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Risk is a characteristic feature of all commodity and capital markets. Over time, variations in the prices of agricultural and non-agricultural commodities occur as a result of interaction of demand and supply forces. The last two decades have witnessed a many-fold increase in the volume of international trade and business due to the ever growing wave of globalization and liberalization sweeping across the world. As a result, financial markets have experienced rapid variations in interest and exchange rates, stock market prices thus exposing the corporate world to a state of growing financial risk. Increased financial risk causes losses to an otherwise profitable organization. This underlines the importance of risk management to hedge against uncertainty. Derivatives provide an effective solution to the problem of risk caused by uncertainty and volatility in underlying asset. Derivatives are risk management tools that help an organization to effectively transfer risk. Derivatives are instruments which have no independent value. Their value depends upon the underlying asset. The underlying asset may be financial or non-financial. The term ³derivative´ can be defined as a financial contract whose value is derived from the value of an underlying asset. Section 2(ac) of Securities Contract (Regulation) Act, (SCRA), 1956 defines derivatives as, a) ³a security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or a contract for difference or any other form of securities; b) ³a contract which derives its value from the prices, or index of prices, of underlying securities´. The underlying asset may be a stock, bond, a foreign currency, commodity or even another derivative security. Derivative securities can be used by individuals, corporations, and financial institutions to hedge an exposure to risk. DERIVATIVE PRODUCTS Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. Various derivatives contracts are described below, FORWARDS A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today¶s pre-agreed price. A forward contract is an agreement between two parties to buy or sell an asset at a specific point of time in future and the price which is paid /received by the parties is decided at the time of entering the contract.
DERIVATIVE RISK MANAGEMENT
FUTURE A future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Future contracts are standardized forward contracts. Future contracts are traded in exchanges and exchange sets the standardized terms in term of quantity, quality, price quotation, date and delivery date (in case ofcommodities). OPTIONS An option contract, as the name suggests, is in some sense an optional contract. An option is the right, but not the obligation, to buy or sell something at a stated date at a stated price. Options are of two types; CALL OPTIONS: A call option gives the buyer of the option the right, but not the obligation to buy a given quantity of the underlying asset, at a given price and on or before a given date. PUT OPTION: Put options give the buyer the right, but the obligation to sell a given quantity of underlying asset at a given price on before a given date. Options can also be European options and American options. This classification is based on the exercise of the options. European options can be exercised at the maturity date of the option. On the other hand, American options can be exercised at any time up to and including the maturity date. WARRANTS Options generally have lives of up-to one year. Long dated options are called as warrants and generally traded over-the-counter. LEAPS Long-Term-Equity-Anticipated Securities are options having a maturity of more than three years or in other words options having a maturity of more than three years are termed as LEAPS. BASKETS Basket options are options on portfolio of underlying assets. Equity index options are a form of basket options SWAPS A swap means a barter or exchange. Thus, a swap is an agreement between two parties to exchange stream of cash flows over a period of time in future. The two commonly used swaps are,
Basing on the type of market. A figure below shows the classification of derivatives. PARTICIPANTS IN DERIVATIVE MARKET The reason for which derivatives are so attractive is that they have attracted different types of investors and have a great deal of liquidity. speculators and arbitrageurs.. It is a telephone. CLASSIFICATION OF DERIVATIVES Broadly derivatives can be classified into two categories. In the exchange traded derivatives. exchange traded derivatives market and over-the-counter derivative market.and computerlinked network of dealers. 2. the derivatives which are standardized in nature are traded. 1. Hedgers: They use derivatives markets to reduce or eliminate the risk associated with price of an asset. hedgers. with cash flows in one direction being in different currency than those in the opposite direction. Speculators: They transact futures and options contracts to get extra leverage in betting on future movements in the price of an asset. silver etc. . gold. derivative market is of two types. ii) CURRENCY SWAPS: These entail swapping both principal and interest between two parities. currencies. The trading of the derivatives is well regulated by the exchanges. When an investor wants to take one side of a contract. commodity derivatives and financial derivatives. Arbitrageurs: Their behavior is guided by the desire to take advantage of a discrepancy between prices of more or less the same assets or competing assets in different markets. whereas in case of financial derivatives the underlying assets are stocks. for example. namely. In case of commodity derivatives. Three broad kinds of participants can be found in derivatives market. If. they see the futures price of an asset getting out of line with the cash price. Majority of the participants in derivatives market belongs to this category. there is usually no problem in finding someone that is prepared to take the other side. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture. the underlying asset can be commodities like wheat. bonds and other interest bearing securities etc. they will take offsetting positions in the two markets to lock in a profit. 3.DERIVATIVE RISK MANAGEMENT i) INTEREST RATE SWAPS: Swaps which entail swapping only the interest related cash flows between the parties in the same currency. The over-the-counter market is an important derivative market and has larger volume of trade than the exchange-traded market.
