CHAPTER - I

INTRODUCTION

1
1.1 INTRODUCTION

A country is termed prosperous if its economy is doing well. There are a large
number of influencing factors which determines the prosperity of the economy, like
Per-capita income of people, GDP, Imports & Exports, Forex Reserves, etc. In short it
can be told that Financial Market is an important contributor to the economy. In this
financial market, capital market plays a significant role. The capital market always
replicates the power and ability of the investors and their faith in the market. Earlier the
capital market was shy. But market deregulations, growth in global trade and
technological development have revolutionized the financial market place. A by-
product of this revolution is increased market volatility, which has led to a
corresponding increase in risk management products. This demand is reflected in the
growth of financial derivatives and derivatives market. But, question arises, are these
derivatives risk free? As world’s one of the greatest investor once said,

“Risk is a part of God’s game, alike for man and nation”

Thus it can be said that these risk management instruments are not risk free.
This indicates the essence of risk management of derivatives.

1.2 RATIONALE

In this world of uncertainty risk management has an immense importance for corporate.
Financial derivatives which are introduced with a prime objective of hedging risk, when
used for speculative purposes resulted with increased risk. Thus, risk management of
financial derivatives is a major area of concern. In case of an exchange, as exchange
plays the role of counterparty for both buyer and seller, it is more exposed to
counterparty risk and all other risk associated with the financial derivatives. This leads
to the essence of risk management of derivatives in exchanges. The various tools used
by the exchanges for risk management includes margins, position limits, and various
rules and regulations laid down by the regulatory authority for derivative trading.

2
All these process of risk management is done by wholly computerized process and with
specific software. The inclusion of latest technology has made the risk management
process more reliable.

The risk management of derivatives not only secures Stock Exchanges, but also creates
confidence in the minds of the investors. This enhances more investments in the
derivatives market, which leads to business prosperity. Thus the most of the exchanges
have their risk management procedure for risk management of derivatives.

1.3 OBJECTIVE

On the above outset, the following are the laid down as the objective of this study,

I. To study the risk associated with derivative market and derivative trading.
II. To study the risk management tools used in Bombay Stock Exchange Limited
for mitigating these risks.
III. To study the margining system for derivatives.

V. To do comparative analysis of the risk management process of BSE with that

of NSE
VI. To give suggestion and recommendations for improvement in risk management
process of derivatives in BSE.

3
1.4 LIMITATIONS

Some of the limitations that are faced during the project are;

1. The information collected is limited by the authenticity and accuracy of

information provided by the interviewees. The data collected from the websites
are limited. Certain information was not disclosed to maintain the secrecy of the
exchange.
2. The time predefined for this project was 8 weeks, which is very short for
covering such a big project.

4
 CHAPTER – II
REVIEW OF LITERATURE

5
2.1 REVIEW OF LITERATURE

Scharfstein and Stein (1993) constructed the models of financial risk management.
These models predicted that firms attempted to reduce the risks arising from large costs
of potential bankruptcy, or had funding needs for future investment projects in the face
of strongly asymmetric information. In many instances, such risk reduction can be
achieved by the use of derivative instruments.

Campbell and Kracaw (1987), Bessembinder (1991), Nance, Smith and Smithson
(1993), Dolde (1995), Mian (1996), as well as Getzy, Minton and Schrand (1997)
and Haushalter (2000) found empirical evidence that firms with highly leveraged
capital structures are more inclined to hedging by using derivatives. The probability of
a firm to encounter financial distress is directly related to the size of the firm’s fixed
claims relative to the value of its assets. Hence, hedging will be more valuable the more
indebted the firm, because financial distress can lead to bankruptcy and restructuring or
liquidation - situations in which the firm faces direct costs of financial distress.

Nance, Smith and Smithson (1993), Dolde (1995), Mian (1996), Getzy, Minton and
Schrand (1997) and Hushalter (2000) argue that larger firms are more likely to hedge
and use derivatives. One of the key factors in the corporate risk management rationale
pertains to the costs of engaging in risk-management activities. The hedging costs
include the direct transaction costs and the agency costs of ensuring that managers
transact appropriately. The assumption underlying this rationale is that there are
substantial economies of scale or economically significant costs related to derivatives
use.

6
Lin, Pantzalis and Park (2007) provided an additional insight into firms’ risk
management practices risk management activities. In particular, their evidence
establishes the use of derivatives as an important corporate policy with real implications
in terms of valuation. It is well documented that larger and more sophisticated firms are
more likely to use derivatives. They provide the additional evidence that information
asymmetry has a more negative impact on firm value for firms that do not use
derivatives. Their findings are consistent with the notion that large numbers of
diversified firms rationally choose to use derivatives to lower information asymmetry
and to thereby reduce the negative valuation effects of diversification. Their evidence
compliments the earlier findings of both the risk management literature and the
diversification discount literature.

Anand and Kaushik (2007) analyse the derivatives usage in India, focusing on foreign
exchange risk management. The questionnaire was mailed to 640 companies, which
were common across two most widely used Indian stock market indices having foreign
exchange exposure. In their study 55 responses were received leading to a response rate
of 8.59%. Answers show that 70.4% of the respondents firms explained that they used
foreign exchange risk management plan or policy or programme because risk managers
had acquired the awareness that these activities not only mitigate the risks but also allow
the reduction of the volatility in profits and in the cost of the capital, therefore increasing
the value of the firms. Also, the firms with high debt ratio were more likely to use
foreign currency derivatives. The authors, finally, classified the finalities to which the
risks managers tended in their activity: the major objective of using derivatives is
hedging the risk for arbitrage purpose and price discovery; the speculation as objective
of using foreign currency derivative is the least preferred option.

Lien and Zhang (2008) revealed financial derivatives markets have helped to support
capital inflows into emerging market economies. On the other hand, using financial
derivatives has had negative effects, leading to exacerbated volatility and accelerated
capital outflow. There is a consensus that the derivatives are seldom the cause of the
crisis, but they could amplify the negative effects of the crisis and accelerate contagion.
The underlying reasons for the negative effects are associated with the leverage nature
of derivatives transactions, non-transparent reporting of transaction risks, and
unsophisticated or insufficient risk management controls in financial institutions, as
well as weak prudential supervision.

7
Nguyen and Faff (2010) investigated the relationship between the use of financial
derivatives and firm risk using a sample of Australian firms. Their results suggest that
this relationship is nonlinear in nature. They found that the use of financial derivatives
is associated with a risk reduction for moderate derivative users. Derivative usage
among extensive derivative users, on the other hand, appears to lead to an increase in
firm risk. They also found that compared to firms that do not make use of derivatives,
there is no evidence that extensive derivative users are exposed to a risk level in excess
of that of nonderivative users. Their results are, therefore, indicative of a hedging
motive behind the use of financial derivatives.

Bartram, Brown and Conrad (2011) used a large sample of nonfinancial firms from
47 countries and examined the effect of derivative use on firm risk and value. They
control for endogeneity by matching users and nonusers on the basis of their propensity
to use derivatives. They also use a new technique to estimate the effect of omitted
variable bias on inferences. They find strong evidence that the use of financial
derivatives reduces both total risk and systematic risk. The effect of derivative use on
firm value is positive but more sensitive to endogeneity and omitted variable concerns.
However, using derivatives is associated with significantly higher value, abnormal
returns, and larger profits during the economic downturn in 2001–2002, suggesting that
firms are hedging downside risk.

