DBA 1754 Financial Derivatives

MBA(DISTANCE MODE)

DBA 1754 FINANCIAL DERIVATIVES

IV SEMESTER COURSE MATERIAL

Centre for Distance EducationAnna University Chennai Chennai 600 025

Author Dr. J. Dr. J. GopuAssistant Professor Department of Management Studies BSA Crescent Engineering College Chennai - 600 048

Reviewer Ms. Yasmeen Haider Ms. YasmeenSenior Lecturer Department of Management Studies BSA Crescent Engineering College Chennai - 600 048

Editorial Board Dr.T.V.Geetha .T.V Dr.T.V.GeethaProfessor Department of Computer Science and Engineering Anna University Chennai Chennai - 600 025

Dr.H.Peeru .H.Peer Dr.H.P eer u MohamedProfessor Department of Management Studies Anna University Chennai Chennai - 600 025

Dr.C Chellappan .C. Dr.C. Chella ppanProfessor Department of Computer Science and Engineering Anna University Chennai Chennai - 600 025

Dr.A.K .A.Kannan Dr.A.K annanProfessor Department of Computer Science and Engineering Anna University Chennai Chennai - 600 025

Copyrights Reserved (For Private Circulation only) ii

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ACKNOWLEDGEMENT

The author has drawn inputs from several sources for the preparation of this course material, to meet the requirements of the syllabus. The author gratefully acknowledges the following sources: N.D.Vohra and B.R.Bagri, Futures and Options II Edition; Tata McGraw Hill Ltd. S.L.Gupta, Financial derivatives, theory, concepts and problems, Prentice Hall India, 2006. www.nseindia.com www.theponytail.com http://www.emecklai.com http://www.geocities.com www.indiainfoline.com http://sasmit.blogspot.com

Inspite of at most care taken to prepare the list of references any omission in the list is only accidental and not purposeful.

Dr. J. Gopu Author

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DBA 1754 FINANCIAL DERIVATIVES

UNIT I - INTRODUCTION Financial derivatives an introduction; Futures market and contracting; Forward market pricing and trading mechanism; Futures pricing theories and characteristics. UNIT II - REGULATIONS Financial derivatives market in India; Regulation of financial derivatives in India. UNIT III - STRATEGIES Hedging strategy using futures; Stock index futures; Short-term interest rate futures; Long-term interest rate futures; Foreign currency futures; Foreign currency forwards. UNIT IV - OPTIONS Options basics; Option pricing models; trading with options; Hedging with options; currency options; Financial Swaps and Options; Swap markets. UNIT V - ACCOUNTING Accounting treatment of derivative transactions; Management of derivatives exposure; Advanced financial derivatives; Credit derivatives. REFERENCES 1. N.D.Vohra and B.R.Bagri, Futures and Options II Edition; Tata McGraw Hill Ltd. 2. S.L.Gupta, Financial derivatives, theory, concepts and problems, Prentice Hall India, 2006.

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CONTENTSUNIT I CHAPTER I FINANCIAL DERIVATIES AN INTRODUCTION1.1 1.2 1.3 INTRODUCTION THE SIGNIFICANCE OF DERIVATIVES TYPES OF DERIVATIVES 1.3.1 Forward Contracts 1.3.2 Future Contracts 1.3.3 Options Contracts 1.3.4 Swap FUTURES MARKET AND CONTRACTING 1.4.1 Contract Specifications 1.4.2 Trading Parameters FORWARDS VS FUTURES DIFFERENCES BETWEEN FORWARDS AND FUTURES CONTRACTS FUTURES PRICES AND FUTURE SPOT PRICES 1 3 3 3 4 4 4 4 5 5 7 8

1.4

1.5 1.6 1.7

UNIT II CHAPTER I FINANCIAL DERIVATIVES MARKET IN INDIA2.1.1 2.1.2 2.1.3 2.1.4 Introduction Derivatives Market in India Development of exchange-traded derivatives The need for a derivatives market 11 11 16 16

CHAPTER II REGULATIONS OF FINANCIAL DERIVATIVES IN INDIA2.2.1 2.2.2 2.2.3 2.2.4 2.2.5 2.2.6 Introduction Regulations by National Stock Exchange Black-Scholes Option Price calculation model Payment of Margins Violations Market Wide Position Limits for derivative contracts on underlying stocks 2.2.7 Price Scan Rangeix

18 18 26 27 27 28 29

2.2.8 Position Limits 2.2.9 Scheme for FIIs and MFs trading in Exchange traded derivatives

29 30

UNIT III CHAPTER I HEDGING STRATEGIES USING INDEX FUTURES3.1.1 Introduction 3.1.2 S&P CNX Nifty 3.1.3 Trading in Nifty 3.1.4 S&P CNX Nifty Futures 3.1.5 CNX Nifty Junior Futures 3.1.6 Cnxit Futures 3.1.7 CNX 100 Futures 3.1.8 BANK Nifty Futures 3.1.9 Nifty Midcap 50 Futures 3.1.10 Futures on Individual Securities 35 35 36 36 41 43 44 46 48 50

CHAPTER II INTEREST RATE FUTURES3.2.1 3.2.2 3.2.3 3.2.4 3.2.5 3.2.6 3.2.7 3.2.8 3.2.9 Introduction Security descriptor Underlying Instrument Trading cycle Expiry day Product Characteristics Trading Parameters Clearing and Settlement Interest Rate Derivatives - Risk Containment 54 54 54 55 55 55 55 57 59

CHAPTER III CUURENCY FUTURES3.3.1 Introduction 3.3.2 To Hedge or Not to Hedge? 3.3.3 Uncorrelated risks 3.3.4 Expected returns are zero 3.3.5 a) How long is the long-run? 3.3.5 b) Risk-return trade-off 3.3.6 Instruments for Hedging Currency Risk 3.3.7 Exchange-Traded Currency Futures 3.3.8 Accessible to All Market Participantsx

61 61 61 62 62 62 62 63 63

3.3.9 Illustrating the Use of Currency Futures 3.3.10 Summary

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UNIT IV CHAPTER I OPTION MARKET4.1.1 Introduction 4.1.2 The main characteristics of a option contract 4.1.3 The market participants 4.1.4 Mini Option contracts on S&P CNX Nifty index 4.1.5 CNXIT Options 4.1.6 CNX 100 Options 4.1.7 BANKNIFTY OPTIONS 4.1.8 NIFTY MIDCAP 50 OPTIONS 4.1.9 Options on Individual Securities 67 67 68 69 69 73 76 79 82

CHAPTER II FINANCIAL SWAPS MARKET4.2.1 4.2.2 4.2.3 4.2.4 4.2.5 4.2.6 4.2.7 4.2.8 4.2.9 4.2.10 4.2.11 4.2.12 4.2.13 4.2.14 4.2.15 4.2.16 4.2.17 4.2.18 4.2.19 4.2.20 Introduction There are Three Basic Motivations for Swaps: Firms use Swaps to Reduce Financing Costs Parallel Loans Back-to-Back Loans Drawbacks of parallel and back to back loans Swap Banks Types of Swaps Swaptions, Caps, Floor and Collars Motivation for Swaps Closing Thoughts Interest Rate Swaps Currency Swaps Flexibility Exposure Hedging Swaps Identifying the risk of the swaps portfolio Constructing the Hedge Portfolio Why will the Dealer only Partially Hedge the Swaps Portfolio? Floating Rate Cash Flow Management 96 96 96 96 97 97 98 98 99 99 99 100 101 102 105 103 104 104 105 105

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4.2.21 4.2.22 4.2.23 4.2.24 4.2.25 4.2.26

Mismatches in the Timing of Short-Term Cash Flows. Mmismatches in the Type of Index used to Hedge. Interest Rate Swaps Valuation of swaps Equity Swaps Equity swaps make the index trading strategy even easier.

