151-212

Chapter 10

Trading

In this chapter we shall take a brief look at the trading system for NSE’s futures and optionsmarket. However, the best way to get a feel of the trading system is to actually watch the screenand observe how it operates.

10.1 Futures and options trading system

The futures & options trading system of NSE, called NEAT-F&O trading system, provides afully automated screen-based trading for Nifty futures & options and stock futures & options ona nationwide basis as well as an online monitoring and surveillance mechanism. It supports anorder driven market and provides complete transparency of trading operations. It is similar tothat of trading of equities in the cash market segment.

The software for the F&O market has been developed to facilitate efficient and transparenttrading in futures and options instruments. Keeping in view the familiarity of trading memberswith the current capital market trading system, modifications have been performed in the existingcapital market trading system so as to make it suitable for trading futures and options.

10.1.1 Entities in the trading system

There are four entities in the trading system. Trading members, clearing members, professionalclearing members and participants.

1. Trading members:Trading members are members of NSE. They can trade either on their ownaccount or on behalf of their clients including participants. The exchange assigns a Trading memberID to each trading member. Each trading member can have more than one user. The number ofusers allowed for each trading member is notifi ed by the exchange from time to time. Each userof a trading member must be registered with the exchange and is assigned an unique user ID. Theunique trading member ID functions as a reference for all orders/trades of different users. This ID iscommon for all users of a particular trading member. It is the responsibility of the trading memberto maintain adequate control over persons having access to the fi rm’s User IDs.

2. Clearing members:Clearing members are members of NSCCL. They carry out risk managementactivities and confi rmation/inquiry of trades through the trading system.

152 Trading

Figure 10.1Market by price in NEAT F&O

3. Professional clearing members:A professional clearing members is a clearing member who is nota trading member. Typically, banks and custodians become professional clearing members and clearand settle for their trading members.

4. Participants: A participant is a client of trading members like fi nancial institutions. These clientsmay trade through multiple trading members but settle through a single clearing member.

10.1.2 Basis of trading

The NEAT F&O system supports an order driven market, wherein orders match automatically.Order matching is essentially on the basis of security, its price, time and quantity. All quantityfields are in units and price in rupees. The lot size on the futures market is for 200 Nifties. Theexchange notifies the regular lot size and tick size for each of the contracts traded on this segmentfrom time to time. When any order enters the trading system, it is an active order. It tries to finda match on the other side of the book. If it finds a match, a trade is generated. If it does not finda match, the order becomes passive and goes and sits in the respective outstanding order book inthe system.

10.1 Futures and options trading system 153

10.1.3 Corporate hierarchy

In the F&O trading software, a trading member has the facility of defining a hierarchy amongstusers of the system. This hierarchy comprises corporate manager, branch manager and dealer.

1. Corporate manager:The term ‘Corporate manager’ is assigned to a user placed at the highestlevel in a trading fi rm. Such a user can perform all the functions such as order and trade h relatedactivities, receiving reports for all branches of the trading member fi rm and also all dealers of thefi rm. Additionally, a corporate manager can defi ne exposure limits for the branches of the fi rm. Thisfacility is available only to the corporate manager.

2. Branch manager:The branch manager is a term assigned to a user who is placed under the corporatemanager. Such a user can perform and view order and trade related activities for all dealers underthat branch.

3. Dealer: Dealers are users at the lower most level of the hierarchy. A Dealer can perform view orderand trade related activities only for oneself and does not have access to information on other dealersunder either the same branch or other branches.

Below given cases explain activities possible for specific user categories:

1. Clearing member corporate manager:He can view outstanding orders, previous trades and netposition of his client trading members by putting the TM ID (Trading member identifi cation) andleaving the Branch ID and and Dealer ID blank.

2. Clearing member and trading member corporate manager:He can view

(a) Outstanding orders, previous trades and net position of his client trading members by puttingthe TM ID and leaving the Branch ID and the Dealer ID blank.

(b) Outstanding orders, previous trades and net positions entered for himself by entering his ownTM ID, Branch ID and User ID. This is his default screen.

(c) Outstanding orders, previous trades and net position entered for his branch by entering his TMID and Branch ID fi elds

(d) Outstanding orders,previous trades, and net positions entered for any of his users/dealers byentering his TM ID, Branch ID and user ID fi elds.

3. Clearing member and trading member dealer:He can only view requests entered by him.

4. Trading member corporate manager:He can view

(a) Outstanding requests and activity log for requests entered by him by entering his own Branchand User IDs. This is his default screen.

(b) Outstanding requests entered by his dealers and/or branch managers by either entering theBranch and/or User IDs or leaving them blank.

5. Trading member branch manager:He can view

(a) Outstanding requests and activity log for requests entered by him by entering his own Branchand User IDs. This is his default screen.

154 Trading

Figure 10.2Security/contract/portfolio entry screen in NEAT F&O

(b) Outstanding requests entered by his users either by fi lling the User ID fi eld with a specifi c useror leaving the User ID fi eld blank.

6. Trading member dealer:He can only view requests entered by him.

10.1.4 Order types and conditions

The system allows the trading members to enter orders with various conditions attached to themas per their requirements. These conditions are broadly divided into the following categories:

� Time conditions

� Price conditions

� Other conditions

Several combinations of the above are allowed thereby providing enormous flexibility to theusers. The order types and conditions are summarized below.

� Time conditions

10.2 The trader workstation 155

– Day order: A day order, as the name suggests is an order which is valid for the day onwhich it is entered. If the order is not executed during the day, the system cancels the orderautomatically at the end of the day.

– Good till canceled(GTC):A GTC order remains in the system until the user cancels it.Consequently, it spans trading days, if not traded on the day the order is entered. The maximumnumber of days an order can remain in the system is notifi ed by the exchange from time to timeafter which the order is automatically cancelled by the system. Each day counted is a calendarday inclusive of holidays. The days counted are inclusive of the day on which the order isplaced and the order is cancelled from the system at the end of the day of the expiry period.

– Good till days/date(GTD):A GTD order allows the user to specify the number of days/date tillwhich the order should stay in the system if not executed. The maximum days allowed by thesystem are the same as in GTC order. At the end of this day/date, the order is cancelled fromthe system. Each day/date counted are inclusive of the day/date on which the order is placedand the order is cancelled from the system at the end of the day/date of the expiry period.

– Immediate or Cancel(IOC):An IOC order allows the user to buy or sell a contract as soonas the order is released into the system, failing which the order is cancelled from the system.Partial match is possible for the order, and the unmatched portion of the order is cancelledimmediately.

� Price condition

– Stop– loss:This facility allows the user to release an order into the system, after the marketprice of the security reaches or crosses a threshold price e.g. if for stop–loss buy order, thetrigger is 1027.00, the limit price is 1030.00 and the market(last traded) price is 1023.00, thenthis order is released into the system once the market price reaches or exceeds 1027.00. Thisorder is added to the regular lot book with time of triggering as the time stamp, as a limit orderof 1030.00. For the stop–loss sell order, the trigger price has to be greater than the limit price.

� Other conditions

– Market price:Market orders are orders for which no price is specifi ed at the time the order isentered (i.e. price is market price). For such orders, the system determines the price.

– Trigger price: Price at which an order gets triggered from the stop–loss book.

– Limit price: Price of the orders after triggering from stop–loss book.

– Pro: Pro means that the orders are entered on the trading member’s own account.

– Cli: Cli means that the trading member enters the orders on behalf of a client.

10.2 The trader workstation

10.2.1 The market watch window

The following windows are displayed on the trader workstation screen.

� Title bar

� Ticker window of futures and options market

156 Trading

� Ticker window of underlying(capital) market

� Tool bar

� Market watch window

� Inquiry window

� Snap quote

� Order/trade window

� System message window

As mentioned earlier, the best way to familiarize oneself with the screen and its varioussegments is to actually spend some time studying a live screen. In this section we shall restrictourselves to understanding just two segments of the workstation screen, the market watchwindow and the inquiry window.

The market watch window is the third window from the top of the screen which is alwaysvisible to the user. The purpose of market watch is to allow continuous monitoring of contractsor securities that are of specific interest to the user. It displays trading information for contractsselected by the user. The user also gets a broadcast of all the cash market securities on the screen.This function also will be available if the user selects the relevant securities for display on themarket watch screen. Display of trading information related to cash market securities will be on“Read only ” format,i.e. the dealer can only view the information on cash market but, cannottrade in them through the system. This is the main window from the dealer’s perspective.

10.2.2 Inquiry window

The inquiry window enables the user to view information such as Market by Order(MBO),Market by Price(MBP), Previous Trades(PT), Outstanding Orders(OO), Activity log(AL), SnapQuote(SQ), Order Status(OS), Market Movement(MM), Market Inquiry(MI), Net Position, Online backup, Multiple index inquiry, Most active security and so on. Relevant information for theselected contract/security can be viewed. We shall look in detail at the Market by Price(MBP)and the Market Inquiry(MI) screens.