Flavio Angelini and Stefano Herzel (2010) explicitly compute closed formulas for the
minimal variance hedging strategy in discrete time of a European option and for the
variance of the corresponding hedging error under the hypothesis that the underlying
asset is a martingale following a geometric Brownian motion. The formulas are easy to
implement, hence the optimal hedge ratio can be employed as a valid substitute of the
standard Black–Scholes delta, and the knowledge of the variance of the total error can
be a useful tool for measuring and managing the hedging risk.

Jitka Hilliard and Wei Li (2013) developed a new volatility measure: the volatility
implied by price changes in option contracts and their underlying, referred to this as
price-change implied volatility. In this study, the authors compared moneyness and
maturity effects of price-change and implied volatilities, and their performance in delta
hedging. They found that delta hedges based on a price-change implied volatility
surface outperform hedges based on the traditional implied volatility surface when
applied to S&P 500 future options.

8
 CHAPTER – III
COMPANY PROFILE

9
3.1 COMPANY PROFILE

Bombay Stock Exchange Limited is the oldest stock exchange of Asia and one
of the oldest in World with a rich heritage. As the first stock exchange in India, the
Bombay Stock Exchange Limited is considered to have played a very important role in
the development of county’s capital market. The BSE is the largest stock exchange of
24 exchanges in India, with over 6000 listed companies. It is also the fifth largest
exchange in the world with a market capitalization of $466 billion.

The Bombay Stock Exchange Limited uses BSE SENSEX, an index of 30 large,
developed BSE stocks. This index gives a measure of overall performance of BSE and
is tracked worldwide.

In addition to individual stocks the Bombay Stock Exchange Limited also a

market for derivatives, which was first introduced in India. Listed derivatives on the
exchange include stock futures and options, Index futures and options and weekly
options. The Bombay Stock exchange is also actively involved with the development
of retail debt market.

The Exchange has a nationwide reach with its presence in 417 cities and towns
of India. The systems and processes of the exchange are designed to safeguard market
integrity and enhance transparency in the operations. The Exchange provides an
efficient and transparent market for trading in equity, debt and derivative instruments.
The BSE provides online trading with the BSE’s Online Trading System (BOLT),
which is a proprietary system of the exchange and is BS 7799-2-2002 certified. The
Surveillance and Clearing Settlement function of the Exchange are ISO 9001:2000
certified.

VISION

“Emerge as the premier Indian stock exchange by establishing global benchmark”

10
3.2 HISTORY

One of the oldest stock exchanges of the world and the first in the country to be
granted permanent recognition under the Securities Contract (Regulation) Act, 1956,
Bombay Stock Exchange Limited has had an interesting rise to prominence over the
past 133 years.

The Bombay Stock Exchange Limited traces its history to the 1850s, when four
Gujarati and one Parsi stock broker would gather under the banyan tree in front of the
Town Hall, where the Horniman Circle is now situated. A decade later, the brokers
moved their venue to another set of foliage, this time under banyan trees at the junction
of Meadows Street and Mahatma Gandhi Road. As the number of brokers increased,
they had to shift from place to place and wherever they went, through sheer habit, they
overflowed to the streets. At last, in 1874, found a permanent place. The new place was,
aptly, called Dalal Street.

This group of brokers in 1875 formed an official organization known as “The

Native Share and Stock Brokers Association”. In 1956, BSE became the first stock
exchange to be recognized by the Indian Government under the Securities Contract
(Regulation) Act, 1956. In 1979, BSE introduced its Index SENSEX and from that time
it achieved many milestones in the capital market. In 2002, the name “The Exchange,
Mumbai” was changed to Bombay Stock Exchange. Subsequently on August 5, 2005,
the exchange turned into a corporate entity from an Association of Persons (AOP),
under the provision of Companies Act, 1956, pursuant to BSE (Corporatization and
Demutualization) Scheme, 2005 notified by Securities and Exchange Board of India
(SEBI). Then it is renamed as the “Bombay Stock Exchange Limited”.

11
3.3 PROMINENT POSITION

The journey of BSE is as eventful and interesting as the history of securities markets of
India. India’s biggest bourse, in terms of listed companies and market capitalization,
BSE has played a pioneering role in Indian securities market. Much before the actual
legislations were enacted, BSE had formulated comprehensive set of rules and
regulations for Indian capital markets. It also laid down best practices adopted by Indian
capital market after India gained its independence. Perhaps, there would not be any
leading corporate in India, which has not sourced BSE’s services in resource
mobilization.

3.4 A PIONEER

BSE as brand is synonymous with the capital markets in India. The BSE
SENSEX is the benchmark equity index that reflects the robustness of the economy and
finance. At par with international standards, BSE has been a pioneer in several areas. It
has a several firsts to its credit,
 First in India to introduce Equity Derivatives
 First in India to launch a Free Float Index
 First in India to launch US$ version of BSE SENSEX.
 First in India to launch Exchange Enable Internet Trading Platform
 First in India to obtain ISO certification for Surveillance, Clearing and Settle.
 First to have exclusive facility for financial training.
 ‘BSE On-Line Trading System’ (BOLT) has awarded with the global recognized
Information Security Management System Standard BS7799-2-2002.
 Moved from Open Outcry to Electronic Trading within just 50 days.

An equal important accomplishment of BSE is the launch of a nationwide investor

awareness campaign – Safe Investing in the Stock Market – under which nationwide
awareness campaigns and dissemination of information through print and electronic
medium was undertaken. BSE also actively promoted the securities market awareness
campaign of the Securities and Exchange Board of India (SEBI).

12
3.5 AWARDS

Bombay Stock Exchange Limited has many awards to its name for its excellence
in several fields, these are
 The World Council of Corporate Governance has awarded the Golden
Peacock Global CSR Award for BSE’s initiatives in Corporate Social
Responsibility (CSR).

 The Annual Reports and Accounts of BSE for the year ended March 31,
2006 and March 31, 2007 have been awarded the ICAI Awards for
excellence in financial reporting.

 The Human Resource Management at BSE has won the Asia – Pacific
HRM Award for its efforts in employer branding through talent
management at work, health management at work and excellence in HR
through technology.

3.6 BSE SWOT ANALYSIS

STRENGHS:

 BSE has inherent advantages: its history, larger scrip base and a stronger brand.
 The SENSEX (BSE’s 30-share sensitive index) is one of the most recognized
indexes and tracked worldwide.
 Apart from lager base of listed companies, BSE also has a historical
perspective.

 Its online trending system (BOLT) has awarded with the global recognized
Information Security Management System Standard BS7799-2-2002.
 It got the ISO certification for its surveillance and clearing and settlement.

13
WEAKNESS:

 The BSE SENSEX, which delivers inferior hedging effectiveness and higher
impact cost.

 At present BSE has fewer than 12% share across the cash and derivative
market of equity markets.
 At present, BSE is almost non-existence in derivatives space.

 BSE also lacks in terms of providing better services to its customers and is not
proactive.

OPPORTUNITIES:

 Corporatization will improve internal management systems and investor

relations, and benefit companies that are listed on BSE.

