RISK MANAGEMENT AT NCDEX

PRESENTATION FOR

UTKAL UNIVERSITY

March 2 & 3, 2009

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AgendaAgenda

Risk Management Settlement Margins and Limits

Margins Mark to market Initial and exposure Additional and special Delivery

Limits Position – client and member Price

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Derivative marketDerivative market

The main features of a Derivative Market are

Instruments: Futures and Options Standardised Contracts No counter party risk to Members Novation Clearing House guarantees each trade No default risk

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Derivative ExchangeDerivative Exchange

The major functions of Derivative Exchange: Price discovery and hedging – functions of a

derivative market

Eliminate counter party default risk for a fee

Guaranteeing counter party risk – service provided by a derivative Exchange

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Risks faced by ExchangeRisks faced by Exchange

An exchange faces Risk because of its operations (same is true for any company/entity). The major risks are -

Credit Risk Settlement Risk Market Risk Other Risks

Liquidity risk Legal risk Operational risk

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What is default? Default – any one party (buyer/seller) may not fulfill its

obligations concerning either payment or delivery.Default in delivery is also termed as Settlement Risk.

Why would someone default?Default can occur due to a sudden movement in the market price of the futures

contract (termed as price risk or market risk)

inability of the counter party to make the payment (termed as credit risk)

inability of the counter party not able to bring the to bring the material for delivery (termed as delivery default)

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Tools to manage default riskTools to manage default risk

Margins Initial Exposure Delivery Special Additional

Mark-to-market Limits

Position – client and member Price

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Fund Requirement from MembersFund Requirement from Members

Amount brought in by trading member Rs. 30 lacs (50 Lacs for PCM)

Cash – interest free

Rs. 15 lakh

(25 lakh by PCM)

Collateral

Rs. 15 lakh

(25 lakh by PCM)

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Other ways to cover default riskOther ways to cover default risk

Fund the default High level of margin – members may trade

elsewhere Low level of margin – Exchange is at risk Flat margin – account for changing volatility Mark to market – ex post

Margins must be collected in advance Margin computation is complex but interesting

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AgendaAgenda

Risk Management Settlement Margins and Limits

Margins Mark to market Initial and exposure Additional and special Delivery

Limits Position – client and member Price

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Margin calculationMargin calculation

NCDEX calculates margin payable by each member

Member may

Charge same margin to his client; or

Charge a mark-up on the prescribed margin to his client, based on his perception of risk associated with that client

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VaR Based MarginVaR Based Margin

Margin based on “Value at Risk” (VaR) model To estimate worst loss that can happen for a time

horizon – one day 99.95% confidence level – 3.29 sigma SPAN® system used for margin calculation Forecast volatility using EWMA (Exponential

weighted moving average) Minimum initial margin for each commodity

traded by the member specified by regulator. 4% for gold, and 5 % for all other commodities

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Return and Return VolatilityReturn and Return Volatility

“Expected Return – The return expected on an investment (an asset or a portfolio) based on a probability distribution, taking into account all possible return scenarios.

• Return Volatility – Represents the variability or uncertainty of an asset’s return; it is measured by a value called standard deviation.

Red" Zone = 68% probability of falling within 1 standard deviation of the asset’s expected return

"Red+Green" Zone = 95% probability of falling within 2 standard deviations of the asset’s expected return.

"Red+Green+Blue" Zone = 99% probability of falling within 3 standard deviations of the asset’s expected return).

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Value at Risk (VaR)Value at Risk (VaR)

DefinitionThe maximum potential loss expected to be incurred on a given position over a specified time horizon at a given level of confidence

Compute VaR on the basis of daily changes in the spot/ futures pricesFor a time horizon >1 day, multiply by T

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VaR methodology for all commodities VaR methodology for all commodities in NCDEX- An Examplein NCDEX- An Example

For e.g. for a July Gold contract, Yesterday’s annualized volatility = σ(n-1) = 16% Number of days in a year = 365Hence, yesterday’s daily volatility = 16% / sqrt (no. of days in a year) = 0.84%Yesterday’s price = P (n-1) = 13000/- Today’s price = P(n) = 13100/- Therefore, return = r(n-1) = ln (P(n) / P(n-1) ) = 0.007663Λ (decay factor) = 0.94Therefore, current volatility sqrt(σn) = sqrt (λ.σ(n-1) + (1 – λ) r(n-1)^2 ) = 0.83%

VaR margin = 3.29 * σ(n) * Sqrt( look ahead days) * price = 359/-

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Exposure MarginExposure Margin Exposure margin is an additional fixed percentage

that vary with individual commodities and is prescribed to take care of extreme events where initial margin may not be sufficient to cover the value at risk.

This exposure margin for a commodity is prescribed based on the performance of the 99% VaR model through Back-Testing procedure. Back-Testing involves testing how well the VaR estimates have performed for the historical data.

At NCDEX Back-Testing involves checking how often the loss in a day has exceeded the 1- day 99% VaR. If the loss has exceeded the 1 day VaR more than twice a year, then the exposure margin is added on till the failures are done away with.

