Ram 2

M P Birla Institute of Management
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A PROJECT REPORT
ON
RISK CONTAINMENT MEASURE IN INDIAN
STOCK INDEX FUTURES MARKET
SUBMITTED IN PARTIAL FULFILLMENT OF THE

REQUIREMENTS OF MBA PROGRAM OF BANGALORE
UNIVERSITY
BY
P.K.DEEPAK GUPTA
03XQCM6026
MP BIRLA INSTITUTE OF MANAGEMENT
ASSOC
IATE BHARATIYA VIDYA BHAVAN
# 43 RACE COURSE ROAD

BANGALORE
2003
-
2005
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DECLERATION
I here by declare that, this Project Report entitled “

Risk Containment Measure
In Indian Stock Index Futures Market
” has been undertaken and completed by me
under the valuable
guidance of
Prof. Santhanam
in partial fulfillment of degree of
Master of Business Administration (MBA) program.
Place: Bangalore
Date:
P.K. DEEPAK GUPTA
Reg No. 03XQCM6026

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PRINCIPAL’S CERTIFICATE
This is to certify that Mr. Deepak Gupta P.K has undertaken Project Work on “
Risk
Containment Measure In Indian Stock Index Futures Mark
et
” under the able
guidance of
Prof. Santhanam,
Place: Bangalore
Date:
Dr. Nagesh Mallavalli
(Principal)
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GUIDE’S CERTIFICATE
This is to certify that the Project Work report titled “

Risk Containment Measure In
Indian Stock Index Futures Market
” has prepared by
Mr. Deepak Gupta P.K
bearing
registration number
03XQCM6026
, under my guidance.
Place: Bangalore
Date:
Prof. Santhanam
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ACKNOWLEDGEMENT
I would li
ke to express my sincere gratitude to my project guide
Prof.
Santhanam,
who guided me through the entire project.
Also I would like to thank Bangalore Stock Exchange, my friends and also my
college who have helped me in completing this project and also f
or having given me this
opportunity.
DEEPAK GUPTA P.K
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EXECUTIVE SUMMARY
The project starts off with the History of Derivatives in India, which
includes Ev
ents that made the launch of Derivatives in India
.
Then the project goes on to the Performance of Commondity

Exchanges in India. The initial move is the analysis of Risk Containment
and related issues taking into considerations LC Gupta and Varma
Commi
ttee reports.
The project also states some risk management strategies implemented

to manage risk in futures market.
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DERIVATIVES IN INDIA
In the Indian context, the securities contracts (regulation) Act 1956, (SCRA) deri
vative
includes
A security derived from a debt instrument, share and loan whether secured or
unsecured. Risk instrument or contract for differences or any other form of
security.
A contract which derives its value from the price or index of prices, of un
derlying
securities.
The Bombay Stock Exchange and National Stock Exchange launched trading in Index
Futures in June 2000. This marked the beginning of exchange traded financial
derivatives in India.
We had a strong Dollar

–
Rupee Forward markets with c
ontracts being traded for 1 to 6
months. The daily trading volume here was approximately US $ 500 million.
Motivation to use derivatives
The real motivation to use derivatives is that they are useful in reallocating risk either
across time or across ind
ividuals with different risk bearing preferences.
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Types of Derivatives
Derivatives are basically classified into two based upon the mechanism th
at is
used to trade on them. They are Over the Counter derivatives and Exchange traded
derivatives. The OTC derivatives are between two private parties and are designed to suit
the requirements of the parties concerned. The Exchange traded ones are standar
dized
ones where the exchange sets the standards for trading by providing the contract
specifications and the clearing corporation provides the trade guarantee and the
settlement activities
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EVENTS THAT MADE THE LAUNCH OF DERIVATIVES IN INDIA
November 1996, SEBI set up a committee under the chairmanship of Dr. L C

Gupta, the well known economist and former SEBI Board Member.
The Committee submitted its report on the March 17 1998. It advocated the
introduction of derivatives in Indian market in a phased manner, starting with the
‘ Index Futures’.
SEBI accepted the report on May 11, 1998 and June 16, 1998, it issued a
circula
tion allowing exchanges to submit their proposals for introduction of
derivative trading.
Government issued notification delineating the areas of responsibility between

RBI and Market Regulator SEBI.
On June 2000, derivative trading started in NSE and BSE.

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What is the role of commodity futures market and why do we need
them?
One answer that is heard in the financial sector is `we need commodity futures
markets so that we will have volumes, brokerage fees, and something to trade''. I think
that is
missing
the point. We have to look at futures market in a bigger perspective
--
what is the role for commodity futures in India's economy?
In India agriculture has traditionally been a area with heavy government

intervention. Government intervenes by trying to ma
intain buffer stocks, they try to fix
prices, they have import
-
export restrictions and a host of other interventions. Many
economists think that we could have major benefits from liberalization of the agricultural
sector.
In this case, the question arises

about who will maintain the buffer stock, how will
we smoothen the price fluctuations, how will farmers not be vulnerable that tomorrow the
price will crash when the crop comes out, how will farmers get signals that in the future
there will be a great need
for wheat or rice. In all these aspects the futures market has a
very big role to play.
If you think there will be a shortage of wheat tomorrow, the futures prices will go
up today, and it will carry signals back to the farmer making sowing decisions tod
ay. In
this fashion, a system of futures markets will improve cropping patterns.
Next, if I am growing wheat and am worried that by the time the harvest comes
out prices will go down, then I can sell my wheat on the futures market. I can sell my
wheat at a
price which is fixed today, which eliminates my risk from price fluctuations.
These days, agriculture requires investments
--
farmers spend money on fertilizers, high
yielding varieties, etc. They are worried when making these investments that by the tim
e
the crop comes out prices might have dropped, resulting in losses. Thus a farmer would
like to lock in his future price and not be exposed to fluctuations in prices.
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The third is the role about storage. Today we have the Food Corporation of India
which i
s doing a huge job of storage, and it is a system which
--
in my opinion
--
does not
work. Futures market will produce their own kind of smoothing between the present and
the future. If the future price is high and the present price is low, an arbitrager w
ill buy
today and sell in the future. The converse is also true, thus if the future price is low the
arbitrageur will buy in the futures market. These activities produce their own "optimal"
buffer stocks, smooth prices. They also work very effectively when
there is trade in
agricultural commodities; arbitrageurs on the futures market will use imports and exports
to smooth Indian prices using foreign spot markets.
In totality, commodity futures markets are a part and parcel of a program for
agricultural libe
ralization. Many agriculture economists understand the need of
liberalization in the sector. Futures markets are an instrument for achieving that
liberalization.
What about futures in bullion?
Futures in gold will be useful, since millions of people in India use gold as a
financial asset and are exposed to fluctuations in the price of gold.
In addition,
it's very easy to start a gold futures market. Gold is a natural
commodity where we should be dealing with warehouse receipts
--
banks have already
started giving gold depositories receipts, which clearing corporations would be
comfortable relying upon. A
market like NSE could start trading in Gold futures with just
a few weeks of preparation.
Obviously the consent of regulators will be required to getting such trading off the
ground. Remarkably enough, it may not be necessary that we should have a gold fut
ures
market in India. There are several well functioning gold futures market outside India.
Maybe we should just use them
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PERFORMANCE OF COMMONDITY EXCHANGES
Year 2002
-
03 witnessed a surge in volumes in the commodity futures markets in
India. The 20 plus
commodity exchanges clocked a volume of about Rs. 100,000 crore in
volumes against the volume of 34,500 crore in 2001
-
02
–
remarkable performance for an
industry that is being revived! This performance is more remarkable because the
commodity exchanges as o
f now are more regional and are for few commodities namely
soybean complex, castor seed, few other edible oilseed complex, pepper, jute and gur.
Interestingly, commodities in which future contracts are successful are

commodities those are not protected th
rough government policies; and trade constituents
of these commodities are not complaining too. This should act as an eye
-
opener to the
policy makers to leave pricing and price risk management to the market forces rather than
to administered mechanisms alo
ne. Any economy grows when the constituents willingly
accept the risk for better returns; if risks are not compensated with adequate or more
returns, economic activity will come into a standstill.
With the value of India’s commodity economy being around R

s. 300,000 crore a
year potential for much greater volumes are evident with the expansion of list of
commodities and nationwide availability. Opening up of the world trade barriers would
mean more price risk to be managed. All these factors augur
well for
the future of futures.
WAY AHEAD FOR COMMONDITY EXCHANGE
Commodity exchanges in India are expected to contribute significantly in

strengthening Indian economy to face the challenges of globalization. Indian markets are
poised to
witness further developments in the areas of electronic warehouse receipts
(equivalent of dematerialized shares), which would facilitate seamless nationwide spot M
P Birla Institute of Management
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market for commodities. Amendments to Essential Commodities Act and implementation

of Value
-
A
dded
-
tax would enable movement of across states and more unified tax
regime, which would facilitate easier trading in commodities. Options contracts in
commodities are being considered and this would again boost the commodity risk
management markets in the
country. We may see increased interest from the international
players in the Indian commodity markets once national exchanges become operational.
Commodity derivatives as an industry are poised to take
-
off which may provide the
numerous investors in this
country with another opportunity to invest and diversify their
portfolio. Finally, we may see greater convergence of markets
–
equity, commodities,
forex and debt
–
which could enhance the business opportunities for those have
specialized in the above mar
kets. Such integration would create specialized treasuries and
fund houses that would offer a gamut of services to provide comprehensive risk
management solutions to India’s corporate and trade community.
In short, we are poised to witness the resurgence

of India’s commodity trading
which has more than 100 years of great history.
FACTORS DRIVING THE GROWTH OF FINANCIAL

