Derivatives Index Futures and Options CHAPTER 1 AN INTRODUCTION TO DERIVATIVES The growth and evolution of financial instruments that

t address the needs of many different end-users in a wide range of different market environments has been explosive, being driven by an underlying demand for risk management products and financial engineering skills that reflects the fact that the overall economic environment within which business is conducted has grown more volatile and more unstable. The international system of fixed exchange rates known as the Bretton Woods agreement was finally abandoned in 1973. Once a system vanished which had forced countries to adjust their inflation rates, interest rates and other tools of economic policy in order to maintain a fixed relationship between their currency and the gold/dollar price, governments were free to pursue divergent monetary policies. The result has a permanent change in the financial environment. Developed economies experienced periods of both rapid price increases (inflation) and price decreases (deflation). Uncertainty and volatility in relation to prices was followed by similar uncertainty and volatility in foreign exchange rates, interest rates and commodity prices. As has already been indicated, the risk associated with a financial environment which lacks stability and is characterized by change and flux has created a demand -- a demand to which the capital markets have responded -- for financial instruments to protect against that risk. These instruments are usually called derivative instruments and a derivative financial instrument can be defined as simply an aggregate or "bundle" of contractually created rights and obligations, the effect of which is to create a transfer or exchange of specified cashflows at defined future points in time. The quantum of these cashflows are determined by reference to, or derived from (hence the word "derivative"), underlying cash or physical markets (e.g. foreign exchange, currency, securities, commodities) or from particular financial indices (such as one of the benchmark interest rates, the London inter bank offered rate or Libor). Derivatives are financial securities whose value is derived from another "underlying" financial security. It is a contractual relationship established by two or more parties where payment is based on some agreed upon benchmark. When one enters into a derivative product agreement, the medium and rate of repayment are specified in detail. There are two types of derivatives: linear derivatives and non-linear derivatives. A linear derivative is one whose payoff function is a linear function. For example, a futures contract has a linear payoff in that every one-tick movement translates directly into a specific dollar value per contract. A non-linear derivative is one whose payoff changes with time and space. Space in this case is the location of the strike with respect to the actual cash rate (or spot rate). One example of a non-linear derivative with a convex payoff profile at some point before the option's maturity is a simple plain vanilla option. As the option becomes

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Derivatives Index Futures and Options progressively more in-the-money, the rate at which the position makes money increases until it asymptotically approaches the linear payoff of the future. Similarly, as the option becomes progressively more out-of-the-money, the rate at which the position loses money until that rate becomes zero. Derivatives are risk-shifting devices. Initially they were used to reduce exposure to changes in foreign exchange rates, interest rates or stock indexes. More recently, derivatives have been used to segregate categories of investment risk that might appeal to different investment strategies used by mutual fund managers, corporate treasurers or pension fund administrators. Some derivative products include leveraging features. These features act to multiply the impact of some agreed upon benchmark in the derivative instrument. Negative movement of a benchmark in a leveraged instrument can act to increase greatly the partys total repayment obligation. Since derivative instruments are generally the product of negotiation between two parties for risk shifting purposes, the leveraging component is unique to that instrument. Options, futures, swaps, swaptions, structured notes are all examples of derivative securities.

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Derivatives Index Futures and Options CHAPTER 2 THE SCENARIO IN INDIA For better or for worse, the Indian economy has entered an era in which Indian companies cannot ignore global markets. In the old era, many prices were controlled. Others, though not controlled, were largely based on controlled prices of inputs. This meant limited uncertainty and limited volatility of prices. Deregulation, freeing of the exchange rate and removal of price and trade controls are measures that are increasing the volatility of prices of various goods and services in India to producers and consumers alike. Gyrations of stock market prices (and market-determined interest and exchange rates) also create instability in portfolio values for mutual funds and unit trusts. Hedging through derivatives can mitigate these risks. The 1960s marked a period of great decline in futures trading in India. Market after market was closed, normally because commodity price rises were attributed to speculation on these markets. There are signs that the late 1990s may be marked by exactly the opposite trend-a largescale revival of futures markets in India. The trend is not confined to the commodity markets. RBI recommended major liberalisation of the forward exchange market and had urged the setting up of rupee-based derivatives in financial instruments. In a momentous and far reaching decision, SEBI gave the go-ahead for stock index futures in May 1998, ushering a new era in Indian financial markets. Derivative trading started with the introduction of Index (Sensex) Futures at the NSE and the BSE in June 2000. The exchange have the Futures and Options Trading System which provides a fully automated trading environment. A committee was setup under the chairmanship of Prof. J.R. Varma along with others to provide the guidelines for derivative trading in India. The first of the 5 contracts of the June series was done on June 9, 2000 between M/s Kaji & Maulik Securities Pvt. Ltd. and M/s Emkay Share & Stock Brokers Ltd. at the rate of 4755. This marked the beginning of exchange traded financial derivatives trading in India. We have a strong dollar-rupee forward market with contracts being traded for one to six months. As of now there is very little trading in futures and options in India. Trades are settled on a weekly basis due to low volumes and volatilities.

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Derivatives Index Futures and Options CHAPTER 3 MARKET STRUCTURE Derivatives can either be traded over the counter on a case by case basis, or on organised exchanges. Over the counter trades are tailored to meet the requirements of individual users, and it is therefore not possible to generalise on the manner of trading. Organisational links with spot market: Several derivatives markets are run as part of the same organisation as the spot market. For example stock options and index futures on the Nikkei index are traded on a separate floor of the Tokyo Stock Exchange. Other derivative markets are not organically linked to any spot market. The Chicago Mercantile Exchange and the London International Financial Futures and Options Exchange are examples. In India commodity exchanges combine spot and futures trading. SEBI has decided that stock index futures will be traded on the stock exchanges. Ownership and Membership: Various ownership structures exist for futures and options markets. Some markets are joint stock companies; either profit seeking or non-profit seeking, while others are associations or other agencies of a non-profit nature. Membership is distinct from ownership. Membership refers to the right to trade on the floor of the exchange. The by-laws of each exchange normally establish the membership criteria; the most important of which is normally financial solvency of a prescribed level. In most Western markets, membership is freely transferable, subject to meeting the exchange requirements. Intermediaries and Brokers: In all derivative exchanges, there are numerous intermediaries who bring together buyers and sellers. These intermediaries may or may not be members. Often each type of intermediary has a distinct specialisation. Member-brokers in most developed country markets are generally large corporate entities while in Indian exchanges they are usually individuals or partnership firms. Some brokers may act as market makers, (i.e. hold a minimum quantity of positions and provide liquidity), while others may only execute trades. The terms floor-broker or pit-broker or pit-trader refer to the people who actually carry out trades on the exchange. Scalpers are floor traders who try to profit from, very small price changes, and carry out a number of trades, each of which is only held for a short while. Scalpers add considerable liquidity to a market amd facilitate smooth trading. Futures commission merchants are those who only execute orders for clients and do not trade on their own account.

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Derivatives Index Futures and Options Initial and Variation Margin: When entering into a futures transaction an amount known as initial margin is to be paid, generally determined as a percentage of the contract value and fixed by the exchange and /or regulatory body. Normally this ranges between 5-10% but is often lower for financial futures. The purpose of margin money is to guard against any default. Options markets usually do not require margins from options buyers, who have no obligation beyond premium payment. Option writers are always subject to margins as in futures markets. Tick and Tick Size: Each exchange usually prescribes the minimum unit of price variation, known as the tick size. Traders often compute profits or losses by counting the number of ticks and multiplying by the contract value. Contract Size and Delivery Month: The exchange, often in consultation with the regulator, determines the minimum contract size and the futures or options contract months to be traded. Depending on the demand there maybe a contract for each month or every 2 or 3 months. Settlement Frequency: Settlement is the process by which changes in position are recorded and each participant is credited (debited) with open gains and losses, so that margin calls can be collected and assessed. In international markets, settlement is done on a daily on the basis of a settlement price, usually the closing price. In some Indian futures markets settlement is done on a weekly basis. Weekly settlement is appropriate for the existing market in India as volumes and volatilities are low. Delivery Mechanism: In international commodities futures markets, delivery means physical delivery of the commodity by the buyer to the clearinghouse. In financial futures markets, delivery may mean actual delivery of the concerned security or financial settlement. In Indian commodity futures markets, financial settlement is also allowed in addition to physical delivery. Physical delivery of commodities can only be made at one or more delivery points specified by the exchange or clearinghouse. Sometimes a price adjustment maybe made if delivery is made in one place instead of another, to reflect transport costs. Clearing Houses: All well developed futures and options markets use a clearinghouse system. In this system, the exchange has an arrangement with a clearinghouse (usually a separate legal entity) whereby the latter becomes a counterparty to every trade in the exchange. The clearinghouse acts as a seller to every buyer and a buyer to every seller. The regulatory significance of this is that if any party defaults the other will not be affected. The clearinghouse mechanism insulates participants from default risk. Clearinghouses are usually owned by banks, financial institutions or major brokers. Indian futures markets do

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Derivatives Index Futures and Options not have full-fledged clearinghouses at present. What is called clearinghouse in Indian markets is more of an accounts section which matches sales and purchases, accounts for margins etc. Trading Systems: There are two main types of trading systems-open outcry and screen based. The former is the older one and essentially a continuous action. This system is prevalent in many western markets and all Indian futures exchanges. There is a physical trading floor where traders shout out their trades. A trader is usually required to keep shouting till his trade is executed, unless he no longer wishes to carry out the trade. The other and more recent trading system, is the automated or screen-based system, also called the on-line system. Several Western markets which use open outcry for normal trading, use screen based systems such as Globex as a secondary system for use after normal trading hours, thereby providing 24-hour trading.