1. Market by order(MBO):The purpose of the MBO is to enable the user to view passive orders inthe trading books in the order of price/time priority for a selected security. The F5 key invokes theselection window for MBO. If a particular contract or security is selected, the details of the selectedcontract or security defaults in the selection screen or else the current position in market watchdefaults. Details of contract or security in the selection screen can also be defaulted from the lastaction. One can select the security from the contract list or from the last operation. The fi elds thatare available on the selection screen are instrument, symbol, expiry and book type. The instrumenttype, symbol, expiry and book type fi elds are compulsory.

2. Market by price(MBP):The purpose of the MBP is to enable the user to view passive orders in themarket aggregated at each price and are displayed in oder of best prices. The window can be invokedby pressing the [F6] key. If a particular contract or security is selected, the details of the selectedcontract or security can be seen on this screen.

10.2 The trader workstation 157

Figure 10.3Market spread/combination order entry

3. Market inquiry(MI):The market inquiry screen can be invoked by using the [F11] key. If a particularcontract or security is selected, the details of the selected contract or selected security defaults inthe selection screen or else the current position in the market watch defaults. The fi rst line of thescreen gives the Instrument type, symbol, expiry, contract status, total traded quantity, life time highand life time low. The second line displays the closing price, open price, high price, low price, lasttraded price and indicator for net change from closing price. The third line displays the last tradedquantity, last traded time and the last traded date. The fourth line displays the closing open interest,the opening open interest, day high open interest, day low open interest, current open interest, lifetime high open interest, life time low open interest and net change from closing open interest. Thefi fth line display very important information, namely the carrying cost in percentage terms.

10.2.3 Placing orders on the trading system

For both the futures and the options market,while entering orders on the trading system, membersare required to identify orders as being proprietary or client orders. Proprietary orders should beidentified as ‘Pro’ and those of clients should be identified as ‘Cli’. Apart from this, in the caseof ‘Cli’ trades, the client account number should also be provided.

158 Trading

The futures market is a zero sum game i.e. the total number of long in any contractalways equals the total number of short in any contract. The total number of outstandingcontracts(long/short) at any point in time is called the “Open interest”. This Open interest figureis a good indicator of the liquidity in every contract. Based on studies carried out in internationalexchanges, it is found that open interest is maximum in near month expiry contracts.

10.2.4 Market spread/combination order entry

The NEAT F&O trading system also enables to enter spread/combination trades. Figure 10.3shows the spread/combination screen. This enables the user to input two or three orderssimultaneously into the market. These orders will have the condition attached to it that unlessand until the whole batch of orders finds a countermatch, they shall not be traded. This facilitatesspread and combination trading strategies with minimum price risk.

10.2.5 Basket trading

In order to provide a facility for easy arbitrage between futures and cash markets, NSE introducedbasket-trading facility. Figure 10.4 shows the basket trading screen. This enables the generationof portfolio offline order files in the derivatives trading system and its execution in the cashsegment. A trading member can buy or sell a portfolio through a single order, once he determinesits size. The system automatically works out the quantity of each security to be bought or sold inproportion to their weights in the portfolio.

10.3 Futures and options market instruments

The F&O segment of NSE provides trading facilities for the following derivative instruments:

1. Index based futures

2. Index based options

3. Individual stock options

4. Individual stock futures

10.3.1 Contract specifi cations for index futures

NSE trades Nifty futures contracts having one-month, two-month and three-month expiry cycles.All contracts expire on the last Thursday of every month. Thus a January expiration contractwould expire on the last Thursday of January and a February expiry contract would cease tradingon the last Thursday of February. On the Friday following the last Thursday, a new contracthaving a three-month expiry would be introduced for trading. Thus, as shown in Figure 10.5 atany point in time, three contracts would be available for trading with the first contract expiringon the last Thursday of that month. Depending on the time period for which you want to take an

10.3 Futures and options market instruments 159

Figure 10.4Portfolio offline order entry for basket trades

exposure in index futures contracts, you can place buy and sell orders in the respective contracts.All index futures contracts on NSE’s futures trading system are coded as shown in Table 10.1.The Instrument type refers to “Futures contract on index” and Contract symbol - NIFTY denotesa “Futures contract on Nifty index” and the Expiry date represents the last date on which thecontract will be available for trading. Each futures contract has a separate limit order book. Allpassive orders are stacked in the system in terms of price-time priority and trades take place atthe passive order price(similar to the existing capital market trading system). The best buy orderfor a given futures contract will be the order to buy the index at the highest index level whereasthe best sell order will be the order to sell the index at the lowest index level.

Trading is for a minimum lot size of 200 units. Thus if the index level is around 1000, thenthe appropriate value of a single index futures contract would be Rs.200,000. The minimum ticksize for an index future contract is 0.05 units. Thus a single move in the index value would implya resultant gain or loss of Rs.10.00(i.e. 0.05*200 units) on an open position of 200 units.

Table 10.1 gives the contract specifications for Nifty futures.

160 Trading

Figure 10.5Contract cycle

The fi gure shows the contract cycle for futures contracts on NSE’s derivatives market. As can be seen, at any givenpoint of time, three contracts are available for trading – a near-month, a middle-month and a far-month. As theJanuary contract expires on the last Thursday of the month, a new three-month contract starts trading from thefollowing day, once more making available three index futures contracts for trading.

TimeJan 30 contract

Feb 27 contract

Mar 27 contract

Apr 24 contract

May 29 contract

Jun 26 contract

Jan Feb AprMar

Table 10.1Contract specification: S&P CNX Nifty FuturesUnderlying index S&P CNX NiftyExchange of trading National Stock Exchange of India LimitedSecurity descriptor N FUTIDX NIFTYContract size Permitted lot size shall be 200 and multiples thereof

(minimum value Rs.2 lakh)Price steps Re. 0.05Price bands Not applicableTrading cycle The futures contracts will have a maximum of three

month trading cycle - the near month(one), the nextmonth(two) and the far month(three). New contract will beintroduced on the next trading day following the expiry ofnear month contract.

Expiry day The last Thursday of the expiry month or theprevious trading day if the last Thursday is a trading holiday.

Settlement basis Mark to market and fi nal settlement will becash settled on T+1 basis.

Settlement price Daily settlement price will be the closingprice of the futures contracts for the trading day and thefi nal settlement price shall be the closing value of theunderlying index on the last trading day.

10.3.2 Contract specifi cation for index options

On NSE’s index options market, contracts at different strikes, having one-month, two-month andthree-month expiry cycles are available for trading. There are typically one-month, two-month


Table 10.2Contract specification: S&P CNX Nifty OptionsUnderlying index S&P CNX NiftyExchange of trading National Stock Exchange of India LimitedSecurity descriptor N OPTIDX NIFTYContract size Permitted lot size shall be 200 and multiples thereof

(minimum value Rs.2 lakh)Price steps Re. 0.05Price bands Not applicableTrading cycle The options contracts will have a maximum of three



Settlement basis Cash settlement on T+1 basis.Style of option European.Strike price interval Rs.20Daily settlement price Premium value(net)Final settlement price Closing value of the index on the last

trading day.

and three-month options, each with five different strikes available for trading. Hence at a givenpoint in time there are minimum� � � � $ or 30 options products. Option contracts are specifiedas follows: DATE-EXPIRYMONTH-YEAR-CALL/PUT-AMERICAN/EUROPEAN-STRIKE.For example the European style call option contract on the Nifty index with a strike price of1040 expiring on the 28th June 2001 is specified as ‘28 JUN 2001 1040 CE’.

Just as in the case of futures contracts, each option product(for instance, the 28 JUN 20011040 CE) has it’s own order book and it’s own prices. All index options contracts are cash settledand expire on the last Thursday of the month. The clearing corporation does the novation. Justas in the case of futures, trading is in minimum market lot size of 200 units. The minimum tickfor an index options contract is 0.05 paise. Table 10.2 gives the contract specifications for Niftyoptions.

Generation of strikes

Let us look at an example of how the various option strikes are generated by the exchange.

� Suppose we start with Nifty at 1500 and options with strikes 1460, 1480, 1500, 1520, 1540.

� The exchange commits itself to an inter–strike distance of say 20.

� When the Nifty closing price crosses 1520, a new set of strikes at 1560 start trading from the nextday.

162 Trading

Table 10.3Contract specification: Stock futuresUnderlying Individual securitiesExchange of trading National Stock Exchange of India LimitedSecurity descriptor N FUTSTKContract size 100 or multiples there of(minimum value of Rs.2 lakh)Price steps Re. 0.05Price bands Not applicableTrading cycle The futures contracts will have a maximum of three



Settlement basis Mark to market and fi nal settlement will becash settled on T+1 basis.

Settlement price Daily settlement price will be the closingprice of the futures contracts for the trading day and thefi nal settlement price shall be the closing price of theunderlying security on the last trading day.

� When the Nifty closing price falls below 1480, a new set of strikes at 1440 start trading from the nextday.

10.3.3 Contract specifi cations for stock futures

Trading in stock futures commenced on the NSE from November 2001. These contracts arecash settled on a T+1 basis. The expiration cycle for stock futures is the same as for indexfutures,index options and stock options. A new contract is introduced on the trading dayfollowing the expiry of the near month contract. Table 10.3 gives the contract specificationsfor stock futures.

