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8/7/2019 Derivatives assgn ppt
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TRADING & SETTLEMENT
WITH THE
PHYSICAL DELIVERYOF SECURITIES
By
Group No: 5
Rakesh Dodai
Mayuresh Paralikar
Madhumita Saha
F-06
F-14
F-22
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Road Map
Name Roll No
Madhumita Saha
Rakesh Dodai
Mayuresh Paralikar
F22
F06
F14
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What is trading
Trading securities is the act of buying and selling securities
with the intention of making a quick profit. Brokerage firms
and investment advisers recommend buying securities for the
anticipated long-term appreciation of the company.
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What is Settlement
Settlement (of securities) is a business process whereby
securities or interests in securities are delivered, usually
against (in simultaneous exchange for) payment of money, to
fulfill contractual obligations, such as those arising under
securities trades.
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Physical delivery
Physical delivery in derivatives markets refers to settlement by
receiving or sending the underlying assets - stock certificates,
head of cattle - to the holder at the contract's maturation date
rather than send the cash equivalent (cash settlement).
Currently it takes place in NASDAQ and Dow Jones.
Indian regulators had attempted to go a step further in 2002
to dissuade some of the speculation in its derivatives market
of the Bombay Stock Exchange (BSE) and require that all
single-stock futures contracts be physically delivered.
Nonetheless, stock futures and options contracts continue to
trade on the BSE on a cash-settled basis.
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PHYSICAL DELIVERY OFSECURITIES
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MAKES SENSE IN CASE OF
OPTIONS ON STOCKS In India, options contracts on individual securities are
American style and are cash settled. Similarly, futures
contracts on shares are also cash settled.
Leverage benefits in futures market encourage large volume.
Better price discovery in the spot market.
Equate options and futures markets and ignored the
fundamental difference in these two instruments.
Exchange-traded equity options
The present practice in India of cash-settling option contracts
is fraught with danger and has on many occasions led to large
speculative practices.
Higher margin will take care of speculative practices in the
futures market.
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Physical delivery contd
SEBI appointed derivatives committee has suggested to
introduce physical delivery of securities.
This will limit the possibility of manipulation and also curb
excessive speculation. In the absence of physical delivery, the system simply flushes
out all trades at the end of the month when the contract
expires.(There is no logical conclusion to the futures trade).
Assets limited , cash unlimited
Fact - Futures contracts on many commodities have been
moved to a cash settlement basis instead of physical
settlement.
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Physical delivery contd
The volume would fall sharply if physical settlement is
introduced.
The costs would go up if traders are forced to settle the
contracts in shares as traders will have to borrow shares. In the US, where physical settlement is followed, the volumes
have hardly picked up.
It is believed that the issue was discussed in the secondary
market advisory committee (SMAC) meeting held recently.
Brokers are unclear as to how securities transaction tax (STT)
will be charged on the transactions settled in the physical
form.
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Physical delivery contd
In the physical settlement, the seller will have to deliver the
underlying shares at the time of expiry of F&O contracts, if he
has not squared off his positions till then.
The buyer will have to take delivery of shares, if his position isopen on the day of expiry.
Brokers fear that investors and traders may end up paying STT
more than once for a single transaction.
For derivatives transactions, STT is levied at rates applicable to
non-delivery deals on the day of trade. Investors or traders
may have to pay STT once more when they actually deliver
securities in the physical form at the time of settlement, at
the rates applicable for delivery-based transactions.
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Physical delivery contd
If they borrow or buy securities for the purpose of delivering
in the market, such transactions will also attract STT.
Issue multiple taxation
STT forms a large part of the overall cost of delivery-basedtransactions.
Currently, STT is charged at 0.125% of the turnover for
delivery-based cash market transactions, on both buy and
sell sides. It is charged at 0.025% on the sell side of non-
delivery-based transactions. The rate is fixed at 0.017% for
sale transactions in the F&O segment.
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Physical delivery contd
Sebi gave stock exchanges four choices
o cash settlement for both stock options and stock futures,
o physical settlement for both stock options and stock futures,
o cash settlement for stock options and
o physical settlement for stock futures or the other way round.
The new process is expected to reduce instances of
manipulation in derivatives contracts, particularly of the
companies with low floating stock.
The derivatives market is more liquid than the cash market.
Investors wanting to buy or sell large quantities and give or
take delivery of the shares can take advantage of physical
settlements.
