A PROJECT REPORT on

Risk Management of Financial Derivatives
Under the guidance Of

Prof. Karishma Singh

Submitted by:
Mohit Bhendarkar Tushar Sevak in partial fulfillment of the requirement for the award of the degree

Of

MBA
IN

Finance

April – 2008-2010

Preface

In every field of education imparted to the students, working on projects and studies play an immense role in bringing out and exhibiting the qualities which are helpful in implementing student‟s knowledge in practical life.

When it comes to the practical knowledge in field of Finance, there are immense areas to be specialized in. One may choose core finance like working capital management, credit policies etc, and one can look forward towards sectors like banking, insurance as well. But in all these fields‟ one thing remains same, which is the Risk Management of financial data and financial instruments. To reduce the risk in trading of financial derivatives it is very important to do Risk Management in the same.

So getting an in-depth knowledge of this field can be of great help to students who are interested in finance. This kind of reports can help us see how the theoretical concepts of Finance are used practically.

December 2007 Ahmedabad

Mohit Bhendarkar Tushar Sevak

Acknowledgement

We would like to express our thanks to Prof. Karishma Singh of Institute of Business Management & Research for the invaluable guidance provided by her.

Words are insufficient to express our deep gratitude towards guide. I would like to give an invaluable thanks to Prof .Karishma Singh who stood by us throughout the preparation of this project not only as a guide but also as a friend. Apart from this all the staff members helps us at each and every stage. We would like to thank them also for their cooperation.

We acknowledge our debt of gratitude to all the authors and publishers whose books, journals, magazines, newspapers and websites. We have relied on for preparing this study.

BONAFIDE CERTIFICATE

Certified that this project report titled “Risk Management of Financial Derivatives” is the bonafide work of “Mohit Bhendarkar & Tushar Sevak” who carried out the project work under my supervision.

SIGNATURE HEAD OF THE DEPARTMENT (Prof. B. N. Mehta)

SIGNATURE FACULTY IN CHARGE (Karishma Singh)

Institute of Business Management & Research
8/182, Sunrise Park, Near ASIA School, Driven In Road, Ahmedabad - 380054. Ph. : 079-26858717 / 40052917 Email : Ahmedabad@ibmrindia.org website : www.ibmrindia.org

Executive Summary
The main plot for my project is to study Financial Derivatives and Risk Management for the same. How it works and how the Risk Management of Financial Derivatives is done. And to test the superiority of trading strategies for Derivatives based on Risk Management Chapter 1 contains some basic information/introduction on Derivatives i.e. what exactly Derivatives are and its history i.e. how derivative market arised and its growth. Chapter 2 contains Trading Strategies using Futures and Options and some related examples. It also contains different types of strategies for trading of the derivatives. Chapter 3 is built up of Risk Management i.e. what is risk and risk management. It also contains risk associates with derivatives and roles banks take in derivative activities as well as different tools related to risk management.

Chapter 4 epitomize brief of risk management of financial derivatives and give the conclusion for the same. Derivatives are financial contracts that are designed to create market price exposure to changes in an underlying commodity, asset or event. In general they do not involve the exchange or transfer of principal or title. Rather their purpose is to capture, in the form of price changes, some underlying price change or event. The term derivative refers to how the price of these contracts are derived from the price of some underlying security or commodity or from some index, interest rate, exchange rate or event. Derivatives are high-risk instruments and hence the exchanges have put up a lot of measures to control this risk. The most critical aspect of risk management is the daily monitoring of price and position and the margining of those positions.

Table of Contents Particular
Chapter 1 Glimpse Background What are the Derivatives? Users of Derivatives History of Derivatives L C Gupta Committee Report The Evaluation and Economic Purpose of Derivatives Future Terminologies Used in Futures Contracts Options Call Option Put Option Calculation of premium of an Option Option Greeks Settlement of Derivatives Regulatory and Taxation Aspects of Derivatives Glossary of Terms Used in Derivatives Growth of Derivatives Market in India Chapter 2 Trading Strategies Using Futures and Options Chapter 3 Risk Management in Derivatives Definition.

Page No. 7 7
8 10 11 13 14 15 25 28 38 42 42 48 49 51 54 56 63 66 66 73 73

Risk Associated with Derivatives Activities Role Banks Take in Derivatives Activities Senior Management and Board Oversight Chapter 4 Conclusion Bibliography

76 76 79 126 125 126

Chapter 1
GLIMPSE
Derivatives are financial contracts that are designed to create market price exposure to changes in an underlying commodity, asset or event. In general they do not involve the exchange or transfer of principal or title. Rather their purpose is to capture, in the form of price changes, some underlying price change or event. The term derivative refers to how the price of these contracts are derived from the price of some underlying security or commodity or from some index, interest rate, exchange rate or event. Examples of derivatives include futures, forwards, options and swaps, and these can be combined with each other or traditional securities and loans in order to create hybrid instruments or structured securities (see Appendix I below for a primer on derivative instruments). Derivatives are traded on derivatives exchanges, such as the Chicago Mercantile Exchange which employs both open outcry in "pits" and electronic order matching systems, and in over-thecounter markets where trading is usually centered around a few dealers and conducted over the phone or electronic messages.

Background
Market deregulation, growth in global trade, and continuing technological developments have revolutionized the financial marketplace during the past two decades. A by-product of this revolution is increased market volatility, which has led to a corresponding increase in demand for risk management products. This demand is reflected in the growth of financial derivatives from the standardized futures and options products of the 1970s to the wide spectrum of over-the-counter (OTC) products offered and sold in the 1990s. Many products and instruments are often described as derivatives by the financial press and market participants. In this guidance, financial derivatives are broadly defined as instruments that primarily derive their value from the performance of underlying interest or foreign exchange rates, equity, or commodity prices.

Financial derivatives come in many shapes and forms, including futures, forwards, swaps, options, structured debt obligations and deposits, and various combinations thereof. Some are traded on organized exchanges, whereas others are privately negotiated transactions. Derivatives have become an integral part of the financial markets because they can serve several economic functions. Derivatives can be used to reduce business risks, expand product offerings to customers, trade for profit, manage capital and funding costs, and alter the risk-reward profile of a particular item or an entire balance sheet.

Although derivatives are legitimate and valuable tools for banks, like all financial instruments they contain risks that must be managed. Managing these risks should not be considered unique or singular. Rather, doing so should be integrated into the bank's overall risk management structure. Risks associated with

derivatives are not new or exotic. They are basically the same as those faced in traditional activities (e.g., price, interest rate, liquidity, credit risk). Fundamentally, the risk of derivatives (as of all financial instruments) is a function of the timing and variability of cash flows.

There have been several widely publicized reports on large derivative losses experienced by banks and corporations. Contributing to these losses were inadequate board and senior management oversight, excessive risk-taking, insufficient understanding of the products, and poor internal controls. These events serve as a reminder of the importance of understanding the various risk factors associated with business activities and establishing appropriate risk management systems to identify, measure, monitor, and control exposure.

What are the derivatives? Derivatives play a useful and important role in hedging and risk management, but they also pose several dangers to the stability of financial markets and thereby the overall economy.

Definition: “Derivative is a financial product which has been derived from another financial product or commodity. Without the underlying product or market, the derivative would have no independent existence. Common types of derivatives are Forwards, Swaps and options.” “Derivatives have risen from the need to manage the risk arising from movements in markets beyond our control, which may severely impact the revenues and costs of the firm.”

A derivative is a financial instrument that derives its value from an underlying asset. This underlying asset can be stocks, bonds, currency, commodities, metals and even intangible, pseudo assets like stock indices.

Derivatives can be of different types like futures, options, swaps, caps, floor, collars etc. The most popular derivative instruments are futures and options.

There are newer derivatives that are becoming popular like weather derivatives and natural calamity derivatives. These are used as a hedge against any untoward happenings because of natural causes.

What exactly is meant by “derives its value from an asset”? What the phrase means is that the derivative on its own does not have any value. It is considered important because of the importance of the underlying. When we say an Infosys future or an Infosys option, these carry a value only because of the value of Infosys.

What are financial derivatives? Financial derivatives are instruments that derive their value from financial assets. These assets can be stocks, bonds, currency etc. These derivatives can be forward rate agreements, futures, options swaps etc. As stated earlier, the most traded instruments are futures and options.

Users of Derivatives
What kind of people will use derivatives? Derivatives will find use for the following set of people:

· Speculators: People who buy or sell in the market to make profits. For example, if you will the stock price of Reliance is expected to go upto Rs.400 in 1 month, one can buy a 1 month future of Reliance at Rs 350 and make profits

· Hedgers: People who buy or sell to minimize their losses. For example, an importer has to pay US $ to buy goods and rupee is expected to fall to Rs 50 /$ from Rs 48/$, then the importer can minimize his losses by buying a currency future at Rs 49/$

· Arbitrageurs: People who buy or sell to make money on price differentials in different markets. For example, a futures price is simply the current price plus the interest cost. If there is any change in the interest, it presents an arbitrage opportunity. We will examine this in detail when we look at futures in a separate chapter.

Basically, every investor assumes one or more of the above roles and derivatives are a very good option for him.

History of Derivatives
The first exchange for trading derivatives appeared to be the Royal Exchange in London, which permitted forward contracting, it was characterized by forward contracting on tulip bulbs around 1637. The first "futures" contracts are generally traced to the Yodoya rice market in Osaka, Japan around 1650. These were evidently standardized contracts, which made them much like today's futures.

In 1972 the Chicago Mercantile Exchange, responding to the now-freely floating international currencies, created the International Monetary Market, which allowed trading in currency futures. These were the first futures contracts that were not on physical commodities. In 1975 the Chicago Board of Trade created the first interest rate futures contract, one based on Ginnie Mae (GNMA) mortgages.

In the area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and, by the early 1900s India had one of the world‟s largest futures industry. In 1952 the government banned cash settlement and options trading and derivatives trading shifted to informal forwards markets.

Exchange-traded commodity derivatives have been trading only since 2000, and the growth in this market has been uneven. The number of commodities eligible for futures trading has increased from 8 in 2000 to 80 in 2004.?

How has this market developed over time? Derivatives have been a recent development in the Indian financial markets. But there have been derivatives in the commodities market. There is Cotton and Oilseed futures in Mumbai, Soya futures in Bhopal, Pepper futures in Cochin, Coffee futures in Bangalore etc. But the players in these markets are restricted to big farmers and industries, who need these as an input to protect themselves from the vagaries of agriculture sector.

Globally too, the first derivatives started with the commodities, way back in 1894. Financial derivatives are a relatively late development, coming into existence only in the 1970‟s. The first exchange where derivatives were traded is the Chicago Board of Trade (CBOT).

In India, the first derivatives were introduced by National Stock Exchange (NSE) in June 2000. The first derivatives were index futures. The index used was Nifty. Option trading was started in June 2001, for index as well as stocks. In November 2001, futures on stocks were allowed. Currently, there are 30 stocks, on which derivative trading is allowed.

L C GUPTA COMMITTEE REPORT
The Committee was appointed by the Securities and Exchange Board of India (SEBI) by a Board resolution dated November 18, 1996 in order "to develop appropriate regulatory framework for derivatives trading in India". List of the Committee members is shown in the end

The Committee‟s concern is with financial derivatives in general and equity derivatives in particular.

THE

EVOLUTION

AND

ECONOMIC

PURPOSE

OF

DERIVATIVES
Appointment of the Committee

1. The Committee was appointed by the Securities and Exchange Board of India (SEBI) by a Board resolution dated November 18, 1996 in order "to develop appropriate regulatory framework for derivatives trading in India". List of the Committee members is shown in the end 2. The Committee‟s concern is with financial derivatives in general and equity derivatives in particular.

The evolution of derivatives 3. The development of futures trading is an advancement over forward trading which has existed for centuries and grew out of the need for hedging the price-risk involved in many commercial operations. Futures trading represents a more efficient way of hedging risk.

Futures vs. Forward contracts

4. As both forward contracts and futures contracts are used for hedging, it is important to understand the distinction between the two and their relative merits. Forward contracts are private bilateral contracts and have well-established commercial usage. They are exposed to default risk by counterparty. Each forward contract is unique in terms of contract size, expiration date and the asset type/quality. The contract price is not transparent, as it is not publicly disclosed. Since the forward contract is not typically tradable, it has to be settled by delivery of the asset on the expiration date.

5. In contrast, futures contracts are standardized tradable contracts. They are standardized in terms of size, expiration date and all other features. They are traded on specially designed exchanges in a highly sophisticated environment of stringent financial safeguards. They are liquid and transparent. Their market prices and trading volumes are regularly reported. The futures trading system has effective safeguards against defaults in the form of Clearing Corporation guarantees for trades and the daily cash adjustment (mark-to-market) to the accounts of trading members based on daily price change. Futures are far more cost-efficient than forward contracts for hedging.

6. Forward contracts are being used in India on a fairly large scale in the foreign exchange market for covering currency risk but there are neither currency futures nor any other financial futures in India at present. This report deals only with exchange-traded derivatives. Over-the-Counter derivatives are not covered here.

A world-wide long-term process 7. The evolution of markets in commodities and financial assets may be viewed as a worldwide long-term historical process. In this process, the emergence of futures

has been recognized in economic literature as a financial development of considerable significance. A vast economic literature has been built around this subject. From "forward" trading in commodities emerged the commodity "futures". The emergence of financial futures is a more recent phenomenon and represents an extension of the idea of organized futures markets.

8. Among financial futures, the first to emerge were currency futures in 1972 in U.S.A., followed soon by interest rate futures. Stock index futures and options first emerged in 1982 only. Since then, financial futures have quickly spread to an increasing number of developed and developing countries. They are recognized as the best and most cost efficient way of meeting the felt need for risk-hedging in certain types of commercial and financial operations. Countries not providing such globally accepted risk-hedging facilities are disadvantaged in today‟s rapidly integrating global economy.

9. The Committee noted that derivatives are not always clearly understood. A few well publicized debacles involving derivatives trading in other countries had created widespread apprehensions in Indian public mind also. While the economic literature recognizes the efficiency-enhancing effect of derivatives on the economy in general and the financial markets in particular, the Committee feels that there is need for educating the public opinion as also the need to ensure effective regulatory checks. Such regulation should be aimed not only at ensuring the market‟s integrity but also at enhancing the market‟s economic efficiency and protecting investors.

Derivatives concept

10. The term "derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the cash asset. A derivative contract or product, or simply "derivative", is to be sharply distinguished from the underlying cash asset, i.e. the asset bought/sold in the cash market on normal delivery terms. A general definition of "derivative" may be suggested here as follows: "Derivative" means forward, future or option contract of pre-determined fixed duration, linked for the purpose of contract fulfillment to the value of specified real or financial asset or to index of securities.