the tapes are replayed to resolve the issue. In a nut shell. The over-the-counter market is not regulated by any regulatory body and hence possesses a huge counterparty risk. This is because. the underlying cash markets witness higher trading volumes. . derivatives help in discovering the future as well as current prices. Thus. 5) Derivatives trading acts as a catalyst for new entrepreneurial activities. 2) The prices of derivatives converge with the prices of underlying at the expiration of derivative contract. A key advantage of over-the-counter market is that all the products are customized. Transfer of risk enables market participants to expand their volume of activity. derivatives markets encourage investment in long run. 1) the most important function of derivatives is risk management. Telephone conversations in the OTC market are usually taped. more people participate in stock market due to the risk transferring nature of derivatives. If there is a dispute about what was agreed.DERIVATIVE RISK MANAGEMENT Traders are done over the phone and are usually between two financial institutions or between a financial institution and one of its clients. Margining. 3) As derivatives are closely linked with the underlying cash market. 4) Speculative trade shift to a more controlled environment of derivative market. ECONOMIC SIGNIFICANCE OF DERIVATIVES Some of the significance of financial derivatives can be enumerated as follows. with the introduction of derivatives. Financial derivatives provide a powerful tool for limiting risks that individuals and organizations face in ordinary conduct of their business. In the absence of an organized derivatives market. monitoring and surveillance of various participants become extremely difficult in these kinds of mixed markets. Market participants are free to negotiate any mutually alternative deal. speculators trade in the cash markets. A disadvantage is that there is usually credit risk in an over-the counter trade.
derivatives were before the time of Christ. its facilities were underutilized in spring. Chicago¶s spot prices rose and fall drastically. The forward contracts proved as a useful device for hedging the price risk. Thales the Milesian purchased option on Olive presses and made a fortunate off of a bumper crop in Olives. Probably the next major event. although their trading was banned by Government of different countries from time to time. however Chicago¶s storage facilities were unable to accommodate the enormous increase in supply that occurred following the harvest. This state of affairs heralded the emergence of financial derivatives. CBOT went one step further and listed the first ³exchange traded´ derivatives in US. which permitted forward contracting on tulip bulbs at around 1637. volatility in the market place and currency turmoil. which made them much like today¶s futures. Its name was changed to Chicago Mercantile Exchange (CME). Similarly. sale. The first exchange for trading derivatives appeared to be Royal Exchange in London. This is due to the unprecedented volatility in the international financial environment. To deal with this problem. starting with the breakdown of Bretton woods systems on 15 August 1971 and ending with the well-known Saturday night massacre of Federal Reserve on 6th October 1979. The origin of derivatives can be traced in Bible. Due to seasonality of grain. the first clearing house for derivatives trading was established. To resolve this problem a group of grain traders created ³to-arrive´ contracts which permitted the farmers to lock in the price and deliver the grains in future. These to-arrive contracts are called as forward contracts. in 1848. In 1919. and distribution of Midwestern grain. . a group of Chicago businessmen formed the Chicago Board of Trade (CBOT). Chicago was developing as a major center for the storage. a spin-off of CBOT. Japan around 1650. The breakdown of Bretton woods system resulted in inflation. So. Since then. In 1925. The primary intention of CBOT was to provide a centralize location for buyers and sellers to negotiate forward contracts. Due to its prime location. and/or had credit guarantee. got approval for futures trading. was the creation of Chicago Board of Trade in 1848. But. derivatives are traded in many exchanges. In 1865. although it is not known whether the contracts are marked to market daily. The first ³futures´ contracts are generally traced to the Yodaya rice market in Osaka. However.DERIVATIVE RISK MANAGEMENT HISTORY OF DERIVATIVES The history of derivatives is quite colorful and surprisingly a lot longer than most people think. and the most significant as far as the history of derivatives markets. ³credit risk´ remained as serious problem. Chicago Butter and Egg Board. These were evidently standardized contracts. the modern derivative market has originated in 1970¶s. which are termed as ³Futures Contracts´.