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Physical delivery contd
Physical settlement of derivative trades good for price
stability
Volatility will increase in the last week prior to expiry. The
market will see more roll-over and more close-out of existingpositions because of two reasons:-
o One, the retail investor's mindset would take some more time to
accept physical delivery of the underlying as a fact of life.
o And two, very few people have the financial wherewithal to take
delivery. Physical delivery of the underlying would largely finish off
the value weighted average price (VWAP) for arbitrage
settlements.
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Physical delivery contd
Market volatility that normally increases around the
settlement date nowadays would get tempered once physical
delivery ushers in.
The prerequisite for successful implementation of physicaldelivery is the presence of a robust securities lending and
borrowing mechanism (SLBM) simply because it would enable
entities with short positions to deliver the underlying, in case
they do not possess them.
The main reason for the delay: NSE, where about 99 per cent
of all equity derivatives trading volume happens, has given a
lukewarm response to the proposal.
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Physical delivery contd
For investors doing strategy-based simultaneous trades in
cash market and stock F&O, a delivery-based settlement helps
them as they do not have to square off their cash market
trades on expiry.
A system which dispenses with physical delivery is an unsound
economic system because it severs the markets only link with
the real economy.
The danger of excessive speculation, particularly short selling,
is heightened by the cash settlement system because it is
easier for speculators to arrange cash than to arrange shares
for settling a position.
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Physical delivery contd
Hence, delivery requirement automatically acts as an
instrument of market discipline. It keeps the tendency
towards excessive speculation under check.
Physical settlement of stock futures will have two moreimportant advantages. These are :
o It will facilitate arbitrage between the futures market and the cash
market, thereby ensuring that the prices remain properly aligned.
o It will help to attract genuine long-term investors into the futures
market by enabling them to acquire securities either from the futuresmarket or from the cash market, as they may find advantageous.
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Physical delivery contd
There are several benefits which will flow from this. They are:
o It will further help in price alignment, make the futures market
investment-oriented to some extent rather than remaining purely
speculative and will increase liquidity in the distant month contracts
which presently have no liquidity.
Cash settlement of futures in deliverable assets has nothing in
its favour except the lobbying power of the speculators.
When derivatives contract are settled physically, there will be
implications for all players in the derivatives segment speculators, arbitrageurs and hedgers.
The speculators today have all profit and losses settled in
cash.
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RISK MANAGEMENT
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Risk Management
Margining System Parameter to be considered
Historical price volatilities
Current and anticipated market conditions PRiME (Portfolio RiskMargining System of HKEx)
Assessment of the maximum potential risk exposure of aportfolio over a one-day period under different realisticallysimulated market scenarios
Movement in the prices Volatilities of underlying assets
Time until expiration
Risk-free interest rate
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Risk Management
DailyMark-To-Market
All open positions are revaluated daily
on the basis of their respective closing prices, losses should
be settled before opening of next trading day
AdditionalMargin on Concentrated Positions
HKCC can impose additional margins on individual
Participants
If a Participant holds positions that account for more than30% of the market risk and the total net open interest
exceeds a certain number of contracts e.g. 20,000 contracts
for HSI Futures, HKCC will increase the margin level by
20% on that Participant.
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Risk Management
HolidayMargin Arrangement
Mitigate the potential market risk on the reopening after the
holiday break
One day Holiday Mandatory to adjust the intra-day call before holiday
More than one Holiday
Mandatory intra-day adjustment
Raises margin level for some major products
Monitoring Client Exposure
HKFE sets a position reporting level for eachMarket
Not allowed to hold positions in excess of 10,000 delta
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Risk Management
HKCC Participant'sDefault
HKCC managed Reserve Fund
Customer positions are netted against each other
HKCC Participant's margin money is applied to anydeficits after netting
Further deficit is withdrawn from the Reserve Fund in
layers
Under no circumstances will customer segregated margindeposits held by the Clearing House for one HKCC
Participant be used to cover either a house or customer
default of another HKCC Participant
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Risk Management
Reserve Fund
To meet its obligations as the counterparty in case of
participant defaults
Reserve Fund Participant contribution
Interest on deposits
Size of the Reserve Fund is monitored by stress testing
Market movement assumptions Default assumptions
30% of the loss-making positions default
Participant with the largest projected loss defaults
Collateral provided by the clearing participants