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Derivatives Index Futures and Options CHAPTER 4 OPTIONS Introduction Options are financial instruments whose value depends on an underlying asset, which could be anything from stocks through indices to commodities. Options are the most versatile trading instrument ever invented. Since options cost less than stock they provide a high leverage approach to trading that can significantly limit overall risk of a trade or provide additional income. Options give the holder the right but not the obligation to buy or sell the underlying asset at a pre-specified price for a fixed duration. Options are either call or put. Call options gives the buyer the right to buy the underlying asset whereas put options gives the buyer the right to sell the underlying asset. For every buyer of an option there is a seller, called the writer. The seller receives an amount called the premium from the buyer. The premium is the per share price that the option holder pays upfront to the seller to acquire the option. The seller keeps the premium regardless of whether the option is exercised or not. The minimum option lot is 100 shares. The premium is dependent on many factors like the underlying asset price, the strike price (the price, which the holder of the option has to pay (or receive), when he decides to exercise his option. It is fixed by the exchange for the entire duration of the option), the volatility of the asset price, the risk free rate of return and the corporate benefits at the time to maturity of the option.

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Derivatives Index Futures and Options There are two kinds of options. An European option, which can only be exercised on the maturity date, and an American option which can be exercised any day till the maturity date of the option. A call option is said to be in the money if the strike price is less than the market price of the underlying asset. A put option is in the money when the strike price is greater than the market price. A call option is said to be out of the money if the strike price is greater than the market price of the underlying asset. A put option is out of the money if the strike price is less than the market price. The option with strike price close to that of the market price of the underlying asset is considered as being at/near the money. The difference between an in-the-money options strike price and the current market price of a share of its underlying security is referred to as the options intrinsic value. Writing options: Option writers can write either covered or uncovered (or naked) options. Covered Call Option: it is simply the process of selling an option against a stock that you own. It helps the writer to minimise his loss. In a covered call option, the writer of the call takes a long position in the stock in the cash market; this will cover his loss in his option position if there is a sharp increase in the price of the stock. Further he is able to bring down his average cost of acquisition in the cash market. However a covered call position puts a cap on the upside. The investor is not able to take advantage of a sharp increase in the stock price from his long position. For shares trading in a narrow range, covered call options are an attractive method to earn above the market return.

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Derivatives Index Futures and Options Covered Put Option: a writer of a put option can create a covered position by selling the underlying security. The effective selling price will increase by the premium amount (if the option is not exercised at maturity). Here again, the investor is not in a position to take advantage of any sharp increase in the price of the asset as the underlying asset has already been sold. If there is a sharp decline in the price of the underlying asset, the option will be exercised and the investor will only be left with the premium amount. Uncovered Call Option: a short call option position in which the writer does not own shares of underlying stock represented by his option contract. Also called a naked call, it is much riskier than a covered call. If the buyer decides to exercise the option the writer would be forced to purchase the stock at the current market price. Uncovered Put Option: a short put position in which the writer does not have a corresponding short stock position or has not deposited, in a cash account, cash or cash equivalents, equal to the exercise value of the put. The nature of uncovered options means that the writers risk is unlimited. Hedging: Corporations in which individual investors place their money have exposure to fluctuations in all kinds of financial prices. Financial prices include foreign exchange rates, interest rates, commodity prices and equity prices. Hedging is a way of reducing some of the risk involved in holding an investment. There are many different risks against which one can hedge and many different ways of hedging. Options provide hedgers seeking to avoid adverse price changes in the cash market with an alternative over hedging with futures contracts. Options protect the hedger from adverse price movements while allowing the hedger to realise profits should the cash market prices move in a positive direction. Delta hedging is a strategy used by option sellers to protect their exposure. It involves taking steps to offset price/rate risk by matching the market response to the underlying asset over a narrow range of price/rate movements. To structure a delta hedge, an option seller takes into account changes in the spot price, the time to expiry and the difference between spot and strike prices. The more the option is in-the-money the greater the amount of delta hedging. A deep in-the-money option has a delta close to 1, or even 1 because it is likely to be exercised; a deep out-of the-money option would be close to or at zero because the option has very little intrinsic value. Spreads: Options spreads are hedged positions, which can be utilised to control a trades risk at the same time limiting gains. This is accomplished by simultaneously taking positions on both sides of the market.

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Derivatives Index Futures and Options Options spreads can be used when one has an inclination as to where the underlying market is heading but is somewhat uncertain. Because the position is hedged, it allows the trader to participate in the market while effectively containing risk, sometimes even more so than with single option positions. Option spreads can also be used when a trader has a specific price target in mind- because spreads limit gains as well as losses. Bull spreads: These are spreads designed to profit in a bull market. The most common bull spread is a vertical spread. A vertical spread always consists of one long option and one short option where both options are of the same type, either put or call and both options expire at the same time. Purchasing the option with the lower exercise price and selling the option with the higher exercise price creates a bullish vertical spread.

Bear spread: These are spreads designed to profit in a bear market. The most common bear spreads are vertical spreads too. Selling the option with the lower exercise price and buying the option with the higher exercise price creates a bearish vertical spread.

Butterfly spread: A butterfly spread consists of three equally spaced exercise prices where all the options are of the same type and all options expire at the same time. A long (short) butterfly spread can be created by buying (selling) one option at each of the outside exercise prices and selling (buying) two options at the inside exercise price. The long butterfly strategy would lead to a profit if the price of the underlying asset remains close to the strike price at which the two calls were sold. The short butterfly

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Derivatives Index Futures and Options strategy would lead to a profit if the price of the underlying asset moves far away from the exercise price at which the two calls were bought. Calendar spread: Also known as time spreads. The most common type of calendar spread consists of opposing positions in two options of the same type, that have the same exercise price but expire at different times. A long (short) time spread position can be created by selling (buying) a short term call option and buying (selling) a longer term call option. The investor of the long position would profit when the price of the underlying asset is close to the strike price of the short call at its expiry date.

Combinations: are strategies, which involve positions in both calls and puts on the same stock. Some of these are called straddles, strips, straps and strangles. Straddle: A straddle consists of both a long call and a long put (a long position), or a short call and a short put (a short position) where both options have the same exercise price and expire at the same date. For a long position, profit is realised if there is a large move in either direction from the options exercise price.

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Derivatives Index Futures and Options

Strangles: A long (short) strangle position is developed by purchasing (selling) both a put and call with different strike prices but the same expiry date. The call strike price is higher than the put strike price. A strangle is similar to a straddle in that a large move in either direction will b profitable. However, a larger move must occur with a strangle than a straddle for a profit to be realised. The benefit compared to a straddle is that the amount of loss can be reduced if the underlying asset price does not make a large move away from the options strike price.

Strips and Straps: These two strategies are a variation of the straddle. A strip consists of one long call and two long puts, all with the same strike prices and expiry dates. A strip strategy may be used by a trader who thinks that a large strike price movement is imminent, but believes that a decrease in stock price is more likely than an increase. A strap strategy is the opposite in that a trader believes that an increase in stock price is more likely than a decrease. Options valuation:

There are two types of factors that affect the value of the option premium.

Quantifiable Factors: - Underlying stock price, - The strike price of the option, - The volatility of the underlying stock, - The time to expiration and; - The risk free interest rate. Non- Quantifiable Factors : - Market participants varying estimates of the underlying asset's future volatility

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Derivatives Index Futures and Options Individuals varying estimates of future performance of the underlying asset, based on fundamental or technical analysis The effect of supply & demand- both in the options marketplace and in the market for the underlying asset The "depth" of the market for that option - the number of transactions and the contract's trading volume on any given day.

Theoretical option valuation models are used by option traders for calculating the fair value of an option on the basis of the above mentioned influencing factors. One way of valuing options is by creating a replicating portfolio. The replicating portfolio consists of stock and loans, which give the same payoff as the option. Since the two investments have identical payoffs they must have the same value today to avoid arbitrage profit (risk free profit). The number of shares required to replicate one call is often called the hedge ratio or option delta. OPTION DELTA = spread of possible option prices

Spread of possible stock prices

An alternative way and more widely used method of calculating an options value is the Black Scholes formula. Present Value of call option = PN(d1) EXe-rtN(d2) Where d1=log (P/EX) +rt + 2t/2 t d2=log( P/EX) +rt- 2t/2 t N(d) = cumulative normal probability density function EX = Exercise price of the option t = time to exercise date P = price of stock now r = risk free rate of interest 2 = variance per period of rate of return on the stock. This is the method used by most option traders to calculate an options price. This method assumes that the price of the underlying stock follows a normal distribution. Yet another way to calculate the options price is by using the general binomial method. This method assumes that the underlying stock follows a binomial distribution. Once the value of the call is determined it can be used to determine the value of the put option by using the Put Call Parity. P = C-S + PV(X)

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Derivatives Index Futures and Options

Where C = Call price S = Stock price PV(X) = Present value of exercise price. Option trading: Given the wide assortment of option strategies, there are several trading options open to a trader. For those option traders who believe that the trend of an underlying security has been established or soon will be established for some time to come, they may wish to hold the option until it approaches expiration and a significant profit is captured. These individuals are referred to as Position traders. Other traders who are not concerned with long term projections in the underlying security and are only interested in what will occur on a trading day are known as Day traders. Position traders and day traders have two very different approaches and attitudes when selecting the appropriate option contract to trade. Most position traders typically choose an expiration month and a strike price matches their price target and the time frame in which they believe that target will be reached. Day traders, on the other hand, are not concerned with which expiration month or strike price they should choose, all they are concerned with is being on the right side of the market in the option that will brin g them the greatest return. When day trading options, various time and price considerations are not as important as they would be to a long-term option trader. Since option positions are held for such a short period of time, the impact of time decay is negligible when day trading and does not really work for or against the trader (unless it is the day of option expiration or one or two trading days before expiration, where time premium typically erodes more rapidly).