11. Derivatives are meant essentially to facilitate temporarily (usually for a few months) hedging of price risk of inventory holding or a financial/commercial transaction over a certain period. In practice, every derivative "contract" has a fixed expiration date, mostly in the range of 3 to 12 months from the date of commencement of the contract. In the market‟s idiom, they are "risk management tools". The use of forward/futures contracts as hedging techniques is a wellestablished practice in commercial and industrial operations. Their application to financial transactions is relatively new, having emerged only about 25 years ago.

12. In order to illustrate the use of this risk hedging technique, we may take the familiar example of a processor or manufacturer, for whom an important source of risk is the fluctuation in the market price of his main raw material. For instance, a maker of gold jewellery may have accepted an export order to be delivered over the next three months. If, in the meanwhile, the cash price of gold (the raw material) rises, the jewellery maker‟s manufacturing and exporting activity can become economically unviable. The availability of gold futures alleviates the manufacturer-exporter‟s problem. He can buy gold futures. Any loss caused by rise in the cash price of gold purchased for the export order will then be offset by profit

on the futures contract. Any extra profit due to fall in gold price will also be offset as there will be loss on the futures contract. Thus, hedging is the equivalent of insurance facility against risk from market price variation. A world without hedging facility is like a world without insurance with respect to the particular kind of risk.

13. The manufacturer-exporter in the example given above could, of course, have bought the all raw material requirement in advance but that would have entailed heavy interest, insurance and storage costs. Thus, the facility of futures trading offers a cost-efficient and convenient way for hedging against price risk.

14. Apart from the risk from variation of raw material price, the manufacturerexporter, in the above example, also faces another risk from variation of exchange rate. If the rupee appreciates before he is able to bring the export proceeds into India, his rupee receipts would be reduced. He may hedge against such currency risk too.

Both Futures and Options needed 15. Futures and options have many similarities and serve similar purposes but the risk profile of an option contract is asymmetric and regulatory complexities are greater as compared to futures contract. Options are contracts giving the holder the right (but not the obligation) to buy (known as "call option") or sell (known as "put option") securities at a pre-determined price (known as "strike price" or "exercise price"), within or at the end of a specified period (known as "expiration period"). American options are exercisable at any time prior to expiration date while European options can be exercised only at the expiration date. For the call option holder, it is worthwhile to exercise the right only if the price of the underlying

securities rises above the exercise price. For the put option holder, it is worthwhile to exercise the right only if the price falls below the exercise price. There can be options on commodities, currencies, securities, stock index, individual stocks and even on futures. Options strategies can be highly complicated.

16. In order to acquire the right of option, the option buyer pays to the option seller (known as "option writer") an Option Premium, which is the price paid for the right. The buyer of an option can lose no more than the option premium paid but his possible gain in unbounded. On the other hand, the option writer‟s possible loss is unbounded but his maximum gain is limited to the "option premium" charged by him to the holder. The most critical aspect of options contracts is the evaluation of the fairness of option premium, i.e. option pricing.

17. The Committee feels that the availability of both financial futures and options would provide to the users a wider choice of hedging instruments than any of them alone. Hedgers vs. Speculators 18. Hedging is the key aspect of derivatives and also its basic economic purpose. In the U.S., the Commodity Futures Trading Commission (CFTC), the futures regulatory authority, while considering proposals for approval of a new derivative product, particularly examines the ability of the product to provide hedging. While the Committee has also emphasized the hedging aspect of derivatives, it fully recognizes that the derivatives market‟s capacity to absorb buying/selling by hedgers is directly dependent on the availability of speculators to act as counterparties to hedgers. Hedging will not be possible if there are no speculators.

19. For the above reason, decisions about many aspects of derivatives trading, e.g., contract size, design and duration, would have to strike a balance between the needs of the hedgers and the necessity to attract an adequate number of wellcapitalized speculators who are prepared to take upon themselves the price risk which hedgers want to give up. The fact is that a futures market, to be able to operate and be liquid, should have both hedging participation and speculative appeal. Some studies of futures markets in the U.S. have shown that hedging activity accounts for about 50-60 per cent of the market‟s total volume.

Remove prohibition on hedging by institutions 20. The Committee is of the opinion that a futures market based wholly or mostly on speculation will not be a sound economic institution. There presently exist in India legal restrictions on the use of derivatives by investment institutions even for purposes of hedging. Such restrictions should be removed in the interest of the institutions themselves.

21. In the case of a hedger, seeking to offset the price risk on his holding of inventory of bonds, equities, foreign currency or commodities by selling futures in the same, his position will as follows:
Regarding Inventory If Prices falls There will be loss on inventory held Regarding Future Transactions There will be profit on futures Sold Remarks Hedger wants to insure against the loss

If Prices rise

There will be Profit on inventory

There will be loss on futures sold

The inventory profit is Unanticipated and is neutralized by loss on futures.

In the case of a pure speculator, as distinguished from a hedger, futures trading is a business by itself as he has no offsetting commercial position. He is not seeking to reduce or transfer risk. On the contrary, he is accepting risk in the pursuit of profit. It is a highly specialized business. His success depends on his forecasting skills in regard to future prices of the particular commodity or financial asset traded in the futures market. The hedging test: practical importance 21. The test of whether a futures transaction is for hedging or for speculation hinges on whether there already exists a related commercial position which is exposed to risk of loss due to price movement. The distinction between hedging and speculation is of great practical importance because some organizations, either by voluntary choice or by regulatory restriction, are allowed to hedge but not to speculate in the forward or futures markets.

Financial Derivative Types 18. The Committee‟s main concern is with equity based derivatives but it has tried to examine the need for financial derivatives in a broader perspective. Financial transactions and asset-liability positions are exposed to three broad types of price risks, viz:

a. equities "market risk", also called "systematic risk" (which cannot be diversified away because the stock market as a whole may go up or down from time to time).

b. interest rate risk (as in the case of fixed-income securities, like treasury bond holdings, whose market price could fall heavily if interest rates shot up), and

c. exchange rate risk (where the position involves a foreign currency, as in the case of imports, exports, foreign loans or investments).

The above classification of price risks explains the emergence of (a) equity futures, (b) interest rate futures and (c) currency futures, respectively. Equity futures have been the last to emerge.

23. The recent report of the RBI-appointed Committee on Capital Account Convertibility (Tarapore Committee) has expressed the view that "time is ripe for introduction of futures in currencies and interest rates to facilitate various users to have access to a wide spectrum of cost-efficient hedge mechanism" (p.24). In the same context, the Tarapore Committee has also opined that "a system of trading in futures ... is more transparent and cost-efficient than the existing system (of forward contracts)". 24. There are inter-connections among the various kinds of financial futures, mentioned above, because the various financial markets are closely inter-linked, as the recent financial market turmoil in East and South-East Asian countries has shown. The basic principles underlying the running of futures markets and their regulation are the same. Having a common trading infrastructure will have important advantages. The Committee, therefore, feels that the attempt should be to develop an integrated market structure.

SEBI-RBI coordination mechanism 25. As all the three types of financial derivatives are set to emerge in India in the near future, it is desirable that such development be coordinated. The Committee

recommends that a formal mechanism be established for such coordination between SEBI and RBI in respect of all financial derivatives markets. This will help to avoid the problem of overlapping jurisdictions.

Since we have talked of hedging, can we compare derivatives to insurance? You buy a life insurance policy and pay a premium to the insurance agent for a fixed term as agreed in the policy. In case you survive, you are happy and the insurance company is happy. In case you don‟t survive, your relatives are happy as the insurance company pays them the amount for which you are insured.

Insurance is nothing but transfer of risk. An insurance company sells you risk cover and buys your risk and you sell your risk and buy a risk cover. The risk involved in life insurance is the death of the policyholder. The insurance companies bet on your surviving and hence agree to sell a risk cover for some premium.

There is a transfer of risk here for a financial cost, i.e. the premium. In this sense, a derivative instrument can be compared to insurance, as there is a transfer of risk at a financial cost.

Derivatives also work well on the concept of mutual insurance. In mutual insurance, two people having opposite risks can enter into a contract and reduce their risk. The most classic example is that of an importer and exporter. An importer buys goods from country A and has to pay in dollars in 3 months. An exporter sells goods to country A and has to receive payment in dollars in 3 months. In case of an importer, the risk is of exchange rate moving up. In case of

an exporter, the risk is of exchange rate moving down. They can cover each others risk by entering into a forward rate after 3 months.

Futures
Future, as the name indicates, is a trade whose settlement is going to take place in the future. However, before we take a look at futures, it will be beneficial for us to take a look at forward rate agreements

What is a forward rate agreement? A forward rate agreement is one in which a buyer and a seller enter into a contract at a specified quantity of an asset at a specified price on a specified date.

An example for this is the exporters getting into forward rate agreements on currencies with banks.

But there is always a risk of one of the parties defaulting. The buyer may not pay up or the seller may not be able to deliver. There may not be any redressal for the aggrieved party as this is a negotiated contract between two parties.

What is a future? A future is similar to a forward rate agreement, except that it is not a negotiated contracted but a standard instrument. A future is a contract to buy or sell an asset at a specified future date at a specified price. These contracts are traded on the stock exchanges and it can change many hands before final settlement is made.

The advantage of a future is that it eliminates counterparty risk. Since there is an exchange involved in between, and the exchange guarantees each trade, the buyer or seller does not get affected with the opposite party defaulting.

Futures

Forwards

Futures are traded on a stock exchange Futures standard terms and conditions No default risk as the exchange provides a counter guarantee are contracts

Forwards are non tradable, negotiated Instruments having Forwards are contracts customized by the buyer and seller

High risk of default by either party

Exit route is provided because of No exit route for these contracts high liquidity on the stock exchange Highly margining and surveillance systems regulated with strong No such systems are present in a forward market.

There are two kinds of futures traded in the market- index futures and stock futures.

There are three types of futures, based on the tenure. They are 1, 2 or 3 month future. They are also known as near and far futures depending on the tenure.

What are Index futures? Index futures are futures contract on the index itself. One can buy a 1, 2 or 3- month index future. If someone wants to take a call on the index, then index futures are the ideal instruments for him.

Let us try and understand what an index is. An index is a set of numbers that represent a change over a period of time.

A stock index is similarly a number that gives a relative measure of the stocks that constitute the index. Each stock will have a different weight in the index The Nifty comprises of 50 stocks. BSE Sensex comprises of 30 stocks.

For example, Nifty was formed in 1995 and given a base value of 1000. The value of Nifty today is 1172. What it means in simple terms is that, if Rs 1000 was invested in the stocks that form in the index, in the same proportion in which they are weighted in the index, then Rs 1000 would have become Rs 1172 today.

There are two popular methods of computing the index. They are price weighted method like Dow Jones Industrial Average (DJIA) or the market capitalization method like Nifty or Sensex.

What the terminologies used in a Futures contract? The terminologies used in a futures contract are:

· Spot Price: The current market price of the scrip/index

· Future Price: The price at which the futures contract trades in the futures market

· Tenure: The period for which the future is traded

· Expiry date: The date on which the futures contract will be settlec

· Basis : The difference between the spot price and the future price

Why are index futures more popular than stock futures? Globally, it has been observed that index futures are more popular as compared to stock futures. This is because the index future is a relatively low risk product compared to a stock future. It is easier to manipulate prices for individual stocks but very difficult to manipulate the whole index. Besides, the index is less volatile as compared to individual stocks and can be better predicted than individual stock.

How is the future price arrived at? Future price is nothing but the current market price plus the interest cost for the tenure of the future.

This interest cost of the future is called as cost of carry.

If F is the future price, S is the spot price and C is the cost of carry or opportunity cost, then

F=S+C

F = S + Interest cost, since cost of carry for a finance is the interest cost

Thus,

F=S (1+r)T

Where r is the rate of interest and T is the tenure of the futures contract. The rate of interest is usually the risk free market rate.

Example 2.1: The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. What will be the price of one-month future?

Solution The price of a future is F= S (1+r)T The one-month Reliance future would be the spot price plus the cost of carry. Since the bank rate is 10 %, we can take that as the market rate. This rate is an annualized rate and hence we recalculate it on a monthly basis.

F=300(1+0.10)(1/12) F= Rs 302.39

Example 2.2: The shares of Infosys are trading at 3000 rupees. The 1 month future of Infosys is Rs 3100. The returns expected from the Gsec funds for the same period is 10 %. Is the future of Infosys overpriced or underpriced?

Solution The 1 month Future of Infosys will be F= 3000(1+.0.10) (1/12) F= Rs 3023.90 But the price at which Infosys is traded is Rs 3100. Thus it is overpriced by Rs 76.

What happens if dividend is going to be declared? Dividend is an income to the seller of the future. It reduces his cost of carry to that extent. If dividend is going to be declared, the same has to be deducted from the cost of carry Thus the price of the future in this case becomes,

F= S (1+r-d) T Where d is the dividend.

Example 2.3: The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. What will be the price of one-month future? Reliance will be paying a dividend of 50 paise per share

Solution: Since Reliance is paying 50 paise per share and the face value of reliance is Rs 10, the dividend rate is 5%. So while calculating futures, F=300(1+0.10-0.05) (1/12) F= Rs. 301.22

What happens if dividend is declared after buying a future? If the dividend is declared after buying a one month future, the cost of carry will be reduced by a pro rata amount. For example, if there is a one month future ending June 30th and dividend is declared on June 15th, then dividend benefit will be reduced from the cost of carry for 15 days.

Since the seller is holding the shares and will transfer the shares to the buyer only after a month, the dividend benefit goes to the seller. The seller will enjoy the benefit to the extent of interest on dividend. Thus net cost of carry = cost of carry – dividend benefits

Example 2.4: The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. Reliance declares a dividend of 5%. What will be the price of one-month future?

Solution: The benefit accrued due to the dividend will be reduced from the cost of the future. One month future will be priced at

F= 300(1+0.10) (1/12) F = 302.39 Cost of Carry= Rs 302.39-Rs 300 = Rs 2.39

The interest benefit of the dividend is available for 15 days, ie 0.5 months.

Dividend for 15 days = 300(1+0.05) (0.5/12) Dividend Benefit = Rs300.61- Rs 300= Rs0.61 Therefore, net cost of the carry is, Rs2.39-Rs0.61 = Rs 1.78

Therefore the price of the future is Rs 300+Rs 1.78 = Rs 301.78

In practice, the market discounts the dividend and the prices are automatically adjusted. The exchange steps into the picture if the dividend declared is more than 10 % of the market price. In such cases, there is an official change in the price. In other cases, the market does the adjustment on its own.