 Derivatives market is growing at exponential rate and BSE with its large
infrastructure and long presence in the capital market has the capability to
expand its market share in this segment.

 If large a private sector bank picks up a strategic stake in BSE, it could give the
exchange access to a large distribution network and promote new products like
derivatives. The strategic investor could also be a market maker (providing buy
and sell quotes at any given time).

 30 to 40 percent of the income of exchange like NASDAQ and NYSE is from

vending data. For BSE, it’s measly 4 percent. The potential for growth then, is
immense.

THREATS:
 Aggressive competitor like NSE poses major threat to BSE’s future.

 NSE’s top 100 stocks alone account for nearly 80 percent of its cash segment’s
turnover, indicating that NSE is clearly the preferred destination for trading in
the top stocks.

14
 CHAPTER – IV
INTRODUCTION TO DERIVATIVES

15
 4.1 DERIVATIVES

Risk is a characteristic feature of all commodity and capital markets. Over time,
variations in the prices of agricultural and non-agricultural commodities occur as a
result of interaction of demand and supply forces. The last two decades have witnessed
a many-fold increase in the volume of international trade and business due to the ever
growing wave of globalization and liberalization sweeping across the world. As a result,
financial markets have experienced rapid variations in interest and exchange rates, stock
market prices thus exposing the corporate world to a state of growing financial risk.

Increased financial risk causes losses to an otherwise profitable organization.

This underlines the importance of risk management to hedge against uncertainty.
Derivatives provide an effective solution to the problem of risk caused by uncertainty
and volatility in underlying asset. Derivatives are risk management tools that help an
organization to effectively transfer risk. Derivatives are instruments which have no
independent value. Their value depends upon the underlying asset. The underlying asset
may be financial or non-financial.

The term “derivative” can be defined as a financial contract whose value is

derived from the value of an underlying asset. Section 2(ac) of Securities Contract
(Regulation) Act, (SCRA), 1956 defines derivatives as,
a) “a security derived from a debt instrument, share, loan whether secured or unsecured,
risk instrument or a contract for difference or any other form of securities;
b) “a contract which derives its value from the prices, or index of prices, of underlying
securities”.

The underlying asset may be a stock, bond, a foreign currency, commodity or

even another derivative security. Derivative securities can be used by individuals,
corporations, and financial institutions to hedge an exposure to risk.

16
4.2 DERIVATIVE PRODUCTS

Derivative contracts have several variants. The most common variants are
forwards, futures, options and swaps. Various derivatives contracts are described below,

4.2.1 FORWARDS

A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at today’s pre-agreed price. A
forward contract is an agreement between two parties to buy or sell an asset at a specific
point of time in future and the price which is paid /received by the parties is decided at
the time of entering the contract.

4.2.2 FUTURE
A future contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Future contracts are standardized forward
contracts. Future contracts are traded in exchanges and exchange sets the standardized
terms in term of quantity, quality, price quotation, date and delivery date (in case of
commodities).

4.2.3 OPTIONS
An option contract, as the name suggests, is in some sense an optional contract.
An option is the right, but not the obligation, to buy or sell something at a stated date at
a stated price. Options are of two types;

 CALL OPTION: A call option gives the buyer of the option the right, but not
the obligation to buy a given quantity of the underlying asset, at a given price
and on or before a given date.

 PUT OPTION: Put options give the buyer the right, but the obligation to sell a
given quantity of underlying asset at a given price on before a given date.

17
 Options can also be European options and American options. This classification
is based on the exercise of the options. European options can be exercised at the
maturity date of the option. On the other hand, American options can be exercised at
any time up to and including the maturity date.

4.2.4 WARRANTS
Options generally have lives of up-to one year. Long dated options are called as
warrants and generally traded over-the-counter.

4.2.5 LEAPS
Long-Term-Equity-Anticipated Securities are options having a maturity of more
than three years or in other words options having a maturity of more than three years
are termed as LEAPS.

4.2.6 BASKETS
Basket options are options on portfolio of underlying assets. Equity index
options are a form of basket options

4.2.7 SWAPS
A swap means a barter or exchange. Thus, a swap is an agreement between two
parties to exchange stream of cash flows over a period of time in future. The two
commonly used swaps are,

 INTEREST RATE SWAPS: Swaps which entail swapping only the interest
related cash flows between the parties in the same currency.

 CURRENCY SWAPS: These entail swapping both principal and interest

between two parities, with cash flows in one direction being in different currency
than those in the opposite direction.

18
4.3 PARTICIPANTS IN DERIVATIVE MARKET

The reason for which derivatives are so attractive is that they have attracted
different types of investors and have a great deal of liquidity. When an investor wants
to take one side of a contract, there is usually no problem in finding someone that is
prepared to take the other side. Three broad kinds of participants can be found in
derivatives market, namely, hedgers, speculators and arbitrageurs.

 Hedgers: They use derivatives markets to reduce or eliminate the risk associated
with price of an asset. Majority of the participants in derivatives market belongs
to this category.

 Speculators: They transact futures and options contracts to get extra leverage in
betting on future movements in the price of an asset. They can increase both the
potential gains and potential losses by usage of derivatives in a speculative
venture.

 Arbitrageurs: Their behaviour is guided by the desire to take advantage of a

discrepancy between prices of more or less the same assets or competing assets
in different markets. If, for example, they see the futures price of an asset getting
out of line with the cash price, they will take offsetting positions in the two
markets to lock in a profit.

19
4.4 CLASSIFICATION OF DERIVATIVES

Broadly derivatives can be classified into two categories, commodity derivatives

and financial derivatives. In case of commodity derivatives, the underlying asset can be
commodities like wheat, gold, silver etc.; whereas in case of financial derivatives the
underlying assets are stocks, currencies, bonds and other interest bearing securities etc.
A figure below shows the classification of derivatives,

Figure – 4.1
Classification of Derivatives

20
 Basing on the type of market, derivative market is of two types, exchange-traded
derivatives market and over-the-counter derivative market. In the exchange-traded
derivatives, the derivatives which are standardized in nature are traded. The trading of
the derivatives is well regulated by the exchanges. The over-the-counter market is an
important derivative market and has larger volume of trade than the exchange-traded
market. It is a telephone- and computer- linked network of dealers. Traders are done
over the phone and are usually between two financial institutions or between a financial
institution and one of its clients. Telephone conversations in the OTC market are usually
taped. If there is a dispute about what was agreed, the tapes are replayed to resolve the
issue. A key advantage of over-the-counter market is that all the products are
customized. Market participants are free to negotiate any mutually alternative deal. A
disadvantage is that there is usually credit risk in an over-the-counter trade. The over-
the-counter market is not regulated by any regulatory body and hence possess a huge
counterparty risk.

4.5 ECONOMIC SIGNIFICANCE OF DERIVATIVES

Some of the significance of financial derivatives can be enumerated as follows;

1. The most important function of derivatives is risk management. Financial

derivatives provide a powerful tool for limiting risks that individuals and
organizations face in ordinary conduct of their business.

2. The prices of derivatives converge with the prices of underlying at the expiration
of derivative contract. Thus, derivatives help in discovering the future as well as
current prices.