The history of financial derivatives is concurrent with the history of various risks in the financial world. INTERNATIONAL DERIVATIVE MARKET The financial derivatives which were meant to address the needs of farmers and merchants have now a major share in the financial market place. . Sydney Futures Exchange etc. Eurex. TheLondon International Financial Futures and Options Exchange (LIFFE). Hong Kong Futures Exchange. Boosted with the breakdown of Bretton woods system. the derivatives got the recognition of risk management instruments and are used by all investors starting from individual investor to institutional investor. derivatives are now traded in almost all major stock exchanges of the world. when the US Federal Reserve started its policy of interest rate deregulation and anti-inflationary monetary policy. Singapore Exchange. In last two decades derivatives has shown a tremendous growth and also continuing to grow in future. the global derivative market is now a wide spread market with a potentialof further growth.DERIVATIVE RISK MANAGEMENT The next major fillip for development of derivatives was provided in October 1979. Apart from these stock exchanges other stock exchanges of various countries has shown a huge growth in derivatives trading. The fascination with risk and its components started during the early 1970¶s has grown substantially since then. Started with the establishment of Chicago Board of Trade (CBOT). This marked the emergence of interest rate derivatives to hedge interest rate risk. This resulted in increased interest rates. Major stock exchanges of derivatives trading are Chicago Mercantile Exchange (CME). resulting in the expansion of financial derivatives market. Thus.
In due course.038 Crore. whereas the value of the NSE cash markets was only Rs. 2000. Around the same period. national electronic commodity exchanges were also set up. Single stock futures were launched on November 9. 3. It provided for withdrawal of prohibition on options in securities. In 1952. Trading in derivatives gained popularity soon after its introduction. If I compare the . financial derivatives market in India has shown a remarkable growth both in terms of volumes and numbers of traded contracts. 2001 and trading in options on individual securities commenced on July 2. Subsequently. The trading in BSE SENSEX options commenced on June 4. beginning the year 2000. 90. 2001. Derivatives trading shifted to informal forwards markets. Introduced in 2000. in 2008. so the further discussion will be confined to equity derivatives only. Securities and Exchange Board of India (SEBI) permitted the derivative segments of two stock exchanges. Futures contracts on individual stocks were launched in November 2001. SEBI approved trading in index futures contracts based on various stock market indices such as. S&P CNX. government policy has shifted in favor of an increased role of market-based pricing and less suspicious derivatives trading. The index futures and options contract on NSE are based on S&P CNX. index-based trading was permitted in options as well as individual securities. The first step towards introduction of financial derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance. Nifty and SENSEX. the value of the NSE derivatives markets was Rs. NSE introduced Interest Rate Futures which were subsequently banned due to pricing issue.DERIVATIVE RISK MANAGEMENT INDIAN DERIVATIVE MARKET Derivatives markets in India have been in existence in one form or the other for a long time. In June 2003. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12. In recent years.75 Cr. In the area of commodities. The trading in index options commenced on June 4. 130. NSE and BSE. NSE alone accounts for 99 percent of the derivatives trading in Indian markets. saw lifting of ban on futures trading in many commodities. the Bombay Cotton Trade Association started futures trading way back in 1875. Equity derivatives market in India has registered an "explosive growth" and is expected to continue the same in the years to come. the Government of India banned cash settlement and options trading.477. The introduction of derivatives has been well received by stock market players. For example. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001 on the recommendation of L. 2001. Since the scope of this project is limited to equity derivatives only. 2001 and the trading in options on individual securities commenced in July 2001. 1995. The last decade. C Gupta committee.551. the turnover of the NSE derivatives market exceeded the turnover of the NSE cash market. and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. Initially.
performance of BSE is not encouraging both in terms of volumes and numbers of contracts traded in all product categories. volume etc.e. Business Growth of Derivatives in India from 2010. All products in equity derivativesegment i. Its equity derivatives market is most boostedone and in turnover it is a major stock exchange.DERIVATIVE RISK MANAGEMENT trading figures of NSE andBSE.2011(May) NSE¶S DERIVATIVE SEGMENT The National Stock Exchange accounts almost 99% of the Indian derivatives market in terms of turnover. Index Futures and Options .