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Exposure limitExposure limit Maximum gross open position of members is

linked to liquid net worth (Rs. 15 lakh) of the member

If the member wants to increase his exposure beyond the limit, additional base capital needs to be brought in

Additional base capital to be in cash/FD/BG/ GoI securities

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Margin for deliveriesMargin for deliveries

In case of deliveries, the margins would be computed as the worst scenario loss to cover 99.9% VaR for a time horizon of T days T= no of days to complete physical settlement

Additional margin would include penalty in case of non-delivery

Margins for delivery shall be collected the day following the day of expiry of the contract

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Special Margin

In case of additional volatility, a special margin at such other percentage as deemed fit by the Regulator/Exchange, may be imposed only on one side, i.e., either on the buy or the sell side would be called as special margins.

Removal of such Margins is at the discretion of the Regulator/ Exchange.

Additional Margin In addition to the above margins the Regulator/Exchange

may impose additional margins on both long and shot sides at such other percentage, as deemed fit.

Removal of such Margins will be at the discretion of the Regulator/Exchange.

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Calendar spread marginCalendar spread margin

When Opposite position is taken in two different contracts and the contracts satisfy certain conditions, ½ (VM + EM) is charged as margin.

The conditions are: (a) there should be correlation between the contracts and (b) far month contract should be sufficiently liquid.

Calendar spread positions are considered as naked (uncovered) position in the far month contract three days before expiry of near month contract Gradual reduction by 33.3% per day for three days

prior to expiry day No credit is given for inter-commodity spread

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Mark-to-MarketMark-to-Market

At the end of the day all open positions are marked-to-market at the daily settlement price (DSP) Last half an hour volume weighted average traded

price; else Last one hour volume weighted average traded

price; else Whole day volume weighted average traded price;

else Previous day’s settlement price; else Theoretical futures price

Member has to bring mark-to-market (MTM) margin through funds transfer the next day

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Final settlement priceFinal settlement price The polled spot price at expiry of contract is

the final settlement price Spot prices are collected from different

centres across the country Statistical methods are used to prevent price

distortion Final settlement price is the price used for

settling trades at expiry of contract. Funds Pay-in and Pay-out are on the basis of

this price

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AgendaAgenda

Risk Management Settlement Margins and Limits

Margins Mark to market Initial and exposure Additional and special Delivery

Limits Position – client and member Price

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Position limitPosition limit

Position limit is the maximum open interest that an individual client or member can hold in any one contract or in all contracts put together for a commodity at any point of time.

The objectives behind setting position limits on open interest are to prevent Short squeeze – it should not happen that at expiry the open

interest that can be converted into delivery is more than the stock available for delivery.

Market concentration – it should not be the case that a single member holds a disproportionately large per cent of open interest.

For the orderly functioning of the market and to ensure smooth rollover of positions in contracts, stringent limits are required as the contract approaches maturity.

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Position limitPosition limit

Position limit Quantity terms Different for client and member Based on production of commodity Commodity level

Market concentration, manipulation, short squeeze

NCDEX monitors all members' positions NCDEX may insist on reduction in position if it

gives rise to risk management concern Hedge limits

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Price LimitsPrice Limits The maximum price movement during a day is

prescribed for every commodity. The limits are prescribed by the FMC. If the price hits the intra day price limit (at upper

side or lower side), there is a cooling period of 15 minutes. Trade is allowed during this cooling off period within the price band.

Thereafter the price band is raised by another fixed percentage as prescribed by the FMC and trade is resumed.

If the price hits the revised price band again during the day, trade is allowed only within the revised price band. No trade/order is permitted during the day beyond the revised limit.

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Pre-Expiry MarginPre-Expiry Margin Pre-expiry margins are levied in respect of all contracts

having provisions relating to seller’s choice/compulsory delivery and at times in intention matching contracts, to ensure roll over of positions from the near month contract to the mid/far month contract, as the near month contract approaches expiry.

This is in line with the rationale that the open interest should reduce towards expiry to avoid manipulation and short squeeze. Currently, pre-expiry margins are triggered five days prior to expiry.

There is an additional margin imposed for the last 5 trading days (last 2 trading days for Gold, Silver and Steel ingots contracts), including the expiry date of the contract.

The additional margin will be added to the normal exposure margin and will be incremental everyday for the last 5 trading days of the contract.

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Margins and limits – necessaryMargins and limits – necessary Margins and limits are risk mitigation tools

designed to protect the Exchange from going bust in case of member default

As in any other business, there are certain rules of the game which need to be followed for the smooth functioning of the market e.g. traffic rules

Margins and limits do not restrict business; they actually make the markets safer for all participants

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One Stop ShopOne Stop Shop

Single point front for farmers to meet all needs

Other needs

NCDEX terminals Institutions Banks Warehouse

Agri-extensionsFertilizers Aiming to provide a whole gamut of services from single platform

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The day when all village and semi-urban centers would be benefited by commodity price knowledge is not too far. After all, this serves the largest purpose for which the electronic trading system was introduced…

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Thank youThank you

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National Commodity & Derivatives Exchange Exchange Plaza, Bandra East, Mumbai 400 051

www.ncdex.com

www.ncdex.com/Circulars/circulars_english.aspx