3. As derivatives are closely linked with the underlying cash market, with the
introduction of derivatives, the underlying cash markets witness higher trading
volumes. This is because; more people participate in stock market due to the risk
transferring nature of derivatives.

21
 4. Speculative trade shift to a more controlled environment of derivative market. In
the absence of an organized derivatives market, speculators trade in the cash
markets. Margining, monitoring and surveillance of various participants become
extremely difficult in these kinds of mixed markets.

5. Derivatives trading acts as a catalyst for new entrepreneurial activities.

In a nut shell, derivatives markets encourage investment in long run. Transfer of risk
enables market participants to expand their volume of activity.

4.6 HISTORY OF DERIVATIVES

The history of derivatives is quite colourful and surprisingly a lot longer than
most people think. The origin of derivatives can be traced in Bible. In Genesis Chapter
29, believed to be about the years 1700 B.C., Jacob purchased an option costing him
seven years labour that granted him the right to marry Laban’s daughter Rachel. Around
580 B.C., Thales the Milesian purchased option on Olive presses and made a fortunate
off of a bumper crop in Olives. So, derivatives were before the time of Christ.

The first exchange for trading derivatives appeared to be Royal Exchange in London,
which permitted forward contracting on tulip bulbs at around 1637. The first “futures”
contracts are generally traced to the Yodaya rice market in Osaka, Japan around 1650.
These were evidently standardized contracts, which made them much like today’s
futures, although it is not known whether the contracts are marked to market daily,
and/or had credit guarantee.

Probably the next major event, and the most significant as far as the history of
derivatives markets, was the creation of Chicago Board of Trade in 1848. Due to its
prime location, Chicago was developing as a major centre for the storage, sale, and
distribution of Midwestern grain. Due to seasonality of grain, however Chicago’s
storage facilities were unable to accommodate the enormous increase in supply that

22
occurred following the harvest. Similarly, its facilities were underutilized in spring.
Chicago’s spot prices rose and fall drastically. To resolve this problem a group of grain
traders created “to-arrive” contracts which permitted the farmers to lock in the price and
deliver the grains in future. These to-arrive contracts are called as forward contracts.
The forward contracts proved as a useful device for hedging the price risk. However,
“credit risk” remained as serious problem. To deal with this problem, a group of
Chicago businessmen formed the Chicago Board of Trade (CBOT), in 1848. The
primary intention of CBOT was to provide a centralize location for buyers and sellers
to negotiate forward contracts. In 1865, CBOT went one step further and listed the first
“exchange traded” derivatives in US, which are termed as “Futures Contracts”. In 1919,
Chicago Butter and Egg Board, a spin-off of CBOT, got approval for futures trading.
Its name was changed to Chicago Mercantile Exchange (CME). In 1925, the first
clearing house for derivatives trading was established.

Since then, derivatives are traded in many exchanges, although their trading was
banned by Government of different countries from time to time. But, the modern
derivative market has originated in 1970’s. This is due to the unprecedented volatility
in the international financial environment, starting with the breakdown of Bretton-
woods systems on 15 August 1971 and ending with the well-known Saturday night
massacre of Federal Reserve on 6th October 1979. The breakdown of Bretton woods
system resulted in inflation, volatility in the market place and currency turmoil. This
state of affairs heralded the emergence of financial derivatives.
The next major fillip for development of derivatives was provided in October
1979, when the US Federal Reserve started its policy of interest rate deregulation and
anti-inflationary monetary policy. This resulted in increased interest rates. This marked
the emergence of interest rate derivatives to hedge interest rate risk.
The history of financial derivatives is concurrent with the history of various risks
in the financial world. The fascination with risk and its components started during the
early 1970’s has grown substantially since then, resulting in the expansion of financial
derivatives market.

23
4.7 INTERNATIONAL DERIVATIVE MARKET

The financial derivatives which were meant to address the needs of farmers and
merchants have now a major share in the financial market place. Started with the
establishment of Chicago Board of Trade (CBOT), derivatives are now traded in almost
all major stock exchanges of the world. Boosted with the breakdown of Brettonwoods
system, the derivatives got the recognition of risk management instruments and are used
by all investors starting from individual investor to institutional investor.

Thus, the global derivative market is now a wide spread market with a potential
of further growth. In last two decades derivatives has shown a tremendous growth and
also continuing to grow in future. Major stock exchanges of derivatives trading are
Chicago Mercantile Exchange (CME), Eurex, Hongkong Futures Exchange, The
London International Financial Futures and Options Exchange (LIFFE), Singapore
Exchange, Sydney Futures Exchange etc. Apart from these stock exchanges other stock
exchanges of various countries has shown a huge growth in derivatives trading.

4.8 INDIAN DERIVATIVE MARKET

Derivatives markets in India have been in existence in one form or the other for
a long time. In the area of commodities, the Bombay Cotton Trade Association started
futures trading way back in 1875. In 1952, the Government of India banned cash
settlement and options trading. Derivatives trading shifted to informal forwards
markets. In recent years, government policy has shifted in favour of an increased role
of market-based pricing and less suspicious derivatives trading. The first step towards
introduction of financial derivatives trading in India was the promulgation of the
Securities Laws (Amendment) Ordinance, 1995. It provided for withdrawal of
prohibition on options in securities. The last decade, beginning the year 2000, saw
lifting of ban on futures trading in many commodities. Around the same period, national
electronic commodity exchanges were also set up.

24
 Derivatives trading commenced in India in June 2000 after SEBI granted the
final approval to this effect in May 2001 on the recommendation of L. C Gupta
committee. Securities and Exchange Board of India (SEBI) permitted the derivative
segments of two stock exchanges, NSE and BSE, and their clearing house/corporation
to commence trading and settlement in approved derivatives contracts. Initially, SEBI
approved trading in index futures contracts based on various stock market indices such
as, S&P CNX, Nifty and SENSEX. Subsequently, index-based trading was permitted
in options as well as individual securities.

The trading in BSE SENSEX options commenced on June 4, 2001 and the
trading in options on individual securities commenced in July 2001. Futures contracts
on individual stocks were launched in November 2001. The derivatives trading on NSE
commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index
options commenced on June 4, 2001 and trading in options on individual securities
commenced on July 2, 2001. Single stock futures were launched on November 9, 2001.
The index futures and options contract on NSE are based on S&P CNX. In June 2003,
NSE introduced Interest Rate Futures which were subsequently banned due to pricing
issue. Since the scope of this project is limited to equity derivatives only, so the further
discussion will be confined to equity derivatives only.
Equity derivatives market in India has registered an "explosive growth" and is expected
to continue the same in the years to come. Introduced in 2000, financial derivatives
market in India has shown a remarkable growth both in terms of volumes and numbers
of traded contracts. NSE alone accounts for 99 percent of the derivatives trading in
Indian markets. The introduction of derivatives has been well received by stock market
players. Trading in derivatives gained popularity soon after its introduction. In due
course, the turnover of the NSE derivatives market exceeded the turnover of the NSE
cash market. For example, in 2008, the value of the NSE derivatives markets was Rs.
130, 90,477.75 Cr. whereas the value of the NSE cash markets was only Rs. 3,551,038
Crore. If I compare the trading figures of NSE and BSE, performance of BSE is not
encouraging both in terms of volumes and numbers of contracts traded in all product
categories.