105 105 106 106 107 107

UNIT V CHAPTER I ACCOUNTING TREATMENT FOR DERIVATIVE TRANSACTIONS5.1.1 5.1.2 5.1.3 5.1.4 5.1.5 5.1.6 5.1.7 5.1.8 5.1.9 5.1.10 5.1.11 5.1.12 5.1.13 5.1.14 Introduction Getting Ready Hedge Accounting Embedded Derivatives Recent Announcement Fair value hedges are accounted for as follows: Cash flow hedges are accounted for as follows: New Accounting Rules for Derivatives and Hedging Activity Fair Value Hedges Cash Flow Hedges Hedges for Net Investment in Foreign Operations Derivatives and Income Statement Volatility Increased Derivatives Disclosure Derivatives Management Systems 111 111 112 113 113 114 114 115 115 116 116 117 117 117

CHAPTER II CREDIT DERIVATIVES5.2.1 5.2.2 5.2.3 5.2.4 Introduction Credit Swaps management. Credit Default Swaps Options on Credit Risky Bonds 122 122 123 124

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UNIT I

NOTES

INTRODUCTIONCHAPTER IFINANCIAL DERIVATIES AN INTRODUCTION1.1 INTRODUCTION In finance, a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Because derivatives are just contracts, just about anything can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region. Derivatives are generally used to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company off of an American exchange (using American dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into euros. Derivative is any financial instrument, whose payoffs depend in a direct way on the value of an underlying variable at a time in the future. This underlying variable is also called the underlying asset, or just the underlying. Usually, derivatives are contracts to buy or sell the underlying asset at a future time, with the price, quantity and other specifications defined today. Contracts can be binding for both parties or for one party only, with the other party reserving the option to exercise or not. If the underlying asset is not traded, for example if the underlying is an index, some kind of cash settlement has to take place. Derivatives are traded in organized exchanges as well as over the counter [OTC derivatives]. Examples of derivatives include forwards, futures, options, caps, floors, swaps, collars, and many others.1 ANNA UNIVERSITY CHENNAI

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Derivative contracts in general and options in particular are not novel securities. It has been nearly 25 centuries since the above abstract appeared in Aristotles Politics, describing the purchase of a call option on oil-presses. More recently, De La Vega (1688), in his account of the operation of the Amsterdam Exchange, describes traded contracts that exhibit striking similarities to the modern traded options. Nevertheless, the modern treatment of derivative contracts has its roots in the inspired work of the Frenchman Louis Bachelier in 1900. This was the first attempt of a rigorous mathematical representation of an asset price evolution through time. Bachelier used the concepts of random walk in order to model the fluctuations of the stock prices, and developed a mathematical model in order to evaluate the price of options on bond futures. Although the above model was incomplete and based on assumptions that are virtually unacceptable in recent studies, its importance lies on the novelty of its ideas, both from an economists and a mathematicians point of view. Unfortunately, this work was not developed further, despite the publication of the Einstein paper on Brownian motion in 1905, which would shed light on the properties of the model and perhaps highlight its misspecifications. The above treatment of security prices was long forgotten until the 70s, when Professor Samuelson and his co-workers at MIT rediscovered Bacheliers work and questioned its underlying assumptions. By construction, the payoff of a call option on the expiration day will depend on the price of the underlying asset on that day, relative to the options exercise price. Common reasoning declares that therefore, the price of the call option today has to depend on the probability of the stock price exceeding the exercise price. One could then argue that a mathematical model that can satisfactory explain the underlying assets price is sufficient in order to price the call option today, just by constructing the probabilistic model of the price on the expiration day. Professors Black, Merton and Scholes recognized that the above reasoning is incorrect: Since todays price incorporates the probabilistic model of the future behavior of the asset price, the option can (and has to) be priced relative to todays price alone. They realized that a levered position, using the stock and the riskless bond that replicates the payoff of the option is feasible, and therefore the option can be priced using no-arbitrage restrictions. Equivalently, they observed that the true probability distribution for the stock price return can be transformed into one which has an expected value equal to the risk free rate, the so called risk adjusted or risk neutral distribution; the pricing of the derivative can be carried out using the risk neutral distribution when expectations are taken. The classic papers produced by this work, namely Black and Scholes (1973) and Merton (1976), triggered an avalanche of papers on option pricing, and resulted in the 1997 Nobel Prize in economics for the pioneers of contingent claims pricing. Even today, nearly thirty years after its publication, the original Black and Scholes paper is one of the most heavily cited in finance?

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1.2 THE SIGNIFICANCE OF DERIVATIVES Every candidate underlying asset will have a value that is affected by a variety of factors, therefore inheriting risk. Derivative contracts, due to the leverage that they offer may seem to multiply the exposure to such risks. However, derivatives are rarely used in isolation. By forming portfolios utilizing a variety of derivatives and underlying assets, one can substantially reduce her risk exposure, when an appropriate strategy is considered. Derivative contracts provide an easy and straightforward way to both reduce risk hedging, and to bear extra risk -speculating. As noted above, in any market conditions every security bears some risk. Using active derivative management involves isolating the factors that serve as the sources of risk, and attacking them in turn. In general, derivatives can be used to hedge risks; reflect a view on the future behavior of the market, speculate; lock in an arbitrage profit; change the nature of a liability; change the nature of an investment;

NOTES

1.3 TYPES OF DERIVATIVES Derivative contracts have several variants. The most common variants are forwards, futures, options and swap. 1.3.1 Forward Contracts A forward contract is an agreement between two parties a buyer and a seller to purchase or sell something at a later date at a price agreed upon today. Forward contracts, sometimes called forward commitments, are very common in everyone life. For example, an apartment lease is a forward commitment. By signing a one-year lease, the tenant agrees to purchase the service use of the apartment each month for the next twelve months at a predetermined rate. Like-wise, the landlord agrees to provide the service each month for the next twelve months at the agreed-upon rate. Now suppose that six months later the tenant finds a better apartment and decides to move out. The forward commitment remains in effect, and the only way the tenant can get out of the contract is to sublease the apartment. Because there is usually a market for subleases, the lease is even more like a futures contract than a forward contract. Any type of contractual agreement that calls for the future purchase of a good or service at a price agreed upon today and without the right of cancellation is a forward contract.

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1.3.2 Future Contracts A futures contract is an agreement between two parties a buyer and a seller to buy or sell something at a future date. The contact trades on a futures exchange and is subject to a daily settlement procedure. Future contracts evolved out of forward contracts and possess many of the same characteristics. In essence, they are like liquid forward contracts. Unlike forward contracts, however, futures contracts trade on organized exchanges, called future markets. For example, the buyer of a future contact, who has the obligation to buy the good at the later date, can sell the contact in the future market, which relieves him or her of the obligation to purchase the good. Likewise, the seller of the futures contract, who is obligated to sell the good at the later date, can buy the contact back in the future market, relieving him or her of the obligation to sell the good. Future contacts also differ from forward contacts in that they are subject to a daily settlement procedure. In the daily settlement, investors who incur losses pay them every day to investors who make profits. 1.3.3 Options Contracts Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. 1.3.4 Swap Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are interest rate swaps and currency swaps. Interest rate swaps: These involve swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. 1.4 FUTURES MARKET AND CONTRACTING This contract is an agreement to buy or sell an asset at a certain time in the future for a certain price. Futures are traded in exchanges and the delivery price is always such that todays value of the contract is zero. Therefore in principle, one can always engage into future without the need of an initial capital: the speculators heaven A futures contract is a forward contract, which is traded on an Exchange. NSE commenced trading in index futures on June 12, 2000. The index futures contracts are based on the popular market benchmark S & P CNX Nifty index.4 ANNA UNIVERSITY CHENNAI