10.3.4 Contract specifi cations for stock options

Trading in stock options commenced on the NSE from July 2001. These contracts are Americanstyle and are settled in cash. The expiration cycle for stock options is the same as for index futuresand index options. A new contract is introduced on the trading day following the expiry of thenear month contract. NSE provides a minimum of five strike prices for every option type(i.e. calland put) during the trading month. There are at least two in–the–money contracts, two out–of–the–money contracts and one at–the–money contract available for trading. Table 10.4 gives thecontract specifications for stock options.


Table 10.4Contract specification: Stock optionsUnderlying Individual securities available

for trading in cash marketExchange of trading National Stock Exchange of India LimitedSecurity descriptor N OPTSTKStyle of option American.Strike price interval Between Rs.2.5 and Rs.100 depending

on the price of the underlyingContract size 100 or multiples thereof(minimum value of Rs.2 lakh)Price steps Re. 0.05Price bands Not applicableTrading cycle The options contracts will have a maximum of three



Settlement basis Daily settlement on T+1 basis and fi naloption exercise settlement on T+3 basis

Daily settlement price Premium value(net)Final settlement price Closing price of underlying on exercise

day or expiry daySettlement day Last trading day

Criteria for stocks eligible for options trading

The following criteria will have to be met before a stock can be considered eligible for optionstrading.

� The stock should be amongst the top 200 scrips, on the basis of average market capitalization duringthe last six months and the average free float market capitalization should not be less than Rs.750crore. The free float market capitalization means the non–promoter holding in the stock. The non–promoter holding in the company should be at least 30%.

� The stock should be amongst the top 200 scrips on the basis of average daily volume(in value terms),during the last six months. Further, the average daily volume should not be less than Rs.5 crore inthe underlying cash market.

� The stock should be traded on at least 90% of the trading days in the last six months.

� The ratio of the daily volatility of the stock vis-a-visthe daily volatility of the index should not bemore than 4, at any time during the previous six months.

Based on these criteria, SEBI approved trading in option contracts on 31 stocks.

164 Trading

10.4 Charges

The maximum brokerage chargeable by a TM in relation to trades effected in the contractsadmitted to dealing on the F&O segment of NSE is fixed at 2.5% of the contract value incase of index futures and 2.5% of notional value of the contract[(Strike price + Premium)* Quantity] in case of index options, exclusive of statutory levies. The transaction chargespayable by a TM for the trades executed by him on the F&O segment are fixed at Rs.2 perlakh of turnover(0.002%)(each side) or Rs.1 lakh annually, whichever is higher. The TMscontribute to Investor Protection Fund of F&O segment at the rate of Rs.10 per crore ofturnover(0.0001%)(each side).

Solved problems

Q: The best buy order for a given futures contract is the order to buy the index at the

1. Highest price

2. Average of the highest and lowest price

3. Lowest price

4. None of the above

A: The best buy order for a given futures contract is the order to buy the index at the highest price whereasthe best sell order is the order to sell the index at the lowest price. The correct answer is number 1. � �

Q: The F&O segment of NSE provides trading facilities for the following derivative instruments:

1. Index based futures

2. Index based options

3. Individual stock options

4. All the above

A: The F&O segment of NSE provides trading facilities for index based futures, index based options,individual stock options and individual stock futures. The correct answer is number 4. � �

Q: At any given time, the F&O segment of NSE provides trading facilities for Nifty futurescontracts.

1. Two

2. Three

3. Nine


A: At any given time NSE trades three Nifty futures contracts having one–month, two–month and three–month expiry cycles. The correct answer is number 2. � �

10.4 Charges 165

Q: The maximum brokerage chargeable by a trading member in relation to trades effected in the contractson the F&O segment of NSE is fi xed at of the contract value, exclusive of statutory levies.

1. 1.5%

2. 1%

3. 2.0%

4. 2.5%

A: The correct answer is number 4. ��

Q: All futures and options contracts expire on the

1. Last Friday of the month

2. Last Thursday of the month

3. Last Tuesday of the month


A: All futures and options contracts expire on the last Thursday of the month. The correct answer isnumber 2. ��

Q: The NEAT-F&O trading system supports an

1. Order driven market

2. Price driven market

3. Demand driven market


A: The NEAT-F&O trading system supports an order driven market. The correct answer is number 1. ��

Q: On the NSE’s NEAT-F&O system, matching of trades takes place at the

1. Active order price

2. Passive order price

3. Market price


A: All passive orders will be stacked in the system in terms of price-time priority and trades will takeplace at the passive order price(similar to the existing capital market trading system). The correct answeris number 2. ��

Q: On 26th January, the Nifty index stands at 1250. The value of a single index futures contract is

1. Rs.125,000

2. Rs.250,000

3. Rs.500,000

4. Rs.200,000

A: Futures trading is for a minimum lot size of 200 units. Thus if the index level is around 1250, then theappropriate value of a single index futures contract would be Rs.250,000. The correct answer is number2. ��

166 Trading

Q: All options contracts expire on the

1. Last Friday of the month


3. Last Tuesday of the month


A: All options contracts will expire on the last Thursday of the month. The correct answer is number 2.��

Q: New options contracts are introduced on the

1. First trading day of the month


3. Last Wednesday of the month

4. On the next trading day following the expiryof near month contract.

A: New options contracts are introduced on the next trading day following the expiry of near monthcontract. The correct answer is number 4. ��

Q: The unique trading member ID is

1. Common for all users of a particular tradingmember.

2. Different for all users of a particular tradingmember.

A: Each user of a trading member must be registered with the exchange and is assigned an unique userID. The unique trading member ID functions as a reference for all orders/trades of different users. ThisID is common for all users of a particular trading member. The correct answer is number 1. ��

Q: A Corporate manager can

1. Perform order and trade related activities

2. Receive reports for all branches of the tradingmember fi rm

3. Receive reports for all dealers of the fi rm

4. Can defi ne exposure limits for the branches ofthe fi rm.

5. All of the above


Q: A dealer can view

1. Outstanding orders, previous trades and netposition of the trading member.

2. Requests entered by him.

3. Outstanding orders, previous trades and netposition entered for his branch.


A: The correct answer is number 2 ��

Chapter 11

Clearing and settlement

National Securities Clearing Corporation Limited (NSCCL) undertakes clearing and settlementof all trades executed on the futures and options (F&O) segment of the NSE. It also acts as legalcounterparty to all trades on the F&O segment and guarantees their financial settlement.

11.1 Clearing entities

Clearing and settlement activities in the F&O segment are undertaken by NSCCL with the helpof the following entities:

11.1.1 Clearing members

In the F&O segment, some members, called self clearing members, clear and settle their tradesexecuted by them only either on their own account or on account of their clients. Someothers, called trading member–cum–clearing member, clear and settle their own trades as wellas trades of other trading members(TMs). Besides, there is a special category of members,called professional clearing members (PCM) who clear and settle trades executed by TMs. Themembers clearing their own trades and trades of others, and the PCMs are required to bring inadditional security deposits in respect of every TM whose trades they undertake to clear andsettle.

11.1.2 Clearing banks

Funds settlement takes place through clearing banks. For the purpose of settlement all clearingmembers are required to open a separate bank account with NSCCL designated clearing bankfor F&O segment. The Clearing and Settlement process comprises of the following three mainactivities:

1. Clearing

2. Settlement

168 Clearing and settlement

Table 11.1Proprietary position of trading member Madanbhai on Day 1

Trading member Madanbhai trades in the futures and options segment for himself and two of his clients. The tableshows his proprietary position. Note: A buy position “200@1000”means 200 units bought at the rate of Rs.1000.

Trading member Madanbhai

Buy SellProprietary position 200@1000 400@1010

Table 11.2Client position of trading member Madanbhai on Day 1

Trading member Madanbhai trades in the futures and options segment for himself and two of his clients. The tableshows his client position.


Buy Open Sell Close Sell Open Buy CloseClient positionClient A 400@1109 200@1000Client B 600@1100 200@1099

3. Risk Management

11.2 Clearing mechanism

The clearing mechanism essentially involves working out open positions and obligations ofclearing (self-clearing/trading-cum-clearing/professional clearing) members. This position isconsidered for exposure and daily margin purposes. The open positions of CMs are arrived at byaggregating the open positions of all the TMs and all custodial participants clearing through him,in contracts in which they have traded. A TM’s open position is arrived at as the summation ofhis proprietary open position and clients’ open positions, in the contracts in which he has traded.While entering orders on the trading system, TMs are required to identify the orders, whetherproprietary (if they are their own trades) or client (if entered on behalf of clients) through ‘Pro/Cli’ indicator provided in the order entry screen. Proprietary positions are calculated on netbasis(buy - sell) for each contract. Clients’ positions are arrived at by summing together net (buy- sell) positions of each individual client. A TM’s open position is the sum of proprietary openposition, client open long position and client open short position.

Consider the following example given from Table 11.1 to Table 11.4. The proprietary openposition on day 1 is simply = Buy - Sell = 200 - 400 = 200 short. The open position for client A= Buy(O) - Sell(C) = 400 - 200 = 200 long, i.e. he has a long position of 200 units. The openposition for Client B = Sell(O) - Buy(C) = 600 - 200 = 400 short, i.e. he has a short position

11.3 Settlement mechanism 169

Table 11.3Proprietary position of trading member Madanbhai on Day 2

Assume that the position on Day 1 is carried forward to the next trading day and the following trades are alsoexecuted.


