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Risk Management of Derivatives in Bombay Stock Exchange
Risk Management of Derivatives in Bombay Stock Exchange
Risk Management of Derivatives in Bombay Stock Exchange
Stock Exchange
Chapter 1
1.1
INTRODUCTION
A country is termed prosperous if its economy is doing well. There are a large
number of influencing factors which determines the prosperity of the economy,
like Per-capita income of people, GDP, Imports & Exports, Forex Reserves, etc.
In short it can be told that Financial Market is an important contributor to the
economy. In this financial market, capital market plays a significant role. The
capital market always replicates the power and ability of the investors and their
faith in the market. Earlier the capital market was shy. But market deregulations,
growth in global trade and technological development have revolutionized the
financial market place. A by-product of this revolution is increased market
volatility, which has led to a corresponding increase in risk management
products. This demand is reflected in the growth of financial derivatives and
derivatives market. But, question arises, are these derivatives risk free? As
worlds one of the greatest investor once said, Risk is a part of Gods game,
alike for man and nation Thus it can be said that these risk management
instruments are not risk free. This indicates the essence of risk management of
derivatives.
1.2
RATIONALE
In this world of uncertainty risk management has an immense importance for
corporate. Financial derivatives which are introduced with a prime objective of
hedging risk, when used for speculative purposes resulted with increased risk.
Thus, risk management of financial derivatives is a major area of concern. In
case of an exchange, as exchange plays the role of counterparty for both buyer
and seller, it is more exposed to counterparty risk and all other risk associated
with the financial derivatives. This leads to the essence of risk management of
derivatives in exchanges.
The various tools used by the exchanges for risk management includes margins,
position limits, and various rules and regulations laid down by the regulatory
authority for derivative trading. All these process of risk management is done by
wholly computerized process and with specific software. The inclusion of latest
technology has made the risk management process more reliable. The risk
management of derivatives not only secures Stock Exchanges, but also creates
confidence in the minds of the investors. This enhances more investments in the
derivatives market, which leads to business prosperity. Thus the most of the
exchanges have their risk management procedure for risk management of
derivatives.
1.3
OBJECTIVE
On the above outset, the following are the laid down as the objective of this
study,
I. To study the risk associated with derivative market and derivative trading.
II. To study the risk management tools used in Bombay Stock Exchange limited
for mitigating these risks.
III. To study the margining system for derivatives.
IV. To study the software used for margining system.
V. To do comparative analysis of the risk management process of BSE with that
Of NSE
VI. To give suggestion and recommendations for improvement in risk
management process of derivatives in BSE.
1.4
RESEARCH METHODOLOGY
1.4.1
SCOPE
The scope of this project is confined to the study of risk management of
derivatives in BSE, about the margining system. The software used for this
purpose, details about the process and tools of risk management and various
problems faced by them.
1.4.2
TIME FRAME
The project has been undertaken on the basis of information provided by BSEs
derivatives segment which consists of the daily prices and volatility of
derivative segment of BSE for the last ten years. This data consist of details
about the daily prices of derivatives products and proportion of investment in
each and every derivatives instrument.
1.4.3
SOURCES OF DATA
The data has been collected from both primary and secondary sources. The
primary data are collected by interviewing brokers and some officials of BSE.
Some data are collected from personnel of the various departments in BSE, like
1.5
LIMITATION
Some of the limitations that are faced during the project are;
1. The information collected is limited by the authenticity and accuracy of
information provided by the interviewees. The data collected from the websites
are limited. Certain information was not disclosed to maintain the secrecy of the
exchange.
2. The time predefined for this project was 8 weeks, which is very short for
covering such a big project.
1.6
CHAPTERISATION
This project is about the risk management of derivatives in BSE. Various
technicalities that are involved in this process has been extensively discussed
and dealt with this report. The report contains the following six chapters, which
are summarized below. Chapter one begins with the introduction to the project
report, stating the importance, objectives and research methodology adopted.
Limitations inherent to the project are also laid down.
Chapter two deals with the history and potentiality of Bombay Stock Exchange
Limited. ,its mission and vision are also laid down. Major events that shaped the
securities market in the country and helped BSE to grow have been mentioned.