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Derivatives Index Futures and Options CHAPTER 5 FUTURES AND FORWARDS Forwards: A forward contract can be regarded as the simplest mode of derivative transaction. It is an agreement to buy or sell an asset (of a specified quantity) at a certain future time for a certain price. No cash is exchanged when the contract is entered into. Such a contract is usually between two financial institutions or a financial institution and one of its corporate clients. One of the parties to a forward contract assumes a long position and agrees to buy the underlying asset at the specified future date at the specified price. The other party to the contract assumes a short position and agrees to sell the asset at the same date for the same price. The specified price in the forward contract is referred to as the delivery price. At the time the contract is entered into, the value of the forward contract is zero to both the parties. A forward contract is settled at maturity. The holder of the short position delivers the asset to the holder of the long position in return for a cash amount equivalent to the delivery price. On the settlement date the forward contract can have a positive or negative value depending on the movement of the price of the underlying asset. It is pertinent to note that the forward price and delivery price of the underlying asset are both equal at the time the contract is entered into. Over a period of time the forward price tends to fluctuate but the delivery price remains constant. The difference between the price as on the settlement date and the price at which the forward contract was entered into determines the value of the contract to both the buyer and the seller. If a participant in the derivatives market has information or analysis, which forecasts an upturn in price, the participant can go long on the forward market instead of the cash market. The participant can wait for the price to rise and then take a reversing transaction. The use of the forward market thus supplies a leverage benefit to the participant. Forward markets however have their share of drawbacks. A forward contract is not dealt with on an exchange. The contract is generally OTC (over the counter) i.e. the deal is agreed upon in an environment where the parties are not constrained to predetermined contract specifications. The parties can write a contract to suit their particular needs as long as it does not violate regulatory constraints. Thus illiquidity and counterparty risks are the main problems.

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Derivatives Index Futures and Options Futures: A futures contract is a contract to buy or sell a certain asset at a specified future time and price; such contracts are normally traded on a stock exchange. This leads to a standardisation, imparts liquidity and creates a set of rules and regulations that have to be adhered to by the parties to the transaction. Infact the exchange provides a mechanism, which gives the two parties a guarantee that the contract will be honoured. A clearinghouse becomes counterparty to both sides of the transaction. As the buyers and the sellers do not know each other it is the clearinghouse which guarantees the trade. Another difference between forwards and futures is that when the contract is entered into the exact delivery date is not specified. The contract is referred to by the delivery month and the exchange specifies the period between which the delivery has to be made. The rules of most futures exchanges permit a certain degree of leverage. A small deposit in the present is enough to purchase an entire contract in the future-this deposit is referred to as the margin. To ensure that every customer stands behind the financial obligations of his contract, the exchange clearing house values each contract at the end of each day and adjusts the cash balance of each traders margin account accordingly. This is called marking to market because the trader is credited with all gains and debited with all losses to his account. The trader can remove from his account any cash resulting from such credits in excess of the margin requirements. Conversely, if the account is debited due to a loss of market value of his contracts, the trader must immediately deposit any cash or permissible collateral required to meet the margin. If the trader does not do so, the concerned futures commission merchant in charge of the account may liquidate the account before the margin monies are exhausted. Sellers on the exchange are subject to minimum capital requirements and other regulations. Any of the following type of investors can take part in the futures market. Speculator: one who makes forecasts about the future movement of the market and takes positions accordingly. Hedger: one who takes a buy or sell position on index futures to offset an equity position he already has. Arbitrageur: one who lends or borrows money from the market, depending on whether rates of return are attractive. Futures trading: The National Stock Exchange's, or NSE's, index futures contracts (one month, two months and three months) will be based on the S&P CNX Nifty, which means that the asset underlying the contract is the portfolio of 50 stocks comprising the index. Unlike commodity futures, where actual delivery takes place at the end of the term specified in the contract, index futures contracts are cash settled. The delivery is actually a cash

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Derivatives Index Futures and Options settlement of the difference between the original transaction price and the final price at the termination of the contract. The contract size specifies the amount of assets to be delivered under one contract. The size of the contract is an important aspect that could influence the success of the contract in the market. If the size of the contract happens to be too big, investors who would like to hedge away small exposures or take small speculative positions will be unable to use the contract. On the other hand, if the contract size is too small, trading may turn out to be expensive as the user would incur transaction costs with each contract traded. The S&P index futures contract trading on the CME trades in multiples of 250, i.e. the value of the S&P 500 futures, contract can be calculated by multiplying the futures index price by $ 250. The S&P CNX Nifty futures will be traded on NSE in multiples of 100. The futures price is based on the cost-of-carry model, where the carrying cost is the cost of financing the purchase of the underlying portfolio minus the present value of dividends obtained from the stocks in the portfolio. A long-position holder, one who has bought a contract, profits from a rising futures price and contract value, because he could then sell at a higher price to offset or liquidate the position. A short-position holder, one who has sold a contract, profits from a price decline, because he could then buy in at a lower price to offset or liquidate the position. The gains or losses of a person buying/selling the contract would depend upon the spot index movements from the time he bought or sold the contract till the time he decides to close his position. For the purpose of ensuring smooth settlement, all index futures contracts are subject to margins by the clearing corporation. Initial margin is the amount that must be deposited with the clearing corporation when the contract is first entered into. This serves as a safeguard against potential losses on outstanding positions and, hence, the amount of exposure that a member can take is based on initial margin deposited by him. On NSE's index futures market, the computation of initial margin will be done using the concept of 'value-at-risk' and will be large enough to cover a one-day loss that can be encountered on 99 per cent of the days. The other margin collected by the clearing corporation is the 'mark-to-market' settlement margin. All open futures positions are re-valued or marked-to-market every day and the margin account is adjusted to reflect the investor's gain or loss. This daily settlement process provides for collection of losses as soon as they have occurred. In short, this ensures that the actual daily losses incurred on all open positions are paid up by the losing member and credited to the account of the gaining member on a T+1 (one day after the trade) basis.

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Derivatives Index Futures and Options Hedging: Futures markets provide an excellent avenue for hedging, speculation and arbitrage. Many of the participants of the futures markets are hedgers. Their aim is to use futures markets to reduce a particular risk that they face. This risk may relate to the price of oil, a foreign exchange rate, the level of the stock market or some other variable. A perfect hedge is supposed to completely eliminate risk. Perfect hedges however are rare. To avoid uncertainty, all one needs to do is hedge their portfolio against market movements using index futures. As we know, every buy position on a stock is a buy position on the index, and similarly every portfolio contains a hidden index exposure, irrespective of whether the portfolio is composed of index stocks or not. Most of the portfolio risk is accounted for by index fluctuations. Hence when one is Long Portfolio, one is invariable Long Index. To remove this index exposure all one needs to do is short the index. A position of Long Portfolio plus Short Index is typically one-tenth as risky as a position that is purely Long Portfolio. For example, suppose I own a portfolio of Rs 3 million, which has a beta of 0.9. How would I hedge this portfolio? By selling Rs 2.7 million of index futures. The portfolio beta is computed as the weighted average of the stock betas. Now to obtain a complete hedge, which would remove the hidden index exposure, I would have to take a short position of portfolio value times portfolio beta which as we mentioned is approximately Rs 2.7 million. So if the Nifty is at 1500 and the market lot on NSE's futures market is 200, each market lot of Nifty would cost 3,00,000. Hence I would have to sell 9 market lots to obtain a position: Long Portfolio: Rs 3,000,000 Short S&P CNX Nifty: Rs 2,700,000 This position will essentially be immune to any fluctuation of the index. If the index goes up, the portfolio gains and the futures lose. If the index goes down, the portfolio loses but the futures gain. In either case, the investor is hedged against market fluctuations. When should investors adopt this strategy? In a case where one anticipates market volatility and simply has no appetite for it. And second, when one plans to sell one's portfolio in the near future and faces uncertainty about the final price obtained in case of sudden drop in the index. But what if ones hedging horizon is two or three years? Obviously in this case, it makes more sense to sell off the shares and buy them back later. The above-mentioned strategy is an ideal way to hedge for shorter time periods. As we are aware, hedging does not remove losses or always make money. The best that can be achieved is a reduction/removal of unwanted exposure. Having said this, there is an important decision that must be made by the investor - that of the degree of hedging.

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Derivatives Index Futures and Options Complete hedging eliminates all risk of gain or loss. Depending upon his/her risk-taking ability, an investor may be able to tolerate some risk of loss in order to be able to hold on to some risk of gain. In such cases, partial hedging would be the best approach to take. In the case of the example above, a complete hedge would require selling Rs 2.7 million of index futures, but an investor may instead choose to sell only Rs 2 million, in the process hoping to make some profit on the unhedged component of the portfolio. The degree of hedging would depend upon an individual's appetite for risk. From a portfolio manager's point of view, the use of index futures market is an ideal technique to alter the portfolio beta. Typically, a portfolio manager who anticipates a bull market would want to increase the beta of her portfolio to take advantage of the expected rise in stock prices. Similarly, if she anticipates a bear market, she may go defensive and reduce the portfolio beta. As mentioned earlier, portfolio beta is the weighted average of stock betas. In the absence of index futures contracts, changing the beta would involve selling some stocks and buying others. For instance, to reduce the beta, she may have to sell high beta stocks and invest the proceeds in buying low beta stocks. Given the high transactions cost in the equity market, this can be an expensive affair. With index futures, the portfolio manager now has an alternative. If we accept that a well-diversified portfolio (about 20 stocks) has near zero unsystematic risk, then combining such a portfolio with a risk-minimizing short position in stock index futures creates a portfolio with zero systematic risk. Now instead of eliminating all systematic risk by hedging, it is possible to hedge only a portion of the systematic risk to reduce, but not eliminate the systematic risk inherent in a portfolio. To do this the portfolio manager will have to sell some futures, but less than the riskminimizing amount. In the example used above, instead of selling nine Nifty futures contract which is the exact risk-minimizing number of contracts, if I sold only five contracts, the new stock/futures portfolio would then have about half the systematic risk as that of the pure stock portfolio. Similarly a portfolio manager can use stock index futures to increase the systematic risk of a portfolio by buying, instead of selling index futures. To illustrate this, assume that instead of selling nine nifty futures contracts, if I bought 18 Nifty futures contracts, the resulting stock/futures portfolio would have twice the systematic risk as the pure stock portfolio. Used appropriately, stock index futures offer a hassle-free, inexpensive technique of changing the risk of a portfolio.