DERIVATIVES IN INDIA
Increased volatility in asset prices in financial markets.
Increased integration of national financial markets with

international markets.
Marked improvement in communication facilities and sharp decline in the costs.
Development of more sophisticated risk management tools, providing ecomomic

agents a wider choice of risk management strategies.
Innovation in derivative
s market, which optimally combine the risks and return
over a large number of financial assets, leading to higher return, reduced risk as
well as transaction costs as compared to individual financial assets
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POPULARITY OF STOCK INDEX FUTURES
There are ma
ny reasons for the wide international acceptance of stock index futures
and for the strong preference for this instrument in India too compared to other forms of
equity derivatives. This is because of the following advantages of stock index futures :
1. I
nstitutional and other large equity holders need
portfolio hedging
facility. Hence,
index
-
based derivatives are more suited to them and more cost
-
effective than derivatives
based on individual stocks. Even pension funds in U.S.A. are known to use stock ind
ex
futures for risk hedging purposes.
1. Stock index is difficult to be manipulated as compared to individual stock prices, more

so in India, and the possibility of cornering is reduced. This is partly because an
individual stock has a limited supply whic
h can be cornered. Of course, manipulation of
stock index can be attempted by influencing the cash prices of its component securities.
While the possibility of such manipulation is not ruled out, it is reduced by designing the
index appropriately. There i
s need for minimizing it further by undertaking cash market
reforms, as suggested by the Committee later in this chapter.
2. Stock index futures enjoy distinctly greater popularity, and are, therefore, likely to be
more liquid than all other types of equi
ty derivatives, as shown both by responses to the
Committee’s questionnaire and by international experience.
3. Stock index, being an average, is much less volatile than individual stock prices. This
implies much lower capital adequacy and margin requirem
ents in the case of index
futures than in the case of derivatives on individual stocks. The lower margins will
induce more players to join the market.
4. In the case of individual stocks, the positions which remain outstanding on the
expiration date will
have to be settled by physical delivery. This is an accepted principle
everywhere. The futures and the cash market prices have to converge on the expiration
date. Since Index futures do not represent a physically deliverable asset, they are cash
settled a
ll over the world on the premise that the index value is derived from the cash M P Birla
Institute of Management
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market. This, of course, implies that the cash market is functioning in a reasonably sound
manner and the index values based on it can be safely accepted as the settlement price
.
5. Regulatory complexity is likely to be less in the case of stock index futures than for
other kinds of equity derivatives, such as stock index options, or individual stock options.
The Index is Pervasive
Index derivatives are a powerful tool for risk

management for anyone who has
portfolios composed of positions in equity. Using index futures and index options,
investors and portfolio managers can hedge themselves against the risk of a downturn in
the market when they should so desire.
For example, f
or many investors, the volatility associated with the budget might
not be a ride that they wish to bear. Today, in the absence of index derivatives, the
investor has only one alternative: to sell off equity, and move into cash or debentures,
prior to the b
udget. Roughly a month after the budget, after the budget
-
related volatility
has subsided, these transactions could be reversed, and the person would be back to the
original equity exposure.
This is expensive in terms of the transactions costs faced in se

lling off a
significant amount of equity. For retail investors, the total cost of this two
-
stage process
could be around 5%, a high price to pay for the privilege of avoiding budget
-
related
volatility.
Using index futures, the same objective would be acco

mplished at around one
--
tenth the cost, or less. Using index options, a very interesting kind of ``portfolio
insurance'' could be obtained, whereby an investor gets paid only if the market index
drops.
These are unique and new forms of risk management in

the country. They are
particularly appealing because the market index is highly correlated with
every
equity
portfolio in the country. By the time a portfolio contains more than 15 stocks, it is very
likely that the correlation between this portfolio and a
market index like the NSE
-
50 M P Birla Institute of Management
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would exceed 80%. This property holds, regardless of the identity of the securities which
make up the portfolio: whether a person holds index stocks or not, the index is highly
correlated with every portfolio in the country.
This fact is quite apparent when we look back at the experience of 1995 and 1996
--
every single equity investor in the country experienced poor returns in that period,
regardless of the kind of portfolio owned. This
widespread
correlation of the risk
expo
sure of investors with the index makes
index
derivatives very special in their risk
management.
One example will help clarify matters. Suppose a person is long ITC.
Unfortunately, by being long ITC on the cash market, he is simultaneously long ITC
and
lon
g index (ITC and the index have a 65% correlation). I.e., if the
index
should drop, he
will suffer, even though he may have no interest in the index when forming his position.
In this situation, this person can match his ITC exposure with an opposing posit
ion using
index futures (i.e. he would be simultaneously long ITC and short index futures) which
effectively strips out his index exposure. Now, he is
truly
long ITC: whether the index
goes up or down, he is unaffected, he is only taking a view on ITC. Thi
s is far closer to
his real interests and objectives, and is much less risky than present market practice (i.e.,
a pure long ITC position).
FUTURES TRADING PROCESS
Any person who wants to trade in futures has to contact a Futures Commission
Merchant (FCM) or a broker. FCM is necessarily a member of the clearing house, An
account has to be ope
ned at his firm. You will be assigned to one of the accounts
executive, who will look after the transactions. Whenever we place an order with the
accounts executive, he will note down the order specifications and immediately transmit
to one of the floor
brokers at the exchange. The floor broker will execute the order and M P Birla Institute
of Management
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reports the transaction to the clearing house. Once he received the conformation form the
clearing house, he calls back the accounts executive giving him all the details about the
trade
. The accounts executive intern passes on these details to his client.
Other responsibilities of the FCM are maintaining all records and reporting the
trading activity of all his clients to the clearing house and sending the clients monthly
statement abou
t their position and account balances.
If the account is opened with a broker who is not a member of the clearinghouse, he
should necessarily route the order through a member.
FUTURES TRADING STRATEGIES
Arbitrage with Nifty futures
Arbitrage is the opportunity of taking advantage of the price difference between

two markets. An arbitrageur will buy at the cheaper market and sell at the c
ostlier market.
It is possible to arbitraged between NIFTY in the futures market and the cash market. If
the futures price is any of the prices given below other than the equilibrium price then the
strategy to be followed is
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Note: The arbitrage opportunity arising when the futures price is underpriced to the cash
price is not feasible if the arbitrageur does not hold the scrip or borrowing of sec
urities is
not possible in the market. This is because the delivery in the spot market comes before
the delivery in the futures market.
Hedging with NIFTY futures

.
Case 1
Short Hedge
Let us assume that an investor is holding a portfolio of following scrips

as given below
on 1
st
May, 2001.
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Trading Strategy to be followed
The investor feels that the market will go down in the next two months and wants to
protect him from any adverse movement. To achieve this the investor has to go short on 2
months NIFTY futures i.e he has to sell June Nifty. This strategy is called
Short H
edge
.
Formula to calculate the number of futures for hedging purposes is

Beta adjusted Value of Portfolio / Nifty Index level
Beta of the above portfolio

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=(1.55*400,000)+(2.06*200,000)+(1.95*175,000)+(1.9*125, 000)/1,000,000
=1.61075 (round to 1.61)
Applying the formula to calculate the number of futures contracts
Assume NIFTY futures to be 1150 on 1

st
May 2001
= (1,000,000.00 * 1.61) / 1150
= 1400 Units
Since one Nifty contract is 200 units, the investor has to sell 7 Nifty contracts.
Short He
dge
Stock Market
Futures Market
1
st
May
Holds Rs 1,000,000.00 in
stock portfolio
Sell 7 NIFTY futures

contract at 1150.
25
th
June
Stock portfolio fall by 6%

to Rs 940,000.00
NIFTY futures falls by

4.5% to 1098.25
Profit / Loss
Loss:
-
Rs 60,000.00
Pr
ofit: 72,450.00
Net Profit: + Rs 15,450.00
Case 2
Long Hedge
Let us assume that an investor feels that the market is at the beginning of a bull run. He is
expecting to get Rs 1,500,000.00 in two months time. Waiting two months to invest could
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mean th
at he might miss the bull run altogether. An alternative to missing the market
move is to use the NIFTY futures market. The investor could simply buy an amount of
NIFTY futures contract that would be equivalent to Rs 1,500,000.00. This Strategy is
called l
ong hedge.
Let us assume that on 1

st
May 2001 the Nifty futures stand at 1150. He expects to get Rs.
1,500,000.00 by June end. He has to buy 2months June Nifty in May. The number of
contracts he should buy is
1,500,000.00/(1150*200) = 6.52 (round to 7)

contracts
Stock Market
Futures Market
1
st
May
The investor expects Rs

1,500,000.00 in two
months
Buys 7 Nifty contracts at

1150
25 June
1,500,000.00 becomes
available for investment
The markets have risen and

the June NIFTY futures
stand at 1195
The
investor will invest Rs
1,500,000.00 in the market
but will not get the same
amount of shares as on 1
st
May 2001
Futures Profit: Rs
63,000.00
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INTRODUCTION TO INDIAN STOCK INDEX FUTURES MARKET
Index Futur
es were introduced in June 2000. A future contract is an agreement
between two parties to buy or well an asset at a certain time at a certain price. In this
market the contract is standardized.
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The features of Future Contracts are as follows:
1.
Highly liquid
2.
Traded in stock exchanges
3.
No presence of counter party
4.
Margins paid by both buyer and seller
5.
Standa
rdized
6.
Mode of delivery is cash settlement
7.
They enable investors/funds to hedge their long/short positions in the market, thus
reducing the risk associated with such stock holdings.
8.
Also, they serve as another investment opportunity for investors looking

to bet on
the markets in general.
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21
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68
9.
As the futures trading would be on the market index, it will be difficult for a few
operators to manipulate the price of the index futures market.
10. Stock index futures are expected to require lower capital

adequacy and margin
requirements and lower brokerage costs.
11. Futures will give a sense of direction to the markets/investors.
12. Contracts are cash settled and hence no paperwork of transferring the stock either
physically or through the deposit
ory mode.
Investors can use futures to hedge their portfolio risk. Say, an investor feels that a
particular stock is undervalued. When he buys it, there are two kinds of risks. Either his
understanding can be wrong, and the company is really not worth more
than its market
price, or the entire market moves against him and generates losses even though his
underlying idea was correct. The second outcome happens most of the time. So now with
Index futures, he will buy the stock and simultaneously short the futu
re.
Consider another investor who had the opposite view. So he shorted the stocks and
bought the futures. If this investor is a portfolio manager, say with the view that the IT
and the Pharma sector will do well, he invests in these sectors and shorts the
futures. On
the other hand, if he feels otherwise, he can short the portfolio of IT and Pharma scrips
and buy futures.
Background
The Securities and Exchange Board of India (SEBI) appointed a committee under
the chairmanship of Dr. L. C. Gupta in November 1996 to "develop appropriate
regulatory framework for derivatives trading in India". In March 1998, the L. C. Gupta
Committee (LCGC) submitted its report recommending the introduction of derivatives
markets in a phased manner beginning with the introduction of index futures. The SEBI
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22
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68
Board while approving the introduction of index futures trading mandated the setting up
of a group to recommend measures for risk containment in the derivative market in India.
Accordingly, SEBI constituted a group consisting of the following in June, 1998:
1. Prof. J.R. Varma, Chairman
2. Dr. R.H. Patil, The National Stock Exchang