25
 Figure 3.2
Business Growth of Derivatives in India from 2000- 2011(May)

Indian Derivatives Market

20000000
18000000
16000000
14000000
12000000
10000000
8000000
6000000
4000000
2000000
0
2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11

Indian Derivatives Market

NSE’S DERIVATIVE SEGMENT

The National Stock Exchange accounts almost 99% of the Indian derivatives
market in terms of turnover, volume etc. Its equity derivatives market is most boosted
one and in turnover it is a major stock exchange. All products in equity derivative
segment i.e. Index Futures and Options and Stock Futures and Options have marked a
tremendous growth over the last decade. The graph below shows the average yearly
turnover in each equity derivative products and average daily turnover of derivative
segment of NSE.

26
 Figure – 3.3
Equity Derivative Market of India

Figure – 3.4
Average Daily Turnover of India’s Derivatives Market

27
 CHAPTER – V
RISK AND RISK MANAGEMENT

28
5.1 RISK

Over the past two decades and so, the markets have seen debacle after another,
each of which has brought its lessons – from some of which the markets have learned
and from many of which markets still need to learn. The Great Depression of 1930’s
has brought remainder to all financial markets or the economies as a whole. The 1987
crash taught markets the dangers of automated trading models and the second and third-
order effects of credit crisis. In 1990, Wall Street learned the horrors of holding huge
illiquid investments. In 1994’s spectacular bond market collapse, financial executives
saw for the first time how correlated global markets had become as the fallout from
Federal Reserve Board rate hikes swept from the US through Europe, before devastating
Mexico and other emerging markets.

The Russian meltdown in August 1998 was widespread and mounting. Banks
and brokerage firms took turns announcing trading losses from emerging markets, high
yield, equities, or dealings with hedge funds. Most recently, the Global Financial
Meltdown, which was started with the US sub-prime mortgage crisis, has captured
almost all economies of the world. Many banks become bankrupt, people loss their job,
increased budgetary deficits are the result of this crisis. Thus, it can be said that, the
financial market is full of risk and uncertainties.

Finance has never been so competitive, so far-flung, and so quantitative.

Information flow has never been so fast. But with the passage of time, financial markets
are becoming more sophisticated in pricing, isolating, repackaging, and transferring
risks. Tools such as derivatives and securitization contribute to this process, but they
pose their own risks. The failure of accounting and regulation to keep abreast of
developments includes yet more risks, with occasionally spectacular consequences.

29
 Practical applications – including risk limits, trader performance-based
compensation, portfolio optimization, and capital calculations – all depend on the
measurement of risk. In the absence of a definition of risk, it is unclear what, exactly,
such measurements reflect.

Charles Tschampion, the MD of the $50 bn GM Pension fund, once said – “Investment
management is not an art, not science, it is engineering. We are in the business of
managing and engineering financial investment risk”; the challenge “is to first not take
more risk than we need to generate the returns that is offered”. It is a profound statement
that well captures the philosophical and mathematical connotation of ‘Risk’.

The terms risk and uncertainty are often used interchangeably though there is a
clear distinction between them. Certainty is a state of being completely confident,
having no doubts of whatever being expected. Uncertainty is just opposite of that. Risk
is situation where there are a number of specific, probable outcomes, but it is not certain
as to which one of them will actually happen. In that context risk is not an abstract
concept. It is a variable, which can be calibrated, measured and compared. So to define
risk, risk entails two essential components; exposure and uncertainty. Thus, risk is the
exposure to uncertainty.

30
5.2 RISK MANAGEMENT PROCESS

Market integration, liberalization, globalization and technical advancement has

resulted with an increased competition in the market and the corporate are hence
exposed to risk. Thus a proper and unbiased assessment of risk is a prerequisite for a
sound management process. Moreover, with the advancement of communication
system and technology, the markets over the world are getting interconnected. Thus
making an effective risk management system is the need of the hour.

Risk management is the process in which risk is minimized with the application
of certain tools. The risk management process essentially comprises of certain steps,
such as, identification, assessment, prioritization, followed by coordinated and
economical application of resources to minimize, monitor and control it. These steps
are described below:

5.2.1 IDENTIFICATION

The risk management process starts with the identification of the factors which
are exposed to risk. It is always of primary concerns to identify the factors which are
more vulnerable and weak points in the system.

5.2.2 ASSESSMENT

After identifying the risk exposure points, it then to be assessed, i.e. to what
extent it is susceptible to that particular risk that has to be measured. Assessment of risk
helps in knowing the extent of vulnerability of a particular factor which is risk exposed.

31
5.2.3 PRIORITIZATION

The next step of risk management process is the prioritization of factors which
are more vulnerable. The assessment of risk results in identifying the factors which are
more risk exposed and then these factors are prioritized from risk management point of
view.

5.2.4 APPLICATION OF RESOURCES TO MINIMIZE RISK

After identifying the most vulnerable factor, the management team applies
economic resources to minimizing the risk. This is the most important stage of risk
management as any wrong step can result a more susceptible situation.

5.2.5 MONITOR

The final step of risk management is monitoring the risk management process.
Simply applying the resources to minimize the risk is not the last step of risk
management, as it is needed to analyze the success of the risk management process. For
this reason, the entire process is monitored and if anything goes wrong, it is rectified.

32
5.3 RISK ASSOCIATED WITH DERIVATIVES TRADING

The continuing discussion of risks and its management in derivative markets illustrates
that there is little agreement on what the risks are and how to control it. One source of
confusion is the sheer profusion of names describing the risks arising from derivatives.
Besides the “price risk” of losses on derivatives from change in underlying asset values,
there is “default risk”, “settlement risk”, and “operational risk”. Last, but certainly not
the least, is the spectre of “systemic risk” that has captured so much congressional and
regulatory attention. All these risks associated with derivatives market are described
below:

5.3.1 PRICE RISK

Price arises for the simple reason that the price of the underlying and price of the
derivatives are correlated. If the prices of the underlying increases, the impact is seen
in corresponding prices of derivatives products i.e. their prices also increase. For an
investor who is short in a futures contract or long in a put option or short in a call option,
there are potential losses. Thus, he or she may default in the obligation of the derivative
contract. This is price risk associated with the derivatives. Default due to Price risk is
mitigated by imposing some risk management tools in exchange-traded derivatives, but
in case of over-the-counter market, since it is largely unregulated, default is more due
to price risk.

33
5.3.2 DEFAULT RISK

This may the most popular and hazardous risk associated with the derivatives.
As derivatives are contracts or agreements, they need the obligations to be performed.
If any party default from the contract, then the contract is meaningless. The risk that
arises from the default of any party in derivatives is called as default risk.

This is common risk that is found in over-the-counter derivative market, but in

exchange-traded market, this type of risk is minimized by regulating the transactions.

Default risk is the risk that losses will be incurred due to default by the
counterparty. As noted above, part of the confusion in the current debate about
derivatives stems from the profusion of names associated with the default risk. Terms
such as “credit risk” and “counterparty risk” are essentially synonyms for default risk.
“Legal risk” refers to the enforceability of the contract. Terms such as “Settlement risk”
and “Herstatt risk” refer to defaults that occur at a specific point in the life of the

contract: date of settlement. These terms do not represent independent risks; they just
describe different occasions or causes of default.