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Derivatives Index Futures and Options Futures Pricing: In general, the Futures Price = Spot Price + Cost of Carry. Cost of carry is the equivalent of interest costs or carrying costs. It is the sum of all costs incurred if a similar position is taken in the cash market and carried to maturity of the futures contract. The typical costs are interest (in the case of financial futures) and also insurance and storage costs (in the case of commodity futures). The revenues that accrue may be dividends in case of index futures. The difference between the futures price and the spot price is known as basis. Although the futures price and the spot price normally move in line with each other the basis is not constant. Generally, basis will decrease with time. And on expiry, the basis is zero and the futures price equals the spot price. Under normal market conditions, futures contracts are priced above the spot price. This is known as the Contango market. It is possible for the futures price to be lower than the spot price; such a situation is known as backwardation. This may happen when the cost of carry is negative, or when the underlying asset is in short supply. Futures contracts are valued using the Spot-Futures Parity Theorem. This theorem states: There are two ways to acquire an asset for some date in the future purchase it now and store it take a long position in futures These two strategies must have the same market determined costs.

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Derivatives Index Futures and Options

STRATEGY A:

ACTION

INITIAL FLOWS
-SO

FLOWS T
ST

AT

STRATEGY B:

BUY STOCK ACTION

INITIAL FLOWS

FLOWS T

AT

LONG FUTURE S
INVEST IN BILL: F0 /( 1+rf )T

ST - F0

-F0 /( 1+rf )T

F0

TOTAL FOR B

-F0 /( 1+rf )T

ST

Since the strategies have the same flows at time T, to avoid arbitrage the initial flows must be equal. Thus: F0 / ( 1+rf )T = SO T F0 = S0 ( 1+rf ) The futures price must equal the carrying cost of stock. A drawback of the conventional cost of carry model mentioned above used for futures pricing is the ignorance of dividends. The actual cost of a futures contract, taking into account the dividends earned is:

F0 = S0 (1+rf )T- D

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Derivatives Index Futures and Options CHAPTER 6 SWAPS A swap is nothing but barter or an exchange but it plays a very important role in international finance. Currency swaps help eliminate the differences between international capital markets. Interest rate swaps help eliminate barriers caused by regulatory structures. The needs of the parties in the swap or diametrically different. Swaps are not listed and traded on exchanges but they do have an informal market and are traded among dealers. A swap is a contract, which can be effectively combined with other kinds of derivative instruments. Interest Rate Swaps: One of the largest components of the global derivatives market and a natural adjunct to the fixed income markets is the interest rate swaps market. An interest rate swap is a contractual agreement entered into between two counterparties under which each agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of principal. The principal amount is notional because there is no need to exchange actual amounts of principal in a single currency transaction: there is no foreign exchange component to be taken account of. Equally, however, a notional amount of principal is required in order to compute the actual cash amounts that will be periodically exchanged. Simply put an interest rate swap is the exchange of one set of cashflows for another. A pre-set index, notional amount and set dates of exchange determine each set of cashflows. The most common type of interest rate swap is the exchange of fixed rate flows for floating rate flows. Differences in the credit quality between entities borrowing money motivate the interest rate swap market. Specifically, some agents may have a better borrowing profile in the short maturities than they do in the long maturities. Other agents (with more creditworthy status) have a comparative advantage raising money in the longer maturities. A counter-party's creditworthiness is an assessment of their ability to repay money lent to them over time. If a company has a good credit rating, they are more likely to be able to pay back a loan over time than a company with a poor credit rating. This effect is magnified with time. By making it easier for less creditworthy agents to borrow in the short term than in the long term, lenders make sure that they are less exposed to this risk. Therefore, we would expect that in fixed-floating interest rate swaps, the entity paying fixed and receiving floating is usually the less creditworthy of the two counterparties.

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Derivatives Index Futures and Options The interest rate swap gives the less creditworthy entity a way of borrowing fixed rate funds for a longer term at a cheaper rate than they could raise such funds in the capital markets by taking advantage of the entity's relative advantage in raising funds in the shorter maturity buckets. Fixed-floating interest rate swaps are not the only kinds of interest rate swaps we can construct. Any kind of interest rate swap is possible, as long as the two counter-parties can come up with differing indices. We could imagine a swap in which there are two different kinds of floating indices or another in which there are two different kinds of fixed indices. Just like an option, a swap can be at-the-money, in-the-money or out-of-the-money. Most swaps are priced to be at-the-money at inception meaning that the value of the floating rate cash flows is exactly the same as the value of the fixed rate cash flows at the inception of the deal. Naturally, as interest rates change, the relative value may shift. Receiving the fixed rate flow will become more valuable than receiving the floating rate flow if interest rates drop or if credit spreads tighten. Investment banks and commercial banks are the market makers for most of these swaps. Most of them warehouse the risk in portfolios, managing the residual interest rate risk of the cash flows. Pricing: If we consider the generic fixed-to-floating interest rate swap, the most obvious difficulty to be overcome in pricing such a swap would seem to be the fact that the future stream of floating rate payments to be made by one counterparty is unknown at the time the swap is being priced. In many countries, for example, there is a deep and liquid market in interest bearing securities issued by the government. These securities pay interest on a periodic basis, they are issued with a wide range of maturities, principal is repaid only at maturity and at any given point in time the market values these securities to yield whatever rate of interest is necessary to make the securities trade at their par value. It is possible, therefore, to plot a graph of the yields of such securities having regard to their varying maturities. This graph is known generally as a yield curve -- i.e.: the relationship between future interest rates and time -- and a graph showing the yield of securities displaying the same characteristics as government securities is known as the par coupon yield curve. A different kind of security to a government security or similar interest-bearing note is the zero-coupon bond. The zero-coupon bond does not pay interest at periodic intervals. Instead it is issued at a discount from its par or face value but is redeemed at par, the accumulated discount which is then repaid representing compounded or "rolled-up"

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Derivatives Index Futures and Options interest. A graph of the internal rate of return (IRR) of zero-coupon bonds over a range of maturities is known as the zero-coupon yield curve. Finally, at any time the market is prepared to quote an investor forward interest rates. Forward deposit rate is a mathematically derived rate, which reflects an arbitrage relationship between current (or spot) interest rates and forward interest rates. In other words, the six month forward interest rate will always be the precise rate of interest, which eliminates any arbitrage profit. The forward interest rate will leave the investor indifferent as to whether he invests for six months and then re-invests for a further six months at the six-month forward interest rate or whether he invests for a twelve month period at today's twelve month deposit rate. The graphical relationship of forward interest rates is known as the forward yield curve. One must conclude, therefore, that even if -- literally -- future interest rates cannot be known in advance, the market does possess a great deal of information concerning the yield generated by existing instruments over future periods of time and it does have the ability to calculate forward interest rates which will always be at such a level as to eliminate any arbitrage profit with spot interest rates. Future floating rates of interest can be calculated, therefore, using the forward yield curve but this in itself is not sufficient to let us calculate the fixed rate payments due under the swap. A further piece of the puzzle is missing and this relates to the fact that the net present value of the aggregate set of cashflows due under any swap is -- at inception -- zero. The truth of this statement will become clear if we reflect on the fact that the net present value of any fixed rate or floating rate loan must be zero when that loan is granted, provided, of course, that the loan has been priced according to prevailing market terms. This must be true, since otherwise it would be possible to make money simply by borrowing money, a nonsensical result However, we have already seen that a fixed to floating interest rate swap is no more than the combination of a fixed rate loan and a floating rate loan without the initial borrowing and subsequent repayment of a principal amount. The net present value of both the fixed rate stream of payments and the floating rate stream of payments in a fixed to floating interest rate swap is zero, therefore, and the net present value of the complete swap must be zero, since it involves the exchange of one zero net present value stream of payments for a second net present value stream of payments. The pricing picture is now complete. Since the floating rate payments due under the swap can be calculated as explained above, the fixed rate payments will be of such an amount that when they are deducted from the floating rate payments and the net cash flow for each period is discounted at the appropriate rate given by the zero coupon yield curve, the net present value of the swap will be zero. It might also be noted that the actual fixed rate produced by the above calculation represents the par coupon rate payable for that maturity if the stream of fixed rate payments due under the swap are viewed as being a hypothetical fixed rate security. This could be proved by using standard fixed rate bond valuation techniques. Users and Uses of Interest Rate Swaps:

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Derivatives Index Futures and Options Interest rate swaps are used by a wide range of commercial banks, investment banks, non-financial operating companies, insurance companies, mortgage companies, investment vehicles and trusts, government agencies and sovereign states for one or more of the following reasons: 1. To obtain lower cost funding 2. To hedge interest rate exposure 3. To obtain higher yielding investment assets 4. To create types of investment asset not otherwise obtainable 5. To implement overall asset or liability management strategies 6. To take speculative positions in relation to future movements in interest rates. The advantages of interest rate swaps include the following: 1. A floating-to-fixed swap increases the certainty of an issuer's future obligations. 2. Swapping from fixed-to-floating rate may save the issuer money if interest rates decline. 3. Swapping allows issuers to revise their debt profile to take advantage of current or expected future market conditions. 4. Interest rate swaps are a financial tool that potentially can help issuers lower the amount of debt service. Currency swaps: Similar to an Interest Rate Swap but where each leg of the swap is denominated in a different currency. A Cross-Currency Swap therefore has two principal amounts, one for each currency. Normally, the exchange rate used to determine the two principals is the then prevailing spot rate although for delayed start transactions, the parties can either agree to use the forward FX rate or agree to set the rate two business days prior to the start of the deal. With an Interest Rate Swap there is no exchange of principal at either the start or end of the transaction as both principal amounts are the same and therefore net out. For a Cross-Currency Swap it is essential that the parties agree to exchange principal amounts at maturity. The exchange of principal at the start is optional (see corporate example below). Like all Swaps, a Cross Currency Swap can be replicated using on-balance-sheet instruments, in this case loan and deposits in different currencies. This explains the necessity for principal exchanges at maturity as all loans and deposits also require repayment at maturity. While the corporate or investor counterparty can elect not to exchange principal at the start, the bank needs to. The bank can replicate this initial exchange by entering into a spot exchange transaction at the same rate quoted in the Cross-Currency Swap. Loosely speaking, all foreign exchange forwards can be described as Cross Currency Swaps as they are agreements to exchange two streams of cashflows (in this case a stream of one!) in different currencies. Many banks manage Long Term Foreign Exchange Forwards as part of the Cross Currency Swap business given the similarities.

