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Margins

The margining system is based on the JR Verma


Committee recommendations. The actual margining
happens on a daily basis while online position
monitoring is done on an intra-day basis.
Daily margining is of two types:
1. Initial margins
2. Mark-to-market profit/loss
The computation of initial margin on the futures
market is done using the concept of Value-at-Risk
(VaR). The initial margin amount is large enough to
cover a one-day loss that can be encountered on 99%
of the days. VaR methodology seeks to measure the
amount of value that a portfolio may stand to lose
within a certain horizon time period (one day for the
clearing corporation) due to potential changes in the
underlying asset market price. Initial margin amount
computed using VaR is collected up-front.
The daily settlement process called "mark-to-
market" provides for collection of losses that have
already occurred (historic losses) whereas initial
margin seeks to safeguard against potential losses on
outstanding positions. The mark-to-market settlement
is done in cash.
Let us take a hypothetical trading activity of a client of
a NSE futures division to demonstrate the margins
payments that would occur.
• A client purchases 200 units of FUTIDX NIFTY
29JUN2001 at Rs 1500.
• The initial margin payable as calculated by VaR
is 15%.
Total long position = Rs 3,00,000 (200*1500)
Initial margin (15%) = Rs 45,000
Assuming that the contract will close on Day + 3 the
mark-to-market position will look as follows:
Position on Day 1

Close PriceLoss Margin Net cash


released outflow
1400*200 20,000 3,000 17,000
=2,80,000 (3,00,000- (45,000- (20,000-
2,80,000) 42,000) 3000)
Payment to (17,000)
be made
New position on Day 2
Value of new position = 1,400*200= 2,80,000
Margin = 42,000

Close PriceGain Addn Net cash


Margin inflow
1510*200 22,000 3,300 18,700
=3,02,000 (3,02,000- (45,300- (22,000-
2,80,000) 42,000) 3300)
Payment to 18,700
be recd

Position on Day 3
Value of new position = 1510*200 = Rs 3,02,000
Margin = Rs 3,300

Close Price Gain Net cash inflow


1600*200 18,000 18,000 + 45,300* =
=3,20,000 (3,20,000- 63,300
3,02,000)
Payment to 63,300
be recd

Margin account*
Initial margin = Rs 45,000
Margin released (Day 1) = (-) Rs 3,000
Position on Day 2 Rs 42,000
Addn margin = (+) Rs 3,300
Total margin in a/c Rs 45,300*
Net gain/loss
Day 1 (loss) = (Rs 17,000)
Day 2 Gain = Rs 18,700
Day 3 Gain = Rs 18,000
Total Gain = Rs 19,700
The client has made a profit of Rs 19,700 at the end
of Day 3 and the total cash inflow at the close of trade
is Rs 63,300.
Settlements
All trades in the futures market are cash settled on a
T+1 basis and all positions (buy/sell) which are not
closed out will be marked-to-market. The closing price
of the index futures will be the daily settlement price
and the position will be carried to the next day at the
settlement price.
The most common way of liquidating an open position
is to execute an offsetting futures transaction by
which the initial transaction is squared up. The initial
buyer liquidates his long position by selling identical
futures contract.
In index futures the other way of settlement is cash
settled at the final settlement. At the end of the
contract period the difference between the contract
value and closing index value is paid.

How to read the futures data sheet?


Understanding and deciphering the prices of futures
trade is the first challenge for anyone planning to
venture in futures trading. Economic dailies and
exchange websites www.nseindia.com and
www.bseindia.com are some of the sources where
one can look for the daily quotes. Your website has a
daily market commentary, which carries end of day
derivatives summary alongwith the quotes.
The first step is start tracking the end of day prices.
Closing prices, Trading Volumes and Open Interest
are the three primary data we carry with Index option
quotes. The most important parameter are the actual
prices, the high, low, open, close, last traded prices
and the intra-day prices and to track them one has to
have access to real time prices.
The following table shows how futures data will be
generally displayed in the business papers daily.