Default risk has two components: the expected exposure and the probability that
default will occur. The expected exposure measures how much capital is likely to be at
risk should the counterparty defaults. The probability of default is the measure of the
possibility that the counterparty will default.

5.3.3 SYSTEMATIC RISK

One of the prominent concerns of regulators is “systematic risk” arising from

derivatives. Although this risk is rarely defined and almost never quantified, the
systemic risk associated with the derivative contracts is often envisioned as a potential
domino effect in which default in one derivative contract spreads to other contracts and
markets, ultimately threatening the entire financial system.

34
 For the purpose of this paper, systemic risk can be defined as widespread default
in any set of financial contracts associated with default in derivatives. If derivative
contracts are to cause widespread default in other markets, there first must be large
defaults in derivative markets. In other words, significant derivative defaults are a
necessary condition for systematic problems.

It is argued that widespread corporate risk management with derivatives

increases the correlation of default among financial contracts. What this argument fails
to recognize, is that the adverse effects of stocks on individual firms should be smaller
precisely because the same shocks are spread more widely. Moe important, to the extent
firms use derivatives to hedge their existing exposures, much of impact of stocks is
being transferred from corporations and investors less able to bear them to
counterparties better able to absorb them.

It is conceivable that financial markets could be hit by a large disturbance. The effect
of such disturbances depends, in particular, on the duration of the disturbances and
whether firms suffer common or independent shocks. If the disturbance were large but
temporary many outstanding derivatives would be essentially unaffected because they
specify only relative infrequent payment. Therefore, a tempore disturbance would
primarily affect contracts with required settlements during this period. If the shock were
permanent, it would affect the derivatives in a much hazardous way.

35
5.4 RISK MANAGEMENT OF DERIVATIVES

Derivatives, which come to light as a hedging instrument against volatility of

market and market related risk, created risk when there is a default. This gave rise to
the essence of risk management of derivatives and derivatives trading. In case of OTC
derivatives, as it is not regulated, it is riskier and there is no risk management at all. But
in case of exchange traded derivatives, several risk management tools are applied to
ensure the integrity of the market. The tools used for risk management of derivatives
are described below:

5.4.1 MARGINS

Margins are upfront payment by the participants of the derivatives market to the
exchanges. This upfront payment is collected to ensure that none will default in future
in obliging his obligation. If someone defaults, then the clearinghouse settles the
contract from this margin account. Exchange’s clearinghouse collects the margin from
the clearing member, the clearing member collects the margin from the trading member
or the brokers and it is the responsibility of the trading members to collect the same
from its clients.

5.4.2 MARK-TO-MARKET MARGIN

In case of futures contracts, the margin is mark-to-market on daily basis i.e. the
gain or loss of a day is settled to the margin account on a daily basis. If the long position
gains, then the amount he gained will be transferred to his account in the end of the day.
Similarly, if the investor losses, the amount that he lost is withdrawn from his account.

36
5.4.3 EXPOSURE LIMITS

If an investor holds quite a large position than his capacity, then the probability
that he will default is more. For this reason, the regulatory body of the derivative market
put an exposure limit for the participants beyond which one cannot take position in the
market. This will ensure the integrity in term that nobody will default.

5.4.4 POSISTION LIMITS

Position limit is more applicable for the high net worth individuals, the FIIs and
the mutual funds. This is because, these people have huge investible cash and they can
direct the market as their wish. This will harm the market and other participants of the
market. Thus a position limit is introduced for this type of risk by the regulators for the
sound running of the market.

5.4.5 FINAL SETTLEMENT

Final settlement is the last part of risk management in case of derivatives. The
settlement is done by the clearing house of the exchange. On exercise the settlement is
done on the closing price of the derivative product and final settlement takes place on
T+1 basis. If the long position exercises his right, then the settlement is done by
randomly assigning the obligation on a short position at the end of the day.

Frankly speaking risk management of derivatives comprises of two things i.e.

margining requirement and the regulatory requirement. Thus risk management of
derivatives is nothing but, complying the rules and regulation laid down by the regulator
and satisfying the margin requirement.

37
 CHAPTER – VI
RESEARCH METHODOLOGY

38
6.4 RESEARCH METHODOLOGY

6.4.1 SCOPE

The scope of this project is confined to the study of risk management of

derivatives in BSE, about the margining system. The software used for this purpose,
details about the process and tools of risk management and various problems faced by
them.

6.4.2 SOURCES OF DATA

The data has been collected from both primary and secondary sources. The
primary data are collected by interviewing brokers and some officials of BSE. Some
data are collected from personnel of the various departments in BSE, like Product and
Strategy Department, Bank of India Shareholding Limited. (Clearinghouse of BSE).
The secondary data consists of books and journals provided by BSE, SEBI circulars and
Guidelines. This also contains the data of derivative segment of NSE, which was
collected from the website of NSE.

6.4.3 TOOLS AND TECHNIQUES

The data so collected were classified and tabulated for analysis and
interpretation. The tools and techniques used in this project are all computerized
programming. The data are programmed in software like visual basic, MATLAB, etc,
to find the implied volatility and price scan range. Finally all these implied volatility
and price scan range are processed in PC – SPAN (software for calculation of margin)
to find out the margin requirement of different participants of the derivative market.
The turnover of derivatives segment of BSE and NSE is drawn in graphs to compare
these two markets.

39
 CHAPTER – VII
DATA ANALYSIS AND INTERPRETATION
AND
FINDINGS

40
INTERPRETATION & ANALYSIS

In the course of study of the risk management process used in BSE for derivative
segment, the following things are observed.

The risk management of derivatives in BSE has two parts; one is the margining
system and the regulatory requirement. The details of these are explained below,

For margining the BSE is following portfolio based margining system and the
margin calculation is done by software known as PC SPAN. The portfolio based
margining model adopted by the exchange takes an integrated view of the risk involved
in the portfolio of each and every individual client comprising of his positions in all
derivatives contract traded on derivative segment. The SPAN (Standard Portfolio
Analysis of Risk System) is a portfolio based margining system developed by Chicago
Mercantile Exchange and it is being used by almost all stock exchanges now. For setting
the margin the exchange has a margin committee, which decides about various factors
to be considered while calculating the margin requirements.

7.1 THE SPAN MARGINING SYSTEM

The SPAN margins are estimates of changes in futures and futures-options

contract prices that would occur under various next-day realizations of futures prices
and implied volatility. The inputs into SPAN are; the futures price scan range, the
implied volatility scan range, the minimum short option charge, the calendar spread
charge, the inter-commodity spread charge. These are described below;

7.1.1 THE FUTURE’S PRICE SCAN RANGE:

The price scan range input sets the maximum underlying price movement that
the margin committee chooses to consider in setting margin collateral requirements.
The future’s price scan range is the clearinghouse margin requirement on a naked future
position and controlling input into the option pricing model simulation that ultimately
determines the margin requirements. The future scan range is set by the margin
committee after examining historical price movements and applying subjective
judgments.