NSE defines the characteristics of the futures contract such as the underlying index, market lot, and the maturity date of the contract. The futures contracts are available for trading from introduction to the expiry date. 1.4.1 Contract Specifications Security descriptor The security descriptor for the S&P CNX Nifty futures contracts is: Market type Instrument Type Underlying Expiry date : : : : N UTIDX NIFTY Date of contract expiry

NOTES

Instrument type represents the instrument i.e. Futures on Index. Underlying symbol denotes the underlying index which is S&P CNX Nifty Expiry date identifies the date of expiry of the contract Underlying Instrument The underlying index is S&P CNX Nifty. Trading cycle S&P CNX Nifty futures contracts have a maximum of 3-month trading cycle - the near month (one), the next month (two) and the far month (three). A new contract is introduced on the trading day following the expiry of the near month contract. The new contract will be introduced for a three month duration. This way, at any point in time, there will be 3 contracts available for trading in the market i.e., one near month, one mid month and one far month duration respectively. Expiry day S&P CNX Nifty futures contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day. 1.4.2 Trading Parameters Contract size The value of the futures contracts on Nifty may not be less than Rs. 2 lakhs at the time of introduction. The permitted lot size for futures contracts & options contracts shall be the same for a given underlying or such lot size as may be stipulated by the Exchange from time to time. Price steps The price step in respect of S&P CNX Nifty futures contracts is Re.0.05.

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Base Prices Base price of S&P CNX Nifty futures contracts on the first day of trading would be theoretical futures price.. The base price of the contracts on subsequent trading days would be the daily settlement price of the futures contracts. Price bands There are no day minimum/maximum price ranges applicable for S&P CNX Nifty futures contracts. However, in order to prevent erroneous order entry by trading members, operating ranges are kept at +/- 10 %. In respect of orders which have come under price freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation the Exchange may approve such order. Quantity freeze Orders which may come to the exchange as Quantity freeze shall be such that have a quantity of more than 15000. In respect of orders which have come under quantity freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation, the Exchange may approve such order. However, in exceptional cases, the Exchange may, at its discretion, not allow the orders that have come under quantity freeze for execution for any reason whatsoever including non-availability of turnover / exposure limit. In all other cases, quantity freeze orders shall be cancelled by the Exchange. Order type/Order book/Order attribute Regular lot order Stop loss order Immediate or cancel Spread order The forward contract

The forward contract is an over-the-counter [OTC] agreement between two parties, to buy or sell an asset at a certain time in the future for a certain price. The party that has agreed to buy has a long position. The party that has agreed to sell has a short position.

Usually, the delivery price is such that the initial value of the contract is zero. The contract is settled at maturity. For example, a long forward position with delivery price will K have the payoffs shown in figure

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NOTES

Forward contract payoffs 1.5 FORWARDS VS FUTURES It can be shown that when interest rates are constant and the same for all maturities, then the futures and forward prices are the same. If the interest rates are stochastic, this relationship does not hold. Whether the forward price is lower than the futures price or higher will depend on the correlation of the underlying asset with the interest rates. This situation arises from the daily settlement procedure that takes place in the futures market. Remember that there is no secondary market for the forward contracts. Suppose that the interest rates and the underlying asset are negatively correlated. That is to say that on average, when the interest rates fall the price of the underlying asset increases, something that is true in the stock markets. Consider an investor that holds a long futures position. When the asset price increases, because of the marking-the-market procedure, the investor is making an immediate gain the basis increases. This extra gain will be invested at an interest rate which is lower than average, due to the negative correlation. In a similar fashion, when the price of the underlying falls, the immediate loss will have to be financed at a rate which is above the average. Forwards are not subject to daily settlements, and therefore not affected by the spot-interest correlation. This makes forward contracts more attractive; in an efficient market when the spot-interest correlation is negative we expect forward prices to be higher than the futures ones. Obviously the inverse will also hold, that is to say when the spot-interest correlation is positive we expect forward prices to be lower than the futures ones. These differences have only a theoretical value, in practice these differences are ignored. Usually the maturity of futures contracts is quite short, and the spot-interest correlation is not that high in absolute terms to imply significant differences. Therefore handbooks and practitioners make the assumption that futures and forwards have the same price, even when interest rates are uncertain. Of course one has to be careful when dealing with longer maturity futures, since then the differences might become quite significant.7 ANNA UNIVERSITY CHENNAI

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In the remaining of these notes we will use the same notation F(t, r) for both forwards and futures, recognizing the pitfalls. Although similar in nature, these two instruments exhibit some fundamental differences in the organization and the contract characteristics. 1.6 DIFFERENCES BETWEEN FORWARDS AND FUTURES CONTRACTSForwards Primary market Secondary market Contracts Delivery Collateral Credit risk Dealers None Negotiated Contracts expire None Depends on parties Futures Organized Exchange the Primary market Standardized Rare delivery Initial margin, mark-themarket None [Clearing House] Wide variety

Market participants Large firms

In the example a futures contract was not available for the investor to hedge against the interest rate risk. One can now see that she could alternative go to some investment company seeking for a forward contract that would suit her needs. 1.7 FUTURES PRICES AND FUTURE SPOT PRICES One very important question that one can ask is: Is the futures price an unbiased estimator of the future spot price? The answer is no in general. Remember the relation between risk and return as stated by the CAPM: there are two types of risk in the economy, namely the systematic and the nonsystematic risk. The nonsystematic risk can be eliminated by holding a well diversified portfolio, which is perfectly correlated with the market. The systematic risk cannot be eliminated, since it is the risk of the portfolio that is inherited from the market as a whole and it cannot be diversified away. The CAPM formula dictates that rp r = (r M r) p We have already seen that a futures contract, when seen as a riskless investment will grow in value with the risk free rate of return. Example 10 (Futures risk) Suppose that an investor takes a long futures position. She puts the present value of the futures position into a risk free investment, to meet the requirements when the contract matures, in order to buy the asset on the delivery date.

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The cash flows of the speculator are F ( t , ) e S ( ) r ( t)

NOTESat time t , and at time .

The present value of this investment is

F(t, ) e r(t ) + Et [S()] e r1 (t )where Et is the conditional expectations operator, and r1 is the discount rate appropriate for the investment meaning the expected return required from investors in order to compensate for the risks that are beard. The fact that the present value of all investment opportunities is equal to zero will give

F(t, ) = Et [S()]e (rr1) ( t ) .It is straightforward to observe that the relationship of the futures with the expected spot price will depend on the relationship between the two returns, which in turn depends on the correlation of the investment with the market due to the CAPM. Example 11 (cont. Futures risk) Consider the case that ST is positively correlated with the market as is the usual case. Then, from the definition of I = var (rm) it is implied that I is positive. The CAPM dictates that an investment with positive will have required return higher than the risk free rate. This in turn will give F(t,r) < Et [S(r)].The inverse will also hold: If STis negatively correlated with the market, then F(t,r) > Et [S(r)].. What is the case where the futures price is an unbiased estimator of the future spot price? This happens only when the investment is not correlated with the market, or equivalently when the investment does not exhibit systematic risk. If fact in this cases the above feature is more of an accident: it is not the case that the futures price became an unbiased estimator, it is more that the asset price happens to grow at the risk free rate of return. Summary Usually, derivatives are contracts to buy or sell the underlying asset at a future time, with the price, quantity and other specifications defined today. Contracts can be binding for both parties or for one party only, with the other party reserving the option to exercise or not. If the underlying asset is not traded, for example if the underlying is an index, some kind of cash settlement has to take place. Derivatives are traded in organized exchanges as well as over the counter [OTC derivatives]. Examples of derivatives include forwards, futures, options, caps, floors, swaps, collars, and many others.cov (r1 , rM )