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Derivatives Index Futures and Options Like all FX Forwards, the Cross-Currency Swap exposes the user to foreign exchange risk. The swap leg the party agrees to pay is a liability in one currency, and the swap leg they have agreed to receive, is an asset in the other currency. One of the major market users for Cross Currency Swaps are Debt issuers, particularly in the Euro-markets where issuers sell bonds in the "cheapest" currency and swap their exposure to their desired currency (see Pricing). A Cross-Currency Swap where both legs are floating rate is part of the Basis Swap product family. Cross Currency Swaps are also known as a CIRCA (a Currency and Interest Rate Conversion Agreement). Pricing: The pricing in a Cross Currency Swap reflect that level where the market is indifferent to receiving the cashflows on either leg. Each leg of the swap can be considered on its own. At the inception of the swap, the present value of one leg (which is calculated using the prevailing zero coupon yield curve for that currency) must be equal to the present value of the other leg at the then prevailing spot rate. Using this simple logic, it would seem natural that a stream of LIBOR flat payments in one currency could be exchanged for a stream of LIBOR flat payments in another currency. This is not always true and the reason is generally a simple case of supply and demand. Where there is excessive demand for Cross Currency Swaps between two particular currencies (or FX Forwards for that matter), the price will tend to rise, and vice versa. This may or may not be to the advantage of the swap user. In general, the price difference is limited to plus or minus 10bp. Like FX forwards, three things influence the price and value of a Cross-Currency Swap: The yield The yield The spot exchange rate Target market: There are three clear target markets: 1. Investors who wish to purchase foreign assets but seek to eliminate foreign currency exposure 2. Debt issuers who can achieve more favourable rates by issuing debt in foreign currency 3. Liability managers seeking to create synthetic foreign currency liabilities Advantages and Disadvantages: Off Balance Sheet on in currency currency one two

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Derivatives Index Futures and Options Can be cheaper than the cash markets (i.e. issuing foreign currency bonds directly) Can elect to exchange principal at the start if desired Simple documentation compared to cash markets (i.e. issuing a bond, arranging a loan) Can be customised Can be reversed at any time (albeit at a cost or benefit) Unlimited loss potential Equity swaps: Equity swaps are exchanges of cashflows in which atleast one of the indices is an equity index. An equity index is a measure of the performance of an individual stock or a basket of stocks. There are many reasons to use equity swaps, some of which come from the motivation behind index trading. This passive investing strategy is gaining ground in the fund management community. Instead of trying to buy individual stocks that are deemed to be undervalued by some method of fundamental analysis, the index trading mechanism chooses a basket of stocks that is selected for its ability to represent the general market or one particular sector of the stock market. The fees associated with funds that engage in index trading are much lower because the investment management is mechanically deterministic. It is prescribed by the index that the investors have chosen. The investment manager is not paid for his discretionary expertise. Equity swaps make the index trading strategy even easier. There are also tax advantages or ownership advantages associated with equity swaps. Emerging markets (and foreign markets, generally) are often illiquid, making it prohibitively dangerous and expensive to use a value-driven stock-picking strategy. This is not to say that investing in emerging markets is to be avoided, though. Under the right economic conditions, emerging markets can deliver outstanding performance compared to developed market returns. But liquidity and flexibility, the nimbleness with which one can get out of a bad position, are important considerations in any investment strategy. Equity swaps make this easier. Uses and Users: Typical uses of equity swaps would be: 1. To permit rapid switching and diversification between international equity markets. 2. To avoid transaction costs and market barriers that may make direct investment in an equity market either impossible or prohibitively expensive. 3. To earn an enhanced coupon yield while retaining ownership of a portfolio of shares. 4. To reduce the cost of a contested acquisition. 5. To protect against share price falls in a stock for stock merger. 6. To encourage employee stock ownership. 7. To avoid exchange limits and restrictions imposed on programme trading in equities

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Derivatives Index Futures and Options CHAPTER 7 SWAPTIONS A swaption is effectively an option on a forward-start IRS, where exact terms such as the fixed rate of interest, the floating reference interest rate and the tenor of the IRS are established upon conclusion of the swaption contract. A 3-month into 5-year swaption would therefore be seen as an option to enter into a 5 year IRS, 3 months from now. It is also important for the calculation of the premium, whether the swaption is a fixed payer or a receiver type. A fixed-rate payer swaption gives the buyer of the option the opportunity to lock into a fixed rate through an IRS on an agreed future date. Such an option can therefore be seen as a call option on a forward swap rate. The option period refers to the time, which elapses between the transaction date and expiry date. The fixed rate of interest on the swaption is called the strike rate. The simplest type of swaption available is an option to pay or receive fixed-rate money against receiving or paying floating rate money. A swaption has all the similarities, properties and characteristics of any conventional option. They are usually European style options. The underlying instrument on which a swaption is based is a forward start IRS. An IRS is an agreement between two parties to exchange a series of future cash flows. They are economically equivalent to a back-to-back offsetting loan and deposit agreement where interest payments on the one leg are based on a fixed rate whilst payments on the remaining leg are based on a floating reference interest rate. IRSs are treated as off balance sheet instruments, as they do not represent an agreement to borrow or lend. The buyer of a payer/receiver swaption pays a premium for the right but not the obligation to pay/receive the fixed rate and receive/pay the floating rate of interest on a forward start IRS. The swaption premium is expressed as basis points. These basis points are applied to the nominal principal of the forward start IRS. Swaptions can be cash settled; therefore at expiry they are marked to market off the applicable forward curve at that time and difference is settled in cash. Marking to market of a swaption depends on the strike rate of the swap and the relationship of the strike price to the underlying, where the underlying is the forward start IRS. If forward swap rates fall, a fixed rate receiver swaption will increase in value in marking such a swaption to market, and a fixed rate payer swaption will decrease in value. Uses of swaptions: Swaptions can be applied in a variety of ways for both active traders as well as for corporate treasurers. Swap traders can use them for speculation purposes or to hedge a portion of their swap books. The attraction of swaptions for corporate treasurers is that the forward element in all swaptions provides the attractions of the forward-start swap, and to the owner of the put or call, also the flexibility to exercise or not, as may be

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Derivatives Index Futures and Options considered appropriate. It is therefore a valuable tool when a borrower has decided to do a swap but is not sure of the timing. Swaptions have become useful tools for hedging embedded optionality which is common to the natural course of many businesses. Certainly, embedded optionality is present whenever products are sold on a 'sale-and-leaseback' basis, where the counterparty to a lease contract has the right to either to extend a lease for a five-year period or terminate a lease after an initial five-year period. The leasing company may be exposed where the lease income is less than the cost of funding the asset, which is being leased. By entering into a 5-year swaption, the leasing company is able to protect itself against the lessee exercising their option to extend the lease. If the lessee decides not to extend, the swap will remain unexercised. A huge advantage of the swaption is that the leasing company could potentially still benefit from entering into a swaption originally if the forward swap rates have moved in his favour during the option period. In any event, the leasing company has immunised itself against loss and bought itself reasonable flexibility, whilst only paying the premium at the start. Swaptions are useful to borrowers targeting an acceptable borrowing rate. By paying an upfront premium, a holder of a payer's swaption can guarantee to pay a maximum fixed rate on a swap, thereby hedging his floating-rate borrowings. The borrower is therefore allowed to remain in low floating-rate funds while at the same time being assured of protection should rates increase expectedly (i.e. when the yield curve is positive) or unexpectedly (i.e. when the yield curve is flat or negative). Swaptions are also useful to those businesses tendering for contracts. Businesses need to settle the question whether to commit to borrowings in the future in their own currency in terms of a tender on a future project. A business would certainly find it useful to bid on a project with full knowledge of the borrowing rate should the contract be won. Swaptions provide protection on callable/putable bond issues. Also, the perception of the value of the embedded call inherent in a callable bond issue often differs between investors and professional option traders, therefore allowing arbitrage. A callable bond issue effectively endows the borrower with an embedded receiver's swaption, which he can sell to a bank and use the premium to reduce his cost of funds. The more innovative borrowers can use this arbitrage opportunity to their advantage in order to bring down their funding cost. Pricing of Swaptions: The pricing methodology depends on setting up a model of the probability distribution of the forward zero-coupon curve at the time of pricing and imposing that model on the forward-start IRSs' cashflow structure, with the aim of obtaining a probability distribution of the net present value of the cashflows. The zero-coupon curve is assumed to undergo a Markov process (which is a distinct class of stochastic process). A stochastic process literally means 'guessable' and can be described as a process, which involves a random variable in which the successive values are inter-dependent in some way. The probability distribution of the forward curve depends amongst other factors on the

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Derivatives Index Futures and Options swaption maturity, the appropriate interest rate for that period, the current forward curve and the implied volatility (the assumed rate of change of the curve). The present value of the forward swap will also obviously depend on the individual cashflows pertaining to the underlying structure of the swap, either accreting or amortising or both, on which the swaption is based. The probability distribution of the forward curve can be modelled by using a binomial numerical model, which uses binomial trees. Alternatively, it can be structured by modelling the stochastic process through one of a number of mathematical models, such as the Black and Scholes model. The market standard tool for pricing swaptions is to simulate the route taken by the modified Black model. This is because of its ease of use and market acceptance. However, the modified Black formula has been subject to extensive criticism from various sources over the years. The more prominent shortcomings illuminated by these authors entail that the particular model looks at the underlying IRS simply as a forward rate; it does not encapsulate the structure of the swap, such as maturity, coupon frequency, etc. Indeed, the more complicated cashflow structures such as rollercoaster or accreting swaps will almost certainly yield incorrect results. In addition, it is shown to be theoretically imperfect, because of the fact that the modified Black model only allows for one stochastic. It also uses a fixed-yield curve, whereas swap traders know that the curve undergoes a stochastic process. Newer models, such as the Ho-Lee, Heath-Jarrow-Merton and Hull-White models, are called arbitrage-free models and are designed to avoid arbitrage possibilities due to changes in the yield curve. Some of the newer models also make the volatility itself a stochastic term.