DERIVATIVE RISK MANAGEMENT and Stock Futures and Options have marked a tremendous growth over the last decade. The graph below shows the average yearly turnover in each equity derivative products and average daily turnover of derivative Segment of NSE. .
DERIVATIVE RISK MANAGEMENT Average daily turnover of the Indian derivative market .
the Global Financial Meltdown. . portfolio optimization. trader performance-based compensation. such measurements reflect. so far-flung. isolating. the financial market is full of risk and uncertainties. but they pose their own risks. the challenge ³is to first not take more risk than we need to generate the returns that is offered´. and so quantitative. Risk is situation where there are a number of specific. Charles Tschampion.risk is the exposure to uncertainty. risk entails two essential components. In 1994¶s spectacular bond market collapse. The 1987 crash taught markets the dangers of automated trading models and the second and third-order effects of credit crisis. Practical applications ± including risk limits. it is engineering. Many banks become bankrupt. the markets have seen debacle after another. Uncertainty is just opposite of that. and transferring risks. So to define risk. exactly. high yield. financial executives saw for the first time how correlated global markets had become as the fallout from Federal Reserve Board rate hikes swept from the US through Europe. it is unclear what. It is a variable. measured and compared. The Great Depression of 1930¶s has brought remainder to all financial markets or the economies as a whole. The Russian meltdown in August 1998 was widespread and mounting. Most recently. repackaging. but it is not certain as to which one of them will actually happen. Thus. many loss their job. The terms risk and uncertainty are often used interchangeably though there is a clear distinction between them. once said ± ³Investment management is not an art. not science. Banks and brokerage firms took turns announcing trading losses from emerging markets. and capital calculations ± all depend on the measurement of risk. it can be said that. The failure of accounting and regulation to keep abreast of developments includes yet more risks. Thus. having no doubts of whatever being expected. increased budgetary deficits are the result of this crisis. Certainty is a state of being completely confident. which can be calibrated. the MD of the $50 bn GM Pension fund. In that context risk is not an abstract concept. exposure and uncertainty. equities. with occasionally spectacular consequences. has captured almost all economies of the world. Tools such as derivatives and securitization contribute to this process. financial markets are becoming more sophisticated in pricing. In the absence of a definition of risk. It is a profound statement that well captures the philosophical and mathematical connotation of µRisk¶.DERIVATIVE RISK MANAGEMENT RISK AND RISK MANAGEMENT RISK Over the past two decades and so. Information flow has never been so fast. or dealings with hedge funds. But with the passage of time. before devastating Mexico and other emerging markets. Finance has never been so competitive. In 1990. which was started with the US sub-prime mortgage crisis. probable outcomes. We are in the business of managing and engineering financial investment risk´. Wall Street learned the horrors of holding huge illiquid investments. each of which has brought its lessons ± from some of which the markets have learned and from many of which markets still need to learn.
For this reason the entire process is monitored and if anything goes wrong. The risk management process essentially comprises of certain steps. Risk management is the process in which risk is minimized with the application of certain tools. with the advancement of communication system and technology. identification. assessment. The assessment of risk results in identifying the factors which are more risk exposed and then these factors are prioritized from risk management point of view. These steps are described below. it then to be assessed. globalization and technical advancement has resulted with an increased competition in the market and the corporate are hence exposed to risk. it isrectified. Assessment of risk helps in knowing the extent of vulnerability of a particular factor which is risk exposed. PRIORITIZATION The next step of risk management process is the prioritization of factors which are more vulnerable. liberalization. Thus a proper and unbiased assessment of risk is a prerequisite for a sound management process. i.DERIVATIVE RISK MANAGEMENT RISK MANAGEMENT PROCESS Market integration. IDENTIFICATION The risk management process starts with the identification of the factors which are exposed to risk. the markets over the world are getting interconnected. to what extent it is susceptible to that particular risk that has to be measured. such as. Simply applying the resources to minimize the risk is not the last step of risk management. . followed by coordinated and economical application of resources to minimize. This is the most important stage of risk management as any wrong step can result a more susceptible situation. ASSESSMENT After identifying the risk exposure points. Thus making an effective risk management system is the need of the hour. It is always of primary concerns to identify the factors which are more vulnerable and weak points in the system. Moreover. MONITOR The final step of risk management is monitoring the risk management process. monitor and control it. the management team applies economic resources to minimizing the risk.e. APPLICATION OF RESOURCES TO MINIMIZE RISK After identifying the most vulnerable factor. prioritization. as it is needed to analyze the success of the risk management process.