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NOTES

Derivative contracts in general and options in particular are not novel securities. It has been nearly 25 centuries since the above abstract appeared in Aristotles Politics, describing the purchase of a call option on oil-presses. More recently, De La Vega (1688), in his account of the operation of the Amsterdam Exchange, describes traded contracts that exhibit striking similarities to the modern traded options. Nevertheless, the modern treatment of derivative contracts has its roots in the inspired work of the Frenchman Louis Bachelier in 1900. This was the first attempt of a rigorous mathematical representation of an asset price evolution through time. Bachelier used the concepts of random walk in order to model the fluctuations of the stock prices, and developed a mathematical model in order to evaluate the price of options on bond futures. Although the above model was incomplete and based on assumptions that are virtually unacceptable in recent studies, its importance lies on the novelty of its ideas, both from an economists and a mathematicians point of view. Unfortunately, this work was not developed further, despite the publication of the Einstein paper on Brownian motion in 1905, which would shed light on the properties of the model and perhaps highlight its misspecifications. Questions 1. What do you mean by Derivatives? Explain its importance 2. Discuss the various types of Derivatives 3. Explain the differences between Forwards and Futures contracts 4. Define Option contract 5. Is the futures price an unbiased estimator of the future spot price? Explain

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UNIT II

NOTES

REGULATIONSCHAPTER - IFINANCIAL DERIVATIVES MARKET IN INDIA2.1.1 Introduction Derivatives are financial contracts whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as: interest rates, exchange rates, commodities, and equities. Derivatives include a wide assortment of financial contracts, including forwards, futures, swaps, and options. The International Monetary Fund defines derivatives as financial instruments that are linked to a specific financial instrument or indicator or commodity and through which specific financial risks can be traded in financial markets in their own right. The value of financial derivatives derives from the price of an underlying item, such as asset or index. Unlike debt securities, no principal is advanced to be repaid and no investment income accrues. While some derivatives instruments may have very complex structures, all of them can be divided into basic building blocks of options, forward contracts or some combination thereof. Derivatives allow financial institutions and other participants to identify, isolate and manage separately the market risks in financial instruments and commodities for the purpose of hedging, speculating, arbitraging price differences and adjusting portfolio risks. 2.1.2 Derivatives Market in India Derivatives markets have had a slow start in India. The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendments) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24-member committee under the Chairmanship of Dr. L.C. Gupta on 18th November 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee recommended that derivatives should be declared as securities so that regulatory framework applicable to trading of securities could also govern trading of securities. SEBI was given more powers and it starts regulating the stock exchanges in a professional manner by gradually introducing reforms in trading.11 ANNA UNIVERSITY CHENNAI

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Derivatives trading commenced in India in June 2000 after SEBI granted the final approval in May 2000. SEBI permitted the derivative segments of two stock exchanges, viz NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivative contracts. Introduction of derivatives was made in a phase manner allowing investors and traders sufficient time to get used to the new financial instruments. Index futures on CNX Nifty and BSE Sensex were introduced during 2000. The trading in index options commenced in June 2001 and trading in options on individual securities commenced in July 2001. Futures contracts on individual stock were launched in November 2001. In June 2003, SEBI/RBI approved the trading in interest rate derivatives instruments and NSE introduced trading in futures contract on June 24, 2003 on 91 day Notional T-bills. Derivatives contracts are traded and settled in accordance with the rules, bylaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. The emergence of the market for derivatives products, most notable forwards, futures, options and swaps can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets can be subject to a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, derivatives products generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivatives products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Factors generally attributed as the major driving force behind growth of financial derivatives are: i. Increased Volatility in asset prices in financial markets, ii. Increased integration of national financial markets with the international markets, iii. Marked improvement in communication facilities and sharp decline in their costs, iv. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and v. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets, leading to higher returns, reduced risk as well as transaction costs as compared to individual financial assets Financial markets are, by nature, extremely volatile and hence the risk factor is an important concern for financial agents. To reduce this risk, the concept of derivatives comes into the picture. Derivatives are products whose values are derived from one or more basic variables called bases. These bases can be underlying assets (for example forex,

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equity, etc), bases or reference rates. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. The transaction in this case would be the derivative, while the spot price of wheat would be the underlying asset. Development of exchange-traded derivatives has probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and may well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. The need for a derivatives market. The derivatives market performs a number of economic functions: i. They help in transferring risks from risk averse people to risk oriented people ii. They help in the discovery of future as well as current prices iii. They catalyze entrepreneurial activity iv. They increase the volume traded in markets because of participation of risk averse people in greater numbers v. They increase savings and investment in the long run The participants in a derivatives market Hedgers use futures or options markets to reduce or eliminate the risk associated with price of an asset. Speculators use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture. Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit. Types of Derivatives Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of upto three years.

NOTES

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Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are : Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating. Factors driving the growth of financial derivatives a. Increased volatility in asset prices in financial markets, b. Increased integration of national financial markets with the international markets, c. Marked improvement in communication facilities and sharp decline in their costs, d. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and d. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE30(Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on Nov. 9, 2001. The index futures and options contract on NSE are based on S&P CNX Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and

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notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products. The following are some observations based on the trading statistics provided in the NSE report on the futures and options (F&O): Single-stock futures continue to account for a sizable proportion of the F&O segment. It constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options, as the former closely resembles the erstwhile badla system. On relative terms, volumes in the index options segment continue to remain poor. This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high commissions by recommending index options to their clients, because low volatility leads to higher waiting time for round-trips. Put volumes in the index options and equity options segment have increased since January 2002. The call-put volumes in index options have decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market. Farther month futures contracts are still not actively traded. Trading in equity options on most stocks for even the next month was non-existent.

NOTES

Daily option price variations suggest that traders use the F&O segment as a less risky alternative (read substitute) to generate profits from the stock price movements. The fact that the option premiums tail intra-day stock prices is evidence to this. Calls on Satyam fall, while puts rise when Satyam falls intra-day. If calls and puts are not looked as just substitutes for spot trading, the intra-day stock price variations should not have a one-toone impact on the option premiums. Commodity Derivatives Futures contracts in pepper, turmeric, gur (jaggery), hessian (jute fabric), jute sacking, castor seed, potato, coffee, cotton, and soybean and its derivatives are traded in 18 commodity exchanges located in various parts of the country. Futures trading in other edible oils, oilseeds and oil cakes have been permitted. Trading in futures in the new commodities, especially in edible oils, is expected to commence in the near future. The sugar industry is exploring the merits of trading sugar futures contracts. The policy initiatives and the modernisation programme include extensive training, structuring a reliable clearinghouse, establishment of a system of warehouse receipts, and the thrust towards the establishment of a national commodity exchange. The Government of India has constituted a committee to explore and evaluate issues pertinent to the establishment and funding of the proposed national commodity exchange for the nationwide trading of commodity futures contracts, and the other institutions and institutional processes such as warehousing and clearinghouses. With commodity futures, delivery is best effected using15 ANNA UNIVERSITY CHENNAI

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warehouse receipts (which are like dematerialised securities). Warehousing functions have enabled viable exchanges to augment their strengths in contract design and trading. The viability of the national commodity exchange is predicated on the reliability of the warehousing functions. The programme for establishing a system of warehouse receipts is in progress. The Coffee Futures Exchange India (COFEI) has operated a system of warehouse receipts since 1998 Exchange-traded vs. OTC (Over The Counter) derivatives markets The OTC derivatives markets have witnessed rather sharp growth over the last few years, which has accompanied the modernization of commercial and investment banking and globalisation of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter. It has been widely discussed that the highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed to market stability originating in features of OTC derivative instruments and markets. The OTC derivatives markets have the following features compared to exchange-traded derivatives: 1. The management of counter-party (credit) risk is decentralized and located within individual institutions, 2. There are no formal centralized limits on individual positions, leverage, or margining, 3. There are no formal rules for risk and burden-sharing, 4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and 5. The OTC contracts are generally not regulated by a regulatory authority and the exchanges self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance. 2.1.3 Development of exchange-traded derivatives Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and May well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. 2.1.4 The need for a derivatives market The derivatives market performs a number of economic functions: They help in transferring risks from risk adverse people to risk oriented people They help in the discovery of future as well as current prices