Buy SellProprietary position 200@1000 400@1010

Table 11.4Client position of trading member Madanbhai on Day 2

Trading member Madanbhai trades in the futures and options segment for himself and two of his clients. The tableshows his client position on Day 2.


Buy Open Sell Close Sell Open Buy CloseClient positionClient A 400@1109 200@1000Client B 600@1100 400@1099

of 400 units. Now the total open position of the trading member Madanbhai at end of day 1is 200(his proprietary open position on net basis) plus 600(the Client open positions on grossbasis), i.e. 800.

The proprietary open position at end of day 1 is 200 short. The end of day open position forproprietary trades undertaken on day 2 is 200 short. Hence the net open proprietary position atthe end of day 2 is 400 short. Similarly, Client A’s open position at the end of day 1 is 200 long.The end of day open position for trades done by Client A on day 2 is 200 long. Hence the netopen position for Client A at the end of day 2 is 400 long. Client B’s open position at the endof day 1 is 400 short. The end of day open position for trades done by Client B on day 2 is 200short. Hence the net open position for Client B at the end of day 2 is 600 short. The net openposition for the trading member at the end of day 2 is sum of the proprietary open position andclient open positions. It works out to be 400 + 400 + 600, i.e. 1400.

The following table illustrates determination of open position of a CM, who clears for twoTMs having two clients.

11.3 Settlement mechanism

All futures and options contracts are cash settled, i.e. through exchange of cash. The underlyingfor index futures/options of the Nifty index cannot be delivered. These contracts, therefore, haveto be settled in cash. Futures and options on individual securities can be delivered as in the spot


Table 11.5Determination of open position of a clearing member

TMs clearing Proprietary trades Trades: Client 1 Trades: Client 2 Open positionthrough CM

Buy Sell Net Buy Sell Net Buy Sell Net Long ShortABC 4000 2000 2000 3000 1000 2000 4000 2000 2000 6000 -PQR 2000 3000 (1000) 2000 1000 1000 1000 2000 (1000) 1000 2000

Total 6000 5000 +2000 5000 2000 +3000 5000 4000 +2000 7000 2000-1000 -1000

market. However, it has been currently mandated that stock options and futures would also becash settled. The settlement amount for a CM is netted across all their TMs/clients, with respectto their obligations on MTM, premium and exercise settlement.

11.3.1 Settlement of futures contracts

Futures contracts have two types of settlements, the MTM settlement which happens on acontinuous basis at the end of each day, and the final settlement which happens on the last tradingday of the futures contract.

MTM settlement:

All futures contracts for each member are marked-to-market(MTM) to the daily settlement priceof the relevant futures contract at the end of each day. The profits/losses are computed as thedifference between:

1. The trade price and the day’s settlement price for contracts executed during the day but not squaredup.

2. The previous day’s settlement price and the current day’s settlement price for brought forwardcontracts.

3. The buy price and the sell price for contracts executed during the day and squared up.

Table 11.6 explains the MTM calculation for a member. The settlement price for the contractfor today is assumed to be 105.

The CMs who have a loss are required to pay the mark-to-market (MTM) loss amount incash which is in turn passed on to the CMs who have made a MTM profit. This is knownas daily mark-to-market settlement. CMs are responsible to collect and settle the daily MTMprofits/losses incurred by the TMs and their clients clearing and settling through them. Similarly,TMs are responsible to collect/pay losses/ profits from/to their clients by the next day. The pay-inand pay-out of the mark-to-market settlement are effected on the day following the trade day. Incase a futures contract is not traded on a day, or not traded during the last half hour, a ‘theoreticalsettlement price’ is computed as per the following formula:


Table 11.6Computation of MTM at the end of the day

The table gives the MTM charged on various positions. The margin charged on the brought forward contract is thedifference between the previous day’s settlement price of Rs.100 and today’s settlement price of Rs.105. Hence onaccount of the position brought forward, the MTM shows a profi t of Rs.500. For contracts executed during the day,the difference between the buy price and the sell price determines the MTM. In this example, 200 units are bought@ Rs.100 and 100 units sold @ Rs.102 during the day. Hence the MTM for the position closed during the day showsa profi t of Rs.200. Finally, the open position of contracts traded during the day, is margined at the day’s settlementprice and the profi t of Rs.500 credited to the MTM account. So the MTM account shows a profi t of Rs.1200.

Trade details Quantity bought/sold Settlement price MTM

Brought forwardfrom previous day 100@100 105 500

Traded during dayBought 200@100Sold 100@102 102 200

Open position 100@100 105 500(not squared up)

Total 1200

F � S� � �

where:

F Theoretical futures price

S Value of the underlying index

r Cost of fi nancing(using continuously compounded interest rate) or rate of interest(MIBOR)

T Time till expiration

e 2.71828

After completion of daily settlement computation, all the open positions are reset to the dailysettlement price. Such positions become the open positions for the next day.

Final settlement for futures

On the expiry day of the futures contracts, after the close of trading hours, NSCCL marks allpositions of a CM to the final settlement price and the resulting profit/loss is settled in cash. Finalsettlement loss/profit amount is debited/ credited to the relevant CM’s clearing bank account onthe day following expiry day of the contract.

Ujjwal

Sticky Note

See qn on Page 31


Settlement prices for futures

Daily settlement price on a trading day is the closing price of the respective futures contractson such day. The closing price for a futures contract is currently calculated as the last half anhour weighted average price of the contract in the F&O Segment of NSE. Final settlement priceis the closing price of the relevant underlying index/security in the capital market segment ofNSE, on the last trading day of the contract. The closing price of the underlying Index/securityis currently its last half an hour weighted average value in the capital market segment of NSE.

11.3.2 Settlement of options contracts

Options contracts have three types of settlements, daily premium settlement, exercise settlement,interim exercise settlement in the case of option contracts on securities and final settlement.

Daily premium settlement

Buyer of an option is obligated to pay the premium towards the options purchased by him.Similarly, the seller of an option is entitled to receive the premium for the option sold by him.The premium payable amount and the premium receivable amount are netted to compute the netpremium payable or receivable amount for each client for each option contract.

Exercise settlement

Although most option buyers and sellers close out their options positions by an offsetting closingtransaction, an understanding of exercise can help an option buyer determine whether exercisemight be more advantageous than an offsetting sale of the option. There is always a possibilityof the option seller being assigned an exercise. Once an exercise of an option has been assignedto an option seller, the option seller is bound to fulfill his obligation (meaning, pay the cashsettlement amount in the case of a cash-settled option) even though he may not yet have beennotified of the assignment.

Interim exercise settlement

Interim exercise settlement takes place only for option contracts on securities. An investor canexercise his in-the-money options at any time during trading hours, through his trading member.Interim exercise settlement is effected for such options at the close of the trading hours, on theday of exercise. Valid exercised option contracts are assigned to short positions in the optioncontract with the same series (i.e. having the same underlying, same expiry date and same strikeprice), on a random basis, at the client level. The CM who has exercised the option receives theexercise settlement value per unit of the option from the CM who has been assigned the optioncontract.


Final exercise settlement

Final exercise settlement is effected for all open long in–the–money strike price options existingat the close of trading hours, on the expiration day of an option contract. All such long positionsare exercised and automatically assigned to short positions in option contracts with the sameseries, on a random basis. The investor who has long in–the–money options on the expiry datewill receive the exercise settlement value per unit of the option from the investor who has beenassigned the option contract.

Exercise process

The period during which an option is exercisable depends on the style of the option. On NSE,index options are European style, i.e. options are only subject to automatic exercise on theexpiration day, if they are in–the–money. As compared to this, options on securities are Americanstyle. In such cases, the exercise is automatic on the expiration day, and voluntary prior tothe expiration day of the option contract, provided they are in–the–money. Automatic exercisemeans that all in–the–money options would be exercised by NSCCL on the expiration day of thecontract. The buyer of such options need not give an exercise notice in such cases. Voluntaryexercise means that the buyer of an in–the–money option can direct his TM/CM to give exerciseinstructions to NSCCL. In order to ensure that an option is exercised on a particular day, thebuyer must direct his TM to exercise before the cut-off time for accepting exercise instructionsfor that day. Usually, the exercise orders will be accepted by the system till the close of tradinghours. Different TMs may have different cut–off times for accepting exercise instructions fromcustomers, which may vary for different options. An option, which expires unexercised becomesworthless. Some TMs may accept standing instructions to exercise, or have procedures for theexercise of every option, which is in–the–money at expiration. Once an exercise instruction isgiven by a CM to NSCCL, it cannot ordinarily be revoked. Exercise notices given by a buyerat anytime on a day are processed by NSCCL after the close of trading hours on that day. Allexercise notices received by NSCCL from the NEAT F&O system are processed to determinetheir validity. Some basic validation checks are carried out to check the open buy position of theexercising client/TM and if option contract is in–the–money. Once exercised contracts are foundvalid, they are assigned.