and ³operational risk´. is the specter of ³systemic risk´ that has captured so much congressional and regulatory attention. This is common risk that is found in over-the-counter derivative market. they need the obligations to be performed. Thus. As noted above. The expected exposure measures how much capital is likely to be at risk should the . This is price risk associated with the derivatives. These terms do not represent independent risks. Terms such as ³credit risk´ and ³counterparty risk´ are essentially synonyms for default risk.e. The risk that arises from the default of any party in derivatives is called as default risk. Terms such as ³Settlement risk´ and ³Herstatt risk´ refer to defaults that occur at a specific point in the life of the contract: date of settlement. Default risk is the risk that losses will be incurred due to default by the counterparty. ³Legal risk´ refers to the enforceability of the contract. All these risks associated with derivatives market are described below. If any party default from the contract. then the contract is meaningless. Default due to Price risk is mitigated by imposing some risk management tools in exchange-traded derivatives. they just describe different occasions or causes of default. he or she may default in the obligation of the derivative contract.DERIVATIVE RISK MANAGEMENT RISK ASSOCIATED WITH DERIVATIVES TRADING The continuing discussion of risks and its management in derivative markets illustrates that there is little agreement on what the risks are and how to control it. their prices also increase. As derivatives are contracts or agreements. but certainly not the least. but in case of over-the-counter market. PRICE RISK Price arises for the simple reason that the price of the underlying and price of the derivatives are correlated. Last. Default risk has two components: the expected exposure and the probability that default will occur. DEFAULT RISK This may the most popular and hazardous risk associated with the derivatives. there are potential losses. there is ³default risk´. but in exchange traded market. the impact is seen in corresponding prices of derivatives products i. part of the confusion in the current debate about derivatives stems from the profusion of names associated with the default risk. If the price of the underlying increases. this type of risk is minimized by regulating the transactions. For an investor who is short in a futures contract or long in a put option or short in a call option. default is more due to price risk. ³settlement risk´. since it is largely unregulated. Besides the ³price risk´ of losses on derivatives from change in underlying asset values. One source of confusion is the sheer profusion of names describing the risks arising from derivatives.
much of impact of stocks is being transferred from corporations and investors less able to bear them to counterparties better able to absorb them. there first must be large defaults in derivative markets. It is conceivable that financial markets could be hit by a large disturbance. a tempore disturbance would primarily affect contracts with required settlements during this period. systemic risk can be defined as widespread default in any set of financial contracts associated with default in derivatives. Therefore. the systemic risk associated with the derivative contracts is often envisioned as a potential domino effect in which default in one derivative contract spreads to other contracts and markets. is that the adverse effects of stocks on individual firms should be smaller precisely because the same shocks are spread more widely. If the disturbance were large but temporary many outstanding derivatives would be essentially unaffected because they specify only relative infrequent payment. on the duration of the disturbances and whether firms suffer common or independent shocks. significant derivative defaults are a necessary condition for systematic problems. SYSTEMATIC RISK One of the prominent concerns of regulators is ³systematic risk´ arising from derivatives. If derivative contracts are to cause widespread default in other markets. Moe important. What this argument fails to recognize. In other words. in particular. ultimately threatening the entire financial system. It is argued that widespread corporate risk management with derivatives increases the correlation of default among financial contracts. For the purpose of this paper. to the extent firms use derivatives to hedge their existing exposures.DERIVATIVE RISK MANAGEMENT counterparty defaults. If the shock were permanent. . The probability of default is the measure ofthe possibility that the counterparty will default. Although this risk is rarely defined and almost never quantified. it would affect the derivatives in a much hazardous way. The effect of such disturbances depends.