41
7.1.2 THE IMPLIED VOLATILITY SCAN RANGE:

The implied volatility scan range is the largest movement in implied volatility
that margin committee chooses. The margin committee sets input scan ranges after
analyzing histograms of absolute value of day-to-day changes in the implied volatility
of traded futures-option contracts. The underlying average implied volatility estimate
that is analyzed is a simple average of eight contracts implied volatility on a given
maturity: the first is in-the-money and first three out-of-the-money implied volatility
estimates for both calls and puts.

7.1.3 THE MINIMUM SHORT OPTION CHARGE:

The minimum short option charge or minimum margin on an option contract is

set at 2.5% of the clearing member’s futures price scan range.

7.1.4THE CALENDAR SPREAD CHARGE:

The calendar spread charge is put into the SPAN is a parameter that sets the
amount of margin collateral, the clearinghouse collects against calendar spread basis
risk in portfolios. The calendar spread basis is the difference between prices of contracts
with different maturities. The basis between nearest quarterly and next quarterly futures
contract is calculated. Histograms of the absolute value changes in basis series are
constructed for different windows periods, and the histograms are considered by the
margin committee while calculating margin.

7.1.5 THE INTER-COMMODITY SPREAD CHARGE:

The inter-commodity spread charge is an input that sets the collateral

requirement that must be posted to protect against correlation risk in inter-commodity
spread positions.

In SPAN, futures and futures options changes are estimate under alternative
scenario that are determined by the values chosen for the price and implied volatility
scan range inputs. In the simulation analysis, the value of each option contract is
estimated for following day using Black Option Pricing Model.

42
 The next-day contract prices are determined under alternative scenarios in which
underlying futures contract’s price and implied volatility move by predetermined
function of their scan range. The futures price and implied volatility scan inputs are
translated into 16 different scenarios that represent alternative combinations of futures
price and implied volatility changes. For each scenario simulated, the contract’s value
is reported as an element called “SPAN risk array”. This average implied volatility is
then “shocked” by the implied volatility scan range in the SPAN simulations. The next
day simulated contract prices are compared with the prior day’s theoretical settlement
price and contract gains and losses are calculated as the difference in these prices. In
extreme price move scenarios, the CME’s margin committee has decided to margin
35% of the simulated price move gain or loss is the value reported in these extreme
price move SPAN array entries. The SPAN risk array is given below,

1. Underlying unchanged; volatility up

2. Underlying down; volatility down
3. Underlying up by 1/3 of price scan range; volatility up
4. Underlying down by 1/3 of price scan range; volatility down
5. Underlying down by 1/3 of price scan range; volatility up
6. Underlying up by 1/3 of price scan range; volatility down
7. Underlying up by 2/3 of price scan range; volatility up
8. Underlying down by 2/3 of price scan range; volatility down
9. Underlying down by 2/3 of price scan range; volatility up
10. Underlying up by 2/3 of price scan range; volatility down
11. Underlying up by 1 of the price scan range; volatility up
12. Underlying down by 1 of the price scan range; volatility down
13. Underlying down by 1 of price scan range; volatility up
14. Underlying up by 1 of price scan range; volatility down
15. Underlying up extreme move, double the price scanning range
16. Underlying down extreme move, double the price scanning range

43
 The clearinghouse of the exchange electronically distributes a SPAN risk array
for every derivative product that it clears and settles. Clearing member firms receive
these arrays and use them to calculate their margin requirements for their customers
account. The maximum loss across the 16 scenarios becomes the “Preliminary” SPAN
margin for that account. The final margin requirements may differ from this preliminary
margin owing to additional margin requirements that resulted from margin requirement
on calendar spreads and minimum margin requirement for written options contracts.
Inter-commodity spread charges also enter into the final margin calculation. Each
written option contract is subjected to minimum margin requirement. For a portfolio,
this margin requirement is the product of the number of written options times the
minimum short option charge.

7.3 MARGINS

The BSE collects margin collateral in advance to minimize its risk exposure. The
margin required for different equity derivatives are explained below;

 The initial margin requirements on all derivative products are based on worst-
case loss of portfolio at client level to cover 99% Vary over one-day horizon.
The initial margin requirement is net at client level and shall be on gross at the
trading and clearing member level.

 For this purpose, the price scan range of index products and stock products is
taken as 3σ and 3.5σ respectively. The price scan range of options and futures
on individual securities is also linked to liquidity. This is measured in terms of
impact cost for an order size of Rs. 5 lakh calculated on the basis of order book
snapshots in the previous six months. If the impact cost exceeds by 1%, the price
scan range is increased by square root of three.

 For stock futures and short stock options contracts a minimum initial margin
equal to 7.5% of the notional value of the contract based on the last available
price of futures and option contract respectively is collected. For index futures a
minimum margin equal to 5% of the notional value of the contract is collected.
For index options a minimum of 3% is charged as the minimum margin.

44
  The margin on calendar spread is calculated on the basis of delta of the portfolio
consisting of futures and options contracts in each month. The spread charge is
specified as 0.5% per month for the difference between the two legs of the spread
subjected to minimum of 1% and maximum of 3%.

7.4 MARK-TO-MARKET OF MARGIN

 For all stock futures and index futures contract, the client’s position is marked-
to-market on a daily basis at portfolio level. The mark-to-market margin is paid
in/out in T+1 day in cash. For determining the mark-to-market margin, the
closing price is taken into consideration.

7.5 EXPOSURE LIMITS

The exposure limit for different equity derivatives products are given below;

 In case of stock futures contracts, the notional value of gross open positions at
any point in time should not exceed 20 times the available liquid net-worth of a
member, i.e. 10% of the notional value of gross open position in single stock
futures or 1.5σ of the notional value of gross open position in single stock futures,
whichever is higher. However, BSE charges exposure margin for better risk
management.

 For stock options contracts, the notional value of gross short open position at any
time would not exceed 20 times of the available liquid net-worth of the member,
i.e. 5% of the notional value of gross short open position in single stock options
or 1.5σ of notional value of gross short open position in single stock options
whichever is higher.

 In case of index products, the notional value of gross open positions at any time
would not exceed 33 1/3 times of the available liquid net worth of the member.
for index products, 3% of the notional value of gross open position would be
collected from the liquid net worth of a member on a real time basis.

45
7.6 POSITION LIMITS

 A market wide limit on the open position on stock options and futures contracts
of a particular underlying stock is 20% of the number of shares held by non-
promoters i.e. 20% of the free float, in terms of number of shares of a company.

 In case of stock futures and options, the stock having applicable market wide
position limit (MWPL) of Rs. 500 crores or more, the combined futures and
options position limits shall be 20% of market wide position limit or Rs. 300
crores, whichever is lower and within which shock futures position cannot
exceed 10% of applicable market wide position limit or Rs. 150 crores,
whichever is lower. This is the position limit for trading members, FII and mutual
funds.

 For stocks having applicable market wide position limit less than Rs. 500 crores,
the combined futures and options position limit would be 20% of applicable
market wide position limit or Rs. 50 crores whichever is lower. This is applicable
for trading members, FII and mutual funds.

 For futures and options contracts, the trading members, FII and mutual funds
position limits shall be higher of; Rs. 500 crores or 15% of total open interest in
the market in equity index futures contracts or equity index options contract
respectively.

 The gross open position of clients, sub-accounts, NRI level and for each scheme
of mutual funds across all derivatives contracts on a particular underlying shall
not exceed higher of; 1% of the free float market capitalization or 5% of the open
interest in underlying stock.