e
3. Mr. Ravi Narain, The National Stock Exchange
4. Mr. Janak Raj, The Reserve Bank of India
5. Mr. Himanshu Kaji, The Stock Exchange, Mumbai
6. Mr. Ajit Surana, The Stock Exchange, Mumbai
7. Mr. Brian Brown, Indosuez W.I. Carr Securities
8. Mr. K.R. Bharat, Credit Suisse First Boston
9. Mr. Sarosh Irani, Jardine Fleming
10. Mr. O.P. Gahrotra, Member Secretary, SEBI
Badla v/s Futures
Badla is a system in which payment is postponed. A Badla transaction is identical

to a spot trans
action in shares, financed by lending against the securities of those shares.
In other words, Badla is akin to lending and borrowing of shares and funds and is not a
variant of futures.
SIMILARITIES
¾
Both Badla and Futures help the investor in leveragin
g his or her position. Hence,
they attract speculative elements into the market.
By allowing for speculation, Badla and Futures improve the liquidity of the cash
markets.
Page
23
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68
DIFFERENCES
Unlike Badla, Future trading is carried out distinctly from each marke
ts. Hence,
the spot and Futures price are different from each other and do not get mixed up.
Another distinguishing feature which can be identified from above is that, while
initiating a contract, the futures price is clear and known in advance in Futures
. In
Badla, the price ultimately paid inclusively of Badla charges is indeterminate and
known only when the transaction is concluded.
In Futures market, the clearing corporation becomes counter party to each trade.
Hence credit risk does not arise. How
ever, Badla give rise to credit risk as there
exists no clearing corporation to take up or assume one leg of every transaction.
In India due to recurring market scandals and large defaults related to Badla,
Securities and Exchange Board of India (SEBI) tr
ied for years to eliminate it. Finally it
was in July 2001 that SEBI successfully banned Badla with the introduction of rolling
settlement cycle and derivatives.
RISK CONTAINMENT AND RELATED ISSUES IN INDEX

FUTURES MARKET
1. VOLATILITY
Volatility is typically calculated by using variance or annualized standard

deviation of the price or return. A measure of th
e relative volatility of a stock to the
market is its beta. A highly volatile market means that prices have huge swings in very
short periods of time.
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24
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68
Several issues arise in the estimation of volatility are:
a. Volatility in Indian market is quite high

as compared to developed markets.
b. The volatility in Indian market is not constant and is varying over time.
2. CALANDER SPREADS
In developed markets, calendar spreads are essentially a play on interest rates with
negligible stock market exposure. As
such margins for calendar spreads are very low.
However, in India, the calendar basis risk could be high because of the absence of
efficient index arbitrage and the lack of channels for the flow of funds from the organised
money market into the index futu
res market.
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3. MARGIN COLLECTION AND ENFORCEMENT
Margin is:
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7²M P Birla Institute of Management
Page
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³
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Buying with borrowed money can be
extremely risky because both gains and

losses are amplified. That is, while the potential for greater profit exists, this comes
at a
hefty price
--
the potential for greater losses. Margin also subjects the investor
to a
number of unique risks such as interest payments for use of the borrowed money.
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Apart from the correct calculation of margin, the actual collection of margin is
also of equal importance. Since initial margins can be deposited in the form of bank
g
uarantee and securities, the risk containment issues in regard to these need to be tackled.
4. CLEARING CORPORATION
It is an organization associated with an exchange to handle the confirmation,

settlement and delivery of transactions, fulfilling the
main o
bligation
of
ensuring
transactions are made in a prompt and efficient manner. Also referred to as "clearing
firms" or 'clearing houses."
In order to make certain that transactions run smoothly,
clearing corporations become the buyer to every seller and th
e seller to every buyer, or,
in
other words, take the off
-
setting position with a client in every transaction.
The clearing corporation provides novation and becomes the counter party for
each trade. In the circumstances, the credibility of the clearing c
orporation assumes
importance and issues of governance and transparency need to be addressed.
5. POSITION LIMIT
It is a predetermined position level set by regulatory bodies for a specific contract

or option.
Position limits are created for the purpose o
f maintaining stable and fair M P Birla Institute of Management
Page
26
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68
markets. Contracts
held by
one individual
investor
with different brokers may be
combined in order to gauge accurately the level of contr
ol held by one party.
It may be necessary to prescribe position limits for the market as a whole and for
the individual clearing member / trading member / client.
6. LEGAL ISSUES
Certain legal opinions seem to be suggesting that mere declaration of cas

h settled
futures as securities under SC(R)A would not put them on a sound legal footing unless
the provisions of the Contract Act were either amended or explicitly overridden. Some
court judgements in foreign countries were said to be extremely worrying i
n this regard.
7. TRADER NET WORTH
Trader networth provides an additional level of safety to the market and works as
a deterrent to the incidence of defaults. A member with high networth would try harder to
avoid defaults as his own networth would be at
stake. The definition of networth needs to
be made precise having regard to prevailing accounting practices and laws.
Even an accurate 99% “value at risk” model would give rise to end of day mark to
market
losses exceeding the margin approximately once e

very six months.
MARGINING SYSTEM
The LCGC recommended that margins in the derivatives markets would be based
on a 99% Value at Risk (VAR) approach. The group discussed ways of operationalizing
Page
27
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68
this recommend
ation keeping in mind the issues relating to estimation of volatility. It is
decided that SEBI should authorise the use of a particular VAR estimation methodology
but should not mandate a specific minimum margin level.
The specific recommendations of the

group are as follows:
1. INITIAL METHODOLOGY
The percentage of the purchase price of securities (that can be purchased on

margin) which the investor must pay for with their own cash or marginable securities.
Also called the initial margin requirement.
According to Regulation T of the Federal Reserve Board, the initial margin is

currently 50%. This level is only a minimum and some brokerages require you to deposit
more than 50%.
For futures contracts, initial margin requirements are set by the exchange
.
2. PERIODIC REPORTING
The committee recommended that the derivatives exchange and clearing

corporation should be required to submit periodic reports (quarterly or half
-
yearly) to
SEBI regarding the functioning of the risk estimation methodology highli
ghting the
specific instances where price moves have been beyond the estimated 99% VAR limits.
3 CONTINOUS REFINING
It also recommended that the derivatives exchange and clearing corporation
should be encouraged to refine this methodology continuously o
n the basis of further
experience. Any proposal for changes in the methodology should be filed with SEBI and
released to the public for comments along with detailed comparative back testing results
of the proposed methodology and the current methodology. T
he proposal shall specify M P Birla Institute of Management
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the date from which the new methodology will become effective and this effective date
shall not be less than three months after the date of filing with SEBI. At any time up to
two weeks before the effective date, SEBI may instruct
the derivatives exchange and
clearing corporation not to implement the change, or the derivatives exchange and
clearing corporation may on its own decide not to implement the change.
The group recommends that the clearing corporation / clearing house sha
ll be
required to disclose the details of incidences of failures in collection of margin and / or
the settlement dues at least on a quarterly basis. Failure for this purpose means a shortfall
for three consecutive trading days of 50% or more of the liquid
net worth of the member.
RISK CONTAINMENT MEASURES
The parameters for risk containment model shall include the following:
1.
Initial Margin or Worst Scenario Loss
The Initial Margin requirement shall be based on the worst scenario loss of a
portfolio of an individual client to cover 99% VaR over one day horizon across
various scenarios of price changes, based on the volatility estimates, and volatility
changes. The estimate at the end of day t (SDt) shall be estimated using the previous
vol
atility estimate i.e., as at the end of t
-
1 day (SDt), and the return (rt) observed in
the futures market during day t. The formula shall be
6'W
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-
1)+(1
-
UW
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Where:
DSDUDPHWHUZKLFKGHWHUPLQHVKRZUDSLGO\YRODWLOLW\HVWLPD
WHVFKDQJHV7KH
YDOXHRI
LVIL[HGDW
SD = Standard deviation of daily returns in the interest rate futures contract.

Page
29
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68
In case of long term futures

, the price scan range shall be 3.5SD and in no case the
initial margin shall be less than 2 % of the notional value of the Futures Contract. For
notional T
-
Bill futures, the price scan range shall be 3.5SD and in no case the initial
margin shall be less
than 0.2% of the notional value of the futures contract.
2.
Calendar Spread Charge
The Calendar Spread margin is charged in addition to the Worst Scenario Loss of
the portfolio. For interest rate futures contract a calendar spread margin shall be at a
fla
t rate of 0.125% per month of spread on the far month contract subject to minimum
margin of 0.25% and a maximum margin of 0.75% on the far side of the spread with
legs up to 1 year apart.
3.
Exposure Limits
The notional value of gross open positions at any
point in time in Futures
contracts on a the Notional 10 year bond shall not exceed 100 times the available
liquid net worth of a member. For futures contracts on the National T
-
Bill, the
notional value of gross open position at any point in the contract s
hall not exceed
1000 times the available liquid net worth of a member.
4.
Real Time Computation
Initially, the zero coupon yield curve shall be computed at the end of the day.
However, the Exchange/yield curve provider shall endeavour to compute the zero
c
oupon yield curve on a real time basis or at least several times during the course of
the day.
5.
Margin Collection and Enforcement
Page
30
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68
The mark to market settlement margin for Interest Rate Futures Contracts shall be
collected before the start of the next day’
s trading, in cash. If mark to market margins
is not collected before start of the next day’s trading, the clearing corporation/house
shall collect correspondingly higher initial margin to cover the potential for losses
over the time elapsed in the collec
tion of margins. The initial margin shall be
calculated measures for index futures.
6.
Position Limits
In the case of Interest Rate Futures Contracts, position limits shall be specified at
the client level and for near month contracts. The client level p
osition limits shall be
Rs. 100 crore or 15% of open interest whichever is higher.
RISK MANAGEMENT
Clearing House h
as developed a comprehensive risk containment mechanism for the F &
O segment. The salient features of risk containment mechanism on the F& O segment
are:
The financial soundness of the members is the key to risk management.