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They catalyze entrepreneurial activity They increase the volume traded in markets because of participation of risk adverse people in greater numbers They increase savings and investment in the long run

NOTES

Summary Derivatives are financial contracts whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as: interest rates, exchange rates, commodities, and equities Derivatives markets have had a slow start in India. The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendments) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives Financial markets are, by nature, extremely volatile and hence the risk factor is an important concern for financial agents. To reduce this risk, the concept of derivatives comes into the picture. Derivatives are products whose values are derived from one or more basic variables called bases. These bases can be underlying assets (for example forex, equity, etc), bases or reference rates. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. The transaction in this case would be the derivative, while the spot price of wheat would be the underlying asset Commodity Derivatives Futures contracts in pepper, turmeric, gur (jaggery), hessian (jute fabric), jute sacking, castor seed, potato, coffee, cotton, and soybean and its derivatives are traded in 18 commodity exchanges located in various parts of the country. Futures trading in other edible oils, oilseeds and oil cakes have been permitted. Trading in futures in the new commodities, especially in edible oils, is expected to commence in the near future. The sugar industry is exploring the merits of trading sugar futures contracts. The policy initiatives and the modernisation programme include extensive training, structuring a reliable clearinghouse, establishment of a system of warehouse receipts, and the thrust towards the establishment of a national commodity exchange. Questions The derivatives market performs a number of economic functions, Discuss What is the feature of OTC derivatives markets? Explain the development of Derivatives Market in India What are the factors generally attributed as the major driving force behind growth of financial derivatives in India? What do you understand by Swaps?17 ANNA UNIVERSITY CHENNAI

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CHAPTER IIREGULATIONS OF FINANCIAL DERIVATIVES IN INDIA2.2.1 Introduction The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary preconditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as securities so that regulatory framework applicable to trading of securities could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and realtime monitoring requirements. The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include derivatives within the ambit of securities and the regulatory framework was developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the threedecade old notification, which prohibited forward trading in securities. 2.2.2 Regulations by National Stock Exchange 2.2.2.1 Minimum Base Capital A Clearing Member (CM) is required to meet with the Base Minimum Capital (BMC) requirements prescribed by NSCCL before activation. The CM has also to ensure that BMC is maintained in accordance with the requirements of NSCCL at all points of time, after activation. Every CM is required to maintain BMC of Rs.50 lakhs with NSCCL in the following manner: 1. Rs.25 lakhs in the form of cash. 2. Rs.25 lakhs in any one form or combination of the below forms:

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i.

Cash

ii. Fixed Deposit Receipts (FDRs) issued by approved banks and deposited with approved Custodians or NSCCL iii. Bank Guarantee in favour of NSCCL from approved banks in the specified format. iv. Approved securities in demat form deposited with approved Custodians. In addition to the above MBC requirements, every CM is required to maintain BMC of Rs.10 lakhs, in respect of every trading member(TM) whose deals such CM undertakes to clear and settle, in the following manner: 1. Rs.2 lakhs in the form of cash. 2. Rs.8 lakhs in a one form or combination of the following: Cash Fixed Deposit Receipts (FDRs) issued by approved banks and deposited with approved Custodians or NSCCL Bank Guarantee in favour of NSCCL from approved banks in the specified format. Approved securities in demat form deposited with approved Custodians.

NOTES

Any failure on the part of a CM to meet with the BMC requirements at any point of time, will be treated as a violation of the Rules, Bye-Laws and Regulations of NSCCL and would attract disciplinary action inter-alia including, withdrawal of trading facility and/ore clearing facility, closing out of outstanding positions etc. 2.2.2.2 Additional Base Capital Clearing members may provide additional margin/collateral deposit (additional base capital) to NSCCL and/or may wish to retain deposits and/or such amounts which are receivable from NSCCL, over and above their minimum deposit requirements, towards initial margin and/ or other obligations. Clearing members may submit such deposits in any one form or combination of the following forms: Cash Fixed Deposit Receipts (FDRs) issued by approved banks and deposited with approved Custodians or NSCCL Bank Guarantee in favour of NSCCL from approved banks in the specified format. Approved securities in demat form deposited with approved custodians

2.2.2.3 Effective Deposits / Liquid Networth Effective deposits All collateral deposits made by CMs are segregated into cash component and noncash component.19 ANNA UNIVERSITY CHENNAI

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For Additional Base Capital, cash component means cash, bank guarantee, fixed deposit receipts, T-bills and dated government securities. Non-cash component shall mean all other forms of collateral deposits like deposit of approved demat securities. At least 50% of the Effective Deposits should be in the form of cash. 2.2.2.4 Liquid Networth Liquid Networth is computed by reducing the initial margin payable at any point in time from the effective deposits. The Liquid Networth maintained by CMs at any point in time should not be less than Rs.50 lakhs (referred to as Minimum Liquid Net Worth). 2.2.2.5 Margins NSCCL has developed a comprehensive risk containment mechanism for the Futures & Options segment. The most critical component of a risk containment mechanism for NSCCL is the online position monitoring and margining system. The actual margining and position monitoring is done on-line, on an intra-day basis. NSCCL uses the SPAN (Standard Portfolio Analysis of Risk) system for the purpose of margining, which is a portfolio based system 2.2.2.6 Initial Margin NSCCL collects initial margin up-front for all the open positions of a CM based on the margins computed by NSCCL - SPAN. A CM is in turn required to collect the initial margin from the TMs and his respective clients. Similarly, a TM should collect upfront margins from his clients. Initial margin requirements are based on 99% value at risk over a one day time horizon. However, in the case of futures contracts (on index or individual securities), where it may not be possible to collect mark to market settlement value, before the commencement of trading on the next day, the initial margin may be computed over a two-day time horizon, applying the appropriate statistical formula. The methodology for computation of Value at Risk percentage is as per the recommendations of SEBI from time to time. 2.2.2.7 Initial margin requirement for a member For client positions - shall be netted at the level of individual client and grossed across all clients, at the Trading/ Clearing Member level, without any setoffs between clients. For proprietary positions - shall be netted at Trading/ Clearing Member level without any setoffs between client and proprietary positions. For the purpose of SPAN Margin, various parameters are specified from time to time.

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In case a trading member wishes to take additional trading positions his CM is required to provide Additional Base Capital (ABC) to NSCCL. ABC can be provided by the members in the form of Cash Bank Guarantee, Fixed Deposit Receipts and approved securities. 2.2.2.8 Premium Margin In addition to Initial Margin, Premium Margin would be charged to members. The premium margin is the client wise margin amount payable for the day and will be required to be paid by the buyer till the premium settlement is complete. 2.2.2.9 Assignment Margin Assignment Margin is levied on a CM in addition to SPAN margin and Premium Margin. It is required to be paid on assigned positions of CMs towards Interim and Final Exercise Settlement obligations for option contracts on individual securities, till such obligations are fulfilled. The margin is charged on the Net Exercise Settlement Value payable by a Clearing Member towards Interim and Final Exercise Settlement and is deductible from the effective deposits of the Clearing Member available towards margins. Assignment margin is released to the CMs for exercise settlement pay-in. 2.2.2.10 Margin Reports The following margin reports are downloaded to members on a daily basis: 1. Margin Statement of Clearing Members : MG-09 2. Margin Statement of Trading Member/ Custodial Participant : MG-10 3. Margin Payable Statement of Clearing Member : MG-11 4. Detail Margin File of Clearing Members : MG - 12 5. Client Level Margin File of Trading Members : MG-13 Details of Margin Reports 2.2.2.11 NSCCL SPAN The objective of SPAN is to identify overall risk in a portfolio of futures and options contracts for each member. The system treats futures and options contracts uniformly, while at the same time recognizing the unique exposures associated with options portfolios like extremely deep out-of-the-money short positions, inter-month risk and inter-commodity risk. Because SPAN is used to determine performance bond requirements (margin requirements), its overriding objective is to determine the largest loss that a portfolio might reasonably be expected to suffer from one day to the next day.