What happens in case a bonus/ stock split is declared on the stock in which I have a futures position? If a bonus is declared, the settlement price is adjusted to reflect the bonus. For example, if you have 200 Reliance at Rs 300 and there is a 1:1 bonus, then the position becomes 400 Reliance at Rs 150 so that the contract value is unaffected.

But is the Future really traded in this way in the market? What has been discussed above is the theoretical way of arriving at the future price. This can be used as a base for calculation future price But the actual market price that we see on the trading screen depends on liquidity too. So the prices that we observe in real world are also a function of demand-supply position in that stock.

How do future prices behave compared to spot prices?

Future prices lead the spot prices. The spot prices move towards the future prices and the gap between the two is always closing with as the time to settlement decreases. On the last day of the future settlement, the spot price equals the future price.

Is the futures price always higher than the spot price? The futures price can be lower than the spot price too. This depends on the fundamentals of the stock. If the stock is not expected to perform well and the market takes a bearish view on them, then the futures price can be lower than the spot price.

Future prices can fall also due to declaration of dividend.

What happens in case of index futures? In case of index futures, the treatment of the futures calculation is the same. The future value is calculated as the spot index value plus the cost of carry.

What happens if I buy an index future and there is a dividend declared on a stock that comprises the index?

Practically speaking, the index is corrected for these things in case there is a dividend declared for such a stock.

Theoretically, dividend is adjusted in the following manner:

1. The contribution of the stock to the index is calculated. The index, as discussed earlier, is a market capitalization index.

2. Then the number of shares in the index is calculated. This is obtained by dividing the contribution to the index by the market price.

3. The dividend on the index is the dividend on the number of shares of the stock in the index.

4. The interest earned on the dividend is calculated and reduced from the cost of carry to obtain the net cost of carry.

Example 2.5: The index is at 1000. There is a dividend of Rs 5 per share on HLL. HLL contributes to 15 % of the index. The market price of HLL is Rs 150. What will be the cost of the 1 month future if the bank rate is 10%?

Solution: The future will be priced at F= 1000(1+0.10)(1/12) F= 1008 The weight of HLL in the index is 15% ie 0.15*1000=150. The market price of HLL is Rs 150 Therefore, the number of shares of HLL in the index=1 The dividend earned on this is Rs 5 Dividend benefit on Rs 5 is 5(1+0.10) (1/12) Dividend benefit = Rs 0.04 Cost of the future will be Rs 1008-Rs 0.05= Rs 1007.95 But in practice, the market discounts the dividends and price adjustment is made accordingly. All that is okay in theory, but what happens in the real world? In the real world, derivatives are highly volatile instruments and there have been lot of losses in the various financial markets. The classic examples have been Long Term Capital Markets (LTCM) and Barings. We will examine what happened exactly at various places later in the book.

As a result, the regulators have decided that a minimum of Rs 2 lacs should be the contract size. This is done primarily to keep the small investors away from a volatile market till enough experience and understanding of the markets is acquired. So the initial players are institutions and high net worth individuals who have a risk taking capacity in these markets. Because of this minimum amount, lots are decided on the market price such that the value is Rs 2 lacs. As a result one has to buy a minimum of 200 Nifties or in case of Sensex, 50.

Similarly minimum lots are decided for individual stocks too. Thus you will find different stock futures having different market lots. The lots decided for each stock was such that the contract value was Rs 2 lacs. This was at the point of introduction of these instruments. However the lot size has remained the same and has not been adjusted for the price changes. Hence the value of the contract may be slightly lower in case of certain stocks.

Trading, i.e. Buying and Selling take place in the same manner as the stock markets. There will be an F & O terminal with the broker and the dealer will enter the orders for you. Another fact of the real world is that, since the future is a standard instrument, you can close out your position at any point of time and need not hold till maturity.

How is the trading done on the exchange? Buying of futures is margin based. You pay an up front margin and take a position in the stock of your choice. Your daily losses/ gains relative to the future price will be monitored and you will have to pay a mark to market margin. On the final day settlement is made in cash and is the difference between the futures price

and the spot price prevailing at that time For example, if the future price is Rs 300 and the spot price is Rs 330, then you will make a cash profit of Rs 30. In case the spot price is Rs 290, you make a cash loss of Rs 10. Thus futures market is a cash market.

In future, there is a possibility that the futures may result in delivery. In such a scenario, the future market will be merged with the spot market on the expiration day and it will follow the T+ 3 rolling settlement prevalent in the stock markets

How does the mark to market mechanism work? Mark to market is a mechanism devised by the stock exchange to minimize risk. In case you start making losses in your position, exchange collects money to the extent of the losses up front. For example, if you buy futures at Rs 300 and its price falls to Rs 295 then you have to pay a mark to market margin of Rs 5. This is over and above the margin money that you pay to take a position in the future.

Options
What are options? As seen earlier, futures are derivative instruments where one can take a position for an asset to be delivered at a future date. But there is also an obligation as the seller has to make delivery and buyer has to take delivery.

Options are one better than futures. In option, as the name indicates, gives one party the option to take or make delivery. But this option is given to only one party in the transaction while the other party has an obligation to take or make delivery. The asset can be a stock, bond, index, currency or a commodity But since the other party has an obligation and a risk associated with making good the obligation, he receives a payment for that. This payment is called as premium.

The party that had the option or the right to buy/sell enjoys low risk. The cost of this low risk is the premium amount that is paid to the other party.

Thus we have seen an option is a derivative that gives one party a right and the other party an obligation to buy /sell at a specified price for a specified quantity. The buyer of the right is called the option holder. The seller of the right (and buyer of the obligation) is called the option writer. The cost of this transaction is the premium.

For example, a railway ticket is an option in daily life. Using the ticket, a passenger has an option to travel. In case he decides not to travel, he can cancel the ticket and get a refund. But he has to pay a cancellation fee, which is analogous to

the premium paid in an option contract. The railways, on the other hand, have an obligation to carry the passenger if he decides to travel and refund his money if he decides not to travel. In case the passenger decides to travel, the railways get the ticket fare. In case he does not, they get the cancellation fee. The passenger on the other hand, by booking a ticket, has hedged his position in case he has to travel as anticipated. In case the travel does not materialize, he can get out of the position by canceling the ticket at a cost, which is the cancellation fee.

But I hear a lot of jargons about options? What are all these jargons? There are some basic terminologies used in options. These are universal terminologies and mean the same everywhere.

a. Option holder: The buyer of the option who gets the right

b. Option writer: The seller of the option who carries the obligation

c. Premium: The consideration paid by the buyer for the right

d. Exercise price: The price at which the option holder has the right to buy or sell. It is also called as the strike price.

e. Call option: The option that gives the holder a right to buy

f. Put option: The option that gives the holder a right to sell

g. Tenure: The period for which the option is issued

h. Expiration date: The date on which the option is to be settled

i. American option: These are options that can be exercised at any point till expiration date

j. European option: These are options that can be exercised only on the expiration date

k. Covered option: An option that an option writer sells when he has the underlying shares with him.

l. Naked option: An option that an option writer sells when he does not have the underlying shares with him

m. In the money: An option is in the money if the option holder is making a profit if the option was exercised immediately

n. Out of money: An option is in the money if the option holder is making a loss if the option was exercised immediately

o. At the money: An option is in the money if the option holder evens out if the option was exercised immediately

How is money made in an option? The money made in an option is called as the option pay off. There can be two pay off for options, for put and call option

Call option: A call option gives the holder a right to buy shares. The option holder will make money if the spot price is higher than the strike price. The pay off assumes that the option holder will buy at the strike price and sell immediately at the spot price. But if the spot price is lower than the strike, the option holder can simply ignore the option. It will be cheaper to buy from the market. The option holder loss is to the extent of premium he has paid.

But if the spot price increases dramatically then he can make wind fall profits. Thus the profit for an option holder in a call option is unlimited while losses are capped to the extent of the premium.

Conversely, for the writer, the maximum profit he can make is the premium amount. But the losses he can make are unlimited.

Put Option The put option gives the right to sell. The option holder will make money if the spot price is lower than the strike price. The pay off assumes that the option holder will buy at spot price and sell at the strike price But if the spot price is higher than the strike, the option holder can simply ignore the option. It will be beneficial to sell to the market. The option holder loss is to the extent of premium he has paid. But if the spot prices falls dramatically then he can make wind fall

profits. Thus the profits for an option holder in a put option is unlimited while losses are capped to the extent of the premium. This is a theoretical fallacy as the maximum fall a stock can have is till zero, and hence the profit of a option holder in a put option is capped.

Conversely, the maximum profit that an option writer can make in this case is the premium amount.

But in the above pay off, we had ignored certain costs like premium and brokerage. These are also important, especially the premium. So, in a call option for the option holder to make money, the spot price has to be more than the strike price plus the premium amount.

If the spot is more than the strike price but less than the sum of strike price and premium, the option holder can minimize losses but cannot make profits by exercising the option.

Similarly, for a put option, the option holder makes money if spot is less than the strike price less the premium amount. If the spot is less than the strike price but more than the strike price less premium, the option holder can minimize losses but cannot make profits by exercising the option.

Example 3.1: The call option for Reliance is selling at Rs 10 for a strike price of Rs 330. What will be the profit for the option holder if the spot price touches a) Rs. 350 b)337

Solution

a. The option holder can buy Reliance at a price of Rs 330. He has also paid a premium of Rs 10 for the same. So his cost of a share of Reliance is Rs 340. He can sell the same in the spot market for Rs 350. He makes a profit of Rs 10

b. The option holder can buy Reliance at a price of Rs 330. He has also paid a premium of Rs 10 for the same. So his cost of a share of Reliance is Rs 340. He can sell the same in the spot market for Rs 337 He makes a loss of Rs 3.

But he has reduced his losses by exercising the option. Had he not exercised the option, he would have made a loss of Rs 10, which is the premium that he paid for the option.

But should one always buy an option? The buyer seems to enjoy all advantages, then why should one write an option? This is not always the case. The writer of the option too can make money. Basically, the option writers and option holders are people who are taking a divergent view on the market. So if the option writer feels the markets will be bearish, he can write call options and pocket the premium. In case the market falls, the option holder will not exercise the option and the entire premium amount can be a profit But if the option writer is bullish on the market, then he can write put options. In case the market goes up, the option holder will not exercise the option and the premium amount is a profit for the option writer. The other area that an

option writer makes money is the spot price lying in the range between the strike price and the strike plus premium

For example, if you write a call option on Reliance for a strike price of Rs 300 at a premium of Rs 30. If the spot price is Rs 320, then the option holder will exercise the option to reduce losses and buy it at Rs 300. But you have already got the premium of Rs 30. So in effect, you have sold the stock at Rs. 330, which is Rs 10 above the spot price! This profit increases even more if you calculate the opportunity cost of Rs 30 as this amount is received up front.

Let us look at a typical pay off table for a call option, for the buyer as well as writer. Let us assume a call option with a strike price of Rs 200 and a premium of Rs 10

Table 3.1: Pay off Table for buyer and writer of an option

Spot Price 180 190 195 200(=Strike Price) 205 210 220

Whether Exercised No No No Yes/No Yes Yes Yes

Buyer’s gain/loss -10 -10 -10 -10 -5 0 +10

Writer gain/loss +10 +10 +10 +10 +5 0 -10

Net 0 0 0 0 0 0 0

In the above pay off table, if we take 200 as the median value, we see that the writer has made money 5 out of 7 occasions. He has made money even when the option is exercised, as long as the spot price is below the strike price plus the premium.

Thus writers also make money on options, as the buyer is not at an advantage all the time.

What are the options that are currently traded in the market? The options that are currently traded in the market are index options and stock options on the 30 stocks. The index options are European options. They are settled on the last day. The stock options are American options.

There are 3 options-1, 2,3 month options. There can be a series of option within the above time span at different strike prices. Another lingo in option is Near and Far options. A near option means the option is closer to expiration date. A Far option means the option is farther from expiration date. A 1 month option is a near option while a 3 month option is a far option.

In option trading, what gets quoted in the exchange is the premium and all that people buy and sell is the premium.

We said we could have different option series at various strike prices. How is this strike price arrived at? The strike price bands are specified by the exchange. This band is dependent on the market price. Market Price Rs. <50 50-150 150-250 250-500 500-1000 >1000 Strike Price Interval Rs. 2.5 5 10 20 30 50

Thus if a stock is trading at Rs. 100 then there can be options with strike price of Rs 105,110,115, 95, 90 etc.

How is the premium of an option calculated? In practice, it is the market that decides the premium at which an option is traded. There are mathematical models, which are used to calculate the premium of an option.

The simplest tool is the expected value concept. For example, for a stock that is quoting at Rs 95. There is a 20 % probability that it will become Rs 110. There is a 30 % probability that it will become Rs 105. There is 30% probability that the stock will remain at Rs.95 and a 20 % probability that it will fall to Rs 90.

If the strike price of a call option is to be Rs 100, then the option will have value when the spot goes to Rs 105 or Rs 110. It will be un-exercised at Rs 95 and Rs 90.

If it is Rs105 and Rs 110, the money made is Rs 10 and 15 respectively. The expected returns for the above distribution is 0.20*15+0.30*10=Rs 6.

Thus this the price that one can pay as a premium for a strike price of Rs 100 for a stock trading at Rs 95. Rs 6 will also be the price for the seller for giving the option holder this opportunity.

This is a very simple thumb calculation. Even then, one would require a lot of background data like variances and expected price movements. There are more advanced probabilistic models like the Black Scholes model and the Binomial Pricing model that calculates the options. One need not go deep into those and it would suffice to say that option calculators are readily available. Please visit

www.indiainfoline.com/stok/ to use an option calculator based on Black Scholes Model. The Black Scholes Model is presented in greater detail.

I keep reading about option Greeks? What are they? They actually sound like Greek and Latin to me. There are something called as option Greeks but they are nothing to be scared of. The option Greeks help in tracking the volatility of option prices.

The option Greeks are:

a. Delta: Delta measures the change in option price (the premium) to the change in underlying. A delta of 0.5 means if the underlying changes by 100 % the option price changes by 50 %.

b. Theta: It measures the change in option price to change in time

c. Rho: It is the change in option price to change in interest rate

d. Vega: It is the change in option price to change in variance of the underlying stock

e. Gamma: It is the change in delta to the change in the underlying. It is a double derivative (the mathematical one) of the option price with respect to underlying. It gives the rate of change of delta.

These are just technical tools used by the market players to analyze options and the movement of the option prices.

We saw that the stock options are American options and hence can be exercised any time. What happens when one decided to exercise the option?

When the option holder decides to exercise the option, the option will be assigned to the option writer on a random basis, as decided by the software of the exchange. The European options are also the similarly decided by the software of the exchange. The index options are European options.

