303 banking -derivative risk management-draft

8/8/2019 303 Banking -Derivative Risk Management-draft

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DERIVATIVE RISK MANAGEMENT

INTRODUCTION

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 demandand 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.

DERIVATIVE PRODUCTS

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

options and swaps. Various derivatives contracts are described below,

FORWARDS

A forward contract is a customized contract between two entities, where settlement takes place

on a specific date in the future at todays 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.


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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 contractsare traded in exchanges and exchange sets the standardized terms in term of quantity, quality,

price quotation, date and delivery date (in case ofcommodities).

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.

WARRANTS

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

generally traded over-the-counter.

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.

BASKETS

Basket options are options on portfolio of underlying assets. Equity index options are a form ofbasket options

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,


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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.

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 behavior 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.

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,

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.


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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. Marketparticipants 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 possesses a huge counterparty risk.

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 apowerful 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 absenceof 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.


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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. Thales the Milesian purchased option on Olivepresses 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 todays 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 center for the storage, sale, and distribution of Midwestern grain. Dueto seasonality of grain, however Chicagos storage facilities were unable to accommodate the

enormous increase in supply that occurred following the harvest. Similarly, its facilities were

underutilized in spring. Chicagos 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 1970s. 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 Bretton woods system resulted in inflation, volatility in the market place and

currency turmoil. This state of affairs heralded the emergence of financial derivatives.


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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 1970s has grown

substantially since then, resulting in the expansion of financial derivatives market.

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 Boardof Trade (CBOT), derivatives are now traded in almost all major stock exchanges of the world.

Boosted with the breakdown of Bretton woods 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 potentialof 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, Hong Kong Futures Exchange, TheLondon

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.


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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 hasshifted in favor 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 tothis 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 NiftyIndex 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


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trading figures of NSE andBSE, performance of BSE is not encouraging both in terms of

volumes and numbers of contracts traded in all product categories.

Business Growth of Derivatives in India from 2010- 2011(May)

NSES 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 boostedone and in turnover it is a

major stock exchange. All products in equity derivativesegment i.e. Index Futures and Options


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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.


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Average daily turnover of the Indian derivative market


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RISK AND RISK MANAGEMENT

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 whichmarkets still need to learn. The Great Depression of 1930s 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 1994s 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 capturedalmost 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 distinctionbetween 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.


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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 aregetting 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,

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.

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.

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.

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.

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 isrectified.


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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, settlementrisk, 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,

PRICE RISK

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

correlated. If the price 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 shemay 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.

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 ofsettlement. 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


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counterparty defaults. The probability of default is the measure ofthe possibility that the

counterparty will default.

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 amuch hazardous way.


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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 tradedderivatives, several risk management tools are applied to ensure the integrity of the market. The

tools used for risk management of derivatives are described below;

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.

Exchanges 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 thetrading members to collect the same from its clients.

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.

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.

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.


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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 shortposition 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.


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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 isthe 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.

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, theimplied volatility scan range, the

minimum short option charge, the calendar spread charge, the inter-commodity spread charge.

These are described below;

THE FUTURES PRICE SCAN RANGE:

The price scan range inputs sets the maximum underlying price movement that the margincommittee chooses to consider in setting margin collateral requirements. The futures 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.

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.


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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 members futures price scan range.

THE 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.

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 contracts 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 volatilitychanges. For each scenario simulated, the contracts 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 days theoretical settlement price and contract gains and losses are calculated as the

difference in these prices. In extreme price move scenarios, the CMEs 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,


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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

WORKING OF SPAN MARGIN SYSTEM


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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.

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 3 and

3.5 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%.

MARK-TO-MARKET OF MARGIN


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o For all stock futures and index futures contract, the clients 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.

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 1.5 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 wouldnot 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 1.5 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 any time would not

exceed 33 1/3 times of the available liquid net worth of the member. For index products, 3% of

the notional value of gross open position would be collected from the liquidnet worth of a

member on a real time basis.

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% ofapplicable market wide position limit or Rs.

50 crore whichever is lower. Thisis applicable for trading members, FII and mutual funds.


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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% ofthe 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.

FINAL SETTLEMENT

o On expiry of a stock futures or index futures contract, the contract is settled in cash at the finalsettlement 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.


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bibiliography

www.bseindia.com

www.investorworld.com

www.yahoo.com/finance

http://www.bis.org/publ/cpss06.pdf

http://www.premiumdata.net/

http://www.emeraldinsight.com/journals.htm?articleid=1527485&show=pdf

http://www.cboe.com/learncenter/glossary.aspx

http://www.cme.com/SPAN/

http://www.sgx.com/

http://www.asx.com/

http://www.sebi.gov/

http://www.myiris.com

http://www.bseindia.com/riskmanagement/about.asp

http://www.en.wikipedia.org/wiki/Risk_Management

303 banking -derivative risk management-draft

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