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Derivatives Index Futures and Options

CHAPTER 8 ACCOUNTING GUIDELINES FOR CLEARING MEMBERS

The Guidelines provided in this Note cover the following areas: 1. Collection of Initial Margin from Clients 2. Issue of Collateral Receipt Notes/Collateral Return Notes to Clients 3. Collateral Register 4. Reporting of Collateral to Clients 5. Payment of Initial Margin to Clearing House/Clearing Corporation 6. Bills to be raised on Clients 7. Collection of Mark to Market Margins and Options Premiums from Clients 8. Squaring Up of Transactions 9. Daily Transactions vis--vis Clearing House/Clearing Corporation 10. Payments/Receipts to/from Clearing House/Clearing Corporation 11. Payments to Clients 12. Controls and Balances 13. Reporting to Exchange Member Default Appendix - Examples

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Derivatives Index Futures and Options Conventions Followed: Accounting Entries: All accounting entries are provided in a box. The name of the Account is first mentioned. Thereafter the default category of the Account (viz. Whether the Account is an Asset or a Liability or Income or Expense) is mentioned. Please note that the Account categorisation is a default categorisation, and is normally expected to fall into that category. However, if underlying transactions are unusual, an Asset could become a Liability and vice-versa. From the financial controls point of view, such an Account which assumes an irregular position is indicative of abnormalities and can easily be picked up during scrutiny. Then the details of whether the Account is required to be Debited or Credited is provided. In some illustrative cases, the amounts are also provided. Scope of the Accounting Guidelines The Guidelines focus on the areas involving the Exchange, Clearing Members, Trading Members and Clients. Regular accounting norms for Members including their Brokerage Income Accounting, Service Tax Accounting, Income Tax Accounting are not covered in these Guidelines. For the purpose of these Guidelines, the term Client includes Trading Member unless otherwise particularly specified. The terms Clearing House and Clearing Corporation are used interchangeably in these Guidelines. The term cash includes cheques and bank drafts. The records could be maintained in electronic form (with regular and sufficient back up). However, they should be available as and when required. Bye-laws, rules and regulations The Accounting Guidelines presented here are subject to the Bye-laws, rules and regulations of the Derivatives Segment of the Stock Exchange. In case of any differences between these Guidelines and the Bye-laws, rules and regulations, the Bye-laws, rules and regulations shall prevail. 1. Collection of Initial Margin from Clients The terms Initial Margin and Total Requirement have been used interchangeably throughout the guidelines.

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Derivatives Index Futures and Options The term Total Requirement means the Initial Margin requirement for a portfolio as calculated by the risk management software used and prescribed by the exchange. It is an amount, which is receivable from the client by the Clearing Member and would help the Clearing Member in monitoring his receivables from clients or in adjusting the collateral already collected from the clients. In some situations however, the total requirement or initial margin can be favourable to the client. This would tend to happen mostly in cases where the client has a long option position or where long option positions are larger than short option positions with the same underlying. Clearing Members are required to ensure that the client does not withdraw such favourable initial margin. Clearing Members shall collect Initial Margin upfront from all his Clients. The Initial Margin may be collected in cash, cash equivalents and approved dematerialised equity securities from Clients. Cash Equivalents include the following: 1. 2. 3. 4. Bank Guarantees Fixed Deposits Treasury Bills Dated Government Securities

Collateral shall be marked-to-market at least on a weekly basis. On these values, the hair-cut as specified in the Report of the Professor J R Varma Group on Risk Containment Measures in the Indian Stock Index Futures Market (hereafter in these Guidelines referred to as the J R Varma Report for brevity) shall be applied. The hair-cuts specified are 10% on debt securities and 15% on dematerialised equity securities. In cases where the same Collateral are being valued by the Clearing House on a particular basis, the Clearing Member shall follow the basis as followed by the Clearing House. However, the Clearing Member can be more conservative in valuation than the Clearing House. The values of collateral may further be rounded off to such amounts as may be recommended by the Clearing House from time to time. The exchange may from time to time provide specifications on acceptability of various classes of securities/collateral.

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Derivatives Index Futures and Options At the point of receipt of Cash towards Initial Margin from Clients, the Clearing Member should pass the following accounting entry: Cash Account (Asset) Debit To Clients (Specific Code) Initial Margin Account (Liability) Credit The receipt of cash shall also be recorded in the Memorandum records. At the point of receipt of Collateral from Clients, the receipt shall be recorded in Memorandum records and shall remain outside the financial ledger. Additional Collateral collected from time to time shall be recorded in a similar manner in the Memorandum records. If any of the Collateral is returned back, the Memorandum records shall be updated accordingly. The Memorandum records shall be updated at the point of marking to market of collaterals every week so as to recognise the revaluation in the Collateral. Collateral Receipt and Return Notes shall evidence receipt of Collateral and Returns of Collateral as explained below. Updation in the Memorandum records shall provide references to these Collateral Receipt and Return Notes. In cases where Cash paid against Initial Margin is refunded back to the Client, the following accounting entry will be passed: Client (Specific Code) Initial Margin Account (Liability) Cash Account (Asset) Debit Credit

2. Issue of Collateral Receipt Notes/Collateral Return Notes to Clients The Clearing Member shall issue a Collateral Receipt Note to the Client providing the details of Collateral received including the values thereof as recognised by the Clearing Member after considering the hair-cuts applicable. The Receipt shall clearly state that these Collateral are being collected towards Initial Margin for Derivatives Products Trading. At the time of returning back Collateral to clients, a Collateral Return Note shall be prepared providing details of the Collateral returned back. Values of the Collateral as recognised by the Clearing Member shall also be indicated in the Collateral Return Note.

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Derivatives Index Futures and Options Collateral Receipt and Return Notes shall be pre-numbered serially. Office copies of Collateral Receipt and Return Notes should be maintained by the Clearing Member and shall be provided to the Inspection Department if required by them. 3. Collateral Register All Collateral collected from Clients by the Clearing Member should be recorded in a Register, which shall provide details of such Collateral. Reference of the Collateral Receipt/Return Note shall be provided in the Register. The Register shall be updated on daily basis for any further Collateral collected/returned. If such Collateral are further deposited by the Clearing Member with the Clearing House, appropriate remarks may be provided in the Register, in the Clients folio. Further, details of Collateral deposited with the Clearing House shall be maintained independently in a separate folio in the Register. Appropriate cross-references of Collateral collected from Clients and deposited with Clearing House may be provided in this folio (wherever applicable). 4. Reporting of Collateral to Clients Every week, a statement of Collateral held by the Clearing Member along with the values thereof (as recognised by the Clearing Member) shall be provided to each Client. Appropriate remarks may also be provided on this statement wherever such Collateral has been further provided by the Clearing Member to the Clearing House. 5. Payment of Initial Margin to Clearing House The Clearing Member shall pay Initial Margin to the Clearing House as may be applicable upfront. Such Initial Margin may be paid by way of cash, cash equivalents and dematerialised equity securities. The break-up of each class of Collateral shall follow the principles enunciated in the J. R. Varma Report. In case of payments of Cash (by way of Initial Margin) by the Clearing Member to the Clearing House, the following Accounting Entry shall be passed: Clearing House Account (Asset) Cash Account (Asset) Debit Credit

The Clearing Member shall also maintain Memorandum records, which shall be updated for payment of Cash to the Clearing House. In case of payment of Initial Margin by way of Collateral to the Clearing House, the Clearing Member shall record the payment in Memorandum records. This payment shall remain outside the financial ledger. The value to be recorded in the Memorandum records shall be based on the value accorded by the Clearing House to such Collateral for the

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Derivatives Index Futures and Options purpose of Initial Margin. Further, the Clearing House shall revalue the Collateral on a weekly basis. The Clearing Member shall accordingly update his Memorandum records to reflect such valuation. The revaluation shall be reflected in the Memorandum records on the same day as communicated by the Clearing House to the Clearing Member. In cases where the Clearing Member requests for release of Cash paid towards Initial Margin from the Clearing House and the Cash is so released, the following accounting entry shall be passed: Cash Account (Asset) Debit Clearing House Account (Asset) Credit

The receipt of Cash shall also be appropriately recorded in the Memorandum records of the Clearing Member. In case where the Clearing Member requests for release of Collateral provided to the Clearing House towards Initial Margin, and the Collateral is so released, the Memorandum records of the Clearing Member shall be appropriately updated for the receipt of such Collateral from the Clearing House. 6. Bills to be raised on Clients It is desirable that Bills are raised by Clearing Members on all Clients on daily basis. In cases where the Client provides a written declaration and agrees to a weekly billing system, the Clearing Member may raise Bills on a weekly basis. It shall be the responsibility of the Clearing Member to ensure that Initial Margins are adequately collected from all Clients, and further that premium and Mark to Market Margins are collected on a T+1 basis. The mere fact that Bills are raised on Weekly basis (instead of Daily basis) shall not prevent the collection of all Margins as required by the Exchange on timely basis. The onus of ensuring collection of all Margins within stipulated time-frame lies on the Clearing Members. Bills shall be raised for the following: Initial Margin as at the end of the Day of entering into the Transaction Variation in Initial Margin as at the end of each Trading Day thereafter (till the expiry of the Contract or till squaring up of the transaction) Mark to Market Margin for each Trading Day thereafter (till the expiry of the Contract or till squaring up of the transaction) Option Premium Payable by the Client Option Premium Payable to the Client

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Derivatives Index Futures and Options No accounting entries shall be passed in the financial ledger for Initial Margin and for Variations in the Initial Margin on subsequent days payable/receivable with respect to the transactions entered into. The Initial Margin details shall be recorded in Memorandum records, which shall be updated on daily basis. In cases where the Initial Margin is paid/refunded in Cash to/by the Client, an accounting entry will be passed as covered by Section 1 above. The Clearing Member shall keep track and provide statements to the Clients on daily basis giving atleast the following details: Client Name Client Code INITIAL MARGIN DETAILS AS AT ________________ (Date) Initial Margin collected from you: Cash Collateral 1. 2. 3. 4. xxxxxx Total Initial Margin collected xxxxxx -------Initial Margin payable based on Open Positions Total Initial Margin Payable by Client xxxx xxxxxx xxxxxx xxxxxx xxxxxx xxxxxx _____

Position Details: Product Series Code Quantity Buy/Sell

Xx
Xx

xx
xx

xx
xx

Buy
Sell

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Derivatives Index Futures and Options The Clearing Members are advised to give details pertaining to squared off transactions and exercised/ assigned options in an appropriate manner, on the day of such event, for the easy and enhanced understanding of the client. It should be noted that if the Total Initial Margin payable by Client is in favour of the Client it would be added to his collateral and the client can take up positions against such favourable margins. However, the Client is not allowed to withdraw this amount.