In future, there is a possibility that the options may result in delivery. In such a scenario, the option market will be merged with the spot market on the expiration day and it will follow the T+ 3 rolling settlement prevalent in the stock markets

SETTLEMENT OF DERIVATIVES
How are futures settled on the stock exchange?

Mark to market settlement There is a daily settlement for Mark to Market .The profits/ losses are computed as the difference between the trade price or the previous day‟s settlement price, as the case may be, and the current day‟s settlement price. The party who have suffered a loss are required to pay the mark-to-market loss amount to exchange which is in turn passed on to the party who has made a profit. This is known as daily mark-to-market settlement.

Theoretical daily settlement price for unexpired futures contracts, which are not traded during the last half an hour on a day, is currently the price computed as per the formula detailed below:

F = S * e rt

where : F = theoretical futures price S = value of the underlying index/ stock r = rate of interest (MIBOR- Mumbai Inter bank Offer Rate) t = time to expiration Rate of interest may be the relevant MIBOR rate or such other rate as may be specified.

After daily settlement, all the open positions are reset to the daily settlement price.

The pay-in and pay-out of the mark-to-market settlement is on T+1 days (T=Trade day). The mark to market losses or profits are directly debited or credited to the broker account from where the broker passes to the client account

Final Settlement On the expiry of the futures contracts, exchange marks all positions to the final settlement price and the resulting profit / loss is settled in cash.

The final settlement of the futures contracts is similar to the daily settlement process except for the method of computation of final settlement price. The final settlement profit / loss is computed as the difference between trade price or the previous day‟s settlement price, as the case may be, and the final settlement price of the relevant futures contract. clearing bank account on T+1 day (T= expiry day). This is then passed on the client from the broker. Open positions in futures contracts cease to exist after their expiration day

How are options settled on the stock exchange?

Daily Premium Settlement Premium settlement is cash settled and settlement style is premium style. The premium payable position and premium receivable positions are netted across all option contracts for each broker at the client level to determine the net premium payable or receivable amount, at the end of each day.

The brokers who have a premium payable position are required to pay the premium amount to exchange which is in turn passed on to the members who have a premium receivable position. This is known as daily premium settlement. The brokers in turn would take this from their clients.

The pay-in and pay-out of the premium settlement is on T+1 days (T=Trade day). The premium payable amount and premium receivable amount are directly debited or credited to the broker, from where it is passed on to the client.

Interim Exercise Settlement for Options on Individual Securities Interim exercise settlement for Option contracts on Individual Securities is effected for valid exercised option positions at in-the-money strike prices, at the close of the trading hours, on the day of exercise. Valid exercised option contracts are assigned to short positions in option contracts with the same series, on a random basis. The interim exercise settlement value is the difference between the strike price and the settlement price of the relevant option contract.

Exercise settlement value is debited/ credited to the relevant broker account on T+3 day (T= exercise date). From there it is passed on to the clients.

Final Exercise Settlement Final Exercise settlement is effected for option positions at in-the-money strike prices existing at the close of trading hours, on the expiration day of an option contract. Long positions at in-the money strike prices are automatically assigned to short positions in option contracts with the same series, on a random basis.

For index options contracts, exercise style is European style, while for options contracts on individual securities, exercise style is American style. Final Exercise is Automatic on expiry of the option contracts.

Exercise settlement is cash settled by debiting/ crediting of the clearing accounts of the relevant broker with the respective Clearing Bank, from where it is passed to the client.

Final settlement loss/ profit amount for option contracts on Index is debited/ credited to the relevant broker clearing bank account on T+1 day (T = expiry day), from where it is passed

Final settlement loss/ profit amount for option contracts on Individual Securities is debited/ credited to the relevant broker clearing bank account on T+3 day (T = expiry day), from where it is passed

Open positions, in option contracts, cease to exist after their expiration day.

REGULATORY AND TAXATION ASPECTS OF DERIVATIVES
Since derivatives are a highly risky market, as experience world over has shown, there are tight regulatory controls in this market.

The same is true of India. In India, a committee was set up under Dr L C Gupta to study the introduction of the derivatives market in India.

This committee formulated the guidelines and framework for the derivatives market and paved the way for the derivatives market in India.

There other committee that has far reaching implications in the derivatives market is the J R Verma Committee. This committee has recommended norms for trading in the exchange. A lot of emphasis has been laid on margining and surveillance so as to provide a strong backbone in systems and processes and ensure stringent controls in a risky market.

As for the taxation aspect, the CBDT is treating gains from derivative transactions as profit from speculation. Similarly losses in derivative transactions can be treated as speculation losses for tax purpose.

GLOSSARY OF TERMS USED IN DERIVATIVES
1. Arbitrage - The simultaneous purchase and sale of a commodity or financial instrument in different markets to take advantage of a price or exchange rate discrepancy. 2. Backwardation – The price differential between spot and back months when the nearby dates are at a premium. It is the opposite of „contango.‟ 3. Butterfly spread – The placing of two inter-delivery spreads in opposite directions with the centre delivery month common to both. The perfect butterfly spread would require no net premium paid.

4. Calendar Spread - An option strategy in which a short-term option is sold and a longer-term option is bought both having the same striking price. Either puts or calls may be used. 5. Call option – An option that gives the buyer right to buy a futures contract at a premium, at the strike price. 6. Contango – The price differential between spot and back months when the marking dates are at a discount. It is the opposite of „backwardation.‟ 7. Currency swap – A swap in which the counterparties‟ exchange equal amounts of two currencies at the sot exchange rate.

8. Derivative – A derivative is an instrument whose value is derived from the value of one or more underlying assets, which can be commodities, precious metals, currency, bonds, stocks, stock indices, etc. Derivatives involve the trading of rights or obligations based on the underlying product, but do not directly transfer property. 9. Double option – An option that gives the buyer the right to buy and/or sell a futures contract, at a premium, at the strike price. 10. Futures contract – A legally binding agreement for the purchase and sale of a commodity, index or financial instrument some time in the future. 11. Hedge fund – A large pool of private money and assets managed aggressively and often riskily on any futures exchange, mostly for short-term gain. 12. In-the money option – An option with intrinsic value. A call option is in-the money if its strike price is below the current price of the underlying futures contract and a put option is in-the-money if it is above the underlying.

13. Kerb trading - Trading by telephone or by other means that takes place after the official market has closed. Originally it took place in the street on the kerb outside the market. 14. Margin call – A demand from a clearing house to a clearing member or from a broker to a customer to bring deposits up to a required minimum level to guarantee performance at ruling prices.

15. Mark to market – A process of valuing an open position on a futures market against the ruling price of the contract at that time, in order to determine the size of the margin call. 16. Naked option – An option granted without any offsetting physical or cash instrument for protection. Such activity can lead to unlimited losses.

17. Option - Gives the buyer the right, but not the obligation, to buy or sell stock at a set price on or before a given date. Investors who purchase call options bet the stock will be worth more than the price set by the option (the strike price), plus the price they paid for the option itself. Buyers of put options bet the stock's price will go down below the price set by the option. 18. Out-of-the money option – An option with no intrinsic value. A call option is out-of-the money if its strike price is above the underlying and a put option is so if its below the underlying.

19. Premium - The price of an option contract, determined on the exchange, which the buyer of the option pays to the option writer for the rights to the option contract. 20. Spread – The difference between the bid and asked prices in any market. 21. Stop-loss orders – An order placed in the market to buy or sell to close out an open position in order to limit losses when the market moves the wrong way.

22. Straddle – The simultaneous purchase and sale of the same commodity to different delivery months or different strategies. 23. Swap – An agreement to exchange one currency or index return for another, the exchange of fixed interest payments for a floating rate payments or the exchange of an equity index return for a floating interest rate. 24. Underlying – The currency, commodity, security or any other instrument that forms the basis of a futures or options contract. 25. Writer – The person who originates an option contract by promising to perform a certain obligation in return for the price of the option. Also known as Option Writer. 26. All-or nothing Option – An option with a fixed, predetermined payoff if the underlying instrument is at or beyond the strike price at expiration.

27. Average Options - A path dependant option that calculates the average of the path traversed by the asset, arithmetic or weighted. The payoff therefore is the difference between the average price of the underlying asset, over the life of the option, and the exercise price of the option.

28. Barrier Options - These are options that have an embedded price level, (barrier), which if reached will either create a vanilla option or eliminate the existence of a vanilla option. These are referred to as knock-ins/outs that are further explained below. The existence of predetermined price barriers in an option makes the probability of pay off all the more difficult. Thus the reason a buyer

purchases a barrier option is for the decreased cost and therefore increased leverage. 29. Basket Option – A third party option or covered warrant on a basket of underlying stocks, currencies or commodities. 30. Bermuda Option – Like the location of the Bermudas, this option is located somewhere between a European style option which can be exercised only at maturity and an American style option which can be exercised any time the option holder chooses. This option can be exercisable only on predetermined dates,

31. Compound Options - This is simply an option on an existing option such as a call on a call, a put on a put etc, a call on a put etc. 32. Cross-Currency Option – An outperformance option struck at an exchange rate between two currencies.

33. Digital Options - These are options that can be structured as a "one touch" barrier, "double no touch" barrier and "all or nothing" call/puts. The "one touch" digital provides an immediate payoff if the currency hits your selected price barrier chosen at outset. The "double no touch" provides a payoff upon expiration if the currency does not touch both the upper and lower price barriers selected at the outset. The call/put "all or nothing" digital option provides a payoff upon expiration if your option finishes in the money

34. Knockin Options - There are two kinds of knock-in options, i) up and in, and ii) down and in. With knock-in options, the buyer starts out without a vanilla

option. If the buyer has selected an upper price barrier and the currency hits that level, it creates a vanilla option with maturity date and strike price agreed upon at the outset. This would be called an up and in. The down and in option is the same as the up and in, except the currency has to reach a lower barrier. Upon hitting the chosen lower price level, it creates a vanilla option. 35. Multi-Index Options – An outperformance option with a payoff determined by the difference in performance of two or more indices. 36. Outperformance Option – An option with a payoff based on the amount by which one of two underlying instruments or indices outperforms the other.

37. Rainbow Options - This type of option is a combination of two or more options combined each with its own distinct strike, maturity, etc. In order to achieve a payoff, all of the options entered into must be correct.

38. Quantity Adjusting Options (Quanto) - This is an option designed to eliminate currency risk by effectively hedging it. It involves combining an equity option and incorporating a predetermined fx rate. Example, if the holder has an in the- money Nikkei index call option upon expiration, the quanto option terms would trigger by converting the yen proceeds into dollars which was specified at the outset in the quanto option contract. The rate is agreed upon at the beginning without the quantity of course, since this is an unknown at the time. 39. Secondary Currency Option – An option with a payoff in a different currency than the underlying trading currency.

40. Swap Option – An option to enter into a swap contract. 41. Tandem Options – A sequence of options of the same type, usually covering non-overlapping time periods and often with variable strikes. 42. Up-and-Out Option – The call pays off early if an early exercise price trigger is hit. The put expires worthless if the market price of the underlying risks is above a pre-determined expiration price. 43. Zero Strike Price Option – An option with an exercise price of zero, or close to zero, traded on exchanges where there is transfer tax, owner restriction or other obstacle to the transfer of the underlying.

GROWTH OF DERIVATIVES MARKET IN INDIA The derivatives market in India has rapidly grown and is fast becoming very popular. It is offering an alternate source for people to deploy investible surplus and make money out of it
The table below indicates the growth witnessed in the derivatives market.

Note: 1.Stock futures were started only in November 2001 2.Index options and stock options were started only in June and July 2001 respectively

BLACK AND SCHOLES OPTION PRICING FORMULA The options price for a Call, computed as per the following Black Scholes formula:

C = S * N (d1) - X * e- rt * N (d2) and the price for a Put is : P = X * e- rt * N (-d2) - S * N (-d1)

Where: C = price of a call option P = price of a put option S = price of the underlying asset X = Strike price of the option r = rate of interest t = time to expiration

δ = volatility of the underlying
N represents a standard normal distribution with mean = 0 and standard deviation = 1

ln represents the natural logarithm of a number. Natural logarithms are based on the constant e (2.718).

Chapter 2
Trading Strategies using Futures and Options
So far, we have seen a lot of theoretical stuff on derivatives. But how is it going to help me in practice? There are a lot of practical uses of derivatives. As we have seen, derivatives can be used for profits and hedging. We can use derivatives as a leverage tool too.

How do I use derivatives as a leverage? You can use the derivatives market to raise funds using your stocks. Conversely, you can also lend funds against stocks.

Does that mean derivatives are badla revisited? The derivative product that comes closest to Badla is futures. Futures is not badla, though a lot of people confuse it with badla. The fundamental difference is badla consisted of contango and backwardation (undha badla and vyaj badla) in the same market. Futures is a different market segment altogether. Hence derivatives is not the same as badla, though it is similar.

How do I raise funds from the derivatives market? This is fairly simple. Say, you have Infosys, which is trading at Rs 3000. You have shares lying with you and are in urgent need of liquidity. Instead of pledging your shares and borrowing from banks at a margin, you can sell the stock at Rs 3000. Suppose you need this liquidity only for a month and also do not want to part with Infosys. You can buy a 1 month future at Rs 3050. After a month you

get back your Infosys at the cost of an additional Rs 50. This Rs 50 is the financing cost for the liquidity.

The other beauty about this is you have already locked in your purchase cost at Rs 3050. This fixes your liquidity cost also and you are protected against further price losses.

How do I lend into the market? The lending into the market is exactly the reverse of borrowing. You have money to lend. You can buy a stock and sell its future. Say, you buy Infosys at Rs 3000 and sell a 1 month future at Rs 3100. In effect what you have done is lent Rs 3000 to the market for a month and earned Rs 100 on it. Suppose I don’t want to lend/borrow money. I want to speculate and make profits? When you speculate, you normally take a view on the market, either bullish or bearish. When you take a bullish view on the market, you can always sell futures and buy in the spot market. If you take a bearish view on the market, you can buy futures and sell in the spot market.

Similarly, in the options market, if you are bullish, you should buy call options. If you are bearish, you should buy put options Conversely, if you are bullish, you should write put options. This is so because, in a bull market, there are lower chances of the put option being exercised and you can profit from the premium.

If you are bearish, you should write call options. This is so because, in a bear market, there are lower chances of the call option being exercised and you can profit from the premium

How can I arbitrage and make money in derivatives? Arbitrage is making money on price differentials in different markets. For example, future is nothing but the future value of the spot price. This future value is obtained by factoring the interest rate. But if there are differences in the money market and the interest rates change then the future price should correct itself to factor the change in interest. But if there is no factoring of this change then it presents an opportunity to make money- an arbitrage opportunity. Let us take an example.