This is because. This will ensure the integrity in term that nobody will default. This will harm the market and other participants of the market. it is more risky and there is no risk management at all. MARGINS Margins are upfront payment by the participants of the derivatives market to the exchanges. then the probability that he will default is more. This upfront payment is collected to ensure that none will default in future in obliging his obligation. as it is not regulated. the regulatory body of the derivative market put an exposure limit for the participants beyond which one cannot take position in the market.e. . these people have huge investible cash and they can direct the market as their wish. created risk when there is a default. Exchange¶s clearinghouse collects the margin from the clearing member. POSISTION LIMITS Position limit is more applicable for the high net worth individuals. This gave rise to the essence of risk management of derivatives and derivatives trading. But in case of exchange traded derivatives. If someone defaults then the clearinghouse settles the contract from this margin account. several risk management tools are applied to ensure the integrity of the market. the gain or loss of a day is settled to the margin account on a daily basis. if the investor losses. the amount that he lost is withdrawn from his account. the margin is mark-to-market on daily basis i. For this reason. The tools used for risk management of derivatives are described below. In case of OTC derivatives. the FIIs and the mutual funds. the clearing member collects the margin from the trading member or the brokers and it is the responsibility of the trading members to collect the same from its clients. Thus a position limit is introduced for this type of risk by the regulators for the sound running of the market. MARK-TO-MARKET MARGIN In case of futures contracts. EXPOSURE LIMITS If an investor holds quite a large position than his capacity. If the long position gains. which come to light as a hedging instrument against volatility of market and market related risk.DERIVATIVE RISK MANAGEMENT RISK MANAGEMENT OF DERIVATIVES Derivatives. then the amount he gained will be transferred to his account in the end of the day. Similarly.
. On exercise the settlement is done on the closing price of the derivative product and final settlement takes place on T+1 basis. If the long position exercises his right. complying the rules and regulation laid down by the regulator and satisfying the margin requirement.DERIVATIVE RISK MANAGEMENT FINAL SETTLEMENT Final settlement is the last part of risk management in case of derivatives. margining requirement and the regulatory requirement. then the settlement is done by randomly assigning the obligation on a short position at the end of the day. The settlement is done by the clearing house of the exchange.e. Thus risk management of derivatives is nothing but. Frankly speaking risk management of derivatives comprises of two things i.
. the minimum short option charge. the futures price scan range. The inputs into SPAN are. The details of these are explained below.DERIVATIVE RISK MANAGEMENT INTERPRETATION AND ANALYSIS In the course of study of the risk management process used in BSE for derivative segment. The underlying average implied volatility estimate that is analyzed is a simple average of eight contracts implied volatility on a given maturity: the first is in-the-money and first three out-ofthe-money implied volatility estimates for both calls and puts. the inter-commodity spread charge. For margining the BSE is following portfolio based margining system and the margin calculation is done by software known as PC SPAN. For setting the margin the exchange has a margin committee. the calendar spread charge. THE FUTURE¶S PRICE SCAN RANGE: The price scan range inputs sets the maximum underlying price movement that the margin committee chooses to consider in setting margin collateral requirements. The margin committee sets input scan ranges after analyzing histograms of absolute value of day-to-day changes in the implied volatility of traded futures-option contracts. one is the margining system and the regulatory requirement. The SPAN (Standard Portfolio Analysis of Risk System) is a portfolio based margining system developed by Chicago Mercantile Exchange and it is being used by almost all stock exchanges now. The future scan range is set by the margin committee after examining historical price movements and applying subjective judgments. THE IMPLIED VOLATILITY SCAN RANGE: The implied volatility scan range is the largest movement in implied volatility that margin committee chooses. These are described below. which decides about various factors to be considered while calculating the margin requirements. The risk management of derivatives in BSE has two parts. The portfolio based margining model adopted by the exchange takes an integrated view of the risk involved in the portfolio of each and every individual client comprising of his positions in all derivatives contract traded on derivative segment. the following things are observed. THE SPAN MARGINING SYSTEM The SPAN margins are estimates of changes in futures and futures-options contract prices that would occur under various next-day realizations of futures prices and implied volatility. The future¶s price scan range is the clearinghouse margin requirement on a naked future position and controlling input into the option pricing model simulation that ultimately determines the margin requirements. theimplied volatility scan range.