Therefore, the requirements
for membership in terms of capital adequacy (net
worth, security deposits) are quite stringent.
Clearing Houses charges an upfront initial margin for all the open operations of a
Clearing member. It specifies the initial margin requirements for each
futur
es/options contract on a daily basis. It also follows value at risk based M P Birla Institute
of Management
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31
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68
margining through SPAN. The Clearing Member in turn collects the initial
margin form the Trading Members and their respective clients.
¾
The open position of the members are marked t
o market based on contract
settlement price for each contract. The difference is settled in cash on a T+1
basis.
Clearing houses on line position monitoring system monitors a CM’s open

positions on a real time basis. Limits are set for each CM based on
his capital
deposits. The online position monitoring system generates alters whenever a CM
reaches a position limit set up by NSCCL. NSCCL monitors the CMs while TMs
are monitored for contract wise position limit violation.
CMs are provided a trading tem

inal for the purpose of monitoring the open
positions of all the TMs clearing and settling through him. A CM may set
exposure limits for a TM clearing and settling through him. NSCCL assists the
CM to monitor the intra day exposure limits set up by a CM a
nd whenever a TM
exceeds the limits, it stops that particular TM from further trading.
A member is alerted of his position to enable him to adjust his exposure or bring
in additional capital. Position violations result in withdrawal of trading facility
fo
r all TMs if a CM in case of a violation by the CM.
A separate settlement gurantee fund for this segment has been created out of the
capital of members. The fund has a balance of Rs. 648 crores at the end of March
2002.
The most critical component of ris

k containment mechanism for F & O segment is the
margining system and online position monitoring. The actual position monitoring and
margining system is carried out online through Parallel Risk Management System
(PRISM) . Prism uses SPAM ( Standard Portf
olio Analysis of Risk) system for the
purpose of computation of online margins, based on the parameters defined by RBI.
POSITION LIMITS FOR FIIS
The position limits specified for FIIs and their sub

-
account is as under:
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At the level of the FII
In the ca
se of index related derivative products, the position limit is 15%
of open interest in all futures and options contract on a particular
underlying index, or Rs. 100 crore, whichever is higher.
In case of underlying security, the position limit is 7.5 % of

open interest,
in all futures and options contracts on a particular underlying security, or
Rs. 50 crore, whichever is higher.
At the level of the sub

-
account:
The CM/TM is required to disclose to the NSCCL details of any person or

persons acting in conce
rt who together own 15% or more of the open
interest of all futures and options contracts on a particular underlying
index on the exchange.
In case of futures and option contracts on securities the gross open

position across all futures and options contra
cts on a particular underlying
security of a sub account of an FII, should not exceed the higher or 1% of
the free float market capitalization (in terms of number of shares) or 5% of
the open interest in the derivative contracts on a particular underlying
stock (in terms of number of contracts). These position limits are
applicable on the combined position in all futures and options contracts
on an underlying security on the exchange.
If people trade on foreign derivatives exchanges, won't that hurt the

interests of India's exchanges?
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68
From the viewpoint of India's securities industry, it would be great to trade gold
futures
--
it would yield revenues and it wo
uld raise sophistication. If that can be
achieved, it would be great, but it looks like it will take a while for the regulatory
apparatus to permit gold futures in India.
From the view point of the Indian economy

--
and the economy is much more
than the se
curities industry
--
the important point is not the colour of the skin. It does not
matter whether an Indian or a foreigner is running the exchange. The important point is to
have access to these products. There are many situations where we would be better
off by
merely giving permissions to Indian to go abroad and trade in these markets.
Why do we take it for granted that we have to wait for India's markets to develop.
Witness the two year delay in getting an index futures market started
--
these delays fo
rce
India's households and companies to continue to live with risk. India's economy will
benefit from having access to derivatives, whether they are come about through India's
regulators and exchanges or not. If the Singapore government is friendly to deri
vatives
markets in a way that India's government is not, India's citizens should go ahead and
reduce their risk by using futures markets in Singapore.
Hence we should not approach commodity derivatives looking only at the Indian
securities industry. The in
terest of Indian consumers, households and producers is more
important, as these are the people who are exposed to risk and price fluctuations. To the
extent that foreign derivatives markets can reduce the risk for Indians, this is good.
The RBI has recent

ly released the R. V. Gupta committee report on these issues.
It is an excellent piece of work, which paves the way for Indians to benefit from using
foreign commodity futures markets. I think that this report is going to be a milestone in
the history of I
ndia's financial sector.
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SEBI REGULATIONS OF 1992
(BROKER AND SUB

-
BROKERS)
In this section we shall
have a look at the regulations that apply to brokers under the
SEBI Regulations.
BROKERS:
A broker is an intermediary who arranges to buy and sell securities on behalf of

clients. According to section 2 (c) of the SEBI rules, a stock broker means a memb
er of a
recognized stock exchange. No stock broker is allowed to buy or sell or deal in
securities, unless he or she holds a certificate of registration granted by SEBI. A stock
broker applies for registration to SEBI through a stock exchange or stock ex
changes of
which he or she is admitted as a member. SEBI may grant a certificate to a stock broker
subject to the condition that:
He holds the membership of any stock exchange.
He shall abide by the rules. Regulations and bye

-
laws of the stock exchange o
r
stock exchanges of which he is a member.
In case of any change in the status and constitution, he shall obtain prior
permission of SEBI to continue to buy, sell or deal in securities in any stock
exchange
He shall pay the amount of fee for registration i

n the prescribed manner
He shall take adequate steps for redressal of grievances of the investor with in one
month of the date of the receipt of the complaint and keep SEBI informed about
the member, nature and other particulars of the complaints.
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REGULAT
ION FOR DERIVATIVES TRADING
SEBI setup a 24 member committee under the chairmanship of Dr. L.C. Gupta to
develop the appropriate regulatory framework for derivatives trading in India.
The committee submitted its report in March 1998. On may 11, 1998 SEB
I
accepted the recommendations of the committee and approved the phased introduction of
derivatives trading in India beginning with stock index futures. SEBI also approved the
“Suggestive by
-
laws” recommended by the committee for regulation and control of
trading and settlement of derivatives contracts.
The provisions for SC( R ) A and regulatory framework developed their undergovern
trading in securities. The amendment of the SC( R )A to include derivatives within the
ambit of ‘securities’ in the SC( R)
A made trading in derivatives possible within the
framework of the Act.
Any Exchange fulfilling the eligibility criteria as prescribed in the LC Gupta

committee report may apply to SEBI for grant of recognition under Section 4 of
the SC( R)A, 1956 to star
t trading derivatives. The derivatives exchange/segment
should have a separate governing council and representation of trading/clearing
member shall be limited to maximum of 40% of the total members of the
governing council. The exchange shall regulate t
he sales practices of its members
and will obtain prior approval of SEBI before start of trading in any derivative
contract.
The exchange shall have minimum 50 members.
The members of an existing segment of the exchange will not automatically

become the me
mbers of derivative segment. The embers of the derivative
segment need to fill the eligibility conditions as laid down by the LC Gupta
committee.
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The clearing and settlement of derivatives trades shall be through a SEBI approval
clearing corporation/house
. Clearing corporation/house complying with the
eligibility as laid down by the committee have to apply to SEBI grant of approval.
Derivative brokers/dealers and clearing members are required to seek registration

from SEBI. This is in addition to their r
egistration as broker of existing stock
exchange. The minimum net worth for clearing member of the derivatives
clearing corporation/house shall be Rs. 300 lakhs.
The net worth of the member shall be computed as follows:
Capital + Free reserves
Less: non
-
allowable assets viz.,
(a)
Fixed assets
(b)
Pledged securities
(c)
Member’s card
(d)
Non
-
allowable securities (unlisted securities)
(e)
Bad deliveries
(f)
Doubtful debts and advances
(g)
Prepaid expenses
(h)
Intangible assets
(i)
30% marketable securities
The minimum contract value shall n

ot be less than Rs. 2 lakhs. Exchanges
should also submit details of the futures contract they propose to
introduce.
¾
The initial margin requirement, exposure limits linked to capital adequacy
and margin demands related to the risk of loss on the position
shall be
prescribe by SEBI/Exchange from time to time.
The LC Gupta committee report requires strict enforcement of “Know

your customer” rule and requires that every client shall be registered with
the derivatives broker. The members of the derivatives se
gment are also M P Birla Institute of Management
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required to make their clients aware of the risks involved in derivatives

trading by issuing to the client Risk Disclosure Document and obtain a
copy of the same duly signed by the client.
The trading member are required to have qualified ap

proval user and sales
person who have passed a certification program approved by SEBI.
REGULATION FOR RISK MANAGEMENT
The following risk management measures have been prescribed by SEBI:
1. Liquid Networth Requirement:
The clearing member’s minimum li

quid net worth must be at least Rs. 50 lakh at
any point of time.
2. Initial Margin Computation:

A portfolio based margining approach has been adopted which takes an integrated
view of the risk involved in the portfolio of each individual client compri
sing of his
position in all derivative contracts. The initial margin requirement are based on worst
scenario loss of a portfolio of an individual client to cover 99% VAR over one day time
horizon. Provided, however, in the case of futures, where it may n
ot be possible to collect
the mark to market settlement value, before the commencement of trading on the next
day, the initial margin may be computed over a two day time horizon, applying the
appropriate statistical formula. The methodology for computatio
n of Value at Risk is as
per recommendation of SEBI from time to time.
Initial margin requirements for a member are as follows:
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a.
For client positions

–
It shall be netted at the level of individual client and grossed
across all clients, at the Trading/C
learing Member Level, without any setoffs
between clients.
b.
For proprietary position

–
It shall be betted at Trading/Clearing Member Level
without any setoffs between client and proprietary positions.
For the purpose of SPAN margin, various parameters shal

l be specified hereunder or such
other parameters as may be specified by the relevant authority form time to time:
•
Calendar Spread Charge: Calendar Spread Charge covers the calendar

(inter
-
month etc.,) basis risk that may exist for portfolios containing
f
utures and options with different expirations. In the case of Futures and
Options contracts on Index and Individual securities, the margin on
calendar spread shall be calculated on the basis of delta of the portfolio
consisting of futures and options cont
racts in each month.
A calendar spread position shall be treated as non spread (naked) positions

in the far month contract, 3 trading days prior to expirations of the near
month contract.
Premium Margin: Premium Margin shall mean and include premium

amoun
t due to be paid to clearing corporation towards premium
settlement, at client level. Premium Margin for a day shall be levied till
the completion of pay in towards the premium settlement.
Position Limit: Position limit have been specified by SEBI at tra

ding
member, client, market and FII level respectively;
Trading Member Position Limit:

There is a position limit in derivative
contracts on an index of 15% of the open interest of all derivative
contracts on the same underlying or Rs. 100 crore, whicheve
r is higher, in
all the futures and options contracts on the same underlying. The trading
member positions limits is linked to the market wide position limit is less
than or equal to Rs. 250 crore, the trading member limit in such securities
shall be 20%
of the market wide position limit. For securities, in which M P Birla Institute of
Management
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the market wide position limit is greater than Rs. 250 crore, the trading
member position limit in such stocks shall be Rs. 50 crore.
The position of all FII/Sub accounts shall be monitored at t

he end
of the day for limits of 7.5% of the open interest of all derivative contracts
on the same underlying or Rs. 50 crore, whichever is higher, in all the
futures and option contracts on the same underlying security as per
existing applicable position l
imits.
For futures contracts open interest shall be equivalent to the open

positions in that futures contract multiplied by its last available closing
price.
Market Wide Position Limits:

The market wide limit of open position on
all futures on a partic
ular stocks shall be lower of 30 times the average
number of shares traded daily, during the previous calendar month, in the
relevant underlying security in the underlying segment of the relevant
exchange, or, 10% of the number of shares held by non
-
promot
ers in the
relevant underlying security i.e., 10% of the free float, in terms of number
of shares of a company.
RISK MANAGEMENT DEVELOPED BY

16&&/
NSCCL has developed a comprehensive risk containment mechanism for the F&O
segment. The sailent features
of risk containment mechanism on the F&O segment are:
The financial soundness of the members is the key to risk management.

Therefore, the requirement for membership in terms of capital adequacy (net
worth, security deposits) are quite stringent.
NSCCL c
harges an upfront initial margin for all the open positions of a CM. It
specifies the initial margin requirement for each futures contract on a daily basis.
It also follows value at risk (VAR) based margining through SPAN. The CM is
turn collects the in
itial margin from the TMs and their respective clients.
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The open positions of the members are marked to market based on contact
settlement price for each contract. The difference is settled in cash on a T+1
basis.
NSCCL’s online position monitoring system

monitors a CM’s open position on a
real time basis. Limits are set for each CM based on his capital deposits. The
online position monitoring system generates alerts whenever a CM reaches a
position limit set up by NSCCL. NSCCL, monitors the CM’s for MT
M value
violation, while TMs are monitored for contract wise position limit violation.
CMs are provided a trading terminal for the purpose of monitoring the open
positions of all the TMs clearing and settling through him. A CM may set
exposure limits for
a TM clearing and settling through him. NSCCL assists the
CM to monitor the intra
-
day exposure limits set up by a CM and whenever a TM
exceed the limits, it stops that particular TM from further trading.
¾
A member is alerted of his position to enable him t
o adjust his exposure or bring
in additional capital. Position violations result in withdrawal or trading facility
for all TMs of a CM in case of a violation by the CM.
A separate settlement gurantee fund for this segment has been created out of the
capit
al of members. The fund has a balance of Rs. 13002 million at the end of
march 2003/
The most critical component of risk management mechanism for F&O segment is
the margining system and online position monitoring. The actual position monitoring
and marg
ining is carried out online through Parallel Risk Management System
(PRISM). PRISM uses SPAN ® (Standard Portfolio Analysis of Risk) system for the
purpose of computation of online margins, based on the parameters defined by SEBI.
ELIGIBILITY OF STOCKS F
OR FUTURES
The stocks which are eligible for futures trading should meet the following criteria:
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68
The stock should be amongst the top 200

scrips, on the basis of average market
capitalization during the last six months and the average free float market
capitalization should not be less than Rs. 750 crore. The free float market
capitalization means the non
-
promoter holding in the stock.
¾
The
stock should be amongst the top 200 scrips on the basis of average daily
volume (in value terms), during the last six months. Further, the average daily
volume should not be less than Rs. 5 crore in the underlying cash market.
The stock should be traded

on atleast 90% of the trading days in the last six
months, with the exception of cases in which a stock is unable to trade due to
corporate actions like de
-
mergers etc.,
The non promoter holding in the company should be at least 30%.
The ratio of the daily

volatility of the stock vis
-
à
-
vis the daily volatility of the
index (either BSE 30 sensex or S&P CNX Nifty) should not be more than 4, at
any time during the previous six months. For this purpose the volatility would be
computed as per the exponentially
weighted moving average formula.
The stock on which options contracts are permitted to be traded on one derivative
exchange/segment would also be permitted to trade on other derivative
exchange/segments.
VALUE AT RISK MODELS IN THE INDIAN STOCK MARKET
1.
The Exponentially Weighted Moving Average Method

The successful use of value at risk models is critically dependent upon estimates of
the volatility of underlying p
rices. The principal difficulty is that the volatility is not
constant over time
-
if it were, it could be estimated with very high accuracy by using a M P Birla Institute of
Management
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sufficiently long sample of data. Thus models of time varying volatility become very
important. Practiti
oners have often dealt with time varying parameters by confining
attention to the recent past and ignoring observations from the distant past.
Econometricians have on the other hand developed sophisticated models of time varying
volatility like the GARCH (
Generalised Auto
-
Regressive Conditional Heteroscedasticity)
model.
Straddling the two are the exponentially weighted moving average (EWMA) methods
popularised by J. P. Morgan’s Risk Metrics system. EWMA methods can be regarded as

a variant of the practiti
oner’s idea of using only the recent past because the practitioners’
idea is essentially that of a simple moving average where the recent past gets a weight of
one and data before that gets a weight of zero. The variation in EWMA is that the
observations a
re given different weights with the most recent data getting the highest
weight and the weights declining rapidly as one goes back. Effectively, therefore,
EWMA is also based on the recent past, in fact, it is even more responsive than the
simple moving av
erage to sudden changes in volatility. EWMA can also be regarded as a
special case of GARCH in which the “persistence parameter” is set to unity. This means
that unlike GARCH, EWMA does not have a notion of long run volatility at all and is
therefore more
robust under regime shifts.
EWMA is computationally very simple to implement (even simpler than a simple

moving average). The volatility at the end of day t,
WLVHVWLPDWHGXVLQJWKHSUHYLRXV
volatility estimate SDt
-
1 (as at the end of day t
-
1), and the
return rt observed in the index
during day t:
6'W
A§
6'W
-
1)^2 + (1
-
UW
A§
ZKHUH
ﾏ
LVDSDUDPHWHUZKLFKGHWHUPLQHVKRZUDSLGO\YRODWLOLW\HVWLP
DWHVFKDQJH
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68
2.
Empirical Tests on the Indian Stock Market
3.
Whatever intuitive or theoretical meri

ts a value at risk model may have, the
ultimate test of its usability is how well it holds up against actual data. For example,
tentative results3 indicate that foreign exchange markets in India are best modelled by
processes that allow jumps and that EWMA
methods do not perform well in that market
at all. Empirical tests of the EWMA model in the Indian stock market are therefore of
great importance. The EWMA model was therefore tested using historical data on the
Indian stock market indices
-
the NSE
-
50 In
dex (Nifty) and the BSE
-
30 Index (Sensex).
2.1 Sample Period

The data period used is from July 1, 1990 to June 30, 1998. The long sample
period reflects the view that risk management studies must attempt (wherever possible) to
cover at least two full busi
ness cycles (which would typically cover more than two
interest rate cycles and two stock market cycles). It has been strongly argued on the other
hand that studies must exclude the securities scam of 1992 and must preferably confine
itself to the period a
fter the introduction of screen based trading (post 1995).
The view taken in this study is that the post 1995 period is essentially half a
business cycle though it includes complete interest rate and stock market cycles. The post
1995 period is also an a
berration in many ways as during this period there was a high
positive autocorrelation in the index which violates weak form efficiency of the market.
(High positive autocorrelation is suggestive of an administered market; for example, we
see it in a manag
ed exchange rate market). The autocorrelation in the stock market was
actually low till about mid 1992 and peaked in 1995
-
96 when volatility reached very low
levels. In mid
-
1998, the autocorrelation dropped as volatility rose sharply. In short there
is dis
tinct cause for worry that markets were artificially smoothed during the 1995
-
97
periods.
Similarly, this study takes the view that the scam is a period of episodic volatility
(event risk) which could quite easily recur. If we disregard issues of morality
and legality, M P Birla Institute of Management
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44
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68
the scam was essentially a problem of monetary policy or credit policy. Since both the
bull and bear sides of the market financed themselves through the scam in roughly equal
measure, the scam was roughly neutral in terms of direct buy or se
ll pressure on the
market. What caused a strong impact on stock prices was the vastly enhanced liquidity in
the stock market. The scam was (in its impact on the stock market) essentially equivalent
to monetary easing or credit expansion on a large scale. T
he exposure of the scam was
similarly equivalent to dramatic monetary (or credit) tightening. Any sudden and sharp
change in the stance of monetary policy can be expected to have an impact on the stock
market very similar to the scam and its exposure. A pr
udent risk management system
must be prepared to deal with events of this kind.
2.2 Logarithmic Return
The usual definition of return as the percentage change in price has a very serious
problem in that it is not symmetric. For example, if the index rises
from 1000 to 2000, the
percentage return would be 100%, but if it falls back from 2000 to 1000, the percentage
return is not
-
100% but only
-
50%. As a result, the percentage return on the negative side
cannot be below
-
100%, while on the positive side, t
here is no limit on the return. The
statistical implication of this is that returns are skewed in the positive direction and the
use of the normal distribution becomes inappropriate.
For statistical purposes, therefore, it is convenient to define the retu

rn in
logarithmic terms as rt = ln(It/It
-
1) where It is the index at time t. The logarithmic return
can also be rewritten as rt = ln(1+Rt) where Rt is the percentage return showing that it is
essentially a logarithmic transformation of the usual return. In
the reverse direction, the
percentage return can be recovered from the logarithmic return by the formula, Rt =
exp(rt)
-
1. Thus after the entire analysis is done in terms of logarithmic return, the results
can be restated in terms of percentage returns. It
is worth pointing out that the percentage
return and the logarithmic return are very close to each other when the return is small in
magnitude. However, when there is a large return (positive or negative) the logarithmic
return can be substantially differ
ent from the percentage return. For example, in the
earlier illustration of the index rising from 1000 to 2000 and then dropping back to 1000,
Page
45
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68
the logarithmic returns would be +69.3% and