Example 4.1: A stock is quoting for Rs 1000. The 1-month future of this stock is at Rs 1005. The risk free interest rate is 12%. What should be the trading strategy?

Solution: The strategy for trading should be : Sell Spot and Buy Futures Sell the stock for Rs 1000. Buy the future at Rs 1005. Invest the Rs1000 at 12 %. The interest earned on this stock will be 1000(1+.012)(1/12) =1009

So net gain the above strategy is Rs 1009- Rs 1005 = Rs 4

Thus one can make a risk less profit of Rs 4 because of arbitrage. But an important point is that this opportunity was available due to mis-pricing and the market not correcting itself. Normally, the time taken for the market to adjust to corrections is very less. So the time available for arbitrage is also less.

As everyone rushes to cash in on the arbitrage, the market corrects itself.

A negative b means that the price of the stock falls when the index rises. So, if you have a position in a stock, you can hedge the same by buying the index at b times the value of the stock.

Example 4.2: The b of HPCL is 0.8. The Nifty is at 1000 . If I have Rs 10000 worth of HPCL, I can hedge my position by selling 8000 of Nifty. Ie I will sell 8 Nifties.

Scenario 1 If index rises by 10 %, the value of the index becomes 8800 ie a loss of Rs 800 The value of my stock however goes up by 8 % ie it becomes Rs 10800 ie a gain of Rs 800. Thus my net position is zero and I am perfectly hedged.

Scenario 2 If index falls by 10 %, the value of the index becomes Rs 7200 a gain of Rs 800 But the value of the stock also falls by 8 %. The value of this stock becomes Rs 9200 a loss of Rs 800.

Thus my net position is zero and I am perfectly hedged.

But again, b is a predicted value based on regression models. Regression is nothing but analysis of past data. So there is a chance that the above position may not be fully hedged if the b does not behave as per the predicted value.

How do I use options in my trading strategy? Options are a great tool to use for trading. If you feel the market will go up. You should buy a call option at a level lower than what you expect the market to go up.

If you think that the market will fall, you should buy a put option at a level higher than the level to which you expect the market fall.

When we say market, we mean the index. The same strategy can be used for individual stocks also.

A combination of futures and options can be used too, to make profits.

We have seen that the risk for an option holder is the premium amount. But what should be the strategy for an option writer to cover himself? An option writer can use a combination strategy of futures and options to protect his position. The risk for an option writer arises only when the option is exercised. This will be very clear with an example.

Suppose I sell a call option on Reliance at a strike price of Rs 300 for a premium of Rs 20. The risk arises only when the option is exercised. The option will be exercised when the price exceeds Rs 300. I start making a loss only after the price exceeds Rs 320(Strike price plus premium).

More importantly, I have to deliver the stock to the opposite party. So to enable me to deliver the stock to the other party and also make entire profit on premium, I buy a future of Reliance at Rs 300.

This is just one leg of the risk. The earlier risk was of the call being exercised. The risk now is that of the call not being exercised. In case the call is not exercised, what do I do? I will have to take delivery as I have bought a future.

So minimize this risk, I buy a put option on Reliance at Rs 300. But I also need to pay a premium for buying the option. I pay a premium of Rs 10.Now I am fully covered and my net cash flow would be

Premium earned from selling call option : Rs 20 Premium paid to buy put option : (Rs 10)

Net cash flow : Rs 10

But the above pay off will be possible only when the premium I am paying for the put option is lower than the premium that I get for writing the call.

Similarly, we can arrive at a covered position for writing a put option too, Another interesting observation is that the above strategy in itself presents an opportunity to make money. This is so because of the premium differential in the put and the call option. So if one tracks the derivative markets on a continuous basis, one can chance upon almost risk less money making opportunities.

What are the other strategies using derivatives? The other strategies are also various permutations of multiple puts, calls and futures. They are also called by exotic names , but if one were to observe them closely, they are relatively simple instruments.

Some of these instruments are: · Butter fly spread – It is the strategy of simultaneous buying of put and call · Calendar Spread – An option strategy in which a short-term option is sold and a longer-term option is bought both having the same striking price. Either puts or calls may be used. · Double option – An option that gives the buyer the right to buy and/or sell a futures contract, at a premium, at the strike price · Straddle – The simultaneous purchase and sale of option of the same specification to different periods. · Tandem Options – A sequence of options of the same type, with variable strike price and period. · Bermuda Option – Like the location of the Bermudas, this option is located somewhere between a European style option which can be exercised only at maturity and an American style option which can be exercised any time the option holder chooses. This option can be exercisable only on predetermined dates.

Chapter 3
RISK MANAGEMENT IN DERIVATIVES

What is risk? The word “Risk” certainly used frequently in everyday conversation and seems to be well-understood by those using it. To most people, risk implies some form of uncertainty about an outcome in a given situation. An event might occur and if it does, the outcome any not be favourable of us; it is not an outcome we look forward to. The word risk implies both doubt about the future, and the fact that the outcome could leave us in a worse position than we are in at the moment.

Definition:“Risk: The degree of dispersion of variability around the expected or "best" value which is estimated to exist for the economic variable in question, e.g., a quantitative measure of the upper and lower limits which are considered reasonable for the factor being estimated.” “Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for.”

While technically correct, this definition does not explain what decisionmakers really need to understand. For decision-makers it is better to define risk with an example – an example in plain English.

“Risk (Plain English Explanation): I think it will cost $1 million, but there's a chance that it might be a little higher or a little lower.”

What is risk management? Risk management provides structured systems for identifying and analysing potential risks, and devising and implementing responses appropriate to their impact. The responses generally draw on strategies of risk prevention, risk transfer, impact mitigation or risk acceptance (see Step 3 below for more details on each type of response). Within a single activity or proposal, a mix of each of these strategies may have application for different individual risks.

Definition “Risk management is the process of identifying and controlling an organization‟s losses. However, risk management is often defined too narrowly. It is not just a safety Programme or that part of the organization that deals only with insurance matters- although safety and insurance are both components of a risk management programme”

“Risk management is a central part of any organisation‟s strategic management. It is the process whereby organizations methodically address the risks attaching to their activities with the goal of achieving sustained benefit within each activity and across the portfolio of all activities.”

Derivatives are high-risk instruments and hence the exchanges have put up a lot of measures to control this risk.

The most critical aspect of risk management is the daily monitoring of price and position and the margining of those positions.

NSE uses the SPAN (Standard Portfolio Analysis of Risk). SPAN is a system that has origins at the Chicago Mercantile Exchange, one of the oldest derivative exchanges in the world.

The objective of SPAN is to monitor the positions and determine the maximum loss that a stock can incur in a single day. This loss is covered by the exchange by imposing mark to market margins.

SPAN evaluates risk scenarios, which are nothing but market conditions. The specific set of market conditions evaluated, are called the risk scenarios, and these are defined in terms of:

(a) How much the price of the underlying instrument is expected to change over ne trading day, and

(b) How much the volatility of that underlying price is expected to change over one trading day.

Based on the SPAN measurement, margins are imposed and risk covered. Apart from this, the exchange will have a minimum base capital of Rs 50 lacs and brokers need to pay additional base capital if they need margins above the permissible limits.

Risks Associated with Derivative Activities
Risk is the potential that events, expected or unanticipated, may have an adverse impact on the bank‟s capital and earnings. The OCC has defined nine categories of risk for bank supervision purposes. These risks are: strategic, reputation, price, foreign exchange, liquidity, interest rate, credit, transaction, and compliance. These categories are not mutually exclusive. Any product or service may expose the bank to multiple risks. For analysis and discussion purposes, however, the OCC identifies and assesses each risk separately. Derivative activities must be managed with consideration of all of these risks.

Roles Banks Take in Derivative Activities
National banks participating in the derivative markets function in two general roles: dealer and end-user. These two roles are not mutually exclusive; in most cases, a bank that functions as a derivative dealer will also be an enduser.

Dealers
A bank that markets derivative products to customers is considered a dealer. For purposes of this guidance, the OCC has classified dealers into two types.

Tier I. A Tier I dealer acts as a market-maker, providing quotes to other dealers and brokers, and other market professionals. Tier I dealers may also take proprietary positions in derivatives in anticipation of changes in prices or volatility.

Tier I dealers actively solicit customer business, often using a dedicated sales force. These dealers also develop new derivative products. Typically, they have systems and personnel that allow them to tailor derivatives to the needs of their customers. Large portfolios, complex contracts, and high transaction volume distinguish Tier I dealers from other market participants.

Tier II. The primary difference between Tier I and Tier II dealers is that Tier II dealers are not market-makers. Tier II dealers tend to restrict quotes to a select customer base even though they may have a high volume of transactions. Tier II dealers typically do not actively develop new products. Risk Management of Financial Derivatives 4 Comptroller's Handbook Tier II dealers may match or offset their customer transactions with other dealers or professional counterparties or they may choose to manage risk on an aggregate basis.

Throughout this guidance, the terms dealer and dealing will collectively refer to both customer and proprietary trading activities.

End-Users
An end-user engages in derivative transactions for its own account. An enduser may use derivatives as a substitute for cash market investments, a tool for interest rate risk management, or for other balance sheet management purposes. In this guidance, the OCC has classified end-users into two types, which are defined below.

Active Position-Taker. This type of end-user employs derivatives to dynamically manage risk, either to reduce risk or purposefully increase the risk profile of the institution.

Active position-takers often use derivatives as surrogates for cash market instruments. These banks generally have large derivative positions relative to their total asset size. They also tend to use more complex derivative structures than other end-users.

Limited End-User. Limited end-users are characterized by smaller portfolios and lower transaction volume than active position-takers. This type of end-user primarily uses derivatives as an investment alternative or to manage interest rate risk. Many limited end-users engage in derivatives solely through ownership of structured notes in their investment portfolios. These banks tend to use simpler, more mature products (although certain structured notes may be extremely complex and illiquid). Comptroller's Handbook 5 Risk Management of Financial Derivatives The following chart may be useful in distinguishing among participants in derivative markets: Derivative Activity Provides quotes to dealers Develops new products Provides quotes to Customers Uses complex structures Acts as principal Takes position risk Uses mature products X X X X X X X X X X X X * X X X Tire I Dealer X X X X Tire II Dealer Active Position Taker Limited End Users

*Although limited end-users generally tend to use simpler products, some have purchased certain structured notes that may be extremely complex and illiquid.

Senior Management and Board Oversight
The safe and sound use of derivatives is contingent upon effective senior management and board oversight. It is the responsibility of the board to hire a competent executive management team, endorse the corporate vision and the overall business strategy (including the institutional risk appetite), and hold executive management accountable for performance. The board must understand the role derivatives play in the overall business strategy.

It is the responsibility of senior management to ensure the development of risk management systems. This entails developing and implementing a sound risk management framework composed of policies and procedures, risk measurement and reporting systems, and independent oversight and control processes.

The formality of senior management and board oversight mechanisms will differ depending on the derivatives activities conducted by the bank. However, the board and senior management must provide adequate resources (financial, technical expertise, and systems technology) to implement appropriate oversight mechanisms.

The management of derivative activities should be integrated into the bank's overall risk management system using a conceptual framework common to the bank's other businesses. For example, the price risk exposure from derivative transactions should be assessed in a comparable manner to and aggregated with all other price risk exposures. Risk consolidation is particularly important because the

various risks contained in derivatives and other market activities can be interconnected and may transcend specific markets.

Policies and Procedures
A bank‟s policies should provide a framework for the management of risk. Dealers and active position-takers should have written policies for derivative activities to ensure proper identification, quantification, evaluation, and control of risks. Banks whose derivative activities are limited in volume, scope, and nature may not need the formality of written policies and procedures provided that the board and senior management have established and communicated clear goals, objectives, authorities, and controls for this activity.

Derivative policies need not be stand-alone documents. Rather, derivative related guidelines can be included in policies that control financial risk-taking (e.g., price, interest rate, liquidity, and credit risk) on an aggregate bank level, as well as at the functional business unit or product level. Operating, Comptroller's Handbook 7 Risk Management of Financial Derivatives accounting, compliance, and capital management policies should also address the use of derivatives.

Senior management should ensure that policies identify managerial oversight, assign clear responsibility, and require development and implementation of procedures to guide the bank's daily activities. Policies should detail authorized activities, as well as activities that require one-off approval and activities that are considered inappropriate. Policies should articulate the risk tolerance of the bank in terms of comprehensive risk limits, and require regular risk position and performance reporting.

When developing policies and controls for derivative activities, senior management should not overlook the bank‟s use of derivatives in a fiduciary capacity. Fiduciary policies are usually separate from the commercial bank policies because of business and customer privacy considerations. National banks that purchase derivative instruments for fiduciary accounts should fully understand the associated credit, interest rate, liquidity, price, and transaction risks of such instruments. Additionally, national bank fiduciaries should consider the compliance and reputation risks presented by investing fiduciary assets in derivatives, and the appropriateness of derivative instruments for customer accounts.

Policies must keep pace with the changing nature of derivative products and markets. On an ongoing basis, the board or appropriate committee should review and endorse significant changes in derivative activities. At least annually, the board, or a designated committee, should also approve key policy statements. Meeting minutes should document these actions. (Note: Given the extent and nature of demands placed on the board, committees may be created to handle matters requiring detailed review or in-depth consideration, with each committee reporting to the board. Accordingly, the words board and committee are used synonymously throughout this document.)

New Products
Before transacting new types of derivative products, senior management should comprehensively analyze the new product or activity. A mechanism to capture and report all new products is critical to the board and senior management's ability to execute proper oversight of the bank's risk profile.

New products frequently require different pricing, processing, accounting, and risk measurement systems. Management and the board must ensure that adequate knowledge, staffing, technology, and financial resources exist to accommodate the activity. Furthermore, plans to enter new markets/products should consider the cost of establishing appropriate controls, as well as attracting professional staff with the necessary expertise.

The new product approval process should include a sign-off by all relevant areas such as risk control, operations, accounting, legal, audit, and senior and line management. Depending on the magnitude of the new product or activity and its impact on the bank‟s risk profile, senior management, and in some cases, the board, should provide the final approval.

For new as well as existing products, a uniform product assessment process should be part of the overall risk management function. The goal of this process should be to ensure that all significant risks and issues are addressed. Elements that should be included in a uniform product assessment are listed in appendix A.

Defining a product or activity as new is central to ensuring that variations on existing products receive the proper review and authorization. Factors that should be considered when deciding whether or not a product must be routed through the

new-product process include, but are not limited to: capacity changes (e.g., enduser to dealer), structure variations (e.g., nonamortizing swap versus amortizing interest rate swap), products which require a new pricing methodology, legal or regulatory considerations (e.g., the requirement to obtain OCC approval of the bank‟s plan to engage in physical commodity transactions ), and market characteristics (e.g., foreign exchange forwards in major currencies as opposed to emerging market currencies).