Some examples of transactions, Memorandum entries and financial accounting entries are provided below: Facts of the Case A Client enters into a transaction for sale of one Contract of June future at 10:30 in the morning, at 4000 price, its contract value being Rs.2,00,000. The Client also enters into a long position of one Contract on the June 4000 Call that is, one long June Call at a strike price of 4000 at a premium of 160. The risk management software indicates that the Initial Margin payable is Rs 25,000 at this time of the morning. At end of day, the price of the June future has closed at a higher level at 4100 and the Contract Value at the end of the day is Rs 2,05,000. A mark to market loss of Rs 5,000 has arisen. Further, the risk management software indicates that the Initial Margin/Total Requirement to be maintained is Rs 26,000. Control and Accounting Implications The Clearing Member shall ensure the following: 1. Initial Margin of Rs 25,000 is collected from the client upfront (i.e. before execution of the Futures transaction) 2. The enhanced initial margin of Rs.1,000 should be collected. 3. Option Premium of Rs 8,000 (160x50) is collected from the Client on T+1 basis in cash. 4. Mark to Market Loss on the Futures position of Rs 5,000 is collected from the Client on T+1 basis in cash. In cases where the Initial Margin is paid/refunded in Cash to/by the Client, an accounting entry will be passed as covered by Section 1 above. As already explained above, the Clearing Member shall appropriately reflect all cash and Collateral collected towards Initial Margin in the daily statement. A Bill shall be raised on the Client for the Mark to Market Variation of Rs 5,000. Accounting entries can be passed as under :

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Derivatives Index Futures and Options Client (Specific Code) Account (Liability) Debit Rs 5,000 Clearing House Mark to Market Variation (Liability) Credit Rs 5,000 The entry indicates that on the one hand the Clearing Member is required to collect Rs 5,000 from the Client, while on the other hand, he is liable to pay the same amount to the Clearing House. A Bill shall be raised on the Client for the Option Premium of Rs 8,000. An accounting entry shall be passed in the financial books for this bill as under: Client (Specific Code) Account (Liability) Debit Rs 8,000 Clearing House Option Premium & Settlement Account(Liability) Credit Rs 8,000 The entry indicates that on the one hand the Clearing Member is required to collect Rs 8,000 from the Client, while on the other hand, he is liable to pay the same amount to the Clearing House. A bill shall be raised for additional Initial Margin for Rs. 1,000 but no accounting entry shall be passed. 7. Collection of Mark to Market Margins and Option Premiums from Clients Mark to Market Margins on futures are to be collected by the Clearing Member from the client only in cash. Cash equivalents or equity Collateral are not permitted. Option Premiums are to be collected by Clearing Members from clients only in cash. Cash equivalents or Collateral are not permitted. At the point of collection, the Clearing Member shall issue a Receipt and the following accounting entry shall be passed: Cash Account (Asset) Debit Rs 13,000 Client (Specific Code) Account (Liability) Credit Rs 13,000

It is possible in some cases that the Client has paid excess Initial Margin in Cash. The Clearing Member cannot, on his own, adjust such excess Initial Margin paid in Cash, towards Mark to Market Margins or towards Option Premiums. The Client is required to specifically request the Clearing Member in writing that the excess Initial Margin paid in Cash be adjusted towards the Mark to Market Margins or towards Option Premiums of that particular day. The request shall mention the exact amount that is required to be transferred to the Mark to Market Margin Account or to the Option Premium from the Initial Margin Account. The client may, if the Clearing Member agrees, give a one-time written request for a specific period, that excess Initial Margin paid in Cash be adjusted

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Derivatives Index Futures and Options towards Mark to Market Margins on futures or towards the Net Option Premium payable by the client. The Clearing Member has the right to refuse the request of the Client to effect such adjustments, in which case the Client shall be required to bring in the Mark to Market Margins or the Option Premium in Cash. However, in case of default by the Client, the Clearing Member can adjust the excess Initial Margin paid in Cash against the Mark to Market Margin or the Option Premium. The Clearing Member shall refuse such requests in cases where the balance Initial Margin (after the adjustment) falls below the required level. If the request is accepted, or where the Clearing Member decides to adjust, the appropriate adjustment shall be effected and the following accounting entry shall be passed. Client (Specific Code) Initial Margin Account (Liability) Debit Client (Specific Code) Account (Liability) Credit 8. Squaring Up of Transactions On account of squaring up of certain positions by the client, the margin requirements on the portfolio may increase or decrease. Mark to Market Margin on Futures positions squared up during the day will be calculated based on the difference between yesterdays closing price and the price at which the square up was effected. For example, if yesterdays closing price was Rs 4,900 (one contract), which was squared up today for Rs 4,800, a loss of Rs 5,000 would arise (1*50*100). No accounting entry shall be passed for reduction of the Initial Margin in the financial books. In cases where the Initial Margin is paid/refunded in Cash to/by the Client, an accounting entry will be passed as covered by Section 1 above. Memorandum records shall be updated and the balance Initial Margin available from the client will stand enhanced as at the end of the day, if a particular lot which has been squared up during the day has resulted in a reduction of Initial Margin. A financial entry shall be passed for the Mark to Market Variation of Rs 5,000 as under: Client Specific Code (Liability) Account Debit Rs Clearing House Mark to Market Variation (Liability) Account Rs 5,000 5,000 Credit

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Derivatives Index Futures and Options

In the event of exercise/assignment of options, the resultant difference between the strike price and the exercise price shall be accounted for in the Options Premium & Settlement Account. For example, a holder of a Sensex June call option at a strike of 4000, exercises his option on the expiry of the series and the settlement price is 4200, the member would be liable to pay the holder Rs.10,000 (200*50). A financial entry for the above will be passed as shown under: Clearing House Option Premium & Settlement(Liability) Account Debit 10,000 Client Specific Code (Liability) Account Credit Rs 10,000 Rs

Similarly when an option is assigned against a writer of a Sensex June put option at a strike of 4000 on the expiry of the series and the settlement price is 3900, the member would be entitled to receive from the writer Rs.5,000 (100*50). A financial entry for the above will be passed as shown under: Client Specific Code (Liability) Account Debit Rs 5,000 Clearing House Option Premium & Settlement (Liability) Account Credit Rs 5,000 9. Daily Transactions vis--vis Clearing House The above transactions (explained vis--vis clients) shall have reciprocal effects vis--vis the Clearing House. Some examples of transactions and corresponding accounting entries are provided below: A Clearing Member enters into several transactions during the course of the day. The Initial Margin to be collected based on these transactions (based on the point of time when they were entered into during the day) is Rs 4 lakhs. At end of day, the Initial Margin payable comes to Rs. 3.50 lakhs. Further, due to the change between the contract prices and the closing prices, a mark to market variation demand of Rs 5 lakhs has arisen. Further, Option Premium payable to the Clearing House based on various transactions during the day is Rs 3 lakhs. No financial accounting entries will be passed for the Initial Margin payable (both during the day and for the position at the end of the day). Memorandum records of the Clearing Member shall be updated for the Initial Margin payable as at the end of the day.

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Derivatives Index Futures and Options

A financial entry will be required for the Option Premium of Rs.3 lacs and Mark to Market Margin of Rs 5 lakhs demanded by the Clearing House. Clearing House Mark to Market Variation (Liability) Account Debit Rs 5 lakhs Clearing House Account (Asset) Credit Rs 5 lakhs Clearing House Option Premium & Settlement (Liability) Account Debit Rs 3 lakhs Clearing House Account (Asset) Credit Rs 3 lakhs The Clearing House Mark to Market Variation Account and the Clearing House Option Premium & Settlement Account will stand reduced to zero once the above Debit is effected and the Credits are effected by Debits to various Clients. If this Account is not zero by the end the day T+1, the difference may be indicative of errors or omissions and should be scrutinised by the Clearing Member carefully. 10. Payments/Receipts to/from Clearing House The Clearing Member shall effect payment of Mark to Market Margins and Option Premiums to the Clearing House. These Mark to Market Margins and Option Premiums should be paid by the Clearing Member irrespective of whether the Clearing Member has been able to collect the Mark to Market Margins and Option Premiums from his clients or otherwise. At the point of payment of Mark to Market Margins and Option Premiums to the Clearing House the following accounting entry shall be passed: Clearing House Account (Asset) To Cash Account (Asset) Debit Credit

Apart from payment of Mark to Market Margins and Option Premiums, other payments like cash payments for enhancement of Initial Margin could also be effected from time to time and a similar accounting entry passed for such payments. The Clearing Member may also receive from time to time from the Clearing House amounts against release of Mark to Market Margins, Option Premiums, amounts by way of release of Initial Margin, etc. for which the following accounting entry shall be passed: Cash Account (Asset) Debit Clearing House Account (Asset) 11. Payments to Clients Credit

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Derivatives Index Futures and Options Payments effected by Clearing Member to Clients may occur on release of Mark to Market Margins, Option Premiums to Clients or on squaring up of transactions and payments against such transactions, release of Initial Margins, release of excess Margins collected, etc. The following accounting entry shall be passed at the point of such payments: Client Account (Liability) Cash Account (Asset) 12. Controls and Balances The system envisaged requires the following controls to be instituted: Clearing Members shall collect Initial Margin upfront Clearing Members shall collect Mark to Market Margins on T+1 basis Clearing Members shall collect Option Premiums on T+1 basis Clearing Members shall promptly pay such margins as may be required to be paid to the Clearing House. Clearing Members may collect Initial Margins by way of cash, cash equivalents, dematerialized equity securities. Mark to Market Margins shall be collected strictly on cash basis only. Option Premiums shall be collected strictly on cash basis only. Clearing Members may collect higher margins from clients than what is stipulated by the exchange/clearing house. Clearing Members are required to make good any shortfall from collections of margins from clients Clearing Members are advised not to fund clients Debit Credit

Daily Initial Margin Statement The Daily Statement of Initial Margin will ensure that Clients have adequately funded their Initial Margin on day to day basis. Any shortfall of Initial Margin shall be clearly indicated in the Statement and the Client shall be required to make good the shortfall immediately. Clearing Members are expected to design their control systems in such a manner that a shortfall cannot arise in the first place. Client (Specific Code) Account (Liability) The Clients Account in the financial ledger at the end of any trading day+1 should not carry a debit balance at any time. If the Account carries a Debit Balance, the implication is that the Client has not paid the Mark to Market margins or the option premiums correctly.