Assignment process

The exercise notices are assigned in standardized market lots to short positions in the optioncontract with the same series (i.e. same underlying, expiry date and strike price) at the clientlevel. Assignment to the short positions is done on a random basis. NSCCL determines shortpositions, which are eligible to be assigned and then allocates the exercised positions to any oneor more short positions. Assignments are made at the end of the trading day on which exerciseinstruction is received by NSCCL and notified to the members on the same day. It is possiblethat an option seller may not receive notification from its TM that an exercise has been assignedto him until the next day following the date of the assignment to the CM by NSCCL.


Exercise settlement computation

In case of index option contracts, all open long positions at in–the–money strike prices areautomatically exercised on the expiration day and assigned to short positions in option contractswith the same series on a random basis. For options on securities, where exercise settlementmay be interim or final, interim exercise for an open long in–the–money option position canbe effected on any day till the expiry of the contract. Final exercise is automatically effectedby NSCCL for all open long in–the–money positions in the expiring month option contract, onthe expiry day of the option contract. The exercise settlement price is the closing price of theunderlying(index or security) on the exercise day(for interim exercise) or the expiry day of therelevant option contract(final exercise). The exercise settlement value is the difference betweenthe strike price and the final settlement price of the relevant option contract. For call options,the exercise settlement value receivable by a buyer is the difference between the final settlementprice and the strike price for each unit of the underlying conveyed by the option contract, whilefor put options it is difference between the strike price and the final settlement price for eachunit of the underlying conveyed by the option contract. Settlement of exercises of options onsecurities is currently by payment in cash and not by delivery of securities. It takes place forin-the-money option contracts.

The exercise settlement value for each unit of the exercised contract is computed as follows:

Call options� Closing price of the security on the day of exercise� Strike price

Put options� Strike price� Closing price of the security on the day of exercise

For final exercise the closing price of the underlying security is taken on the expiration dayThe exercise settlement by NSCCL would ordinarily take place on 3rd day following the day ofexercise. Members may ask for clients who have been assigned to pay the exercise settlementvalue earlier.

Special facility for settlement of institutional deals

NSCCL provides a special facility to Institutions/Foreign Institutional Investors (FIIs)/MutualFunds etc. to execute trades through any TM, which may be cleared and settled by their own CM.Such entities are called custodial participants (CPs). To avail of this facility, a CP is required toregister with NSCCL through his CM. A unique CP code is allotted to the CP by NSCCL. Alltrades executed by a CP through any TM are required to have the CP code in the relevant fieldon the trading system at the time of order entry. Such trades executed on behalf of a CP areconfirmed by their own CM (and not the CM of the TM through whom the order is entered),within the time specified by NSE on the trade day though the on-line confirmation facility. Tillsuch time the trade is confirmed by CM of concerned CP, the same is considered as a tradeof the TM and the responsibility of settlement of such trade vests with CM of the TM. Onceconfirmed by CM of concerned CP, such CM is responsible for clearing and settlement of dealsof such custodial clients. FIIs have been permitted to trade in all the exchange traded derivative

11.4 Risk management 175

contracts subject to compliance of the position limits prescribed for them and their sub-accounts,and compliance with the prescribed procedure for settlement and reporting. A FII/a sub-accountof the FII, as the case may be, intending to trade in the F&O segment of the exchange, is requiredto obtain a unique Custodial Participant (CP) code allotted from the NSCCL. FIIs/sub–accountsof FIIs which have been allotted a unique CP code by NSCCL are only permitted to trade onthe F&O segment. The FII/sub–account of FII ensures that all orders placed by them on theExchange carry the relevant CP code allotted by NSCCL.

11.4 Risk management

NSCCL has developed a comprehensive risk containment mechanism for the F&O segment. Thesalient features of risk containment mechanism on the F&O segment are:

1. The fi nancial soundness of the members is the key to risk management. Therefore, the requirementsfor membership in terms of capital adequacy (net worth, security deposits) are quite stringent.

2. NSCCL charges an upfront initial margin for all the open positions of a CM. It specifi es the initialmargin requirements for each futures/options contract on a daily basis. It also follows value-at-risk(VaR) based margining through SPAN. The CM in turn collects the initial margin from the TMsand their respective clients.

3. The open positions of the members are marked to market based on contract settlement price for eachcontract. The difference is settled in cash on a T+1 basis.

4. NSCCL’s on-line position monitoring system monitors a CM’s open positions on a real-time basis.Limits are set for each CM based on his capital deposits. The on-line position monitoring systemgenerates alerts whenever a CM reaches a position limit set up by NSCCL. NSCCL monitors theCMs for MTM value violation, while TMs are monitored for contract-wise position limit violation.

5. CMs are provided a trading terminal for the purpose of monitoring the open positions of all the TMsclearing and settling through him. A CM may set exposure limits for a TM clearing and settlingthrough him. NSCCL assists the CM to monitor the intra-day exposure limits set up by a CM andwhenever a TM exceed the limits, it stops that particular TM from further trading.

6. A member is alerted of his position to enable him to adjust his exposure or bring in additional capital.Position violations result in withdrawal of trading facility for all TMs of a CM in case of a violationby the CM.

7. A separate settlement guarantee fund for this segment has been created out of the capital of members.The fund had a balance of Rs. 648 crore at the end of March 2002.

The most critical component of risk containment mechanism for F&O segment is themargining system and on-line position monitoring. The actual position monitoring andmargining is carried out on–line through Parallel Risk Management System (PRISM). PRISMuses SPAN(r) (Standard Portfolio Analysis of Risk) system for the purpose of computation ofon-line margins, based on the parameters defined by SEBI.


11.4.1 NSE–SPAN

The objective of NSE–SPAN is to identify overall risk in a portfolio of all futures and optionscontracts for each member. The system treats futures and options contracts uniformly, whileat the same time recognizing the unique exposures associated with options portfolios, likeextremely deep out–of–the–money short positions and inter–month risk. Its over–riding objectiveis to determine the largest loss that a portfolio might reasonably be expected to suffer from oneday to the next day based on 99% VaR methodology. SPAN considers uniqueness of optionportfolios. The following factors affect the value of an option:

1. Underlying market price

2. Strike price

3. Volatility(variability) of underlying instrument

4. Time to expiration

5. Interest rate

As these factors change, the value of options maintained within a portfolio also changes.Thus, SPAN constructs scenarios of probable changes in underlying prices and volatilities inorder to identify the largest loss a portfolio might suffer from one day to the next. It then setsthe margin requirement to cover this one–day loss. The complex calculations(e.g. the pricing ofoptions) in SPAN are executed by NSCCL. The results of these calculations are called risk arrays.Risk arrays, and other necessary data inputs for margin calculation are provided to membersdaily in a file called the SPAN risk parameter file. Members can apply the data contained inthe risk parameter files, to their specific portfolios of futures and options contracts, to determinetheir SPAN margin requirements. Hence, members need not execute complex option pricingcalculations, which is performed by NSCCL. SPAN has the ability to estimate risk for combinedfutures and options portfolios, and also re–value the same under various scenarios of changingmarket conditions.

11.4.2 Margins

The margining system for F&O segment is explained below:

� Initial margin: Margin in the F&O segment is computed by NSCCL upto client level for openpositions of CMs/TMs. These are required to be paid up-front on gross basis at individual clientlevel for client positions and on net basis for proprietary positions. NSCCL collects initial marginfor all the open positions of a CM based on the margins computed by NSE-SPAN. A CM is requiredto ensure collection of adequate initial margin from his TMs up-front. The TM is required to collectadequate initial margins up-front from his clients.

� Premium margin: In addition to initial margin, premium margin is charged at client level. Thismargin is required to be paid by a buyer of an option till the premium settlement is complete.


� Assignment margin for options on securities: Assignment margin is levied in addition to initialmargin and premium margin. It is required to be paid on assigned positions of CMs towardsinterim and fi nal exercise settlement obligations for option contracts on individual securities, tillsuch obligations are fulfi lled. The margin is charged on the net exercise settlement value payable bya CM towards interim and fi nal exercise settlement.

� Client margins: NSCCL intimates all members of the margin liability of each of their client.Additionally members are also required to report details of margins collected from clients to NSCCL,which holds in trust client margin monies to the extent reported by the member as having beencollected form their respective clients.

11.4.3 Margin/position limit violations

PRISM generates various alerts whenever a CM exceeds any limits set up by NSCCL. These aredetailed below:

� Initial margin violation: Initial margin limits are set by NSCCL for each CM based on the collateraldeposited by the CM in accordance with SEBI recommendations. CMs are provided a F&O clearingmember terminal for the purpose of monitoring the open positions of all the TMs and/or CPs clearingand settling through him. A CM may also set initial margin limits for a TM clearing and settlingthrough him. NSCCL assists a CM to monitor the intra-day initial margin limits. Whenever a TMexceeds the limits, his trading facility is withdrawn. Initial margin on positions taken by a CM iscomputed on a real time basis, i.e. for each trade. The initial margin amount is reduced from theeffective deposits of a CM with NSCCL. As the effective deposit is used up to 70%, 80%, and 90%,the member receives a warning message on his terminal. Once it is used 100%, the clearing facilityprovided to a CM is automatically withdrawn. The liquid net worth of a CM at any point of timeshould not be less than Rs.50 lakh. Withdrawal of clearing facility of a CM in case of a violation leadsto automatic withdrawal of trading facility for all TMs and/or CPs clearing and settling through suchCM. Similarly, the initial margin on positions taken by a TM is also computed on a real time basisand compared with the TM initial margin limits set by his CM. The initial margin amount is reducedfrom the TM initial margin limit set by a CM. As the TM limit is used up to 70%, 80%, and 90%,the member receives a warning message on his terminal. Once it is used 100%, the trading facilityprovided to the TM is automatically withdrawn. A member is provided with adequate warnings onthe violation before his trading/clearing facility is withdrawn. A CM may appropriately reduce hisexposure to contain the violation or alternately bring in additional capital.