NOTES

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In standard pricing models, three factors most directly affect the value of an option at a given point in time: 1. Underlying market price 2. Volatility (variability) of underlying instrument 3. Time to expiration As these factors change, so too will the value of futures and options maintained within a portfolio. SPAN constructs scenarios of probable changes in underlying prices and volatilities in order to identify the largest loss a portfolio might suffer from one day to the next. It then sets the margin requirement at a level sufficient to cover this one-day loss. i. Mechanics of SPAN ii. Risk Arrays iii. Composite Delta iv. Calendar spread or Intra commodity or Inter month Risk Charge v. Short option Minimum Charge vi. Net Buy Premium (only for option contracts) vii. Computation of Initial Margin Overall Portfolio Margin Requirement viii. Black Scholes Option Price calculation model. 2.2.2.12 Mechanics of SPAN The complex calculations (e.g. the pricing of options) in SPAN are executed by the Clearing Corporation. The results of these calculations are called Risk arrays. Risk arrays, and other necessary data inputs for margin calculation are then provided to members in a file called the SPAN Risk Parameter file. This file will be provided to members on a daily basis. Members can apply the data contained in the Risk parameter files, to their specific portfolios of futures and options contracts, to determine their SPAN margin requirements. Hence members need not execute complex option pricing calculations, which would be performed by NSCCL. SPAN has the ability to estimate risk for combined futures and options portfolios, and re-value the same under various scenarios of changing market conditions. 2.2.2.13 Risk Arrays The SPAN risk array represents how a specific derivative instrument (for example, an option on NIFTY index at a specific strike price) will gain or lose value, from the current point in time to a specific point in time in the near future (typically it calculates risk over a one day period called the look ahead time), for a specific set of market conditions which may occur over this time duration.22 ANNA UNIVERSITY CHENNAI


The specific set of market conditions evaluated, are called the risk scenarios, and these are defined in terms of : 1. how much the price of the underlying instrument is expected to change over one trading day, and 2. how much the volatility of that underlying price is expected to change over one trading day. The results of the calculation for each risk scenario i.e. the amount by which the futures and options contracts will gain or lose value over the look-ahead time under that risk scenario - is called the risk array value for that scenario. The set of risk array values for each futures and options contract under the full set of risk scenarios, constitutes the Risk Array for that contract. In the Risk Array, losses are represented as positive values, and gains as negative values. Risk array values are typically represented in the currency (Indian Rupees) in which the futures or options contract is denominated. SPAN further uses a standardized definition of the risk scenarios, defined in terms of i. the underlying price scan range or probable price change over a one day period, ii. and the underlying price volatility scan range or probable volatility change of the underlying over a one day period. These two values are often simply referred to as the price scan range and the volatility scan range. There are sixteen risk scenarios in the standard definition. These scenarios are listed as under: a. Underlying unchanged; volatility up b. Underlying unchanged; volatility down c. Underlying up by 1/3 of price scanning range; volatility up d. Underlying up by 1/3 of price scanning range; volatility down e. Underlying down by 1/3 of price scanning range; volatility up f. Underlying down by 1/3 of price scanning range; volatility down g. Underlying up by 2/3 of price scanning range; volatility up h. Underlying up by 2/3 of price scanning range; volatility down i. Underlying down by 2/3 of price scanning range; volatility up j. Underlying down by 2/3 of price scanning range; volatility down k. Underlying up by 3/3 of price scanning range; volatility up l. Underlying up by 3/3 of price scanning range; volatility down m. Underlying down by 3/3 of price scanning range; volatility up n. Underlying down by 3/3 of price scanning range; volatility down23

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o. Underlying up extreme move, double the price scanning range (cover 35% of loss) p. Underlying down extreme move, double the price scanning range (cover 35% of loss) SPAN uses the risk arrays to scan probable underlying market price changes and probable volatility changes for all contracts in a portfolio, in order to determine value gains and losses at the portfolio level. This is the single most important calculation executed by the system. As shown above in the sixteen standard risk scenarios, SPAN starts at the last underlying market settlement price and scans up and down three even intervals of price changes (price scan range). At each price scan point, the program also scans up and down a range of probable volatility from the underlying markets current volatility (volatility scan range). SPAN calculates the probable premium value at each price scan point for volatility up and volatility down scenario. It then compares this probable premium value to the theoretical premium value (based on last closing value of the underlying) to determine profit or loss. Deep-out-of-the-money short options positions pose a special risk identification problem. As they move towards expiration, they may not be significantly exposed to normal price moves in the underlying. However, unusually large underlying price changes may cause these options to move into-the-money, thus creating large losses to the holders of short option positions. In order to account for this possibility, two of the standard risk scenarios in the Risk Array (sr. no. 15 and 16) reflect an extreme underlying price movement, currently defined as double the maximum price scan range for a given underlying. However, because price changes of these magnitudes are rare, the system only covers 35% of the resulting losses. After SPAN has scanned the 16 different scenarios of underlying market price and volatility changes, it selects the largest loss from among these 16 observations. This largest reasonable loss is the Scanning Risk Charge for the portfolio - in other words, for all futures and options contracts. 2.2.2.14 Composite Delta SPAN uses delta information to form spreads between futures and options contracts. Delta values measure the manner in which a futures or options value will change in relation to changes in the value of the underlying instrument. Futures deltas are always 1.0; options deltas range from -1.0 to +1.0. Moreover, options deltas are dynamic: a change in value of the underlying instrument will affect not only the options price, but also its delta.

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In the interest of simplicity, SPAN employs only one delta value per contract, called the Composite Delta. It is the weighted average of the deltas associated with each underlying price scan point. The weights associated with each price scan point are based upon the probability of the associated price movement, with more likely price changes receiving higher weights and less likely price changes receiving lower weights. Please note that Composite Delta for an options contract is an estimate of the contracts delta after the lookahead - in other words, after one trading day has passed. 2.2.2.15 Calendar Spread or Intra-commodity or Inter-month Risk Charge As SPAN scans futures prices within a single underlying instrument, it assumes that price moves correlate perfectly across contract months. Since price moves across contract months do not generally exhibit perfect correlation, SPAN adds an Calendar Spread Charge (also called the Inter-month Spread Charge) to the Scanning Risk Charge associated with each futures and options contract. To put it in a different way, the Calendar Spread Charge covers the calendar (inter-month etc.) basis risk that may exist for portfolios containing futures and options with different expirations. For each futures and options contract, SPAN identifies the delta associated each futures and option position, for a contract month. It then forms spreads using these deltas across contract months. For each spread formed, SPAN assesses a specific charge per spread which constitutes the Calendar Spread Charge. The margin for calendar spread shall be calculated on the basis of delta of the portfolio in each month. Thus a portfolio consisting of a near month option with a delta of 100 and a far month option with a delta of 100 would bear a spread charge equivalent to the calendar spread charge for a portfolio which is long 100 near month futures contract and short 100 far month futures contract. A calendar spread would be treated as a naked position in the far month contract three trading days before the near month contract expires. 2.2.2.16 Short Option Minimum Charge Short options positions in extremely deep-out-of-the-money strikes may appear to have little or no risk across the entire scanning range. However, in the event that underlying market conditions change sufficiently, these options may move into-the-money, thereby generating large losses for the short positions in these options. To cover the risks associated with deep-out-of-the-money short options positions, SPAN assesses a minimum margin for each short option position in the portfolio called the Short Option Minimum charge, which is set by the NSCCL. The Short Option Minimum charge serves as a minimum charge towards margin requirements for each short position in an option contract.