When in doubt as to whether a product requires compliance with the new product approval process, bank management should err on the side of conservatism and apply the process to the proposed product or activity.

Oversight Mechanisms
A bank's board of directors and senior management can readily approve policies delineating permissible derivative activities and risk tolerances. However, the volume and complexity of activities at many banks makes it impractical for these directors and senior management to oversee the day-today management of derivative activities. Consequently, they rely on strong risk control and audit functions to ensure compliance with policies.

The risk control and audit functions should possess the independence, authority, and corporate stature to be unimpeded in identifying and reporting their findings. It is equally important to employ individuals with sufficient experience and technical expertise to be credible to the business line they monitor and senior executives to whom they report. Evaluations of these employees and their compensation should be independent of the businesses they monitor and audit.

Risk Control The role and structure of the risk control function (also referred to as market risk management at banks with significant trading activities) should be commensurate with the extent and complexity of the derivative activities. Because measuring and controlling the risk of some derivative activities can be more complex than doing so for traditional products, a strong risk control function is a key element in assisting board members and senior managers in fulfilling their oversight responsibilities.

Risk control units should regularly evaluate risk-taking activities by assessing risk levels and the adequacy of risk management processes. These units should also monitor the development and implementation of control policies and risk measurement systems. Risk control personnel staff should periodically communicate their observations to senior management and the board.

Depending on the nature and extent of a bank's activities, the risk control function can be structured in various ways. At banks with significant derivative activities, the risk control function should be a separate unit reporting directly to the board or a board committee. If independence is not compromised, this unit may report to a senior executive with no direct responsibility for derivative activities.

Banks with smaller and less complex derivative activities may not find it economically feasible to establish a separate risk control unit. Often the most practical solution for such banks is the use of independent treasury support units, or qualified outside auditors or consultants. These individuals report risk-taking

and management issues to the board or a committee, such as an Asset Liability Management Committee (ALCO). The selected approach should be structured to ensure sufficient stature and expertise in the oversight role.

Audit Audits should be conducted by qualified professionals who are independent of the business line being audited. Audits should supplement, and not be a substitute for, a risk control function.

The scope of audit coverage should be commensurate with the level of risk and volume of activity. The audit should include an appraisal of the adequacy of operations, compliance, and accounting systems and the effectiveness of internal controls. Auditors should test compliance with the bank‟s policies, including limits. The audit should include an evaluation of the reliability and timeliness of information reported to senior management and the board of directors. Auditors should trace and verify information provided on risk exposure reports to the underlying data sources. The audit should include an appraisal of the effectiveness and independence of the risk management process. Auditors might ensure that risk measurement models, including algorithms, are properly validated. The audit should include an evaluation of the adequacy of the derivative valuation process and ensure that it is performed by parties independent of risk-taking activities. Auditors should test derivative valuation reports for accuracy. For hedge transactions, auditors should review the appropriateness of accounting treatment and test for compliance with accounting policies.

The level of auditor expertise should also be consistent with the level and

complexity of activities and degree of risk assumed. In many cases, banks choose to out-source audit coverage to ensure that the professionals performing the work possess sufficient knowledge and experience.

Risk Measurement
Accurate measurement of derivative-related risks is necessary for proper monitoring and control. All significant risks should be measured and integrated into a bank-wide or corporate-wide risk management system. For example, price risk measurement should incorporate exposure from derivatives, as well as cash products.

Measurement of some types of risk is an approximation. Certain risks, such as liquidity risk, can be very difficult to quantify precisely and can vary with economic and market conditions. At a minimum, management should regularly assess vulnerabilities to these risks in response to changing circumstances. The sophistication and precision of risk measurement methods will vary by the types, volumes, and riskiness of the activities. Various types of risk measurement methods are discussed later in this guidance within each risk section (e.g., sections on price, credit, and liquidity risk).

Risk Limits
Risk limits serve as a means to control exposures to the various risks associated with derivative activities. Limits should be integrated across the bank and measured against aggregate (e.g., individual and geographical) risks. Limits should be compatible with the nature of the bank's strategies, risk measurement systems, and the board‟s risk tolerance. To ensure consistency between limits and

business strategies, the board should annually approve limits as part of the overall budget process. Outside the annual approval process, changes in resources or market conditions should prompt the board to reassess limits and make appropriate revisions. Annual approvals of limits and any interim revisions should be communicated to appropriate parties within the bank (e.g., traders, risk managers, operations, and audit).

Risk-Adjusted Return Analysis
As measurement and performance systems have continued to develop, techniques to evaluate business risks and corresponding earnings performance have evolved. The ability to measure and assess the risk-return relationship of various businesses has resulted in further steps to measure the risk-adjusted return on capital. This analysis allows senior management to judge whether the financial performance of individual business units justifies the risks undertaken.

The capacity to allocate risk-adjusted capital to the business units requires systems to comprehensively measure the inherent risks associated with the risktaking activity. Internal financial reporting systems should be able to attribute risks and earnings to their appropriate sources. Management should measure earnings against capital allocated to the activity, adjusted for price, interest rate, credit, liquidity, transaction, and other risks.

Management Information Systems
The frequency and composition of board and management reporting should depend upon the nature and significance of derivative activities. Where applicable, board and management reports should consolidate information across functional and geographic divisions.

Board and management reporting should be tailored to the intended audience, providing summary information to senior management and the board and more detailed information to line management. For example, the board, or designated committee, should periodically receive information illustrating trends in aggregate exposure, compliance with business strategies and risk limits, and riskadjusted return performance. Line management should receive more detailed reports with sufficient information to assess risk levels, returns, and the consistency with strategic objectives. Examples of types of reports that the board and management should receive are listed in each of the major sections of this guidance.

Ideally, management reports should be generated by control departments independent of the risk-takers. When risk-takers provide information (e.g., valuations or volatilities on thinly traded derivative contracts) for management reports, senior management should be informed of possible weaknesses in the data, and these positions should be audited frequently.

Personnel and Compensation Plans
Because of their increased complexity, derivative activities require a highly skilled staff particularly in the risk-taking, risk control, and operational functions. Management should regularly review the knowledge, skills, and number of people needed to engage in existing and new derivative activities. They should also ensure that the staff is appropriately balanced and that no area is understaffed in terms of skill or number.

Management should ensure that compensation programs are sufficient to recruit and retain experienced staff. However, compensation programs should not encourage excessive risk-taking. Because of the leverage and volatility associated with derivatives and the consequent ability to generate large profits in a relatively short time, employees may be tempted to take excessive risk. Therefore, it is important that compensation programs do not motivate an employee to take risk that is incompatible with corporate strategies, risk appetite, policies, or applicable laws and regulations. Compensation that is based on short-term results may not take into account long-term risks.

Strategic Risk
Strategic risk is the risk to earnings or capital arising from adverse business decisions or improper implementation of those decisions. This risk is a function of the compatibility between an organization‟s strategic goals, the business strategies developed to achieve those goals, the resources deployed in pursuit of these goals, and the quality of implementation. The resources needed to carry out business strategies are both tangible and intangible. They include communication channels, operating systems, delivery networks, and managerial capacities and capabilities.

Strategic risk may arise when the bank‟s business approach is not well developed or properly executed because of: an inability to react to changes in market condition, shifts in internal management focus, lack of internal coordination and communication to facilitate product delivery, or an inability to assemble the necessary financial, personnel, and systems infrastructure. Proper strategic planning and consistent market approach are integral to the success of the product or business activity.

Reputation Risk
Reputation risk is the risk to earnings or capital arising from negative public opinion. This affects the institution‟s ability to establish new relationships or services, or continue servicing existing relationships. This risk can expose the institution to litigation, financial loss, or damage to its reputation. Reputation risk is present throughout the organization and includes the responsibility to exercise an abundance of caution in dealing with its customers and community. This risk is present in such activities as asset management and agency transactions.

Price Risk (Tier I and Tier II Dealers)
Price risk is the risk to earnings or capital arising from changes in the value of portfolios of financial instruments. This risk arises from market-making, dealing, and position-taking activities for interest rate, foreign exchange, equity and commodity markets. Many banks use the term price risk interchangeably with market risk. The primary accounts affected by price risk are those that are revalued for financial presentation (e.g., trading accounts for securities, derivatives, and foreign exchange products).

Dealers are exposed to price risk to the degree they have unhedged exposure relating to customer trades or proprietary positions. The degree of price risk depends on the price sensitivity of the derivative instrument and the time it takes to liquidate or offset (close out) the position. Price sensitivity is generally greater for instruments with leverage, longer maturities, or option features. In deep, liquid markets the time it takes to close out a position is usually assumed to be at most one business day. In less liquid markets, it may take much longer.

Types of Price Risk
The primary factors that affect the price of derivative contracts are interest rates, foreign exchange rates, equity prices, and commodity prices. In addition to the absolute changes in these factors, the volatility of those changes can influence the prices of derivative products that have option or leverage features.

When evaluating the sensitivity of a derivative contract to a change in price risk factors, the contract's terms, maturity, and timing and amount of future cash flows must be considered. When evaluating the potential impact on a portfolio of contracts, the extent to which contracts may complement or offset one another should also be considered.

Price risk factors and pertinent aspects of options and leveraged products are discussed below.

Interest Rates The magnitude of the exposure from an adverse change in interest rates depends on the sensitivity of the instrument to changes in interest rates as well as the absolute change in interest rates. In general, values of long-term instruments are more sensitive to interest rate changes than the values of short-term instruments.

Interest rate exposure can arise from either a parallel shift in the yield curve (term structure exposure) or a change in the shape of the yield curve (yield curve twist exposure).

Foreign Exchange Rates
The exposure from an adverse change in foreign exchange rates is a function of spot foreign exchange rates and domestic and foreign interest rates. Any forward premium or discount in the value of a foreign currency relative to the domestic currency is determined largely by relative interest rates. Foreign exchange rates can be and have been very volatile (e.g., EMS crisis of 1992).

Equity Prices
The exposure from an adverse change in equity prices is usually classified as either systematic or unsystematic (security-specific) risk. Systematic risk arises from an event (of any magnitude) that affects all equities simultaneously. For example, when the economy is growing, all equities will likely be affected either in a cyclical (e.g., luxury goods) or countercyclical (e.g., discount stores) fashion. Unsystematic risk represents price risk unique to the equity of a particular company (and its equity derivatives). Equity markets can be more volatile than

other financial markets; therefore, equity derivatives can experience larger price fluctuations than other financial derivatives.

Commodity Prices
Like equity derivatives, commodity derivatives usually expose an institution to higher levels of price risk than other financial derivatives, because of the price volatility associated with uncertainties about supply and demand and the concentration of market participants in the underlying cash markets. Because of these market characteristics, the commodity derivative markets are generally much less liquid than the interest rate and foreign exchange markets (where there are a large number of market participants), and fluctuations in market liquidity often accompany price volatility. An evaluation of exposure to adverse changes in commodity prices should be performed on a market-by market basis. Depending on the level and nature of commodity exposure, this evaluation may include an analysis of historical price behavior and an assessment of the structure of market supply and demand to evaluate the potential for unusually large price movements.

Basis Risk
Basis risk is the risk that the correlation between two prices may change. (Correlation is the relationship between mathematical or statistical variables.) For example, if a bank uses an interest rate swap priced off of Libor to hedge a primebased loan portfolio, it is exposed to basis risk because changes in prime and Libor will not move exactly in tandem with each other.

Option Characteristics
The value of an option is the function of several variables, including the current spot price of the underlying asset, the volatility of the price of the underlying asset, interest rates, time to expiration, and the option‟s exercise price.

The potential exposure from options is measured by evaluating the sensitivity of options prices to changes in price risk factors. Sensitivity or exposure can be measured in aggregate (i.e., the total value of the option) or in components. These components are referred to as “the Greeks,” because most of them are designated by letters of the Greek alphabet.

The primary component measures of options sensitivity are: Delta – the sensitivity of an option‟s value to changes in the price of the underlying instrument. Gamma – the amount delta would change in response to a change in the price of the underlying instrument. Vega (also known as kappa) – the sensitivity of an option‟s price to change in the volatility of the underlying instrument. Theta – the amount an option's price would be expected to change to reflect the passage of time (also called time decay). Rho – the amount an option's price would change for an incremental move (generally one basis point) in short-term interest rates.

Price Risk Management
Dealers involved in derivative activities must establish an effective process for managing price risk. The level of structure and formality associated with this process should be commensurate with the level of risk in the bank‟s activities. Key components of price risk management systems include: • Reliable and independent pricing and revaluation systems. • Accurate and validated risk measurement processes.

• Stress testing to show how the portfolio would perform under certain extreme events. • Meaningful processes for establishing price risk limits. • Timely and effective risk reporting, monitoring, and exception approval processes.

Pricing and Revaluation Systems
Derivative dealers need pricing and revaluation systems to effectively manage exposure to price risk factors. These systems (and price risk measurement systems discussed below) require similar input data that describe the derivative contract‟s terms, maturity, and expected cash flow. These systems may be the same, integrated, or separate.

Pricing system(s) are used to determine reliable prices for derivative products being purchased and sold. Such pricing systems allow dealers to evaluate prices offered in the market, identify profits and losses on positions, and identify potential risks in the portfolio. A pricing system is often developed by the business using the system. In these situations, the systems should be maintained by an independent party and subject to a rigorous validation process. Validation is discussed later and in appendix D.

Revaluation systems provide mark-to-market information for reporting positions and recording profits and losses. It is imperative that the input used for determining the fair value of positions and profits/losses be independent of risktaking personnel (see the “Transaction Risk” section for further comments on periodic revaluations).

Banks should regularly review their pricing and revaluation models to ensure they provide a reasonable estimate of value. In addition, banks should continually monitor acceptance of the pricing model‟s results in the marketplace. If the model‟s results are inconsistent with the market, banks must decide whether to continue using the model.

Price Risk Measurement
There are a variety of ways to measure price risk, some of which are far more sophisticated than others. The degree of sophistication in price risk measurement should be related to (1) the type and amount of price risk, (2) the ability of management to understand the nature, limitations, and meaning of the measurement and (3) the nature of trading activities. The less sophisticated

methods are only appropriate when a bank uses conservative strategies, the level of price risk is low relative to earnings and capital, or price risk is linear (no option exposure). For instance, Tier II dealers with largely matched positions would not be expected to have sophisticated risk measurement systems. Institutions with large or complex derivative activities or large open positions need the more sophisticated measurement methods that rely on mathematical models to replicate price behavior.