� Member-wise position limit violation: The member-wise position limit check is carried out byPRISM on open position of a TM. The open position in all index futures and index option contractsof any TM, cannot exceed 15% of the total open interest of the market or Rs. 100 crore, whicheveris higher at any time, including during trading hours. The open positions in all the futures and optioncontracts on the same underlying security of any TM, cannot exceed 7.5% of the total open interestof the market or Rs. 50 crore, whichever is higher, at any time, including during trading hours. Forfutures contracts, open interest is equivalent to the open positions in the futures contract multipliedby last available traded price or closing price, as the case may be. For option contracts, open interestis equivalent to the notional value which is computed by multiplying the open position in that optioncontract multiplied with the last available closing price of the underlying.

� Exposure Limit Violation:PRISM monitors exposure of members. The exposure for a CM to allfutures and option contracts cannot exceed 33.33 times the liquid net worth for index options and


index futures contracts, and 20 times the liquid net worth for futures/options contracts on individualsecurities. This means that 3% of exposure in case of index futures/options and 5% of exposure incase of stock futures/options shall not exceed liquid networth, after adjusting for initial margin.

� Market-wide position limit violation for futures and options on securities: PRISM monitors marketwide position limits for futures and option contracts on individual securities. The open positionacross all members, across all futures and option contracts on an underlying security, conveyed bythe number of units of underlying security, cannot exceed lower of the following limits: 30 times theaverage number of shares traded daily, during the previous calendar month, in the relevant underlyingsecurity in the underlying segment of the relevant exchange, or 10% of the number of shares held bynon-promoters in the relevant underlying security, i.e. 10% of the free float in terms of the number ofshares of a company. When the total open interest in an option contract, across all members, reaches80% of the market wide position limit for a contract, the price scan range and volatility scan range(for SPAN margin) are doubled. NSCCL specifi es the market-wide position limits once every month,at the beginning of the month, which is applicable for the subsequent month.

� Client– wise position limit violation: This occurs when the open position of any client exceeds 1%of the free float market capitalization (in terms of no. of shares) or 5% of the open interest (interms of number of shares) whichever is higher, in all the futures and option contracts on the sameunderlying security. The TM/CM through whom the client trades/clears his deals shall be liable forsuch violation and penalty may be levied on such TM/CM which he may in turn recover from theclient. In the event of such a violation, TM/CM shall immediately ensure, that the client does nottake fresh positions and reduces the positions of such clients to be within permissible limits. Forfutures contracts, open interest is equivalent to the open positions in the futures contract multipliedby last available traded price or closing price, as the case may be. For option contracts, open interestis equivalent to the notional value which is computed by multiplying the open position in that optioncontract multiplied with the last available closing price of the underlying.

� Position limits for FIIs: The position limits specifi ed for FIIs and their sub-account/s is as under:

– At the level of the FII�

In the case of index related derivative products, the position limit is 15% of open interestin all futures and options contracts on a particular underlying index, or Rs.100 crore,whichever is higher.

�

In the case of an underlying security, the position limit is 7.5% of open interest, inall futures and options contracts on a particular underlying security, or Rs.50 crore,whichever is higher.

– At the level of the sub-account�

The CM/TM is required to disclose to the NSCCL details of any person or persons actingin concert who together own 15% or more of the open interest of all futures and optionscontracts on a particular underlying index on the exchange.

�

In the case of futures and option contracts on securities, the gross open position across allfutures and options contracts on a particular underlying security of a sub-account of anFII, should not exceed the higher of 1% of the free float market capitalization (in termsof number of shares) or 5% of the open interest in the derivative contracts on a particularunderlying stock (in terms of number of contracts).


These position limits are applicable on the combined position in all futures and options contracts onan underlying security on the Exchange.

� Misutilisation of TM/constituent’s collateral and/or deposit: A CM cannot utilize the collateral ofone TM and/or constituent towards the exposure and/or obligations of another TM and/or constituent.Where such an act is detected, it is treated as a violation.

� Violation of exercised positions: NSCCL verifi es whether open long positions for such CM/TMand/or constituent exist in relation to option contracts, which are exercised by a CM/TM, beforeinitiating exercise processing. Where contracts are exercised though there are no open positions,such cases are treated as violations.

Solved ProblemsQ: In futures trading, profi ts are received or losses are paid

1. In the delivery month

2. On daily settlement

3. On the day of expiry of the contract

4. On a weekly settlement basis


Q: Which of the following prices is used to compute MTM of a futures contract in case it is not traded ona given day?

1. Closing price of the underlying

2. Closing price of the futures contract

3. Theoretical price

4. MTM is not levied in such cases


Q: Exercise settlement for option contracts takes place at

1. Settlement price of the futures contract


3. Closing price of the far month contract

4. Closing price of the options contract


Q: On the last day of trading, settlement for futures contracts takes place at

1. Average of high and low for the underlyingon that day


3. Closing price of the far month contract

4. Closing price of the options contract



Q: In the case of options, fi nal exercise settlement is

1. Sequential

2. Random

3. Automatic

4. Voluntary


Q: Which of the following option contracts are compulsorily settled on exercise date?

1. In the money options contracts

2. At the money options contracts

3. Out of the money options contracts

4. Deep out of the money options contracts


Q: The market-wide position limit for stock futures/options is

1. higher of 10% of non–promoter holding or 30times the average traded quantity

2. lower of 10% of non–promoter holding or 30times the average traded quantity

3. higher of 1% of non–promoter holding or 5%of open interest in the market

4. lower of 1% of non–promoter holding or 5%of open interest in the market


Q: Assignment margin is charged at

1. Client level

2. Trading member level

3. Clearing member level

4. Institution level


Q: A Trading member Manojbhai took proprietary positions in a November 2000 expiry contract. Hebought 3000 trading units at 1210 and sold 2400 at 1220. The end-of-day settlement price for November2000 expiry contract is 1220. If the initial margin per unit for the November 2000 contract is Rs 100 perunit, then the total initial margin payable by Manojbhai would be

1. Rs.60,000

2. Rs.30,000

3. Rs.3,00,000

4. Rs.5,40,000



Q: Initial margin is collected to

1. Make good losses on the outstanding position

2. Make good daily losses

3. Safeguard against potential losses on out-standing positions


A: Initial margin seeks to safeguard against potential losses on outstanding positions. The correct answeris number 3. ��

Q: The initial margin amount is large enough to cover a one-day loss that can be encountered on

1. 99% of the days.

2. 90% of the days.

3. 95% of the days.



Q: On expiry of a derivatives contract, the settlement price is the

1. Spot price of underlying asset

2. Futures close price

3. Spot price plus cost-of-carry

4. None of the above.

A: On expiry, the settlement price is the spot price of the underlying asset(index closing value in caseof index futures/options and closing price of stock on spot market in case of stock futures/options). Thecorrect answer is number 1. ��

Q: The following are the details of trading member Ratanlal’s proprietary and client position:Proprietary : he buys 600 units @ 1020 and sells 1800 units @ 1025.Client A: he buys 2000 units @ 1015Client B: he buys 1600 units @ 1016 and sells 800 units @ 1022.The settlement price of the day is 1023. What is MTM profi t/loss for Ratanlal?

1. Rs.31,800

2. Rs.28,400

3. Rs.26,600

4. Rs.31,200

A: The index closes at 1023. He makes a profi t of 1800 on the proprietary buy position (i.e. (1023-1020)*600) and a profi t of 3600 on the proprietary sell position (i.e. (1025-1023)*1800). On client A’saccount he makes a profi t of Rs.16,000 (i.e. (1023 -1015)*2000). On client B’s account he makes a profi tof Rs.11,200(i.e. (1023-1016)*1600) and a loss of Rs.800(i.e. (1023-1022)*800). Hence his MTM profi tis (1800+3600+16,000+11,200-800). The correct answer is number 1. ��

Ujjwal

Highlight


Q: What is the outstanding position on which initial margin will be calculated if Mr.Madanlal buys 800which @ 1060 and sells 400 units @1055?

1. 1250 units

2. 800 units

3. 450 units

4. 400 units


Q: What will be MTM profi t/loss of Mr. Ramesh if he buys 800 @ 1040 and sells 600 @ 1045? Thesettlement price of the day was 1035.

1. - 4000

2. - 6000

3. + 6000

4. + 2000


Q: Mr. Amar buys 600 units @ 1040 and sells 400 units @ 1030. The settlement price is 1030. What ishis MTM profi t/loss?