The third chapter deals with the conceptual study of derivatives and its
mechanism. A snapshot of international and Indian derivative market was also
laid down. A brief idea about equity derivatives was also mentioned in this
chapter.
Chapter four contains the conceptual idea of risk management process. This
chapter also throws light on the essence of risk management; risk associated
with derivatives trading and risk management of derivatives. The fifth chapter
comprises of analysis and interpretation part. Chapter six contains the
summarized list of all important findings. And finally, the ultimate chapter aims
CHAPTER TWO
2.1 COMPANY PROFILE
Bombay Stock Exchange Limited is the oldest stock exchange of Asia and one
of the oldest in World with a rich heritage. As the first stock exchange in India,
the Bombay Stock Exchange Limited is considered to have played a very
important role in the development of countys capital market. The BSE is the
largest stock exchange of 24 exchanges in India, with over 6000 listed
companies. It is also the fifth largest exchange in the world with a market
capitalization of $466 billion. The Bombay Stock Exchange Limited uses BSE
SENSEX, an index of 30 large, developed BSE stocks. This index gives a
measure of overall performance of BSE and is tracked worldwide. In addition
to individual stocks the Bombay Stock Exchange Limited also a market for
derivatives, which was first introduced in India. Listed derivatives on the
exchange include stock futures and options, Index futures and options and
weekly options. The Bombay Stock exchange is also actively involved with the
development of retail debt market.
The Exchange has a nationwide reach with its presence in 417 cities and towns
of India. The systems and processes of the exchange are designed to safeguard
market integrity and enhance transparency in the operations. The Exchange
provides an efficient and transparent market for trading in equity, debt and
derivative instruments. The BSE provides online trading with the BSEs Online
First in India to obtain ISO certification for Surveillance, Clearing and Settle.
First to have exclusive facility for financial training.
BSE On-Line Trading System (BOLT) has awarded with the global recognized
Information Security Management System Standard BS7799-2-2002. Moved
from Open Outcry to Electronic Trading within just 50 days. An equal important
accomplishment of BSE is the launch of a nationwide investor awareness
campaign Safe Investing in the Stock Market under which nationwide
awareness campaigns and dissemination of information through print and
electronic medium was undertaken. BSE also actively promoted the securities
market awareness campaign of the Securities and Exchange Board of India
(SEBI).
2.5 AWARDS
Bombay Stock Exchange Limited has many awards to its name for its
excellence in several fields, these are
The World Council of Corporate Governance has awarded the Golden Peacock
Global CSR Award for BSEs initiatives in Corporate Social Responsibility
(CSR).
The Annual Reports and Accounts of BSE for the year ended March 31, 2006
and March 31, 2007 have been awarded the ICAI Awards for excellence in
financial reporting.
The Human Resource Management at BSE has won the Asia Pacific HRM
Award for its efforts in employer branding through talent management at work,
health management at work and excellence in HR through technology.
CHAPTER THREE
INTRODUCTION TO DERIVATIVES
3.1 DERIVATIVES
Risk is a characteristic feature of all commodity and capital markets. Over time,
variations in the prices of agricultural and non-agricultural commodities occur
as a result of interaction of demand and supply forces. The last two decades
have witnessed a many-fold increase in the volume of international trade and
business due to the ever growing wave of globalization and liberalization
sweeping across the world. As a result, financial markets have experienced
rapid variations in interest and exchange rates, stock market prices thus
exposing the corporate world to a state of growing financial risk. Increased
financial risk causes losses to an otherwise profitable organization. This
underlines the importance of risk management to hedge against uncertainty.
Derivatives provide an effective solution to the problem of risk caused by
uncertainty and volatility in underlying asset. Derivatives are risk management
tools that help an organization to effectively transfer risk. Derivatives are
instruments which have no independent value. Their value depends upon the
underlying asset. The underlying asset may be financial or non-financial.
The term derivative can be defined as a financial contract whose value is
derived from the value of an underlying asset. Section 2(ac) of Securities
Contract (Regulation) Act, (SCRA), 1956 defines derivatives as,
a) a security derived from a debt instrument, share, loan whether secured or
unsecured, risk instrument or a contract for difference or any other form of
securities;
b) a contract which derives its value from the prices, or index of prices, of
underlying securities. The underlying asset may be a stock, bond, a foreign
currency, commodity or even another derivative security. Derivative securities
can be used by individuals, corporations, and financial institutions to hedge an
exposure to risk.
the standardized terms in term of quantity, quality, price quotation, date and
delivery date (in case of commodities).