Value-at-risk (VAR) is one of the most common methods used by dealer banks to measure aggregate price risk. VAR is an estimate of the potential loss within a specified confidence interval in a portfolio‟s value over a defined holding period. In trading pios that are marked-to-market daily, VAR is usually translated into a potential reduction in the bank‟s future earnings. VAR is most valuable as a high-level management information tool because it reduces a bank‟s multiple price risks to a single number or to a small number of key statistics. The trading desks will manage their individual exposures using more detailed information. See the “Evaluating Price Risk Measurement” section for more information on VAR.

Evaluating Price Risk Measurement
Banks should regularly re-evaluate risk measurement models to ensure that they provide a reasonable estimate of risk. Management should ensure that the models are used for their intended purpose and that material limitations of the models are well understood at appropriate levels within the organization.

Price Risk Limits
The price risk limit structure should be consistent with the board‟s risk appetite and the capabilities of the risk measurement system. Institutions should use a variety of limits to adequately capture the range of price risks or to address risks that the measurement system does not capture. A single type of limit is generally not sufficient on its own to control price risk. However, many types of limits tend to complement each other. For instance, aggregate VAR limits are a mechanism to control risk on a bank or entity-wide level. Traders will need supplemental limits (e.g., stop-loss limits) to control risk at the desk or portfolio level. Standard limits used to control price risks are described below.

Value-at-Risk Limits. These sensitivity limits are designed to restrict potential loss to an amount equal to a board-approved percentage of projected earnings or capital. All dealers except Tier II dealers with largely matched positions should use VAR limits.

Loss Control Limits. Loss control limits require a specific management action if the defined level of loss is approached or breached. If such limits are exceeded, policy should require that a position be closed out or that a higher level of management be contacted for approval of maintaining the exposure. In many cases, the limits are established to foster communication, rather than limit management's ability to maintain a position. For instance, a position that currently exhibits unrealized losses may continue, in management‟s estimation, to make economic sense over the time horizon it is expected to be held.

Tenor or Gap Limits. Tenor (maturity) or gap (repricing) limits are designed to reduce price risk by limiting the maturity and/or controlling the volume of transactions that matures or reprices in a given time period. Such limits can be used to reduce the volatility of derivative revenue or expenses by staggering the maturity and/or repricing, thereby smoothing the effect of changes in market factors affecting price.

Notional or Volume Limits. Notional or volume limits are most effective for controlling operational capacity and, in some cases, liquidity risk. Specifically, in the case of exchangetraded futures and options, volume limits on open interest may be advisable in less liquid contracts.

Options Limits. Limits specific to option exposure should be established for any dealer with sizable option positions. Such limits should consider the sensitivity of positions to changes in delta, gamma, vega, theta, and rho. Generally, this type of analysis requires the modeling capabilities addressed in the previous discussion of VAR limits.

Product Concentration Limits. Product concentration limits may be useful to ensure that a concentration in any one product does not significantly increase the price risk of the portfolio as a whole.

Banks are exposed to interest rate risk through their structural balance sheet positions. Banks using derivatives in an active position-taker or limited enduser capacity may do so: • To limit downside earnings exposure. • To preserve upside earnings potential. • To increase return. • To minimize income or economic value of equity (EVE) volatility.

The primary difference between an active position-taker/limited end-user and a dealer is that an end-user, rather than seeking to profit from short-term price movements, tries to manage its structural interest rate risk profile.

Interest Rate Risk (Active Position-Takers and Limited End-Users)
The following discussion of interest rate risk applies to banks that use derivatives as active position-takers or limited end-users. Dealers, in addition to trading derivatives, can also be categorized as active position-takers or limited endusers when they use derivatives to manage interest rate risk in their treasury units. Interest rate risk is the risk to earnings or capital arising from movements in interest rates. The economic (capital) perspective focuses on the value of the bank in today‟s interest rate environment and the sensitivity of that value to changes in interest rates. Interest rate risk arises from differences between the timing of rate changes and the timing of cash flows (repricing risk); from changing relationships

among different yield curves affecting bank activities (basis risk); from changing rate relationships across the spectrum of maturities (yield curve risk); and from interest-related options embedded in bank products (options risk). The evaluation of interest rate risk must consider the impact of complex illiquid hedging strategies or products, and also the potential impact on fee income that is sensitive to changes in interest rates. When trading is separately managed, this impact is on structural positions rather than trading portfolios.

Interest Rate Risk Management
Each institution using derivatives must establish an effective process for managing interest rate risk. The level of structure and formality in this process should be commensurate with the activities and level of risk approved by senior management and the board.

Contributing to effective supervision of interest rate risk are: • Appropriate board and management supervision. • Well-formulated policies and procedures. • Reliable pricing and valuation systems. • Accurate risk identification and measurement processes. • Interest rate risk limits. • Timely and effective risk reporting, monitoring, and exception approval processes.

Limited end-users and active position-takers are not expected to have the same degree of sophistication in their pricing systems as dealers. By definition, end-users are not quoting prices to customers. However, end-users must understand the factors affecting the price of derivatives to be able to effectively measure and manage potential risks to earnings and capital. In addition, end-users should have access to several pricing sources to ensure the reasonableness of the prices being quoted. Because active position-takers use derivatives to alter their interest rate risk profile, they should have valuation and risk measurement systems comparable to the standards described for dealers (see the “Price Risk” section for more information). Limited end-users do not need the same sophisticated systems as those used by dealers or active position-takers. Nevertheless, they must be able to obtain market valuations and thoroughly assess the risks of the derivatives they hold. Independent third parties may be used for market values. However, any issues affecting independence (e.g., obtaining market values from the same dealer who sold the derivatives) need to be assessed by management and balanced against mitigating factors.

Interest Rate Risk Measurement
Risk measurement systems should be able to identify and quantify in timely fashion the major sources of interest rate risk. The OCC expects all national banks to have systems that enable them to measure the amount of earning sat-risk to changes in interest rates. Management at banks with significant medium- and longterm positions should be able to assess the longer-term impact of changes in interest rates on earnings and economic value of equity.

The appropriate method of assessing longer-term exposures will depend upon the maturity and complexity of the bank‟s assets, liabilities, and off-balance

sheet activities. Methods range from gap reports that cover the full maturity range of the bank‟s activities to EVE measurement systems and simulation models.

Interest Rate Risk Limits
Interest rate risk limits should be commensurate with the level and type of interest rate exposure being taken. Standard limits used to control interest rate risk are described below.

Earnings and EVE-at-Risk Limits. These sensitivity limits are designed to restrict the amount of potential loss exposure. Active position-takers and limited end-users should be able to calculate the potential exposure of projected future reported earnings under varying interest rate scenarios. Endusers with significant medium- and longer-term positions should also be able to assess the impact of changes in interest rates on EVE.

Gap Limits. Gap (re-pricing) limits are designed to reduce loss exposure due to interest rate changes by controlling the volume of financial instruments that reprice or mature in a given time period.

Notional or Volume Limits. Because notional limits do not provide a readily comparable proxy for interest rate risk, they are generally not acceptable by themselves. Nonetheless, limited end-users may use notional limits to control initial entry into derivative

markets. Such limits may be satisfactory for banks holding very small volumes of plain-vanilla derivative products.

Liquidity Risk
Liquidity risk is the risk to earnings or capital from a bank‟s inability to meet its obligations when they come due, without incurring unacceptable losses. Liquidity risk includes the inability to manage unplanned decreases or changes in funding sources. Liquidity risk also arises from the failure to recognize or address changes in market conditions that affect the ability to liquidate assets quickly and with minimal loss in value. All institutions involved in derivatives face these two types of liquidity risk. For ease of discussion, these risks are referred to as funding liquidity risk and market liquidity risk. Controlling, measuring, and limiting both types of liquidity risk are vital activities and the sections that follow provide additional information on how to do so.

In developing guidelines for controlling liquidity risk, banks should consider the possibility of losing access to one or more markets, either because of concerns about their own creditworthiness, the creditworthiness of a major counterparty, or because of generally stressful market conditions. At such times, the bank may have less flexibility in managing its price, interest rate, credit, and liquidity risks. Banks that are market-makers in OTC derivatives or that dynamically hedge their positions require constant access to financial markets, and that need may increase in times of market stress. A bank‟s liquidity plan should consider its ability to access alternative markets, such as futures or cash markets, or to provide sufficient collateral or other credit enhancements in order to continue trading under a broad range of scenarios.

Risk management systems for liquidity risk are intertwined with those used in the management of price and interest rate risk. Consideration of market depth and the cash flow characteristics of particular instruments are critical in the establishment of risk limits and construction of portfolio stress tests. The management of price, interest rate, and liquidity risk is not conducted in isolation. As such, the examination of risk management systems for these three risks should be conducted concurrently.

Types of Liquidity Risk
Market Liquidity Risk Market liquidity risk is the risk that a bank may not be able to exit or offset positions quickly, and in sufficient quantities, at a reasonable price. This inability may be due to inadequate market depth, market disruption, or the inability of the bank to access the market. Some bond and exotic product markets lack depth because of relatively fewer market participants. Even normally liquid markets can become illiquid during periods of market disruption (e.g., the stock market crash of October 1987, when there were more sellers than buyers). Market liquidity risk can also arise when a bank finds it difficult to access markets because of real or perceived credit or reputation problems of its own or of a major counterparty.

Funding Liquidity Risk Funding liquidity risk is the possibility that a bank may be unable to meet funding requirements at a reasonable cost. Such funding requirements arise each day from cash flow mismatches in swap books, the exercise of options, and the

implementation of dynamic hedging strategies. The rapid growth of financial derivatives in recent years has focused increasing attention on the cash flow impact of such instruments.

Liquidity Risk Management
The level of structure and formality in the liquidity risk management process should be commensurate with the activities and level of risk approved by senior management and the board. Liquidity risk is highest for dealers or active positiontakers with significant unmatched derivative cash flows and significant foreign currency cash flows. These dealers and end-users should evaluate the cash flow impact of their off-balance-sheet activities in the context of the overall liquidity monitoring process. Tier II dealers and limited end-users with largely matched or relatively small positions may require less formal liquidity monitoring.

In dealer banks, market liquidity is controlled through price-risk-limit structures and risk management systems. Limits include restrictions on market participation, allowable tenors, and overall risk levels. In addition, the liquidity of markets and products should be considered when establishing the holding periods for price risk measurement. Management over these exposures should be monitored by the risk control function.

Communication Managers responsible for derivatives and funding activities must regularly communicate market conditions to senior management. In turn, senior management must ensure that personnel are aware of any strategies or events that could affect market perception of the bank. Well-developed lines of communication, whether

formal or informal, should be established between derivative managers and funding managers.

Liquidity Risk Measurement
Measurement of liquidity risk must include calculation of the liquidity impact of all significant on- and off-balance-sheet positions. The methods used to measure market liquidity risk should be similar in sophistication to those used in measuring price or interest rate risks. Particular care should be taken in evaluating and revising the amount of time it would take to exit or offset a position. Likewise, internal communication networks should enable the quick flow of market information.

Liquidity Risk Limits
In controlling liquidity risk, banks often place limits on tenor, open interest, payment mismatches, and notional or contract volumes. Banks should adopt reasonable holding periods. The initial and ongoing authorization to transact a product or to enter a market should ensure that the liquidity of those markets/products is commensurate with the bank's risk appetite. In addition, the bank's operating procedures should provide for early warning of potential liquidity concerns in the market.

Early Termination Agreements The use of early termination agreements has grown in recent years as market participants have sought avenues to reduce counterparty credit exposure. However, the use of these agreements can be a double-edged sword.

Credit Enhancements When the bank provides collateral to a counterparty, liquidity policies should define the maximum amount of assets that can be encumbered by collateral and margining arrangements, as well as the source of those assets. Limits should also be placed on the level of assets tied to collateral agreements with common triggers such as a credit rating threshold. The bank should carefully monitor and analyze the market environment and the potential collateral and margin demands under both current and adverse market conditions. The implications of these agreements should be formally incorporated into the bank's contingency funding plan. See the sections on credit, transaction, and compliance risk for more information.

Close-Out Reserves Dealers using mid-market valuations should consider establishing valuation reserves to reflect the potential for market illiquidity upon closing out a position. In illiquid markets, bid/ask spreads can be wide and traders may find it difficult to close out a position at a reasonable cost. The potential additional cost of closing out the position would be reflected in the reserve.

Foreign Exchange Risk
Foreign exchange risk is the risk to earnings or capital arising from movement of foreign exchange rates. This risk is applicable to cross-border investing and operating activities. Market-making and position-taking in foreign currencies should be captured under price risk. Foreign exchange risk is also known as translation risk. Foreign exchange translation risk arises from holding

accrual accounts denominated in foreign currency, including loans, bonds, and deposits (i.e., cross-border investing). It also includes foreign-currencydenominated derivatives such as structured notes, synthetic investments, structured deposits, and off-balance-sheet derivatives used to hedge accrual exposures. Accounting conventions require periodic revaluation of these accounts at current exchange rates. This revaluation translates the foreign-denominated accounts into U.S. dollar terms. Banks should record these accrual-based products under appropriate systems that identify, measure, monitor, and control foreign exchange exposure.

Credit Risk
Credit risk is the risk to earnings or capital of an obligor's failure to meet the terms of any contract with the bank or otherwise to perform as agreed. Credit risk arises from all activities in which success depends on counterparty, issuer, or borrower performance. It arises any time bank funds are extended, committed, invested, or otherwise exposed through actual or implied contractual agreements, whether reflected on or off the balance sheet.

Types of Credit Risk
Credit risk in derivative products comes in the form of pre-settlement risk and settlement risk.

Pre-settlement risk is the risk of loss due to a counterparty defaulting on a contract during the life of a transaction. Presettlement exposure consists of both current exposure (the replacement cost of the derivative transaction or its market value) and the add-on (an estimate of the future replacement cost of the derivative).

Settlement risk is the loss exposure arising when a bank meets its obligation under a contract before the counterparty meets its obligation. A failure to perform may be due to counterparty default, operational breakdown, or legal impediments.

Credit Risk Management
Each institution must have an effective means of measuring and controlling derivatives credit risk. Examiners need to know whether the bank is a dealer or end-user and whether risk controls are appropriate. A prudently controlled environment will include the following: • Effective senior management and board oversight. • Policies and procedures. • Strong credit review, approval, and limit processes. • Accurate and validated risk measurement systems. • Timely and effective risk reporting, monitoring, and exception approval processes. • Proper credit documentation standards.

Credit Risk Measurement

Pre-settlement Risk Banks should have a system to quantify pre-settlement risk. Pre-settlement credit risk can be estimated using a variety of methods. Techniques have evolved from using the full notional amount of the contract, to a percentage of the notional amount, to loan equivalent estimates. Many banks now employ highly sophisticated computer models to simulate the potential credit exposure over the life of a derivative contract.