NOTES

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For example, suppose that the Short Option Minimum charge is Rs. 50 per short position. A portfolio containing 20 short options will have a margin requirement of at least Rs. 1,000, even if the scanning risk charge plus the inter month spread charge on the position is only Rs. 500. 2.2.2.17 Net Buy Premium (only for option contracts) In the above scenario only sell positions are margined and offsetting benefits for buy positions are given to the extent of long positions in the portfolio by computing the net option value. To cover the one day risk on long option positions (for which premium shall be payable on T+1 day), net buy premium to the extent of the net long options position value is deducted from the Liquid Networth of the member on a real time basis. This would be applicable only for trades done on a given day. The Net Buy Premium margin shall be released towards the Liquid Networth of the member on T+1 day after the completion of pay-in towards premium settlement. 2.2.2.18 Computation of Initial Margin - Overall Portfolio Margin Requirement The total margin requirements for a member for a portfolio of futures and options contract would be computed as follows: i. SPAN will add up the Scanning Risk Charges and the Intracommodity Spread Charges.

ii. SPAN will compares this figure (as per i above) to the Short Option Minimum charge iii. It will select the larger of the two values between (i) and (ii) iv. Total SPAN Margin requirement is equal to SPAN Risk Requirement (as per above), less the net option value, which is mark to market value of difference in long option positions and short option positions. v. Initial Margin requirement = Total SPAN Margin Requirement + Net Buy Premium 2.2.3 Black-Scholes Option Price calculation model The options price for a Call, computed as per the following Black Scholes formula: C = S * N (d1) - X * e- rt * N (d2) and the price for a Put is : P = X * e- rt * N (-d2) - S * N (-d1) where : d1 = [ln (S / X) + (r + 2 / 2) * t] / * sqrt(t)

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d2 = [ln (S / X) + (r - 2 / 2) * t] / * sqrt(t) = d1 - * sqrt(t) C = price of a call option P = price of a put option S price of the underlying asset X = Strike price of the option r = rate of interest t = time to expiration = volatility of the underlying N represents a standard normal distribution with mean =0 and standard deviation = 1 ln represents the natural logarithm of a number. Natural logarithms are based on the constant e (2.71828182845904). Rate of interest may be the relevant MIBOR rate or such other rate as may be specified. SPAN is a registered trademark of the Chicago Mercantile Exchange, used herein under License. The Chicago Mercantile Exchange assumes no liability in connection with the use of SPAN by any person or entity. 2.2.4 Payment of Margins The initial margin is payable upfront by Clearing Members. Initial margins can be paid by members in the form of Cash, Guarantee, Fixed Deposit Receipts and approved securities Non-fulfillment of either the whole or part of the margin obligations will be treated as a violation of the Rules, Bye-Laws and Regulations of NSCCL and will attract penal charges at 0.7 percent per day of the amount not paid throughout the period of nonpayment. In addition NSCCL may at its discretion and without any further notice to the clearing member, initiate other disciplinary action, inter-alia including, withdrawal of trading facilities and/ or clearing facility, close out of outstanding positions, imposing penalties, collecting appropriate deposits, invoking bank guarantees/ fixed deposit receipts, etc. 2.2.5 Violations PRISM (Parallel Risk Management System) is the real-time position monitoring and risk management system for the Futures and Options market segment at NSCCL. The risk of each trading and clearing member is monitored on a real-time basis and alerts/ disablement messages are generated if the member crosses the set limits.27

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Initial Margin Violation Exposure Limit Violation Trading Memberwise Position Limit Violation Client Level Position Limit Violation Market Wide Position Limit Violation Violation arising out of misutilisation of trading member/constituent collaterals and/ or deposits Violation of Exercised Positions

Clearing members, who have violated any requirement and / or limits, may submit a written request to NSCCL to either reduce their open position or, bring in additional cash deposit by way of cash or bank guarantee or FDR or securities. A penalty of Rs. 5000/- is levied for each violation and is debited to the clearing account of clearing member on the next business day. In respect of violation on more than one occasion on the same day, penalty in case of second and subsequent violation during the day will be increased by Rs.5000/- for each such instance. (For example in case of second violation for the day the penalty leviable will be Rs.10000/-, Rs.15000 for third instance and so on). The penalty is charged to the clearing member irrespective of whether the clearing member brings in margin deposits subsequently. Where the penalty levied on a clearing member/ trading member relates to a violation of Client-wise Position Limit, the clearing member/ trading member may in turn, recover such amount of penalty from the concerned clients who committed the violation 2.2.6 Market Wide Position Limits for derivative contracts on underlying stocks At the end of each day the Exchange shall test whether the market wide open interest for any scrip exceeds 95% of the market wide position limit for that scrip. If so, the Exchange shall take note of open position of all client/ TMs as at the end of that day in that scrip, and from next day onwards the client/ TMs shall trade only to decrease their positions through offsetting positions till the normal trading in the scrip is resumed. The normal trading in the scrip shall be resumed only after the open outstanding position comes down to 80% or below of the market wide position limit. A facility is available on the trading system to display an alert once the open interest in the futures and options contract in a security exceeds 60% of the market wide position limits specified for such security. Such alerts are presently displayed at time intervals of 10 minutes.

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At the end of each day during which the ban on fresh positions is in force for any scrip, when any member or client has increased his existing positions or has created a new position in that scrip the client/ TMs shall be subject to a penalty of 1% of the value of increased position subject to a minimum of Rs.5000 and maximum of Rs.1, 00,000. The positions, for this purpose, will be valued at the underlying close price. The penalty shall be recovered from the clearing member affiliated with such trading members/clients on a T+1 day basis along with pay-in. The amount of penalty shall be informed to the clearing member at the end of the day. 2.2.7 Price Scan Range To compute worst scenario loss on a portfolio, the price scan range for option on individual securities and futures on individual securities would also be linked to liquidity, measured in terms of impact cost for an order size of Rs 5 lakh calculated on the basis of order book snapshots in the previous six months. Accordingly if the mean value of the impact cost exceeds 1%, the price scanning range would be scaled up by square root of three. This would be in addition to the requirement on account of look ahead period as may be applicable. The mean impact cost as stipulated by SEBI is calculated on the 15th of each month on a rolling basis considering the order book snap shots of previous six months. If the mean impact cost of a security moves from less than or equal to 1% to more than 1%, the price scan range in such underlying shall be scaled by square root of three and scaling shall be dropped when the impact cost drops to 1% or less. Such changes shall be applicable on all existing open position from the third working day from the 15th of each month. The detail of impact cost on the list of underlyings on which derivative contracts are available and the methodology of computation of the same are available at our website. 2.2.8 Position Limits Clearing Members are subject to the following exposure / position limits in addition to initial margins requirements i. Exposure Limits ii. Trading Member wise Position Limit iii. Client Level Position Limit iv. Market Wide Position Limits (for Derivative Contracts on Underlying Stocks) v. Collateral limit for Trading Members

NOTES

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DBA 1754

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2.2.9 Scheme for FIIs and MFs trading in Exchange traded derivatives 2.2.9.1 Position Limits The position limits for FII, Mutual Funds , FII sub-accounts & MF schemes shall be as under: 2.2.9.2 At the level of the FII and MF i. FII & MF Position limits in Index options contracts:

FII and MF position limit in all index options contracts on a particular underlying index shall be Rs.500 crores or 15 % of the total open interest of the market in index options, whichever is higher. This limit would be applicable on open positions in all options contracts on a particular underlying index. ii. FII & MF Position limits in Index futures contracts:

FII and MF position limit in all index futures contracts on a particular underlying index shall be Rs.500 crores or 15 % of the total open interest of the market in index futures, whichever is higher. This limit would be applicable on open positions in all futures contracts on a particular underlying index. In addition to the above, FIIs & MFs shall take exposure in equity index derivatives subject to the following limits: Short positions in index derivatives (short futures, short calls and long puts) not exceeding (in notional value) the FIIs / MFs holding of stocks. Long positions in index derivatives (long futures, long calls and short puts) not exceeding (in notional value) the FIIs / MFs holding of cash, government securities, T-Bills and similar instruments. In this regard, if the open positions of an FII / MF exceeds the limits as stated in item no a or b, such surplus would be deemed to comprise of short and long positions in the same proportion of the total open positions individually. Such short and long positions in excess of the said limits shall be compared with the FIIs / MFs holding in stocks, cash etc as stated above. iii. Stock Futures & Options For stocks having applicable market-wise position limit (MWPL) of Rs. 500 crores or more, the combined futures and options position limit shall be 20% of applicable MWPL or Rs. 300 crores, whichever is lower and within which stock futures position cannot exceed 10% of applicable MWPL or Rs. 150 crores, whichever is lower.