. the clearinghouse collects against calendar spread basis risk in portfolios. In SPAN. THE INTER-COMMODITY SPREAD CHARGE: The inter-commodity spread charge is an input that sets the collateral requirement that must be posted to protect against correlation risk in inter-commodity spread positions.DERIVATIVE RISK MANAGEMENT THE MINIMUM SHORT OPTION CHARGE: The minimum short option charge or minimum margin on an option contract is set at 2. the contract¶s value is reported as an element called ³SPAN risk array´. This average implied volatility is then ³shocked´ by the implied volatility scan range in the SPAN simulations. and the histograms are considered by the margin committee while calculating margin. the value of each option contract is estimated for following day using Black Option Pricing Model. The SPAN risk array is given below. The basis between nearest quarterly and next quarterly futures contract is calculated. In the simulation analysis. The next-day contract prices are determined under alternative scenarios in which underlying futures contract¶s price and implied volatility move by predetermined function of their scan range.5% of the clearing member¶s futures price scan range. The calendar spread basis is the difference between prices of contracts with different maturities. the CME¶s margin committee has decided to margin 35% of the simulated price move gain or loss is the value reported in these extreme price move SPAN array entries. For each scenario simulated. Histograms of the absolute value changes in basis series are constructed for different windows periods. The next day simulated contract prices are compared with the prior day¶s theoretical settlement price and contract gains and losses are calculated as the difference in these prices. In extreme price move scenarios. The futures price and implied volatility scan inputs are translated into 16 different scenarios that represent alternative combinations of futures price and implied volatility changes. futures and futures options changes are estimate under alternative scenario that are determined by the values chosen for the price and implied volatility scan range inputs. THE CALENDAR SPREAD CHARGE: The calendar spread charge is put into the SPAN is a parameter that sets the amount of margin collateral.
double the price scanning range WORKING OF SPAN MARGIN SYSTEM . Underlying down by 1of price scan range. volatility up 4. volatility up 12. volatility down 3. volatility up 6. volatility down 9. Underlying up extreme move.DERIVATIVE RISK MANAGEMENT 1. Underlying up by 2/3 of price scan range. Underlying down. volatility down 11. volatility up 8. Underlying down by 1 of the price scan range. Underlying down by 1/3 of price scan range. Underlying up by 2/3 of price scan range. volatility down 5. Underlying down extreme move. Underlying up by 1/3 of price scan range. Underlying down by 2/3 of price scan range. Underlying up by 1 of the price scan range. Underlying unchanged. volatility down 15. Underlying down by 2/3 of price scan range. double the price scanning range 16. Underlying up by 1/3 of price scan range. volatility up 10. volatility up 2. Underlying down by 1/3 of price scan range. volatility down 13. volatility up 14. volatility down 7. Underlying up by 1 of price scan range.
This is measured in terms of impact cost for an order size of Rs. o For this purpose. The spread charge is specified as 0.5% per month for the difference between the two legs of the spread subjected to minimum of 1% and maximum of 3%. Each written option contract is subjected to minimum margin requirement. The final margin requirements may differ from this preliminary margin owing to additional margin requirements that resulted from margin requirement on calendar spreads and minimum margin requirement for written options contracts. If the impact cost exceeds by 1%. o For stock futures and short stock options contracts a minimum initial margin equal to 7. For a portfolio. the price scan range is increased by square root of three. The maximum loss across the 16 scenarios becomes the ³Preliminary´ SPAN margin for that account. the price scan range of index products and stock products is taken as 3 and 3.5 respectively. 5 laky calculated on the basis of order book snapshots in the previous six months. Clearing members firms receive these arrays and use them to calculate their margin requirements for their customers account.The initial margin requirement is net at client level and shall be on gross at the trading and clearing member level. this margin requirement is the product of the number of written options times the minimum short option charge. Inter-commodity spread charges also enter into the final margin calculation. o The margin on calendar spread is calculated on the basis of delta of the portfolio consisting of futures and options contracts in each month. For index futures a minimum margin equal t 5% of the notional value of the contract is collected. The margin required for different equity derivatives are explained below.5% of the notional value of the contract based on the last available price of futures and option contract respectively is collected. MARGINS The BSE collects margin collateral in advance to minimize its risk exposure.DERIVATIVE RISK MANAGEMENT The clearinghouse of the exchange electronically distributes a SPAN risk array for every derivative product that it clears and settles. o The initial margin requirements on all derivative products are based on worst case loss of portfolio at client level to cover 99% Vary over one day horizon. The price scan range of options and futures on individual securities is also linked to liquidity. MARK-TO-MARKET OF MARGIN . For index options a minimum of 3% is charged as the minimum margin.