Settlement Risk Settlement risk exposure is the cumulative amount of funds or assets delivered for payment and lasts from the time an outgoing payment order can no longer be canceled unilaterally, until the time the incoming payment is received with finality and reconciled. The duration of an individual bank‟s settlement exposure will depend on the characteristics of the relevant payments systems as well as on the bank‟s internal reconciliation procedures.

Credit Risk Limits
Counterparty credit limits should be approved before the execution of derivative transactions. Banks should establish counterparty credit limits in much the same way as traditional credit lines. Documentation in the credit file should support the purpose, payment source, and collateral (if any). Evaluations of individual counterparty credit limits should aggregate limits for derivatives with the credit limits established for other activities, including commercial lending.

Mechanisms to Reduce Credit Exposure
A number of mechanisms can reduce credit exposure, including netting arrangements, credit enhancements, and early termination agreements. In recent years, banks have increasingly used these tools not only to reduce credit exposure but also to minimize transaction costs and manage credit lines more efficiently.

Before recognizing the reduction in credit risk that these arrangements provide, banks must ensure that they are properly documented and legally enforceable. Terms of these arrangements are usually outlined in a standardized master agreement covering specific products such as the International Swaps and Derivatives Association (ISDA) agreement, Foreign Exchange and Options Agreement (FEOMA), and International Currency Options Market (ICOM) agreement. Banks must also ensure that the arrangements are legally enforceable in the relevant jurisdictions. See the “Compliance Risk” section for more information on documentation and enforceability. Finally, banks must ensure that they have adequate operational capacity to perform the necessary calculations or otherwise accommodate these arrangements.

Additional information regarding netting, credit enhancements, and early termination agreements may be found in the “Transaction Risk” and “Compliance Risk” sections and appendices I, J, and K.

Transaction Risk
Transaction risk is the risk to earnings or capital arising from problems with service or product delivery. This risk is a function of internal controls, information systems, employee integrity, and operating processes.

Transaction risk exists in all products and services. Derivative activities can pose challenging operational risks because of their complexity and continual evolution. The operations function, which is discussed in a later section, refers to the product support systems and related processes.

As part of their fiduciary responsibility, the board and senior management must institute a sound internal control framework to prevent losses caused by fraud and human error. Fundamental to this framework is the segregation of the operations and risk-taking functions. Many well publicized financial mishaps (e.g., the Barings Bank, Daiwa Bank, and Sumitomo Corporation) have illustrated the peril of failing to segregate key risk-taking and operational functions.

Transaction Risk Management
In order to effectively manage transaction risk, senior managers must fully understand the processing cycle and must change processes and technology when necessary. They should identify areas of transaction risk and estimate the loss a bank could suffer from a given exposure.

To minimize transaction risk and ensure efficient processing, all personnel involved in derivatives activities should understand the differing roles played by sales, trading, risk control, credit, operations, and accounting. Operations personnel cannot adequately support a business activity they do not understand. Insufficient knowledge of derivatives prevents an understanding of the risks involved and may prevent effective internal controls from being implemented. The operations unit needs to evolve from a clerical processing room into a professional, value-adding

division that is competent in derivative products. The staff must be self-reliant, knowledgeable of derivative products, and have technical abilities that enable them to communicate and work effectively with front office traders. Accordingly, a bank should provide back office personnel with appropriate continuing education.

A properly controlled transaction risk management function should include: • Effective board and senior management supervision. • Policies and procedures. • Segregation of risk-taking and operational duties. • Skilled and experienced operations personnel. • Timely financial, exposure, and risk reporting (as applicable).

• Operational performance measures.

• Technology commensurate with the level and complexity of activity.

Transaction Risk Measurement
The level of transaction risk associated with a bank's derivative activities is related to (1) the volume and complexity of transactions and (2) the efficiency and integrity of the operations department. The better the bank‟s ability to prevent

losses from human error, fraud, and weak operational systems, the lower will be the level of transaction risk.

Role of Operations
The function of an operations department is to process transactions, record contracts, and reconcile transactions and databases. A properly functioning operations department will help ensure the integrity of financial information and minimize operations, settlement, and legal risks. The operations area should provide the necessary checks to detect unauthorized trades.

Confirmation Process The purpose of the confirmation process is to verify that each derivative counterparty agrees to the terms of the trade. For each trade, a confirmation is issued by the bank, and the counterparty either issues its own confirmation or affirms the bank‟s confirmation. To reduce the likelihood of fraud or human error, this confirmation process must be conducted independently of the risk-taking unit.

Unconfirmed and Disputed Trades All incoming confirmations should be sent to the attention of a department that is independent of the risk-taking unit. Incoming information should be compared with the outgoing confirmation, and any disputes should be carefully researched. Disputes or unconfirmed trades should be brought immediately to the attention of the operations manager. All disputes and unconfirmed trades should be regularly reported to a senior operations officer.

Netting Netting is an agreement between counterparties to offset positions or obligations. Payment (or settlement) netting is a bilateral (two-party) agreement intended to reduce settlement risk. Payment netting is a mechanism in which parties agree to net payments payable between them on any date, in the same currency, under the same transaction or a specified group of transactions. Payment netting goes on continually during the life of a master agreement. Payment netting reduces credit and transaction risk by allowing the bank to make one payment instead of settling multiple transactions individually. However, a bank should not perform payment netting without first ensuring that netting agreements are properly documented and legally enforceable. Banks often use standardized master agreements such as the International Swaps and Derivatives Association (ISDA) agreement, Foreign Exchange and Options Agreement (FEOMA), and

International Currency Options Market (ICOM) agreement to document netting arrangements. The credit and compliance risk aspects of netting are discussed in their respective sections.

Reconciliations To ensure that data has been accurately captured, critical data points and reports should be promptly reconciled. The person who reconciles accounts must be independent of the person who initiates the transaction or inputs transaction data.

Broker's Commissions and Fees The back office should review brokers' statements, reconcile charges to bank estimates and the general ledger, check commissions, and initiate payment. Brokers should be approved independently of the risk-takers.

Documentation and Record-Keeping Transaction documentation for derivative instruments often requires written confirmation of trades, contract terms, legal authorities, etc. Typically, many of the terms under which the instruments are transacted are stipulated in master agreements and other legal documents.

Revaluation Approaches and Reserves Both the risk control and audit functions should ensure that position valuations are generated from independent sources. Accurate values are key to the generation of reliable reports on risk levels, profitability, and trends. Ideally, much of the valuation process employs valuation model algorithms or electronic data feeds from wire services, with little manual intervention. When reliable revaluation models or data feeds are not available, as is the case with some illiquid or highly customized products, operations personnel or other independent personnel should obtain values from other dealers or use approved mathematical techniques to derive values.

Compliance Risk
Compliance risk is the risk to earnings or capital arising from violations, or nonconformance with, laws, rules, regulations, prescribed practices, or ethical standards. The risk also arises when the laws or rules governing certain bank products or activities of the bank‟s clients may be ambiguous or untested.

Compliance risk exposes the institution to fines, civil money penalties, payment of damages, and the voiding of contracts. Compliance risk can lead to a diminished reputation, reduced franchise value, limited business opportunities, lessened expansion potential, and an inability to enforce contracts.

The legal authority of national banks to enter into derivative transactions is well-established. The OCC has recognized that national banks may enter into derivative transactions as principal when the bank may lawfully purchase and sell the underlying instrument or product for its own account, as a dealer or marketmaker; or when the bank uses the transaction to hedge the risks arising from legally permissible activities.

A national bank may also enter into derivative transactions as principal or agent when the bank is acting as a financial intermediary for its customers and whether or not the bank has the legal authority to purchase or sell the underlying instrument for its own account. Accordingly, a national bank may enter into derivative transactions based on commodities or equity securities, even though the bank may not purchase (or may be restricted in purchasing) the underlying commodity or equity security for its own account.

Counterparty Authority
The enforceability of many OTC derivative contracts (e.g., swaps and options) in the event of counterparty insolvency has not been tested in the courts in all jurisdictions. Therefore, competent legal counsel should review applicable documents before such transactions are executed. Counsel should be familiar with the economic substance of the transaction, the laws of the jurisdictions in which the parties reside, and laws governing the market in which the instrument was traded. Whenever standardized documents are not used, contracts should be reviewed by counsel. Standard industry or trade association contracts should be reviewed whenever changes are made.

Limited End-Users A requirement that bank counsel review all derivative contracts could entail significant legal expense and make derivative use uneconomical. An end-user (as well as dealers) can avoid much of this expense by using only standard industry contracts and addendums (e.g., the International Swaps and Derivatives Association, Inc., (ISDA) master agreement) and dealing only with counterparties domiciled in countries where there is high certainty of enforceability.

Dealers and Active Position-Takers National banks should make every effort to ensure that counterparties have the power and authority to enter into derivative transactions. The authority of a counterparty to engage in derivatives can be evidenced by corporate resolutions and certificates of incumbency. Additionally, banks should ensure that transactions are adequately documented. If adequate documentation of transactions is not

obtained, enforcement of the transactions may be precluded under the relevant state law statute of frauds, which may require the existence of a written agreement for enforcement of a contract.

Credit Enhancements
A bank should ensure that its rights with respect to any cash, securities, or other property pledged to the bank by a counterparty to margin, collateralize (secure), or guarantee a derivative contract are enforceable and exercisable and can be used upon the default of the counterparty to offset losses. To be reasonably sure that the pledged rights will be available if needed, the bank must have both access to, and the legal right to use the assets. For example, to establish reasonable access the counterparty should deliver pledged assets directly to the bank or to an independent escrow agent. Furthermore, bank counsel should give an opinion on whether the contract that governs the pledged assets is legally enforceable. See the “Credit Risk” and “Liquidity Risk” sections for more information on credit enhancements.

Bilateral Netting
As discussed above, a national bank must reasonably satisfy itself that the terms of any contract governing its derivative activities with a counterparty are legally sound. This is particularly important with respect to contract provisions that provide for the net settlement of balances between the bank and its counterparties.

Master settlement and close-out netting arrangements, to the extent legally enforceable (during the course of periodic payments and in the event of the

insolvency of the counterparty), constitute a favorable means of reducing exposure to counterparty credit risk.

Where the legal enforceability of netting arrangements has not been established, national banks should not evaluate the risks of derivative transactions on a net basis.

Multilateral Netting
Multilateral netting is the netting of payments between a group of counterparties. Often, under a multilateral netting arrangement, a clearinghouse interposes itself as the legal counterparty. Exchange-traded futures and options clearinghouses are examples of multilateral netting arrangements. Clearinghouses for over-the-counter foreign exchange transactions operate in both the United States and the United Kingdom.

Physical Commodities
National banks may engage in physical commodity transactions in order to manage the risks arising out of commodity derivative transactions if they meet the following conditions: • Any physical transactions supplement the bank's existing risk management activities, constitute a nominal percentage of the bank's risk management activities,

are used only to manage risk arising from otherwise permissible (customer-driven) banking activities, and are not entered into for speculative purposes; and • Before entering into any such physical transactions, the bank has submitted a detailed plan for the activity to the OCC and the plan has been approved. The OCC has concluded that a national bank may engage in physical commodity transactions in order to manage the risks of physical commodity financial derivative transactions. However, to ensure that the bank understands the risks of physical hedging activities, management must first develop a detailed plan, which should be approved by the bank's board and the supervisory staff of the OCC before the bank engages in such activities. Financial derivative transactions with respect to bank-eligible precious metals (gold, silver, platinum, palladium, and copper) are not subject to this guideline.

Equity Derivatives
The OCC has permitted a national bank to make interest payments on customer deposit accounts based on the percentage increase, if any, in the S&P Index from the date the account is opened until maturity, and to hedge its interest obligations to the holders of deposit accounts with futures contracts in the S&P Index. In finding these transactions permissible for national banks, the OCC concluded that offering the account is within the expressly authorized power of national banks to receive deposits. The OCC further concluded that a national bank‟s purchase and sale of S&P Index futures to hedge its interest obligations on the deposit was incidental to the bank‟s expressly authorized deposit-taking authority. In reaching these conclusions, the OCC recognized that because the

futures would be cash settled the bank would not acquire any ownership interest in the securities comprising the S&P Index.

Capital Issues
The board of directors and senior management should ensure that the bank maintains sufficient capital to support the risks that may arise from its derivative activities. Significant changes in the size or scope of a bank's activities should prompt an analysis of the adequacy of the amount of capital supporting those activities. This analysis, which may be incorporated into the bank‟s periodic review of capital adequacy for all activities, should be approved by the board or senior management and be available for bank examiner review. Senior management should ensure that the bank meets all regulatory capital standards for financial derivative activities.

Accounting Issues
Accounting guidance for financial derivative instruments is not comprehensive. Financial Accounting Standard (FAS) 52 and FAS 80 address only futures transactions. Regulatory accounting principles (RAP), set forth in the Instructions to Consolidated Reports of Condition and Income, address only futures, forwards, and options. The lack of comprehensive GAAP or RAP guidance for derivatives has led to inconsistent accounting treatment for some products, particularly swaps.

Both the Financial Accounting Standards Board (FASB) and the OCC are studying accounting standards for derivative transactions. The OCC is working to develop a consistent regulatory accounting policy for all derivative products. In

cooperation with other U.S. banking agencies, the OCC will consider the impact of accounting rules on business decisions, with a view to minimizing regulatory burden. As part of this initiative, the Federal Financial Institutions Examination Council (FFIEC) has announced plans to bring call reports in conformity with GAAP. This change will become effective for reports filed as of March 31, 1997.

Until more authoritative guidance on derivatives is issued, each bank should review its accounting practices and documentation to ensure consistency with the strategies and objectives approved by its board.

Chapter 4
Conclusion
From the study of Risk Management of Financial Derivatives we have concluded that Derivatives are a financial product which has been derived from another financial product or commodity. Without the underlying product or market, the derivative would have no independent existence. Common types of derivatives are Forwards, Swaps and Options.

Derivatives have risen from the need to manage the risk arising from movements in markets beyond our control, which may severely impact the revenues and costs of the firm.

The most critical aspect of risk management of derivatives is the daily monitoring of price and position and the margining of those positions. Derivatives play a key role in financial crisis.

Bibliography
Websites
www.strategies-tactics.com www.risk.net www.worldscibooks.com www.occ.treas.gov www.wikipedia.com www.scribd.com www.yahoofinance.com

Books
Risk Management and Derivatives by Rene M Stulz

Financial Risk Management by The ICFAI University

Risk Management by Mac Millan

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