings are concerned only about equity derivatives.

6.1.1 SPAN MARGINING SYSTEM

The SPAN (Standard Portfolio Analysis of Risk) is a portfolio based margining

approach for calculation of margin requirement of derivatives. This is an integrated

system of margining that reduces margining requirement on derivatives than any other

system of margining. The SPAN margining system in BSE is an efficient system of

margin calculation. The procedure in which the SPAN is calculated in BSE can be

compared to any major exchange of the world and covers almost 99% of risk exposure

of the exchange.

6.1.2 PC SPAN®

o The software used by BSE for margin calculation is PC SPAN®. This software

is developed by the Chicago Mercantile Exchange.

o This software provides adequate information to its user.

o It is user friendly. It provides the margin on a real time basis. As soon as the

data is input to the system, it takes 5 to 7 minutes to calculate the margin

requirement.

o This is efficient software for calculation of SPAN margin and used by almost

all stock exchanges of the world.

6.1.3 RISK MANAGEMENT

o The risk management process for derivatives used by BSE is efficient and

effective system.

o It covers about 99% Vary at any time.



o This also helps in protecting the market and helps in increasing the market

integration.

o On comparing the risk management process of BSE with that of NSE, it is

found that it is almost same. But NSE has an added advantage for the

information related services that it provides.

o BSE provides its data on a graphical format, whereas NSE provides the same

on a tabular format, which is easy to understand.

o The NSE uses PRISM (Parallel Risk Management System), which monitors

the derivatives segment of NSE on a real time basis. But BSE do not have,

this system.

6.2 SUGGESTIONS

Based on the interaction with different broking firms, it is observed that BSE is

comparable to NSE in technical terms. However, BSE lacks in providing better

services and information to the investors, which leads to poor market position in

derivatives.

o During our interaction with the brokers we come to know that, the services

provided by NSE are more reliable than that of BSE. So BSE should try to

provide integrated services to its members to improve its derivatives segment.

o Regarding the risk management procedure, as there is no difference between

NSE and BSE, it can be said that, BSE should continue with this process.

o BSE should improve its monitoring system for better risk management of the

exchange.

o Another major cause for BSE’s lost market share is the failure in providing

data. BSE can focus on this part in particular. It should also provide data in

tabular format rather than graphical format, so that it can be easily understood

by the investors.

o To improve its derivatives segment, BSE has to constantly innovate in terms of

services, products and technology, otherwise it cannot compete with NSE.



o BSE charges more margins for better risk management, which in terms harms

its market position. Thus, a reasonable margin should be charged on the

members for development of derivatives market and better risk management.

6.3 CONCLUSION

BSE with its distinctive feature has a long, colorful and chequered history. It

enjoys a pre-eminent position by having a permanent recognition from the Securities

Contract (Regulation) Act, 1956. It can be considered as an essential concomitant of

the Indian economy. It is performing all the important functions of an ideal stock

exchange by providing a ready and continuous market with negotiability and safety to

investment of investors; redressing their grievance, minimizing risk, and providing a

forum to ensure liquidity and attracting capital from the investors, etc.

Despite the efficiency and transparency, BSE still lags behind NSE and faces a

stiff competition from it. Particularly, NSE holds about 99% of the derivatives market

of India, whereas BSE’s position is negligible. This can be attributed to the following

reasons.

Firstly, lack of detail and timely information of derivative segment and its risk

management is one of the main reasons for the falling market share of the BSE’s

derivatives segment.

Secondly, the data files for margin calculation are not precious as NSE has.

This is also one of the key obstacles in the development of derivative segment of BSE.

When BSE losses NSE gains.

Thirdly, the lack of monitoring system for risk management is another problem

with BSE. NSE has PRISM as the monitoring system which enables it for better risk

management of derivatives.

Coming to risk management of derivatives in BSE, BSE has an efficient and

effective risk management system, which can be compared with any of the exchange



of the world. The SPAN margining system followed by BSE for margin calculation is

one of the most efficient systems of margining. Along with this the regulatory

requirement of BSE makes the risk management system stronger and effective.

Though the margin with which BSE lags behind NSE is too much for

derivatives market, but a committed effort can help BSE to gain supremacy in this

segment. This can be done by making itself more informative, monitoring the risk

management process and taking some aggressive steps for the improvement of the

derivatives segment.

All it needs to do is to take quick and timely decisions for the improvement of

the derivatives segment.



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