3.2.3 OPTIONS
An option contract, as the name suggests, is in some sense an optional contract.
An option is the right, but not the obligation, to buy or sell something at a stated
date at a stated price. Options are of two types;
CALL OPTIONS: A call option gives the buyer of the option the right, but not
the obligation to buy a given quantity of the underlying asset, at a given price
and on or before a given date.
PUT OPTION: Put options give the buyer the right, but the obligation to sell a
given quantity of underlying asset at a given price on before a given date.
Options can also be European options and American options. This classification
is based on the exercise of the options. European options can be exercised at the
maturity date of the option. On the other hand, American options can be
exercised at any time up to and including the maturity date.
3.2.4 WARRANTS
Options generally have lives of up-to one year. Long dated options are called as
warrants and generally traded over-the-counter.
3.2.5 LEAPS
Long-Term-Equity-Anticipated Securities are options having a maturity of more
than three years or in other words options having a maturity of more than three
years are termed as LEAPS.
3.2.6 BASKETS
volumes. This is because; more people participate in stock market due to the
risk transferring nature of derivatives.
4) Speculative trade shift to a more controlled environment of derivative
market. In the absence of an organized derivatives market, speculators trade in
the cash markets. Margining, monitoring and surveillance of various
participants become extremely difficult in these kinds of mixed markets.
5) Derivatives trading acts as a catalyst for new entrepreneurial activities. In a
nut shell, derivatives markets encourage investment in long run. Transfer of risk
enables market participants to expand their volume of activity.
The trading in BSE SENSEX options commenced on June 4, 2001 and the
trading in options on individual securities commenced in July 2001. Futures
contracts on individual stocks were launched in November 2001. The
derivatives trading on NSE commenced with S&P CNX Nifty Index futures on
June 12, 2000. The trading in index options commenced on June 4, 2001 and
trading in options on individual securities commenced on July 2, 2001. Single
stock futures were launched on November 9, 2001. The index futures and
options contract on NSE are based on S&P CNX. In June 2003, NSE introduced
Interest Rate Futures which were subsequently banned due to pricing issue.
Since the scope of this project is limited to equity derivatives only, so the
further discussion will be confined to equity derivatives only.
Equity derivatives market in India has registered an "explosive growth" and is
expected to continue the same in the years to come. Introduced in 2000,
financial derivatives market in India has shown a remarkable growth both in
terms of volumes and numbers of traded contracts. NSE alone accounts for 99
percent of the derivatives trading in Indian markets. The introduction of
derivatives has been well received by stock market players. Trading in
derivatives gained popularity soon after its introduction. In due course, the
turnover of the NSE derivatives market exceeded the turnover of the NSE cash
market. For example, in 2008, the value of the NSE derivatives markets was Rs.
130, 90,477.75 Cr. whereas the value of the NSE cash markets was only Rs.
3,551,038 Crore. If I compare the trading figures of NSE and BSE, performance
of BSE is not encouraging both in terms of volumes and numbers of contracts
traded in all product categories.
NSES DERIVATIVE SEGMENT
The National Stock Exchange accounts almost 99% of the Indian derivatives
market in terms of turnover, volume etc. Its equity derivatives market is most
boosted one and in turnover it is a major stock exchange. All products in equity
derivative segment i.e. Index Futures and Options and Stock Futures and
Options have marked a tremendous growth over the last decade. The graph
below shows the average yearly turnover in each equity derivative products and
average daily turnover of derivative segment of NSE.