Series First HighLow Close No of


Trade Volume Value trades Open
(No of interest
contracts) (Rs in (No of
lakh) contracts)
BSXJUN2000 4755 482047404783.1146 348.70 104 51
BSXJUL2000 4900 490048004830.812 28.98 10 2
BSXAUG20004800 487048004835 2 4.84 2 1
Total 160 38252 116 54

Source: BSE
• The first column explains the series that is being
traded. For e.g. BSXJUN2000 stands for the
June Sensex futures contract.
• The column on volume indicates that (in case of
June series) 146 contracts have been traded in
104 trades.
• One contract is equivalent to 50 times the price of
the futures, which are traded. For e.g. In case of
the June series above, the first trade at 4755
represents one contract valued at 4755 x 50 i.e.
Rs. 2,37,750/-.
Open interest indicates the total gross outstanding
open positions in the market for that particular series.
For e.g. Open interest in the June series is 51
contracts.
The most useful measure of market activity is Open
interest, which is also published by exchanges and
used for technical analysis. Open interest indicates
the liquidity of a market and is the total number of
contracts, which are still outstanding in a futures
market for a specified futures contract.
A futures contract is formed when a buyer and a seller
take opposite positions in a transaction. This means
that the buyer goes long and the seller goes short.
Open interest is calculated by looking at either the
total number of outstanding long or short positions –
not both.
Open interest is therefore a measure of contracts that
have not been matched and closed out. The number
of open long contracts must equal exactly the number
of open short contracts.

Action Resulting open


interest
New buyer (long) and Rise
new seller (short)
Trade to form a new
contract.
Existing buyer sells Fall
and existing seller
buys –The old contract
is closed.
New buyer buys from No change – there is
existing buyer. The no increase in long
Existing buyer closes contracts being held
his position by selling
to new buyer.
Existing seller buys No change – there is
from new seller. The no increase in short
Existing seller closes contracts being held
his position by buying
from new seller.
Open interest is also used in conjunction with other
technical analysis chart patterns and indicators to
gauge market signals. The following chart may help
with these signals.

Price
Open Market
interest
Strong

Warning
signal
Weak

Warning
signal

The warning sign indicates that the Open interest is


not supporting the price direction.
Glossary
Backwardation: A market where future prices of
distant contract months are lower than the near
months.
Basis: The difference between the Index and the
respective contract is the basis i.e. cash netted for
the Futures price. A negative basis means Futures
are at a premium to cash and vice versa. It is the
strengthening and weakening of basis that is tracked
by market players i.e. whether the basis is widening
or narrowing. A widening of basis is indicative of
increasing longs and narrowing means increasing
short positions.
Basis Point: It is equal to one hundredth of a
percentage point
Contango market: This is a market where futures
prices are higher for distant contracts than for nearby
delivery months.
Cost of carry: is an indicator of the demand-supply
forces in the Futures market. It basically means the
annualized interest cost players decide to pay
(receive) for buying (selling) a respective contract. A
higher carry cost is indicative of buying pressure and
vice versa. Carry Cost is a widely used parameter not
only because it is more interpretable being an
annualized figure, as compared to basis (Cash netted
for Futures) but also because it works well with the
trio of Price, Volume and Open Interest in highlighting
the market trend.
Delivery month: Is the month in which delivery of
futures contracts need to be made.
Delivery price: The price fixed by the clearinghouse
at which deliveries on futures contracts are invoiced.
Also known as the expiry price or the settlement price.
Derivative: A financial instrument designed to
replicate an underlying security for the purpose of
transferring risk.
Fair value: Theoretical value of a futures contract
derived from a mathematical model of valuation.
Hedge Ratio: The Hedge Ratio is defined as the
number of Futures contracts required to buy or sell so
as to provide the maximum offset of risk. This
depends on the
• Value of a Futures contract;
• Value of the portfolio to be Hedged; and
• Sensitivity of the movement of the portfolio price
to that of the Index (Called Beta).
The Hedge Ratio is closely linked to the correlation
between the asset (portfolio of shares) to be hedged
and underlying (index) from which Future is derived.
Initial margin: The money a customer needs to pay
as deposit to establish a position in the futures
market. The basic aim of Initial margin is to cover the
largest potential loss in one day.
Mark-to-market: The daily revaluation of open
positions to reflect profits and losses based on closing
market prices at the end of the trading day.
Forward contract: In a forward contract, two parties
agree to do a trade at some future date, at a stated
price and quantity. No money changes hands at the
time the deal is signed.
Futures contract: A futures contract is similar to a
forward contract in terms of its working. The
difference is that contracts are standardized and
trading is centralized. Futures markets are highly
liquid and there is no counterparty risk due to the
presence of a clearinghouse, which becomes the
counterparty to both sides of each transaction and
guarantees the trade.
Far contract: The future that is furthest from its
delivery month i. e. has the longest maturity.
Speculation: Trading on anticipated price changes,
where the trader does not hold another position which
will offset any such price movements.
Spread ratio: The number of futures contracts
bought, divided by the number of futures contracts
sold.
VaR: Value at Risk. A risk management methodology,
which attempts to measure the maximum loss
possible on a particular position, with a specified level
of certainty or confidence.
Strike Price: The price at which an option holder may
buy or sell the underlying asset, which is specified in
an option contract
Glossary