-
69.3% respectively as compared to the
percentage returns of +100% an
d
-
50% respectively.
2.3 Maximum Likelihood Estimation
7KH(:0$PHWKRGUHTXLUHVWKHVSHFLILFDWLRQRIWKHYDOXHRI
ﾏ
2QHFDQHVWLPDWH
itself statistically by the method of maximum likelihood. This process yielded an estimate
for
ﾏ
ﾏ
RI§IRUWKH1L
fty and 0.929 for the Sensex. These values are not statistically
VLJQLILFDQWO\GLIIHUHQWIURPWKHYDOXHRIIRU
ﾏ
XVHGLQ-30RUJDQ¶V5LVN0HWULFV
ﾏ
V\VWHPIRUGDLO\KRUL]RQV
7KHOLNHOLKRRGUDWLRWHVWJLYHVFKL
-
squares with 1 df of 1.89
for the S
ensex and 4.46 for the Nifty which are not significant at the 1% level even
though we have a sample size of over 1750). The analysis was therefore carried out using
D
ﾏ
RIWRSHUPLWHDVLHUFRPSDUDELOLW\DQGIDFLOLWDWHIXUWKHUH[WH
QVLRQVWRWKHPRGHO
.
2.4 Conditional Normality
It is well known that stock market returns are not normally distributed even if one
uses logarithmic returns to induce symmetry. However, the time varying volatility itself
is one major cause for non
-
normality. It is to be expe
cted therefore that the “conditional
distribution” of the return given the volatility estimate is approximately normal. In other
words, the returnon each day divided by the estimated standard deviation for that day
should be roughly normally distributed. T
he results do indicate significant reduction in
non normality. The unconditional distribution has an excess kurtosis6 of 5.42 for Nifty
and 4.77 for Sensex while the “conditional distribution” has an excess kurtosis of only
1.75 for Nifty and 1.13 for Sens
ex. Thus over two
-
thirds of the excess kurtosis is
eliminated by the time varying volatility estimation process.
Nevertheless, the kurtosis (which is a measures the fat tails) is still too large for
use of the normal distribution values without modificati
on. For example, the normal
distribution would imply applying a value of 2.58 SD
ﾏ
IRUDWZRVLGHG³YDOXHDWULVN´OLPLW
of 1%. However, the presence of fat tails even in the conditional stock market returns
implies that it is necessary to use a higher valu
e to get the same degree of protection. A M P Birla Institute of Management
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46
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68
common rule of thumb for distributions with a moderate degree of kurtosis is to use a
value of 3 SD
ﾏ
IRUDµWDLODQGWKLVYDOXHLVXVHGLQWKHUHVWRIWKLVVWXG\
2.5 Margins
Since the volatility estimates are f

or the logarithmic return, the +or
-
ﾏ

è
OLPLWVIRU
a 99% VAR would specify the maximum/minimum limits on the logarithmic returns not
the percentage returns. To convert these into percentage margins, the logarithmic returns
would have to be converted into
percentage price changes by reversing the logarithmic
transformation. Therefore the percentage margin on short positions would be equal to
100(exp(3SDt)
-
1) and the percentage margin on long positions would be equal to 100(1
-
exp(
-
3SDt)). This implies slight
ly larger margins on short positions than on long
positions, but the difference is not significant except during periods of high volatility
where the difference merely reflects the fact that the downside is limited (prices can at
most fall to zero) while t
he upside is unlimited.
2.6 Back Testing Results
Backtesting this model for the period over a 8 year period showed that the 1%
VAR limit was crossed 22 times in the case of Nifty and 23 times in the case of Sensex as
against the expected number of 18 viol
ations. The hypothesis that the true probability of a
violation is 1% cannot be rejected at even the 5% level of statistical significance though
we have a sample size of over 1750. The actual number of violations is therefore well
within the allowable limi
ts of sampling error. In the terminology of the Bank for
International Settlements (“Supervisory framework for the use of ‘backtesting’ in
conjunction with the internal models approach tomarker risk capital requirements”, Basle
Committee on Banking Supervi
sion, January 1996),these numbers are well within the
“Green Zone” where the “test results are consistent with an accurate model, and the
probability of accepting an inaccurate model is low”.
The market movements, margins and margin shortfalls are shown g

raphically in
Figures 1 and 2. The summary statistics about the actual margins on the sell side are M P
Birla Institute of Management
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47
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68
tabulated below while year by year details of the sell side and buy side margins are given
in Tables 1 and 2.
REGULATORY FRAMEWORK FOR DERIVATIVES
REGULATORY OBJECTIVE
(a). Investor protection: Attention needs to be given to the following four aspects:
(i) Fairness and Transparency: The trading rules should

ensure that trading is
conducted in a fair and transparent manner. Experience in other countries shows that in
many cases, derivatives brokers/dealers failed to disclose potential risk to the clients. In
this context, sales practices adopted by dealers f
or derivatives would require specific
regulation. In some of the most widely reported mishaps in the derivatives market
elsewhere , the underlying reason was inadequate internal control system at the user firm
itself so that overall exposure was not contr
olled and the use of derivatives was for
speculation rather than for risk hedging. These experiences provide useful lessons for us
for designing regulations.
(ii) Safeguard for client’s money:
Moneys and securities deposited by clients with the tradi

ng members should not only be
kept in a separate clients account but should also not by attachable for meeting the
broker’s own debts. It should be ensured that trading by dealers on account is totally
segregated from that for clients.
(iii)
Competent and hone

st service:
The eligibility criteria for trading members should be designed to encourage competent
and qualified personnel so that investors/clients are served well. This makes it necessary
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48
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68
to prescribe qualification for derivatives brokers/dealers and th

e sales persons appointed
by them in terms of a knowledge base.
(iv)
Market integrity:
The trading system should ensure that the market’s integrity is safeguarded by
minimizing the possibility of defaults. This requires farming appropriate rules about
capital
adequacy, margins, clearing corporation, etc.
(b)
Quality of markets: The concept of “Quality of Markets” goes well beyond

market integrity and aims at enhancing important market qualities, such as cost
efficiency, price continuity, and price discovery. This
is a much broader objective than
market integrity.
(c)
Innovation : While curbing any undesirable tendencies, the regulation framework

should not stifle innovation which is the source of all economic progress, more so
because financial derivatives represent a
new rapidly developing area, aided by
advancements in information technology.
Of course the ultimate objective of regulation of financial markets has to be

promote more efficiency functioning of markets on the “real” side of the economy, i.e.,
economic ef
ficiency.
MAJOR ISSUES CONCERNING REGULATORY FRAMEWORK
The committee’s attention has been drawn to several important issues connecting
with derivatives trading. The committee has considered such issues, some of which have
a direct bearing on the design
of the regulatory framework. They are listed below:
Should derivatives exchange be organized as independent and separate form an

existing stock exchange?
What exactly should be the division of regulatory responsibility, including both

framing and enforci
ng the regulations, between SEBI and the derivatives
exchange?
Page
49
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68
How should ensure that the derivatives exchange will effectively fulfill its
regulatory responsibility.
What criteria should SEBI adopt for granting permission for derivatives trading to
an exc
hange?
What condition should the clearing mechanism for derivatives trading satisfy in
view of high leverage involved?
What new regulations or changes in existing regulations will have to be

introduced by SEBI for derivative trading?
ARGUMENTS FOR SETTING

UP SEPARATE FUTURES
EXCHANGE
(a)
The trading rules and entry requirements for futures trading would have to be
different from those for cash trading.
(b)
The possibility of
collusion among traders for market manipulation seems to be
greater if cash and futures trading are conducted in the same exchange.
(c)
A separate exchange will start with a clean slate and would not have to restrict the
entry to the existing members only but
the entry will be thrown open to all
potential eligible players.
Implicit Cost of Carry in Inter

-
Index Arbitrage
It is well known that since the BSE and NSE operate different settlement cycles it
is possible to do a form of carry forward (or badla) trad
ing by continuously shifting
positions from one exchange to the other to avoid delivery. A person who has bought on
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50
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68
BSE can square his position on that exchange on or before Friday and simultaneously buy
on NSE. Since he has squared up on BSE, he does not
have to take delivery there. On or
before Tuesday, he can square up on NSE and buy on BSE avoiding delivery at NSE. He
can keep repeating this cycle as long as he likes. Since this is very similar to carry
forward trading (or rolling a futures contract), i
t is clear that this person would implicitly
pay a carry forward charge (contango or backwardation) in the form of a price difference
between the two exchanges.
To model this, this study assumes that a trade in the BSE could be regarded as a
futures contr
act for Friday expiry while a trade on the NSE could be regarded as a futures
contract for Tuesday expiry. The cost of carry model of futures prices tells us that the
futures price equals the cash price plus the cost of carry till the expiry date. Two futu
res
contract with different expiry dates will be priced to yield a price difference equal to the
cost of carry for the difference between the two expiry dates.
The table below summarises the impact of the differing settlement cycles.
(Throughout this stu
dy, day means trading day and yesterday means last trading day).
Days of week
Yesterday
Days to expiry
Today
Days to expiry
Change in
differential
BSE
NSE
DIFF.
BSE
NSE
DIFF
Days to expiry
Monday
-
2
Tuesday
0
3
Wednesday
-
2
-
5
Thursday
-
2
-
2
Friday
3
-
2
-
2
The last column of this table is crucial. It tells us that the relation between BSE and NSE
undergoes a change on Monday and Wednesday.
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68
•
From Friday close to Monday close the BSE contract chan
ges from an expiry 2 days
ahead of NSE to an expiry 3 days after NSE

-
a net positive change of 5 trading days or
one week. From being priced two days’ carry below NSE, the BSE contract will now be
priced three days’ carry above the NSE price causing a net
change of 5 trading days’ or
one week’s cost of carry in the difference between the two prices. Therefore Monday's
return on BSE should exceed that in NSE by one week’s cost of carry
•
Similarly from Tuesday close to Wednesday close the BSE contract changes from an
expiry 3 days after NSE to an expiry 2 days ahead of NSE