1. +Rs.7,200

2. +Rs.8,000

3. -Rs.6,000

4. +Rs.6,000

A: Mr. Amar makes a loss of Rs.6000 on his buy position and breaks even on his sell position. The correctanswer is number 3. ��

Q: Trading member Shantilal took proprietary purchase in a March 2000 contract. He bought 1600 units@1200 and sold 1200 @1220. The end of day settlement price was 1221. What is the outstanding positionon which initial margin will be calculated?

1. 2700 units

2. 1200 units

3. 1500 units

4. 400 units



Q: What is the outstanding position on which initial margin will be charged if no proprietary trading isdone and the details of client trading are: one client buys 800 units @1260. The second client buys 1000units @ 1255 and sells 1200 units @ 1260.

1. 900 units

2. 1000 units

3. 800 units

4. 2700 units

A: One client buys 800, he is long 800. The second buys 1000 and sells 1200, hence he is short 200. Theoutstanding position on which margin is charged is 1000 (i.e. 800 + 200). The correct answer is number2. ��

Q: The May futures contract on INFOSYSTCH closed at Rs.3940 yesterday. It closes today atRs.3898.60. The spot closes at Rs.3800. Raju has a short position of 3000 in the May futures contract.He sells 2000 units of May expiring put options on INFOSYSTCH with a strike price of Rs.3900 for apremium of Rs.110 per unit. What is his net obligation to/from the clearing corporation today?

1. Payin of Rs.344200

2. Payout of Rs.640000



A: On the short position of 3000 May futures contract, he makes a profi t of Rs.124200(i.e. 3000 * (3940- 3898.60)). He receives Rs.220000 on the put options sold by him. Therefore his net obligation from theclearing corporation is Rs.344200. The correct answer in number 3. ��

Q: On April 1,2002, Ms.Shetty has sold 400 calls on Reliance at a strike price of Rs.200 for a premiumof Rs.20/call. On the cash market, Reliance closes at Rs.240 on that day. If the call option is assigned toher on that day, what is her net obligation on April 1,2002?


2. Payin of Rs.8000



A: On the 400 calls sold by her, she receives a premium of Rs.8000. However on the calls assigned to her,she loses Rs.16,000(400 * (240-200)). Her payin obligation is Rs.8000. The correct answer is number 2.

��


Q: Rahul has the following carried forward net positions in the F&O segment on 27th June 2002:

1. Long 500 SBIN June Futures

2. Long 200 SBIN July Futures

3. Short position of 300 SBIN June calls at a strike price of Rs.260

Given below is the data pertaining to SBIN on 2 consecutive days. What is the net funds obligationsto/from the clearing corporation?

Contract Date Futures/options Underlying(spot)descriptor closing price market closing price

June Futures 26-Jun-2002 277 270June 260 calls 26-Jun-2002 9 270June Futures 27-June-2002 275 275June 260 calls 27-Jun-2002 12 275July Futures 26-Jun-2002 278 270July Futures 27-Jun-2002 280 275

1. Payin of Rs.5100

2. Payin of Rs.8700



A: On the long position of 500 June futures, he makes a loss of Rs.1000(i.e.500 * (277-275)). On the longposition of 200 July futures, he makes a profi t of Rs.400(i.e.200 * (280-278)). On the short position of300 June calls, he makes a loss of Rs.4500(i.e. 300 * (275-260)). Therefore the net loss is Rs.5100. Thecorrect answer is number 1. ��

Q: The following are the details of trading member Ratanlal’s proprietary and client position:Proprietary : he buys 500 units @ 1020 and sells 1700 units @ 1025.Client A: he buys 2000 units @ 1015Client B: he buys 1500 units @ 1016.The settlement price of the day is 1023. What is MTM profi t/loss for Ratanlal?

1. Rs.30,700

2. Rs.28,400

3. Rs.26,600

4. Rs.31,400

A: The index closes at 1023. He makes a profi t of 1500 on the proprietary buy position(i.e. (1023-1020)*500) and a profi t of 3400 on the proprietary sell position(i.e. (1025-1023)*1700). On client A’saccount he makes a profi t of Rs.16000(i.e. (1023 -1015)*2000). On client B’s account he makes a profi tof Rs.10500(i.e. (1023-1016)*1500). Hence his MTM profi t is (1500+3400+16000+10500). The correctanswer is number 4. ��

Chapter 12

Regulatory framework

The trading of derivatives is governed by the provisions contained in the SC(R)A, the SEBI Act,the rules and regulations framed thereunder and the rules and bye–laws of stock exchanges.

12.1 Securities Contracts(Regulation) Act, 1956

SC(R)A aims at preventing undesirable transactions in securities by regulating the business ofdealing therein and by providing for certain other matters connected therewith. This is theprincipal Act, which governs the trading of securities in India. The term “securities” has beendefined in the SC(R)A. As per Section 2(h), the ‘Securities’ include:

1. Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a likenature in or of any incorporated company or other body corporate

2. Derivative

3. Units or any other instrument issued by any collective investment scheme to the investors in suchschemes

4. Government securities

5. Such other instruments as may be declared by the Central Government to be securities

6. Rights or interests in securities.

“Derivative” is defined to include:� A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument

or contract for differences or any other form of security

� A contract which derives its value from the prices, or index of prices, of underlying securities.

Section 18A provides that notwithstanding anything contained in any other law for the timebeing in force, contracts in derivative shall be legal and valid if such contracts are:

� Traded on a recognized stock exchange

� Settled on the clearing house of the recognized stock exchange, in accordance with the rules andbye–laws of such stock exchanges.

186 Regulatory framework

12.2 Securities and Exchange Board of India Act, 1992

SEBI Act, 1992 provides for establishment of Securities and Exchange Board of India(SEBI)with statutory powers for (a) protecting the interests of investors in securities (b) promoting thedevelopment of the securities market and (c) regulating the securities market. Its regulatoryjurisdiction extends over corporates in the issuance of capital and transfer of securities, inaddition to all intermediaries and persons associated with securities market.

SEBI has been obligated to perform the aforesaid functions by such measures as it thinks fit.In particular, it has powers for:

� regulating the business in stock exchanges and any other securities markets

� registering and regulating the working of stock brokers, sub–brokers etc.

� promoting and regulating self-regulatory organizations

� prohibiting fraudulent and unfair trade practices

� calling for information from, undertaking inspection, conducting inquiries and audits of the stockexchanges, mutual funds and other persons associated with the securities market and intermediariesand self–regulatory organizations in the securities market

� performing such functions and exercising according to Securities Contracts (Regulation) Act, 1956,as may be delegated to it by the Central Government

12.3 SEBI (Stock brokers and Sub–Brokers) Regulations, 1992

In this section we shall have a look at the regulations that apply to brokers under the SEBIRegulations.

12.3.1 Brokers

A broker is an intermediary who arranges to buy and sell securities on behalf of clients (thebuyer and the seller). According to Section 2(e) of the SEBI (Stock Brokers and Sub-Brokers)Rules, 1992, a stockbroker means a member of a recognized stock exchange. No stockbrokeris allowed to buy, sell or deal in securities, unless he or she holds a certificate of registrationgranted by SEBI. A stockbroker applies for registration to SEBI through a stock exchange orstock exchanges of which he or she is admitted as a member. SEBI may grant a certificateto a stock-broker [as per SEBI (Stock Brokers and Sub-Brokers) Rules, 1992] subject to theconditions that:

1. He holds the membership of any stock exchange;

2. He shall abide by the rules, regulations and bye-laws of the stock exchange or stock exchanges ofwhich he is a member;

12.4 Regulation for derivatives trading 187

3. In case of any change in the status and constitution, he shall obtain prior permission of SEBI tocontinue to buy, sell or deal in securities in any stock exchange;

4. He shall pay the amount of fees for registration in the prescribed manner; and

5. He shall take adequate steps for redressal of grievances of the investors within one month of thedate of the receipt of the complaint and keep SEBI informed about the number, nature and otherparticulars of the complaints.

As per SEBI (Stock Brokers and Sub-Brokers) Regulations, 1992, SEBI shall take intoaccount for considering the grant of a certificate all matters relating to buying, selling, ordealing in securities and in particular the following, namely, whether the stock broker - (a) iseligible to be admitted as a member of a stock exchange; (b) has the necessary infrastructure likeadequate office space, equipment and man power to effectively discharge his activities; (c) hasany past experience in the business of buying, selling or dealing in securities; (d) is subjectedto disciplinary proceedings under the rules, regulations and bye-laws of a stock exchange withrespect to his business as a stock-broker involving either himself or any of his partners, directorsor employees.

12.4 Regulation for derivatives trading

SEBI set up a 24-member committee under the Chairmanship of Dr.L.C. Gupta to develop theappropriate regulatory framework for derivatives trading in India. The committee submitted itsreport in March 1998. On May 11, 1998 SEBI accepted the recommendations of the committeeand approved the phased introduction of derivatives trading in India beginning with stock indexfutures. SEBI also approved the “suggestive bye-laws” recommended by the committee forregulation and control of trading and settlement of derivatives contracts.

The provisions in the SC(R)A and the regulatory framework developed thereunder governtrading in securities. The amendment of the SC(R)A to include derivatives within the ambit of‘securities’ in the SC(R)A made trading in derivatives possible within the framework of that Act.