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Derivatives Index Futures and Options Clients Initial Margin (Specific Code) Account (Liability) This Account indicates the Cash amount collected from the Client towards Initial Margin. The Account can never have a Debit Balance. The Account can be debited for the following purposes: Refund of Cash to the Client against reduction of his Initial Margin Transfer of the balance in this Account to the Client (Specific Code) Account on his request to enable the Client to fund his Mark to Market Margin Transfer of the balance in this Account to the Client (Specific Code) Account on his request to enable the Client to fund his Option Premium. Clearing House Account (Asset) This Account indicates the Cash paid by the Clearing Member to the Clearing House. This account can never carry a Credit balance. Withdrawals of Cash from this Account are possible only on specific request to the Clearing House by the Clearing Member. Clearing House Mark to Market Variation Account (Liability) This Account indicates the liability of the Clearing Member on account of Mark to Market Variation towards the Clearing House. The account is debited by the Mark to Market Margin demanded by the Clearing House and credited by the Mark to Market Margin demanded by the Clearing Member from his various Clients. The account should carry a balance of zero at the end of day T+1 and should be scrutinized if it carries any other balance. Clearing House Option Premium & Settlement Account (Liability) This Account indicates the liability of the Clearing Member on account of Option Premium towards the Clearing House. The account is debited by the Option Premium demanded by the Clearing House and credited by the Option Premium demanded by the Clearing Member from his various Clients. The account should carry a balance of zero at the end of day T+1 and should be scrutinised if it carries any other balance. Please note that both ways the entries can be in reverse positions, in this sense that Mark to Market Margins may be receivable from the Clearing House and payable to the Clients and similarly Option Premiums may be receivable from the Clearing House and payable to Clients. In both cases, these accounts should have a zero balance at the end of day T+1. 13. Reporting to Exchange The Exchange will provide the following details for every member, at the end of each trading day: 1. Initial Margin 2. Mark to Market Margins for Futures positions 3. Option Premium Payable 4. Option Premium Receivable

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Derivatives Index Futures and Options The Exchange will provide details of the Initial Margin, Mark to Market Variation and Option Premiums due from or due to each Clearing Member on a client by-client basis. Each Clearing Member should report back to the Exchange in the evening of every trading day, confirming that the Margins and Option Premiums have been collected from clients. Wherever margins are not collected, the Clearing Member should report the amount of shortage in collection on daily basis. Initial Margins deposited by Clearing Members shall be assumed to be funded by clients in the absence of details from Clearing Members. Mark to Market Margins and Option Premiums shall be assumed not be funded by clients in the absence of reporting from Clearing Members. Clearing Members should therefore be extremely careful about reporting back on the collection/shortage of margins. 14. Member Default

Utilisation of Trade Guarantee Fund (TGF) in case of default by member:

The TGF guarantee shall extend only to claims arising in respect of the Settlement(s) in which the Member is suspended or declared a defaulter (and not in respect of any other Settlement(s)). In case a Client/Trading member has deposited excess collateral towards margin with his Trading/Clearing member respectively, then his collateral will be guaranteed by the TGF only to the extent of his open positions on the Exchange (ByeLaws Chapter XV of the Derivatives Segment). The excess collateral will not be guaranteed under any circumstances. The exchange ceases to be liable (with respect to its Trade Guarantee Fund) on completion of payout. Any further disputes with regard to payments from the Clearing Member to the Trading Member/Client or with regard to payments from the Trading Member to the Client are beyond the scope of the Trade Guarantee Fund.

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Derivatives Index Futures and Options Utilisation of the Investors Protection Fund (IPF) in case of default The IPF shall be utilised to compensate a Client who has suffered and claims an amount payable to him by a Trading or Clearing Member (who has since been declared a defaulter) where: The claim arises directly on account of a trade in a Derivatives Contract which has been entered into between the Client and the Trading/Clearing Member (who has since been declared a defaulter) in accordance with the Bye-laws, Rules and Regulations of the Derivatives Segment The trade in the Derivatives Contract has already been settled by the Clearing House but the payment obligation in respect of which Derivatives Contract has not been completed by the Trading/Clearing Member to the concerned Client The loss is not payable by a Clearing Member or from the Derivatives Segment Trade Guarantee Fund

and shall be subject to such amount as shall be decided by the Governing Council from time to time

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Derivatives Index Futures and Options

APPENDIX
This Appendix seeks to bring out the concept of Margins and Option Premiums through a simple example. The examples are not intended to be comprehensive and should not be construed as part of the Accounting Guidelines above.

Example 1:
A client holds the following positions at the end of a particular day: Product Long Future Long Call Short Put No of Contracts One Two One Contract Value (Rs) 2,00,000 400,000 200,000 Premium (Rs) Not Applicable 17,500 10,000

Based on the Closing Price, the Futures position has a market value of Rs 1,98,000. At the end of the day, the obligations of the client vis--vis the clearing member will be as follows:(numbers not scientifically worked out and meant for illustration only): Rs Initial Margin (from the risk management software) 20,000 Option Premium Payable by Client 17,500 Option Premium Receivable by Client 10,000 Net Option Premium Payable by Client 7,500 Mark to Market Margin Payable by Client 2,000 The Member should ensure the following: 1. Initial Margin by way of cash plus collateral is at least Rs 20,000. 2. Option Premium of Rs 7,500 is collected on day T+1 3. Mark to Market Margin of Rs 2,000 is collected on day T+1

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Derivatives Index Futures and Options

Example 2:
Product Long Call No of Contracts Two Contract Value (Rs) 4,00,000 Premium (Rs) Rs 18108

At the end of the day, the obligations of the client vis--vis the clearing member will provide the following:(numbers not scientifically worked out and meant for illustration only): Total Requirement, as calculated by the risk management software favourable to the Client Option Premium payable by the Client Rs.18108 Option Premium receivable by the Client NIL Net Option Premium Payable by the Client Rs.18108 [Rs.3320]

The Trading Member should ensure the following: 1. The Client does not withdraw the favourable total requirement of Rs.3320. However, the client can continue to take positions on the same. 2. Option Premium of Rs.18108 should be collected in cash on day T+1

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Derivatives Index Futures and Options CHAPTER 9 GUIDELINES FOR PARTICIPATION BY MUTUAL FUNDS IN TRADING IN DERIVATIVE PRODUCTS The Mutual Funds shall be required to adhere to the following guidelines for trading in derivatives: Purpose of investment: Trading in derivatives by mutual funds shall be restricted to hedging and portfolio balancing purposes. The mutual funds shall be required to fully cover their positions in the derivatives market by holding underlying securities / cash or cash equivalents / option and / or obligation for acquiring underlying assets to honour the obligations contracted in the derivatives market. Separate records shall be maintained for holding the cash and cash equivalents / securities for this purpose. The securities held shall be marked to market by the AMC to ensure full coverage of investments made in derivative products at all time. Disclosure requirements: The following disclosure requirements shall be mandatory for mutual fund schemes proposing to invest in derivative products: The intention to trade in derivative products shall be disclosed in the offer documents. The risks and returns ensuing from trading in derivatives shall be explained by means of a simple quantitative example. The appropriate risk factors attendant upon such investments shall be disclosed in a comprehensible and simple manner. The offer document of a scheme envisaging derivative trading shall state unambiguously and clearly the losses that may be suffered by the investors as a consequence of such investments. The mutual funds shall disclose as to how trading in derivatives will help in the furtherance of the investment objectives of the scheme. The mutual funds shall lay down exposure-limits for themselves and disclose the same in the scheme offer-document. Valuation : Regarding valuation of derivative products: The traded derivatives shall be valued at market price in conformity with the stipulations of sub clauses (i) to (v) of clause 1 of the Eighth Schedule to the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996. The valuation of untraded derivatives shall be done in accordance with the valuation method for untraded investments prescribed in sub clauses (i) and (ii) of

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Derivatives Index Futures and Options clause 2 of the Eighth Schedule to the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996. Reporting requirements: The AMC shall cover the following aspects in their reports to trustees periodically, as provided for in the Regulations: Transactions in derivatives, both in volume and value terms. Market value of cash or cash equivalents / securities held to cover the exposure. Any breach of the exposure limit laid down in the scheme offer document. Short-fall, if any, in the assets covering investment in derivative products and the manner of bridging it. The Trustees shall offer their comments on the above aspects in the report filed with SEBI under sub regulation (23) (a) of regulation 18 of Securities and Exchange Board of India (Mutual Funds) Regulations, 1996. Existing schemes: In case the offer document of an existing scheme does not provide for trading in derivatives, the scheme, if it so desires, may trade in derivatives in accordance with these guidelines, provided that: It obtains approval from the trustees. Trustees shall take reasonable steps to ensure that the asset management company possesses adequate expertise and infrastructure for derivative trading. It informs the unit-holders of its intention to trade in derivatives and making all disclosures as mentioned earlier in the guidelines.

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