-
a net negative change of 5
trading days or one week. This is the reverse of the above situation and therefore
Wedn
esday's return on BSE should be lower than that in NSE by one week’s cost of
carry.
To estimate the cost of carry, the Nifty index was used. The Nifty Index based on Last
Traded Prices (LTP) at the NSE was obtained from the NSE and the returns on this ind
ex
were computed. The returns on the Nifty Index was computed separately using BSE
prices for the period from January 1, 1998 to June 30, 1998.
It turns out that on average on Mondays, the return in BSE exceeds that in NSE by 0.61%
while on Wednesdays, it
is the other way around
-
the return in NSE exceeds that in BSE
by 0.71%. This implies that one week’s cost of carry is approximately 0.6
-
0.7% or that
the annual cost of carry is about 30
-
35% on a simple interest basis or 35
-
45% on a
compound interest bas
is. These rates are far above any money market rate and indicates
very strong barriers to the flow of money into financing stock market transactions.
A closer look at Table 1 suggests a way of measuring the volatility of the cost of carry as
well:
•
Both on Monday close and on Tuesday close the BSE contract is for expiry 3 days after
NSE. The difference in the returns between the two exchanges is therefore only due to the
change in the cost of carry during Tuesday. Standard deviation of the differen
tial return is
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68
therefore the standard deviation of daily change in 3 days' cost of carry.
•
Similarly the standard deviation of the differential return on Thursday and Fridays is
equal to the standard deviation of daily change in 2 days' cost of carry of
carry.
The critical assumption in the above is that the differences in prices between the BSE and
NSE is due only to the difference in the two expiry dates and that various other
differences in market microstructure in the two exchanges do not have any imp
act. In
reality perhaps a lot of the fluctuation in the price differences is attributable to these
microstructure differences.
MARKET OUTCOME
In India derivatives are traded only on two exchanges. The details of trades on these
exchanged during 2002
-
03
are presented in the table below. The total exchange traded
derivatives witnessed a volume of Rs. 4423333 million during the current year as against
Rs. 1038480 million during the preceding year. While NSE accounted for about 99.4%
of total turnover, BSE
accounted for less than 1%. It is believed that India is the second
largest market in the world for stock futures.
TRADE DETAILS OF DERIVATIVES MARKET
NSE
BSE
TOTAL
Month/year
No. of
Contracts
Traded
Turnover
( Rs. mn.)
No. of
Contracts
Traded
T
urnover
( Rs.
mn)
No. of
Contracts
Traded
Turnover
(Rs. mn)
OCT 02
1378088
34413
618
140
1378706
334553
NOV 02
1554551
398360
546
132
1555097
398492
DEC 02
1966839
556201
611
160
1967450
556361
JAN 03
2061155
591400
36470
6471
2097625
597871
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FEB 03
1
863217
493948
39513
6848
1902730
500796
MAR 03
1950004
493317
43648
7182
1993652
500499
TOTAL
02
-
03
16768909
4398548
138037
24785
16906946
4423333
The product wise distribution of turnover in F&O segment for the year 2002
-
03 is
presented in the chart b
elow
Product wise distribution of turnover

of F&O segment of NSE 2002-03
Stock
options
23%
Stock
futures
65%
Index
options 2%
Index
futures
10%
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68
CITYWISE DISTRIBUTION OF TURNOVER OF F&O SEGMENT OF NSE 2002

-
03
Sl No.
Location
Share in Turnover
(%)
2001
-
02 2002
-
03
Mumbai
49.08
41.20
Delhi/Ghaziabad
24.28
20.31
Calcutta/Howrah
12.6
15.6
Cochin/Ernakulam/Parur/Kalamserry/Alwaye
2.44
.63
Ahamedabad
2.25
2.1
Chennai
2.01
2.24
Hydrabad/Secundrabad/Kukatpally
1.54
.97
Others
5.2
9.38
TOTAL
100
100
TAXABILITY OF INCOME ARISING FROM DERIVATIVE CONTRACTS
The Income Tax Act does not have any specific provision regarding taxability of
income from derivatives.
Only provisions, which have an indirect bearing on derivative
transaction, are section 73(1) and 43(5). Section 73(1) provides that any loss, computed
in respect of a speculative business carried on by the assessee, shall not be set off expect
against pr
ofits and gains, if any, of any speculative business. Section (43) of the Act
defines a speculative transaction as a transaction in which contract for purchase or sale of
any commodity, including stocks and shares, is periodically or ultimately settled
o
therwise than by actual delivery or transfer of the commodity or scrips. It excludes the
following types of transactions from the ambit of speculative transaction:
1.
A contract in respect of stocks and shares entered into by a dealer or investor

therein to
guard against loss in his holding of stocks and shares through price
fluctuations;
2.
A contract entered into by a member of a forward market or a stock exchange in

the course of any transaction in the nature of jobbing or arbitrage to guard against
loss, wh
ich arise in ordinary course of business as such member.
A transaction is thus considered speculative if

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68
i. It is in commodities, shares, stock or scrips,
ii. It is settled otherwise than by actual delivery
iii.
It is not for arbitrage, and
iv.
The participant has no underlying position
In the absence of a specific provision, it is apprehended that the derivative contracts,

particularly the index futures/options which are essentially cash settled, may be
constructed as speculative transactions.
Therefore, the losses, if any will not be eligible
for set off against other incomes of the assessee and will be carried forward and set off
against speculative income only up to a maximum of eight years. In fact, however, is that
derivative contracts a
re not for purchase/sale of any commodity, stock, share or scrips.
Derivatives are a special class of securities under the Securities Contracts (Regulation)
Act, 1956 and do not any way resemble any other type of securities like shares, stock or
scrips.
Derivative contracts are cash settled, as these can not be settled otherwise.
Derivative contracts are entered into by the hedgers, speculators and arbitrageurs. A
derivatives contract has any of these two parties and hence some of the derivative
contra
cts, (not all), have an element of speculation. All types of participants need to be
provided level playing field so that the market is competitive and efficient. As regards
taxability, the law should not treat income of the hedgers, speculators and arbi
trageurs
differently. Income of all the participants from derivatives need to be treated uniformly.
This is all the more necessary as it is well neigh impossible to ascertain if a participant is
trading for speculation, hedging or arbitrage.
A transacti
on is thus considered speculative, if a participant enters into a hedging
transaction in scrips outside his holdings. It is possible that an investor does not have all
the 30 or 50 stocks represented by the index. As a result an investor’s losses or prof
its
out of derivatives transactions, even though they are of hedging nature in real sense, it is
apprehended, may be treated as speculative. This is contrary to capital asset pricing
model, which states that portfolios in any economy move in sympathy with
the index
although the portfolios do not necessarily contain any security in the index. The index
derivatives are, therefore, used even for hedging the portfolio risk of non
-
index stocks. M P Birla Institute of Management
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68
An investor who does not have the index stocks can also se the in
dex derivatives to hedge
against the market risk as all the portfolios have a correlation with the overall movement
of the market (i.e, index).
In view of
i.
practical difficulties in administration of tax for different purpose of the same

transaction,
ii.
inher
ent nature of a derivative contract requiring its settlement otherwise than
by actual delivery,
iii.
need to provide level playing field to all the parties to derivatives contracts,
and
iv.
need to promote derivatives markets, the exchange

-
traded derivatives
contra
cts need to be exempted from the purview of speculative transactions.
Thus must, however, be taxed as normal business income.
EFFECT OF INTRODUCTION OF INDEX FUTURES ON STOCK

MARKET
VOLATILITY: THE INDIAN EVIDENCE
The Indian capital market has witness

ed a major transformation and structural
change during the past one decade or so as a result of on going financial sector reforms
initiated by the Government of India since 1991 in the wake of policies of liberalization
and globalization. The major objecti
ves of these reforms have been to improve market
efficiency, enhancing transparency, checking unfair trade practices, and bringing the
Indian capital market up to international standards. As a result of the reforms several

changes have also taken place in
the operations of the secondary markets such as
automated on
-
line trading in exchanges enabling trading terminals of the National Stock
Exchange (NSE) and Bombay Stock Exchange (BSE) to be available across the country
and making geographical location of an

exchange irrelevant; reduction in the settlement
period, opening of the stock markets to foreign portfolio investors etc. In addition to
these developments, India is perhaps one of the real emerging markets in South Asian
region that has introduced deriva

tive products on two of its principal existing exchanges
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57
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68
viz., BSE and NSE in June 2000 to provide tools for risk management to investors. There
had, however, been a considerable debate on the question of whether derivatives should
be introduced in India o
r not. The L.C. Gupta Committee on Derivatives, which
examined the whole issue in details, had recommended in December 1997 the
introduction of stock index futures in the first place (1). The preparation of regulatory
framework for the operations of the in

dex futures contracts took another two and a
halfyear more as it required not only an amendment in the Securities Contracts
(Regulation) Act, 1956 but also the specification of the regulations for such contracts.
Finally, the Indian capital market saw the
launching of index futures on June 9, 2000 on
BSE and on June 12, 2000 on the NSE. A year later options on index were also
introduced for trading on these exchanges. Later, stock options on individual stocks were
launched in July 2001.
The latest product
to enter in to the derivative segment on these exchanges is
contracts on stock futures in November 2001. Thus, with the launch of stock futures, the
basic range of equity derivative products in India seems to be complete.
Despite the existence of a well

-
d
eveloped stock market for over a hundred years,
trading on derivative contracts in India (index futures) started only in June 2000. It is but
natural that the market players took time to understand the intricacies involved in the
operations of these new in
struments. This is clearly reflected in the growth of business in
the index futures contracts during the period June 2000 to June 2002. The growth can at
the best be said to be modest not only in terms of the number of contracts involved but
also in terms
of value of such contracts.
As far as developed capital markets are concerned, a number of in

-
depth studies
have been carried out to examine various issues relating to financial derivatives. In recent
years, some attempts have also been made to study vari

ous aspects of index futures
relating to emerging markets . Since the introduction of index futures in India is a
recent phenomenon, there has hardly been any attempt to examine the impact of their
introduction on the underlying stock market volatility .