Backwardation: A market where future prices of distant contract months are lower than the
near months.

Basis: The difference between the Index and the respective contract is the basis i.e. cash
netted for the Futures price. A negative basis means Futures are at a premium to cash and
vice versa. It is the strengthening and weakening of basis that is tracked by market players
i.e. whether the basis is widening or narrowing. A widening of basis is indicative of increasing
longs and narrowing means increasing short positions.

Basis Point: It is equal to one hundredth of a percentage point

Contango market: This is a market where futures prices are higher for distant contracts than
for nearby delivery months.

Cost of carry: is an indicator of the demand-supply forces in the Futures market. It basically
means the annualized interest cost players decide to pay (receive) for buying (selling) a
respective contract. A higher carry cost is indicative of buying pressure and vice versa. Carry
Cost is a widely used parameter not only because it is more interpretable being an annualized
well
figure, as compared to basis (Cash netted for Futures) but also because it works

with the trio of Price, Volume and Open Interest in


highlighting the market trend.
Delivery month: Is the month in which delivery of
futures contracts need to be made.
Delivery price: The price fixed by the
clearinghouse at which deliveries on futures
contracts are invoiced. Also known as the expiry
price or the settlement price.
Derivative: A financial instrument designed to
replicate an underlying security for the purpose of
transferring risk.
Fair value: Theoretical value of a futures contract
derived from a mathematical model of valuation.
Hedge Ratio: The Hedge Ratio is defined as the
number of Futures contracts required to buy or sell
so as to provide the maximum offset of risk. This
Hedging
Stock index futures contracts offer investors, portfolio
managers, mutual funds etc several ways to control
risk. The total risk is measured by the variance or
standard deviation of its return distribution. A common
measure of a stock market risk is the stock’s Beta.
The Beta of stocks are available on the
www.nseindia.com.
While hedging the cash position one needs to
determine the number of futures contracts to be
entered to reduce the risk to the minimum.
Have you ever felt that a stock was intrinsically
undervalued? That the profits and the quality of the
company made it worth a lot more as compared with
what the market thinks?
Have you ever been a ‘stockpicker’ and carefully
purchased a stock based on a sense that it was worth
more than the market price?
A person who feels like this takes a long position on
the cash market. When doing this, he faces two kinds
of risks:
1. His understanding can be wrong, and the company
is really not worth more than the market price or
2. The entire market moves against him and
generates losses even though the underlying idea
was correct.
Everyone has to remember that every buy position on
a stock is simultaneously a buy position on Nifty. A
long position is not a focused play on the valuation of
a stock. It carries a long Nifty position along with it, as
incidental baggage i.e. a part long position of Nifty.
Let us see how one can hedge positions using index
futures:
‘X’ holds HLL worth Rs 9 lakh at Rs 290 per share on
July 01, 2001. Assuming that the beta of HLL is 1.13.
How much Nifty futures does ‘X’ have to sell if the
index futures is ruling at 1527?
To hedge he needs to sell 9 lakh * 1.13 = Rs 1017000
lakh on the index futures i.e. 666 Nifty futures.
On July 19, 2001, the Nifty futures is at 1437 and HLL
is at 275. ‘X’ closes both positions earning Rs 13,389,
i.e. his position on HLL drops by Rs 46,551 and his
short position on Nifty gains Rs 59,940 (666*90).
Therefore, the net gain is 59940-46551 = Rs 13,389.
Let us take another example when one has a portfolio
of stocks:
Suppose you have a portfolio of Rs 10 crore. The
beta of the portfolio is 1.19. The portfolio is to be
hedged by using Nifty futures contracts. To find out
the number of contracts in futures market to neutralise
risk
If the index is at 1200 * 200 (market lot) = Rs 2,40,000
The number of contracts to be sold is:
a. 1.19*10 crore = 496 contracts
2,40,000
If you sell more than 496 contracts you are
overhedged and sell less than 496 contracts you are
underhedged.
Thus, we have seen how one can hedge their
portfolio against market risk.
A portfolio manager owns three stocks