 Any person who holds 15% or more of the open interest in all derivatives
contracts on the index shall be required to disclose the fact to the exchange and
failure of which will attract a penalty.

46
 7.7 FINAL SETTLEMENT

 On expiry of a stock futures or index futures contract, the contract is settled in

cash at the final settlement price. The final settlement price is the closing price
of the underlying stock or the index respectively. The profit or loss is paid in or
out in T+1 day.

 On exercise or assignment of options, the settlement takes place on T+1 basis

and in cash. On expiry, if the options are not exercised or closed out, all in-the-
money options are settled by the exchange at the settlement price. The settlement
price is the closing price of the stock or index in the cash segment. On exercise
of options, the assignment takes place on a random basis at client level. At
present there would not be any exercise limit for trading in options, but the
exchange can specify the limit as per its convenience.

7.8 MAJOR FINDINGS

On course of study of the risk management process of derivatives in BSE, the

following observations are pointed out. Since the study is focused on equity derivatives
only, the findings are concerned only about equity derivatives.

7.8.1 SPAN MARGINING SYSTEM

The SPAN (Standard Portfolio Analysis of Risk) is a portfolio based margining

approach for calculation of margin requirement of derivatives. This is an integrated
system of margining that reduces margining requirement on derivatives than any other
system of margining. The SPAN margining system in BSE is an efficient system of
margin calculation. The procedure in which the SPAN is calculated in BSE can be
compared to any major exchange of the world and covers almost 99% of risk exposure
of the exchange.

47
7.8.2 PC SPAN®

 The software used by BSE for margin calculation is PC SPAN®. This software
is developed by the Chicago Mercantile Exchange.
 This software provides adequate information to its user.

 It is user friendly. It provides the margin on a real time basis. As soon as the data
is input to the system, it takes 5 to 7 minutes to calculate the margin requirement.

 This is efficient software for calculation of SPAN margin and used by almost
all stock exchanges of the world.

7.8.3 RISK MANAGEMENT

 The risk management process for derivatives used by BSE is efficient and
effective system.
 It covers about 99% Vary at any time.

 This also helps in protecting the market and helps in increasing the market
integration.

 On comparing the risk management process of BSE with that of NSE, it is found
that it is almost same. But NSE has an added advantage for the information
related services that it provides.

 BSE provides its data on a graphical format, whereas NSE provides the same
on a tabular format, which is easy to understand.

 The NSE uses PRISM (Parallel Risk Management System), which monitors the
derivatives segment of NSE on a real time basis. But BSE do not have, this
system.

48
CHAPTER – VIII
CONCLUSION

49
8.1 CONCLUSION

BSE with its distinctive feature has a long, colourful and chequered history. It
enjoys a pre-eminent position by having a permanent recognition from the Securities
Contract (Regulation) Act, 1956. It can be considered as an essential concomitant of the
Indian economy. It is performing all the important functions of an ideal stock exchange
by providing a ready and continuous market with negotiability and safety to investment
of investors; redressing their grievance, minimizing risk, and providing a forum to
ensure liquidity and attracting capital from the investors, etc.

Despite the efficiency and transparency, BSE still lags behind NSE and faces a
stiff competition from it. Particularly, NSE holds about 99% of the derivatives market
of India, whereas BSE’s position is negligible. This can be attributed to the following
reasons.

Firstly, lack of detail and timely information of derivative segment and its risk
management is one of the main reasons for the falling market share of the BSE’s
derivatives segment.

Secondly, the data files for margin calculation are not precious as NSE has.
This is also one of the key obstacles in the development of derivative segment of BSE.
When BSE losses NSE gains.

Thirdly, the lack of monitoring system for risk management is another problem
with BSE. NSE has PRISM as the monitoring system which enables it for better risk
management of derivatives.

50
 Coming to risk management of derivatives in BSE, BSE has an efficient and
effective risk management system, which can be compared with any of the exchange of
the world. The SPAN margining system followed by BSE for margin calculation is one
of the most efficient systems of margining. Along with this the regulatory requirement
of BSE makes the risk management system stronger and effective.

Though the margin with which BSE lags behind NSE is too much for derivatives
market, but a committed effort can help BSE to gain supremacy in this segment. This
can be done by making itself more informative, monitoring the risk management
process and taking some aggressive steps for the improvement of the derivatives
segment.

All it needs to do is to take quick and timely decisions for the improvement of
the derivatives segment.

51
 CHAPTER – IX
RECOMMENDATIONS

52
9.1 RECOMMENDATIONS

Based on the interaction with different broking firms, it is observed that BSE is
comparable to NSE in technical terms. However, BSE lacks in providing better services
and information to the investors, which leads to poor market position in derivatives.

 During our interaction with the brokers we come to know that, the services provided
by NSE are more reliable than that of BSE. So BSE should try to provide integrated
services to its members to improve its derivatives segment.

 Regarding the risk management procedure, as there is no difference between NSE

and BSE, it can be said that, BSE should continue with this process.

 BSE should improve its monitoring system for better risk management of the
exchange.

 Another major cause for BSE’s lost market share is the failure in providing data.
BSE can focus on this part in particular. It should also provide data in tabular format
rather than graphical format, so that it can be easily understood by the investors.

 To improve its derivatives segment, BSE has to constantly innovate in terms of

services, products and technology, otherwise it cannot compete with NSE.

 BSE charges more margins for better risk management, which in terms harms its
market position. Thus, a reasonable margin should be charged on the members for
development of derivatives market and better risk management.

53
CHAPTER – X
BIBLIOGRAPHY

54
10.1 BIBLIOGRAPHY

BOOKS AND JOURNALS

Hull, Basu., (2010), “Options, Futures and other Derivatives”. Pearson

publications. New Delhi.

Jarrow, Turnbull., (2000), “Derivative Securities”. South-Western College

Publication, USA.

Bhaskar, Mahapatra., (2003), “Derivatives Simplified: An Introduction to Risk

Management”. Response Books, New Delhi.

Gosain, Varun., (1994), “Derivatives on Emerging Markets”. Derivatives &

Synthetics, Pg. 477- 488.

Kothari, C.R., (1990), “Research Methodology: Methods and Techniques”,

Wishwa Prakashan.

Holton, Glyn., (2004), “Defining Risk”. Financial Analyst Journal, Vol. 60,
No. 6, CFA Institute.

Bernanke, Ben S., (1990), “Clearing and Settlement During the Crash”. Review
of Financial Studies, Vol.3, No. 1, Pg. 167-179.

55
WEBSITES

www.moneycontrol.com

www.nseindia.com

www.bseindia.com

www.investorworld.com

www.yahoo.com/finance

http://www.bis.org/publ/cpss06.pdf

http://www.premiumdata.net/

http://www.emeraldinsight.com/journals.htm?articleid=1527485&show=pdf

http://www.cboe.com/learncenter/glossary.aspx

http://www.cme.com/SPAN/

http://www.sgx.com/

http://www.asx.com/

http://www.sebi.gov/

http://www.myiris.com

http://www.bseindia.com/riskmanagement/about.asp

http://www.en.wikipedia.org/wiki/Risk_Management

56