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RECOMMENDATION BASED ON J.R VERMA COMMITTEE

REPORT ON RISK CONTAINMENT MEASURE
1.
INITIAL MARGIN FIXATION METHODOLOGY:
The
exponential moving average method would be used to obtain volatility
estimate everyday. The estimate at the end of day t, is based using the previous
volatility estimate and the returns observed in the futures market during day t. The
margins for 99% Val
ue at risk would be based on 3 sigma limits. There should be
slightly large margin on short positions than on long positions, but the difference is
significant only during period of high volatility where the difference merely reflects
the fact that the do
wnside is limited while the upside is unlimited. The derivative
exchange may apply higher margins on both buy and sell side in such situation.
For a transactional measure, for first six months of trading (until futures market
stabilizes with reasonable le
vel of trading) a parallel estimation of volatility would be
done using the cash index prices instead of index futures prices and the higher of the
two volatility measure would be used to get margins for the first 6 months initial
margin should not be less
than 5%.
2.
DAILY CHANGES IN MARGIN:]
The volatility estimated at the end of the day’s trading would be used in
calculating margin calls at the end of the same day. This implies that during the
course of trading, market participants would not know the exa
ct margin that would
apply to their positions. Trading software should provide volatility estimation and
margin fixation on a realtime basis on trading work station screen.
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68
3.
MARGINING FOR CALENDER SPREADS:
International Markets levy very low margins on c

alendar spreads. A calendar
spread is a position at one maturity which hedged by an offsetting position at different
maturity like a short position in six month contract coupled with a long position in the
nine month contract. The justification for low m
argins is that a calendar spread is not
exposed to the market risk in underlying at all in India. However, unless banks and
institutions enter the calendar spread in a bigway, it would be possible that the cost of
carry would be driven by an unorganized m
oney market rate as in the case of badla
market. These interest rate could be highly volatile.
4.
MARGIN COLLECTION AND ENFORCEMENT:
A part from correct calculation, the actual collection of margin is also of equal
importance. The group recommended that t
he clearing corporation should lay down
operational guidelines on collection of margins and standard guidelines for back
office accounting at the clearing member and trading member level to facilitate the
detection of non compliance at each level.
OTHER R
ECOMMENDATION
From the purely regulatory angle, a separate exchange for futures trading seems to
be a neater arrangement. However, considering the constraints in infrastructure facilities,
the existing stock exchanges having cash trading may also be permit
ted to trade
derivatives provided they meet the minimum eligibility conditions as indicated below:
1.
The trading should take place through an online screen based trading system
which also has a disaster recovery site. The per half hour capacity of the
comp
uters and the network should be atleast 4 to 5 times of the anticipated
peak load in any half hour or of the actual peak load seen in any half hour M P Birla
Institute of Management
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60
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68
during the preceding six months. This shall be reviewed from time to time
on the basis of experience.
2.
The c
learing of the derivatives market should be done by an independent
clearing corporation, which satisfies the conditions listed.
3.
The exchange must have an online surveillance capacity which moniters

positions, prices and volumes in realtime so as to deter m
arket manipulation.
Price and position limits should be used for improving market quality.
4.
Information about trades, quantities and quotes should be disseminated by

the exchange in real time over at least two information vending networks
which are access
ible to investors in the country.
5.
The exchange should have atleast 50 members to start derivatives trading.
6.
If derivatives trading is to take place at an existing cash market, it should be

done in a separate segment with a separate membership i.e., all mem
bers of
the existing cash market would not automatically become members of the
derivatives market.
7.
The derivatives market should have a separate governing council which
shall not have representation of trading/clearing members of the derivatives
Exchange b
eyond whatever percentage SEBI may prescribe after reviewing
the working of the present governance system of exchanges.
8.
The Chairman of the Governing Council of the Derivative

Division/Exchange shall be a member of the Governing Council, if the
chairman is
a Broker/dealer, then, he shall not carry on any broking or
dealing business on any Exchange during his tenure as Chairman.
9.
The exchange should have arbitration and investor grievances redressal

mechanism operative from all the four areas/regions of the c
ountry.
10.
The exchange should have an adequate inspection capability.
11.
No trading/clearing member should be allowed simultaneously to be on the

governing council of both the derivatives market and the cash market.
12.
If already existing, the exchange should have

a satisfactory record of
monitoring its members, handling investor complaints and preventing
irregularities in trading.
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68
TECHNICAL ANALYSIS OF TITAN INDUSTRIES LTD

This study is for making the real Futures contracts taking Titan Industries as
underlying.
These contracts are mainly based on the information provided by technical
analysis. Fundamental analysis is not included as these contracts for only one month and
only technical analysis can be provided buying and selling points and the movement of
this
stock in one month. Where as fundamental analysis cannot predict the market
The above Graph which indicates the price movement of Titan shows that it is in
bullish trend. This bullish is also supported by the huge volume of shares traded.
Volume gene
rally moves along with prices, and is indicative of the intensity of a price
reaction. Both the price and volume are on the rise.
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62
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68
Thus above are the indicative signs for an investor to go bullish on Titan
Industries Ltd., But whether to trade in Futures a
nd Options of this underlying is yet to be
seen on further evaluation through technical analysis.
Simple Moving Average of Titan Industries Ltd
All simple moving averages 13 days, 34days and 89days does not predict any
reversal in the bullish trend. All
the Moving Averages are below the price line and are
moving in the same direction as the price line there fore showing no signs of trend
reversal in near future and conforming bullishness of the stock in near future also.
As far as these simple moving ave

rages move in the same direction and are below
the price line you can safely bet on the contracts. All this based on simple logic that as
long as price at the end of a period is above the average that prevailed in the immediate
past, prices are on an up tr
end. The converse is true for conforming end or a bear market.
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68
Exponential Moving averages of Titan Industries Ltd
Simple moving averages constructed over long time lags behind the trend so to
minimize that more weightage is given to the present data a
nd an Exponential moving
average is constructed. This moving average is more sensitive to any price changes in the
underling. Thus EMA provides a smooth base for analyzing price trends.
The above graph studies the 34 days, 89days and 200days exponential
moving averages.
All averages do not show any trend reversal of bullish phase in prices of underlying in
near future. All are moving along the price line and are below it, indicating no price fall
in near future.
Page
64
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68
Moving Average Convergence and Diverge

nce (MACD)
The darker line in the MACD and lighter one is the signal line in the above chart
below the price chart. Taking ratio of 9day EMA to 20 day EMA draws the chart and
signal line is 9day EMA.
The chart gives the buying and selling signals. Sin

ce the indicator crosses the
reference line from below, we interpret that point as signal for buying the underlying.
Signal line acts as the trigger, which alerts the trader to take an appropriate buy or sale
decision. In the chart above signal line is a
lso giving buy signal as it is above the
indicator.

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65
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68
CHART6
Page
66
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68
Relative Strength Index is another Oscillator which measures the momentum of

the stock. It moves between 0 and 100. This indicator measures the relative internal
strength of the stock.
7 day
and 13 day’s Relative Strength Index is taken into consideration. The
indicator is well within the two boundaries. But in both the above RSI charts the
indicators are moving above the reference line in a direction indicating an uptrend. Only
when the in
dicator crosses the overbought position or the oversold position line, it is a
warning signal to the trader. Thus it shows that it is safe to enter into the F & O contracts
at this point of time
Rate of Change Index (ROC)
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67
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68
This is one of the simples

t and widely used methods to measure momentum of the
price change over a certain period of time.
A rising index indicates a growth in momentum ( a bullish factor ) and falling

index a loss in momentum ( a bearish factor). The line drawn 112 here is a refe
rence line.
In the above price chart ROC is well above the reference line and still raising indicating
further rise in momentum in near future and the rate at which the price is increasing is
growing.
Based on above technical analysis a person can enter i

nto either futures contracts
or into options.
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68
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68
BIBLIOGRAPHY
NSE
--
Derivatives core module
BSE
--
The study material
MAGAZINES
Business world
Dalal Street magazine
•
Futures and Options
WEB SITES
Investopedia.com
Derivativesindia.com
Nseindia.com
Bseindia.com

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M P Birla Institute of Management

RISK CONTAINMENT MEASURE IN INDIAN

STOCK INDEX FUTURES MARKET

SUBMITTED IN PARTIAL FULFILLMENT OF THE

MP BIRLA INSTITUTE OF MANAGEMENT

# 43 RACE COURSE ROAD

M P Birla Institute of Management

I here by declare that, this Project Report entitled “

Reg No. 03XQCM6026

This is to certify that the Project Work report titled “

M P Birla Institute of Management

DEEPAK GUPTA P.K

M P Birla Institute of Management

Then the project goes on to the Performance of Commondity

The project also states some risk management strategies implemented

M P Birla Institute of Management

We had a strong Dollar

Motivation to use derivatives

M P Birla Institute of Management

EVENTS THAT MADE THE LAUNCH OF DERIVATIVES IN INDIA

November 1996, SEBI set up a committee under the chairmanship of Dr. L C

Government issued notification delineating the areas of responsibility between

On June 2000, derivative trading started in NSE and BSE.

what is the role for commodity futures in India's economy?

In India agriculture has traditionally been a area with heavy government

In this case, the question arises

What about futures in bullion?

PERFORMANCE OF COMMONDITY EXCHANGES

Interestingly, commodities in which future contracts are successful are

With the value of India’s commodity economy being around R

WAY AHEAD FOR COMMONDITY EXCHANGE

Commodity exchanges in India are expected to contribute significantly in

market for commodities. Amendments to Essential Commodities Act and implementation

In short, we are poised to witness the resurgence

FACTORS DRIVING THE GROWTH OF FINANCIAL

Increased volatility in asset prices in financial markets.

Increased integration of national financial markets with

Marked improvement in communication facilities and sharp decline in the costs.

Development of more sophisticated risk management tools, providing ecomomic

M P Birla Institute of Management

POPULARITY OF STOCK INDEX FUTURES

1. Stock index is difficult to be manipulated as compared to individual stock prices, more

The Index is Pervasive

Index derivatives are a powerful tool for risk

This is expensive in terms of the transactions costs faced in se

Using index futures, the same objective would be acco

These are unique and new forms of risk management in

FUTURES TRADING PROCESS

Arbitrage with Nifty futures

Arbitrage is the opportunity of taking advantage of the price difference between

M P Birla Institute of Management

Hedging with NIFTY futures

Let us assume that an investor is holding a portfolio of following scrips

Formula to calculate the number of futures for hedging purposes is

Beta of the above portfolio

=1.61075 (round to 1.61)

Applying the formula to calculate the number of futures contracts

Assume NIFTY futures to be 1150 on 1

= (1,000,000.00 * 1.61) / 1150

Sell 7 NIFTY futures

Stock portfolio fall by 6%

NIFTY futures falls by

Net Profit: + Rs 15,450.00