whichever is lower. the notional value of gross short open position at any time would not exceed 20 times of the available liquid net-worth of the member. the combined futures and options position limit would be 20% ofapplicable market wide position limit or Rs. FII and mutual funds. the client¶s position is marked to. 150 crores. For index products.e. the combined futures and options position limits shall be 20% of market wide position limit or Rs. However BSE charges exposure margin for better risk management. 300 crores.DERIVATIVE RISK MANAGEMENT o For all stock futures and index futures contract. The mark-to-market margin is paid in/out in T+1 day in cash. the notional value of gross open positions at any time would not exceed 33 1/3 times of the available liquid net worth of the member. For determining the mark-to-market margin.e. POSITION LIMITS o A market wide limit on the open position on stock options and futures contracts of a particular underlying stock is 20% of the number of shares held by non-promoters i. Thisis applicable for trading members. EXPOSURE LIMITS The exposure limit for different equity derivatives products are given below.5 of notional value of gross short open position in single stock options whichever is higher. This is the position limit for trading members. o In case of stock futures contracts. 5% of the notional value of gross short open position in single stock options or 1.5 of the notional value of gross open position in single stock futures. o For stocks having applicable market wide position limit less than Rs. o In case of stock futures and options.e. in terms of number of shares of a company. 3% of the notional value of gross open position would be collected from the liquidnet worth of a member on a real time basis. whichever is lower and within which shock futures position cannot exceed 10% of applicable market wide position limit or Rs. FII and mutual funds. 20% of the free float. whichever is higher. the stock having applicable market wide position limit (MWPL) of Rs. the notional value of gross open positions at any point in time should not exceed 20 times the available liquid net-worth of a member. 500 crores. o For stock options contracts. the closing price is taken into consideration. i. 50 crore whichever is lower. i. . 500 crores or more. 10% of the notional value of gross open position in single stock futures or 1.market on a daily basis at portfolio level. o In case of index products.
FINAL SETTLEMENT o On expiry of a stock futures or index futures contract.DERIVATIVE RISK MANAGEMENT o For futures and options contracts. FII and mutual funds position limits shall be higher of. o Any person who holds 15% or more of the open interest in all derivatives contracts on the index shall be required to disclose the fact to the exchange and failure of which will attract a penalty. the settlement takes place on T+1 basis and in cash. if the options are not exercised or closed out. the trading members. . The profit or loss is paid in or out in T+1 day. all in-the money options are settled by the exchange at the settlement price. 500 crores or 15% of total open interest in the market in equity index futures contracts or equity index options contract respectively. but the exchange can specify the limit as per its convenience. 1% of the free float market capitalization or 5% of the open interest in underlying stock. o On exercise or assignment of options. sub-accounts. The final settlement price is the closing price of the underlying stock or the index respectively. o The gross open position of clients. On expiry. At present there would not be any exercise limit for trading in options. NRI level and for each scheme of mutual funds across all derivatives contracts on a particular underlying shall not exceed higher of. On exercise of options. the assignment takes place on a random basis at client level. The settlement price is the closing price of the stock or index in the cash segment. Rs. the contract is settled in cash at the final settlement price.
cboe.DERIVATIVE RISK MANAGEMENT bibiliography www.bis.net/ http://www.com http://www.com/SPAN/ http://www.wikipedia.pdf http://www.org/wiki/Risk_Management .gov/ http://www.com/ http://www.com/learncenter/glossary.aspx http://www.com/ http://www.com www.investorworld.com www.com/finance http://www.myiris.en.bseindia.bseindia.htm?articleid=1527485&show=pdf http://www.emeraldinsight.org/publ/cpss06.com/riskmanagement/about.sgx.sebi.premiumdata.asp http://www.cme.com/journals.yahoo.asx.
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