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For stocks having applicable market-wise position limit (MWPL) less than Rs. 500 crores, the combined futures and options position limit would be 20% of applicable MWPL and futures position cannot exceed 20% of applicable MWPL or Rs. 50 crore which ever is lower.

NOTES

2.2.9. 3 At the level of the sub-account a) Index Futures & Options A disclosure is requirement from any person or persons acting in concert who together own 15% or more of the open interest of all futures and options contracts on a particular underlying index on the Exchange. A failure to do so shall be treated as a violation and shall attract appropriate penal and disciplinary action in accordance with the Rules, Bye-Laws and Regulations of NSE/NSCCL. b) Stock Futures & Options

The gross open position across all futures and options contracts on a particular underlying security, of a sub-account of an FII, should not exceed the higher of : i. 1% of the free float market capitalisation (in terms of number of shares) or ii. 5% of the open interest in the derivative contracts on a particular underlying stock (in terms of number of contracts). These position limits shall be applicable on the combined position in all futures and options contracts on an underlying security on the Exchange. c) Procedures

The Clearing Corporation would monitor the FII position limits at the end of each trading day. For this purpose, the following procedure is prescribed: FIIs intending to trade in the F&O segment of the Exchange shall be required to notify the following details of the Clearing Member/s, who shall clear and settle their trades in the F&O segment, to Clearing Corporation. 1. Name of FII 2. SEBI Registration Number 3. Name of sub-account/s of FII (if any) 4. Name of the Clearing Member/s. A unique code will be allotted by Clearing Corporation to each such FII prior to commencement of trading by them. This will be utilized by Clearing Corporation for the purpose of monitoring position limits at the level of the FII. For e.g. If the name of FII is say XYZ and it has 2 sub accounts viz. scheme 1 and 2, the FII code allotted by NSCCL may be XYZ (comprising 12 characters). Each FII/ sub-account of the FII, as the case may be, intending to trade in the F&O segment of the Exchange, shall further be required to obtain a unique Custodial Participant (CP) code allotted from the Clearing Corporation, through their Clearing Member. CP31 ANNA UNIVERSITY CHENNAI

DBA 1754

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code normally comprises of 12 alphanumeric characters. Clearing Corporation will allot CP codes to each such FII/ sub-account of the FII. he Clearing Member/s of the FII/ subaccount of the FII, are required to furnish the following details to Clearing Corporation, to obtain CP codes: a) Name of FII b) Unique code allotted to the FII by NSCCL (as detailed in 2 above) c) Name of sub-account/s of FII d) CP code/s allotted to the FII/ sub account/s of the FII, in the Capital Market segment of Clearing Corporation Eg. In the example given in 2 above the CP codes allotted by NSCCL may be ABCDEFGH0001 and ABCDEFGH0002. FIIs/ sub accounts of FIIs which have been allotted a unique CP code by Clearing Corporation shall only be permitted to trade on the Exchange. The FII/ sub-account of FII shall ensure that all orders placed by them on the Exchange carry the relevant CP code allotted by Clearing Corporation as specified in point 3 above, in the relevant field in NEATFO. Clearing Member/s of the FII shall submit the details of all the trades confirmed by FII to Clearing Corporation, by the end of each trading day, as per the mechanism specified. Clearing Corporation will monitor the open positions of the FII/ sub-account of the FII for each underlying security and index on which futures and option contracts are traded on the Exchange, against the position limits specified at the level of FII/ sub-accounts of FII respectively, at the end of each trading day. The cumulative FII position may be disclosed to the market on a T + 1 basis, before the commencement of trading on the next day. In the event of an FII breaching the position limits on any underlying, Clearing Corporation will advise the Exchange to withdraw the facility granted to such FII to take any fresh positions in any derivative contracts. Such FII will be required to reduce their open position in such underlying, in accordance with the mechanism provided by Clearing Corporation from time to time. The facility withdrawn may be reinstated upon due compliance of the position limits. It shall also be obligatory on FIIs to report any breach of position limits by them / their sub-account/s, to Clearing Corporation and ensure that such sub-account/s does not take any fresh positions in any derivative contracts in such underlying. The sub-account of FII shall be required to reduce open position in such underlying, in accordance with the mechanism specified by Clearing Corporation. Only upon due compliance of the position limits, the sub-accounts may permitted to take further positions.32 ANNA UNIVERSITY CHENNAI


d) Computation of Position Limits The position limits would be computed on a gross basis at the level of a FII and on a net basis at the level of sub-accounts and proprietary positions. The open position for all derivative contracts would be valued as the open interest multiplied with the closing price of the respective underlying in the cash market. E) Client Margin Reporting Clearing Members (CMs) and Trading Members (TMs) are required to collect upfront initial margins from all their Trading Members/ Constituents. CMs are required to compulsorily report, on a daily basis, details in respect of such margin amount due and collected, from the TMs/ Constituents clearing and settling through them, with respect to the trades executed/ open positions of the TMs/ Constituents, which the CMs have paid to NSCCL, for the purpose of meeting margin requirements. Similarly, TMs are required to report on a daily basis details in respect of such margin amount due and collected from the constituents clearing and settling through them, with respect to the trades executed/ open positions of the constituents, which the trading members have paid to the CMs, and on which the CMs have allowed initial margin limit to the TMs. f) Due date for Margin Reporting

NOTES

The cut off day upto which a member may report client margin details to NSCCL is referred to as the sign off date. It shall be 2 working days after the trade day. g) Non submission of Client Margin Reporting Files

A penalty of Rs.200/- is charged to the members for each day of wrong reporting/ partial reporting or non reporting of client margin in the prescribed format as specified above, beyond 2 working days from the trade day. h) Short reporting of margins in Client Margin Reporting Files

The following penalty shall be levied in case of short reporting by trading/clearing member per instance. The amount of penalty shall vary as per the percentage of short reporting done by members as indicated below :Percentage of short reporting (In terms of Value) < 1% > 1% but less than or equal to 20% >20 Penalty per instance Nil Reprimand Letter Rs. 1000 or 0.10% of the shortage amount whichever is higher subject to a maximum of Rs. 1,00,000/33 ANNA UNIVERSITY CHENNAI

DBA 1754

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Summary The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary preconditions for introduction of derivatives trading in India. Clearing members may provide additional margin/collateral deposit (additional base capital) to NSCCL and/or may wish to retain deposits and/or such amounts which are receivable from NSCCL, over and above their minimum deposit requirements, towards initial margin and/ or other obligations. NSCCL has developed a comprehensive risk containment mechanism for the Futures & Options segment. The most critical component of a risk containment mechanism for NSCCL is the online position monitoring and margining system. The actual margining and position monitoring is done on-line, on an intra-day basis. NSCCL uses the SPAN (Standard

Documents

DBA 1754 Financial Derivatives