CHAPTER FOUR
RISK AND RISK MANAGEMENT
4.1 RISK
Over the past two decades and so, the markets have seen debacle after another,
each of which has brought its lessons from some of which the markets have
learned and from many of which markets still need to learn. The Great
Depression of 1930s has brought remainder to all financial markets or the
economies as a whole. The 1987 crash taught markets the dangers of automated
trading models and the second and third-order effects of credit crisis. In 1990,
Wall Street learned the horrors of holding huge illiquid investments. In 1994s
spectacular bond market collapse, financial executives saw for the first time
how correlated global markets had become as the fallout from Federal Reserve
Board rate hikes swept from the US through Europe, before devastating Mexico
and other emerging markets. The Russian meltdown in August 1998 was
widespread and mounting. Banks and brokerage firms took turns announcing
trading losses from emerging markets, high yield, equities, or dealings with
hedge funds. Most recently, the Global Financial Meltdown, which was started
with the US sub-prime mortgage crisis, has captured almost all economies of
the world. Many banks become bankrupt, many loss their job, increased
budgetary deficits are the result of this crisis. Thus, it can be said that, the
financial market is full of risk and uncertainties. Finance has never been so
competitive, so far-flung, and so quantitative. Information flow has never been
so fast. But with the passage of time, financial markets are becoming more
sophisticated in pricing, isolating, repackaging, and transferring risks. Tools
such as derivatives and securitization contribute to this process, but they pose
their own risks. The failure of accounting and regulation to keep abreast of
developments includes yet more risks, with occasionally spectacular
consequences. Practical applications including risk limits, trader performancebased compensation, portfolio optimization, and capital calculations all
depend on the measurement of risk. In the absence of a definition of risk, it is
unclear what, exactly, such measurements reflect.
Charles Tschampion, the MD of the $50 bn GM Pension fund, once said
Investment management is not an art, not science, it is engineering. We are in
the business of managing and engineering financial investment risk; the
challenge is to first not take more risk than we need to generate the returns that
is offered. It is a profound statement that well captures the philosophical and
mathematical connotation of Risk.
The terms risk and uncertainty are often used interchangeably though there is a
clear distinction between them. Certainty is a state of being completely
risk that has captured so much congressional and regulatory attention. All these
risks associated with derivatives market are described below,
4.3.1 PRICE RISK
Price arises for the simple reason that the price of the underlying and price of
the derivatives are correlated. If the prices of the underlying increases, the
impact is seen in corresponding prices of derivatives products i.e. their prices
also increase. For an investor who is short in a futures contract or long in a put
option or short in a call option, there are potential losses. Thus, he or she may
default in the obligation of the derivative contract. This is price risk associated
with the derivatives. Default due to Price risk is mitigated by imposing some
risk management tools in exchange-traded derivatives, but in case of over-thecounter market, since it is largely unregulated, default is more due to price risk.
4.3.2 DEFAULT RISK
This may the most popular and hazardous risk associated with the derivatives.
As derivatives are contracts or agreements, they need the obligations to be
performed. If any party default from the contract, then the contract is
meaningless. The risk that arises from the default of any party in derivatives is
called as default risk. This is common risk that is found in over-the-counter
derivative market, but in exchange-traded market, this type of risk is minimized
by regulating the transactions. Default risk is the risk that losses will be incurred
due to default by the counterparty. As noted above, part of the confusion in the
current debate about derivatives stems from the profusion of names associated
with the default risk. Terms such as credit risk and counterparty risk are
essentially synonyms for default risk. Legal risk refers to the enforceability of
the contract. Terms such as Settlement risk and Herstatt risk refer to
defaults that occur at a specific point in the life of the contract: date of
settlement. These terms do not represent independent risks; they just describe
different occasions or causes of default. Default risk has two components: the
expected exposure and the probability that default will occur. The expected
exposure measures how much capital is likely to be at risk should the
counterparty defaults. The probability of default is the measure of the possibility
that the counterparty will default.
4.3.3 SYSTEMATIC RISK
One of the prominent concerns of regulators is systematic risk arising from
derivatives. Although this risk is rarely defined and almost never quantified, the
systemic risk associated with the derivative contracts is often envisioned as a
potential domino effect in which default in one derivative contract spreads to
other contracts and markets, ultimately threatening the entire financial system.