Stock Beta No. of shares Stock price(Rs)

A 1.1 100000 400

B 1.2 200000 300

C 1.3 300000 100

The spot Nifty index is 4400 and the futures price is 4450

The stock index futures can be used to

a. decrease portfolio beta to 0.8


b. increase portfolio beta to 1.5

Current Beta of stock portfolio

Stock Value of invest. Fraction of portfolio Wi * Bi


A 4 Crores 4/13 0.3077 * 1.1

B 6 Crores 6/13 0.4615 * 1.2

C 3 Crores 3/13 0.2308 * 1.3

13 Crores Wi = 1.00 1.19


To decrease portfolio beta from 1.19 to 0.8, the portfolio
manager can sell off a portion of equity portfolio and use
the proceeds to buy riskless securities.
Bp = A1B1 + A2B2
0.8 = A1 * 1.19 + ( 1-A1) * 0

A1 = 0.672269

Equity portion in portfolio = 0.672269 * 13 Crores

= 8.7395 crores

Value of portfolio to be hedged = 13 crores - 8.7395 crores

= 4.2605 crores

Hedge Ratio ( HR ) = 1.19 * 4.2605 crores

4400

= 11523 nifty contracts


= 11523 / 50
= 230 lots of 50 each.
b) Increase the portfolio beta to 1.5

1.5 = A1(1.19) + (1-A1)0


A1 = 1.2605
(1 – 1.2605) * 13 Crores = 3.3865 Cr needs to be
borrowed and invested.

Alternatively, the portfolio manager can buy an


equivalent amount of stock index futures
i.e 3.3865 * 1.19 = 4.03 crores

Hedge Ratio = 3.3865 cr * 1.19


4400
= 9159 contracts
= 9159/50
= 183 lots of 50 contracts each.

Alternatively the following formula can be used

No. of futures
contracts reqd =Total portfolio value * ( Desired Beta – existing Beta)
Value of underlying Spot Index
a) beta = 0.8

No. of futures
contracts reqd = 13 Cr * ( 0.8 – 1.19)
4400 * 50
= - 230 lots of 50 each ( Short sell )

b) beta = 1.5

No. of futures
contracts reqd = 13 Cr * ( 1.5 - 1.19)
4400 * 50
= 183 lots of 50 contracts each.( Long )

2) An equity fund manager owns a portfolio of Rs.10


crore in stocks with a portfolio beta of 1.15. He is
concerned that stock prices will fall in the next few
days. But he does not wish to bear the brokerage
costs and the price pressure of selling stocks and
then buying them again after the anticipated decline.
Assuming an underlying spot price of Nifty futures at
4200 and futures at 4500, he decides to use futures to
hedge against the expected market decline.

What is the risk minimising hedge for the stock


position if the fund manager desires a portfolio beta of
a) 0.7 b) 0.5