RISK MANAGEMENT AT NCDEX PRESENTATION FOR

UTKAL UNIVERSITY
March 2 & 3, 2009

Agenda

Risk Management

Settlement Margins and Limits Mark to market Initial and exposure Additional and special Delivery

Margins

Limits

Position client and member Price

Derivative 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

Derivative 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

Risks 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

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)

Tools to manage default risk

Margins

Initial Exposure Delivery Special Additional

Mark-to-market Limits

Position client and member Price

Fund 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)

Other 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

Agenda

Risk Management

Settlement Margins and Limits Mark to market Initial and exposure Additional and special Delivery

Margins

Limits

Position client and member Price

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Margin 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 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 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 assets return; it is measured by a value called standard deviation.

Red" Zone = 68% probability of falling within 1 standard deviation of the assets expected return "Red+Green" Zone = 95% probability of falling within 2 standard deviations of the assets expected return. "Red+Green+Blue" Zone = 99% probability of falling within 3 standard deviations of the assets expected return).

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Value at Risk (VaR)

Definition The 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 prices For a time horizon >1 day, multiply by T

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VaR methodology for all commodities in NCDEX- An Example

For e.g. for a July Gold contract, Yesterdays annualized volatility = (n-1) = 16% Number of days in a year = 365 Hence, yesterdays daily volatility = 16% / sqrt (no. of days in a year) = 0.84% Yesterdays price = P (n-1) = 13000/Todays price = P(n) = 13100/Therefore, return = r(n-1) = ln (P(n) / P(n-1) ) = 0.007663 (decay factor) = 0.94 Therefore, current volatility sqrt(n) = sqrt (.(n-1) + (1 ) r(n-1)^2 ) = 0.83% VaR margin = 3.29 * (n) * Sqrt( look ahead days) * price = 359/15

Exposure 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 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 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 nondelivery 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 margin

When Opposite position is taken in two different contracts and the contracts satisfy certain conditions, (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-Market

At the end of the day all open positions are markedto-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 days 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 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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Agenda

Risk Management

Settlement Margins and Limits Mark to market Initial and exposure Additional and special Delivery

Margins

Limits

Position client and member Price

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Position 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 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 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 Margin

Pre-expiry margins are levied in respect of all contracts having provisions relating to sellers 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 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 Shop

NCDEX terminals

Institutions

Banks

Warehouse

Single point front for farmers to meet all needs

Other needs
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Fertilizers

Agri-extensions

Aiming to provide a whole gamut of services from single platform

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 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

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