For the purpose of this paper, systemic risk can be defined as widespread default
in any set of financial contracts associated with default in derivatives. If
derivative contracts are to cause widespread default in other markets, there first
must be large defaults in derivative markets. In other words, significant
derivative defaults are a necessary condition for systematic problems. It is
argued that widespread corporate risk management with derivatives increases
the correlation of default among financial contracts. What this argument fails to
recognize, is that the adverse effects of stocks on individual firms should be
smaller precisely because the same shocks are spread more widely. Moe
important, to the extent firms use derivatives to hedge their existing exposures,
much of impact of stocks is being transferred from corporations and investors
less able to bear them to counterparties better able to absorb them. It is
conceivable that financial markets could be hit by a large disturbance. The
effect of such disturbances depends, in particular, on the duration of the
disturbances and whether firms suffer common or independent shocks. If the
disturbance were large but temporary many outstanding derivatives would be
essentially unaffected because they specify only relative infrequent payment.
If an investor holds quite a large position than his capacity, then the probability
that he will default is more. For this reason, the regulatory body of the
derivative market put an exposure limit for the participants beyond which one
cannot take position in the market. This will ensure the integrity in term that
nobody will default.
4.4.4 POSISTION LIMITS
Position limit is more applicable for the high net worth individuals, the FIIs and
the mutual funds. This is because, these people have huge investible cash and
they can direct the market as their wish. This will harm the market and other
participants of the market. Thus a position limit is introduced for this type of
risk by the regulators for the sound running of the market.
4.4.5 FINAL SETTLEMENT
Final settlement is the last part of risk management in case of derivatives. The
settlement is done by the clearing house of the exchange. On exercise the
settlement is done on the closing price of the derivative product and final
settlement takes place on T+1 basis. If the long position exercises his right, then
the settlement is done by randomly assigning the obligation on a short position
at the end of the day. Frankly speaking risk management of derivatives
comprises of two things i.e. margining requirement and the regulatory
requirement. Thus risk management of derivatives is nothing but, complying the
rules and regulation laid down by the regulator and satisfying the margin
requirement.
CHAPTER FIVE
The implied volatility scan range is the largest movement in implied volatility
that margin committee chooses. The margin committee sets input scan ranges
after analyzing histograms of absolute value of day-to-day changes in the
implied volatility of traded futures-option contracts. The underlying average
implied volatility estimate that is analyzed is a simple average of eight contracts
implied volatility on a given maturity: the first is in-the-money and first three
out-of-the-money implied volatility estimates for both calls and puts.
5.1.3 THE MINIMUM SHORT OPTION CHARGE:
The minimum short option charge or minimum margin on an option contract is
set at 2.5% of the clearing members futures price scan range.
5.1.4THE CALENDAR SPREAD CHARGE:
The calendar spread charge is put into the SPAN is a parameter that sets the
amount of margin collateral, the clearinghouse collects against calendar spread
basis risk in portfolios. The calendar spread basis is the difference between
prices of contracts with different maturities. The basis between nearest quarterly
and next quarterly futures contract is calculated. Histograms of the absolute
value changes in basis series are constructed for different windows periods, and
the histograms are considered by the margin committee while calculating
margin.
5.1.5 THE INTER-COMMODITY SPREAD CHARGE:
The inter-commodity spread charge is an input that sets the collateral
requirement that must be posted to protect against correlation risk in intercommodity spread positions.
In SPAN, futures and futures options changes are estimate under alternative
scenario that are determined by the values chosen for the price and implied
volatility scan range inputs. In the simulation analysis, the value of each option
contract is estimated for following day using Black Option Pricing Model. The
next-day contract prices are determined under alternative scenarios in which
underlying futures contracts price and implied volatility move by
predetermined function of their scan range. The futures price and implied
volatility scan inputs are translated into 16 different scenarios that represent
alternative combinations of futures price and implied volatility changes. For
each scenario simulated, the contracts value is reported as an element called
SPAN risk array. This average implied volatility is then shocked by the
implied volatility scan range in the SPAN simulations. The next day simulated
contract prices are compared with the prior days theoretical settlement price
and contract gains and losses are calculated as the difference in these prices. In
extreme price move scenarios, the CMEs margin committee has decided to
margin 35% of the simulated price move gain or loss is the value reported in
these extreme price move SPAN array entries. The SPAN risk array is given
below,
margin requirement is the product of the number of written options times the
minimum short option charge.
5.4 MARK-TO-MARKET OF MARGIN
o For all stock futures and index futures contract, the clients position is
marked-to-market on a daily basis at portfolio level. The mark-to-market margin
is paid in/out in T+1 day in cash. For determining the mark-to-market margin,
the closing price is taken into consideration.
5.5 EXPOSURE LIMITS
The exposure limit for different equity derivatives products are given below;
o In case of stock futures contracts, the notional value of gross open positions at
any point in time should not exceed 20 times the available liquid net-worth of a
member, i.e. 10% of the notional value of gross open position in single stock
futures or 1.5 of the notional value of gross open position in single stock
futures, whichever is higher. However BSE charges exposure margin for better
risk management.
o For stock options contracts, the notional value of gross short open position at
any time would not exceed 20 times of the available liquid net-worth of the
member, i.e. 5% of the notional value of gross short open position in single
stock options or 1.5 of notional value of gross short open position in single
stock options whichever is higher.
o In case of index products, the notional value of gross open positions at ant
time would not exceed 33 1/3 times of the available liquide networth of the
member. for index products, 3% of the notional value of gross open position
would be collected from the liquide networth of a member on a real time basis.
5.6 POSITION LIMITS
o A market wide limit on the open position on stock options and futures
contracts of a particular underlying stock is 20% of the number of shares held
by non-promoters i.e. 20% of the free float, in terms of number of shares of a
company.
o In case of stock futures and options, the stock having applicable market wide
position limit (MWPL) of Rs. 500 crores or more, the combined futures and
options position limits shall be 20% of market wide position limit or Rs. 300
crores, whichever is lower and within which shock futures position cannot
exceed 10% of applicable market wide position limit or Rs. 150 crores,
whichever is lower. This is the position limit for trading members, FII and
mutual funds.
o For stocks having applicable market wide position limit less than Rs. 500
crores, the combined futures and options position limit would be 20% of
applicable market wide position limit or Rs. 50 crore whichever is lower. This is
applicable for trading members, FII and mutual funds.
o For futures and options contracts, the trading members, FII and mutual funds
position limits shall be higher of; Rs. 500 crores or 15% of total open interest in
the market in equity index futures contracts or equity index options contract
respectively.
o The gross open position of clients, sub-accounts, NRI level and for each
scheme of mutual funds across all derivatives contracts on a particular
underlying shall not exceed higher of; 1% of the free float market capitalization
or 5% of the open interest in underlying stock.
o Any person who holds 15% or more of the open interest in all derivatives
contracts on the index shall be required to disclose the fact to the exchange and
failure of which will attract a penalty.
settlement price is the closing price of the stock or index in the cash segment.
On exercise of options, the assignment takes place on a random basis at client
level. At present there would not be any exercise limit for trading in options, but
the exchange can specify the limit as per its convenience.
CHAPTER SIX
6.1 MAJOR FINDINGS
On course of study of the risk management process of derivatives in BSE, the
following observations are pointed out. Since the study is focused on equity
derivatives only, the findings are concerned only about equity derivatives.
6.1.1 SPAN MARGINING SYSTEM
services and information to the investors, which leads to poor market position in
derivatives.
o During our interaction with the brokers we come to know that, the services
provided by NSE are more reliable than that of BSE. So BSE should try to
provide integrated services to its members to improve its derivatives segment.
o Regarding the risk management procedure, as there is no difference between
NSE and BSE, it can be said that, BSE should continue with this process.
o BSE should improve its monitoring system for better risk management of the
exchange.
o Another major cause for BSEs lost market share is the failure in providing
data. BSE can focus on this part in particular. It should also provide data in
tabular format rather than graphical format, so that it can be easily understood
by the investors.
o To improve its derivatives segment, BSE has to constantly innovate in terms
of services, products and technology, otherwise it cannot compete with NSE.
o BSE charges more margins for better risk management, which in terms harms
its market position. Thus, a reasonable margin should be charged on the
members for development of derivatives market and better risk management.
6.3 CONCLUSION
BSE with its distinctive feature has a long, colorful and chequered history. It
enjoys a pre-eminent position by having a permanent recognition from the
Securities Contract (Regulation) Act, 1956. It can be considered as an essential
concomitant of the Indian economy. It is performing all the important functions
of an ideal stock exchange by providing a ready and continuous market with
do is to take quick and timely decisions for the improvement of the derivatives
segment.
BIBLIOGRAPHY
Websites
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