1. Any Exchange fulfi lling the eligibility criteria as prescribed in the LC Gupta committee reportmay apply to SEBI for grant of recognition under Section 4 of the SC(R)A, 1956 to start tradingderivatives. The derivatives exchange/segment should have a separate governing council andrepresentation of trading/clearing members shall be limited to maximum of 40% of the total membersof the governing council. The exchange shall regulate the sales practices of its members and willobtain prior approval of SEBI before start of trading in any derivative contract.

2. The Exchange shall have minimum 50 members.

3. The members of an existing segment of the exchange will not automatically become the members ofderivative segment. The members of the derivative segment need to fulfi ll the eligibility conditionsas laid down by the LC Gupta committee.

4. The clearing and settlement of derivatives trades shall be through a SEBI approved clearingcorporation/house. Clearing corporations/houses complying with the eligibility conditions as laiddown by the committee have to apply to SEBI for grant of approval.


5. Derivative brokers/dealers and clearing members are required to seek registration from SEBI. Thisis in addition to their registration as brokers of existing stock exchanges. The minimum networth forclearing members of the derivatives clearing corporation/house shall be Rs.300 Lakh. The networthof the member shall be computed as follows:

� Capital + Free reserves� Less non-allowable assets viz.,

(a) Fixed assets

(b) Pledged securities

(c) Member’s card

(d) Non-allowable securities(unlisted securities)

(e) Bad deliveries

(f) Doubtful debts and advances

(g) Prepaid expenses

(h) Intangible assets

(i) 30% marketable securities

6. The minimum contract value shall not be less than Rs.2 Lakh. Exchanges should also submit detailsof the futures contract they propose to introduce.

7. The initial margin requirement, exposure limits linked to capital adequacy and margin demandsrelated to the risk of loss on the position shall be prescribed by SEBI/Exchange from time to time.

8. The L.C.Gupta committee report requires strict enforcement of “Know your customer” rule andrequires that every client shall be registered with the derivatives broker. The members of thederivatives segment are also required to make their clients aware of the risks involved in derivativestrading by issuing to the client the Risk Disclosure Document and obtain a copy of the same dulysigned by the client.

9. The trading members are required to have qualifi ed approved user and sales person who have passeda certifi cation programme approved by SEBI.

12.4.1 NSE’s certifi cation in fi nancial markets

A critical element of financial sector reforms is the development of a pool of human resourceshaving right skills and expertise to provide quality intermediation services in each segment ofthe market. In order to dispense quality intermediation, personnel providing services need topossess requisite skills and knowledge. This is generally achieved through a system of testingand certification. Such testing and certification has assumed added significance in India as thereis no formal education/training on financial markets, especially in the area of operations. Takinginto account international experience and needs of the Indian financial market, NSE offers NCFM(NSE’s Certification in Financial Markets) to test practical knowledge and skills that are requiredto operate in financial markets in a very secure and unbiased manner and to certify personnel witha view to improve quality of intermediation. NCFM offers a comprehensive range of modulescovering many different areas in finance including a module on derivatives. The module on

12.5 Regulation for clearing and settlement 189

derivatives has been recognized by SEBI. SEBI requires that derivative brokers/dealers and salespersons must mandatorily pass this module of the NCFM.

12.5 Regulation for clearing and settlement

1. The LC Gupta committee has recommended that the clearing corporation must perform full novation,i.e. the clearing corporation should interpose itself between both legs of every trade, becoming thelegal counterparty to both or alternatively should provide an unconditional guarantee for settlementof all trades.

2. The clearing corporation should ensure that none of the Board members has trading interests.

3. The defi nition of net-worth as prescribed by SEBI needs to be incorporated in theapplication/regulations of the clearing corporation.

4. The regulations relating to arbitration need to be incorporated in the clearing corporationsregulations.

5. Specifi c provision/chapter relating to declaration of default must be incorporated by the clearingcorporation in its regulations.

6. The regulations relating to investor protection fund for the derivatives market must be included inthe clearing corporation application/regulations.

7. The clearing corporation should have the capabilities to segregate upfront/initial margins depositedby clearing members for trades on their own account and on account of his clients. The clearingcorporation shall hold the clients’ margin money in trust for the clients’ purposes only and shouldnot allow its diversion for any other purpose. This condition must be incorporated in the clearingcorporation regulations.

8. The clearing member shall collect margins from his constituents (clients/trading members). He shallclear and settle deals in derivative contracts on behalf of the constituents only on the receipt of suchminimum margin.

9. Exposure limits based on the value at risk concept will be used and the exposure limits will becontinuously monitored. These shall be within the limits prescribed by SEBI from time to time.

10. The clearing corporation must lay down a procedure for periodic review of the networth of itsmembers.

11. The clearing corporation must inform SEBI how it proposes to monitor the exposure of its membersin the underlying market.

12. Any changes in the the bye-laws, rules or regulations which are covered under the “Suggestive bye-laws for regulations and control of trading and settlement of derivatives contracts” would requireprior approval of SEBI.


The importance of adequate risk–management and control, both at the exchange level and at the levelof members of the exchange, can never be overstated. The failure of Barings is a case in point of lackof trader controls and what it can result into.In the 1980s, Barings had installed a credit risk–management system in London and was in the processof installing market risk–management system. The system had the capacity to price derivatives andto support VAR reports. Baring’s technology, however, was far more advanced in London than in itsforeign branches. As big systems were expensive to install and support for small operations, the bankrelied heavily on local management for its smaller foreign branches.The most risky aspect of the Barings affair was Leeson’s joint responsibility for front and back–offi cefunctions, which allowed him to hide trading losses. In July 1992, he created a special “error”account,numbered 88888, which was hidden form the trade fi le, price fi le, and the London gross fi le. Losingtrades and unmatched trades were parked in this account. Daily reports to Baring’s Asset and Liabilityshowed Leeson’s trading positions on the Nikkei 255 as fully matched. Reports to London thereforeshowed no risk. Had Barings used internal audits to provide independent checks on input, the companymight have survived.

Box 12.11: A lesson in risk management: Barings

Table 12.1Eligibility criteria for membership on F&O segmentParticulars CM and F&O segment CM, WDM and F&O segment(all values in Rs.Lakh)

Net worth 1 100 200Interest free securitydeposit(IFSD)2 125 275Collateral securitydeposit(CSD)3 25 25Annual subscription 1 2

1: No additional networth is required for self clearing members. However, a networth of Rs. 300Lakh is required for TM–CM and PCM.2 & 3: Additional Rs. 25 Lakh is required for clearing membership(SCM,TM–CM). In addition,the clearing member is required to bring in IFSD of Rs.2 Lakh and CSD of Rs.8 lakh per tradingmember he undertakes to clear and settle.

12.6 Regulation for membership

The eligibility criteria for membership on the F&O segment is as given in Table 12.1. Table 12.2gives the requirements for professional clearing membership. As mentioned earlier, anybodyinterested in taking membership of F&O segment is required to take membership of “CM andF&O segment” or “CM,WDM and F&O segment”. An existing member of CM segment canalso take membership of F&O segment. A trading member can also be a clearing member bymeeting additional requirements. There can also be only clearing members.

12.7 Regulations for risk management 191

Table 12.2Requirements for professional clearing membershipParticulars F&O segment CM & F&O segment(all values in Rs.Lakh)

Eligibility Trading members of Trading members ofNSE/SEBI registered NSE/SEBI registeredcustodians/recognized custodians/recognizedbanks banks

Networth 300 300Interest free security deposit(IFSD) 25 34Collateral security deposit 25 50Annual subscription Nil 2.5

Note: The PCM is required to bring in IFSD of Rs.2 Lakh and CSD of Rs.8 Lakh per tradingmember whose trades he undertakes to clear and settle in the F&O segment.

12.7 Regulations for risk management

12.7.1 Liquid networth requirements� Liquid net worth for a clearing member means: a)total liquid assets deposited by a clearing member

with the clearing corporation towards initial margin and capital adequacy, less b) initial marginapplicable to the total gross open positions at any given point of time of all trades cleared throughthe clearing member. A clearing member’s minimum liquid net worth must be at least Rs.50 Lakh atany point of time.

� Liquid assets include cash, fi xed deposits, bank guarantees, treasury bills, government securities ordematerialized securities (with suitable haircuts) pledged in favor of clearing corporation.

� At least 50% of the total liquid assets shall be in the form of cash equivalents viz. cash, bankguarantee, fi xed deposits, T-bills and dated government securities.

� Bank guarantees: Not more than 5% of the settlement guarantee fund or 1% of the total liquid assetsdeposited with the clearing corporation, whichever is lower, may be exposed to bank guarantees of asingle bank which is not rated P1 (or P1+) or equivalent by a RBI recognized credit rating agency.

Further, not more than 50% of the settlement guarantee fund or 10% of the total liquid assetsdeposited with the clearing corporation, whichever is lower, may be exposed to bank guaranteesissued by all such lower rated banks put together.

� Securities: Equity securities may be deposited only in dematerialized form.

The acceptable securities are determined by taking the top 100 securities by market capitalization outof the top 200 securities by market capitalization and also by trading value. This list is updated on thebasis of the average market capitalization over the period of six months. When a security is droppedfrom the list of acceptable securities, existing deposits of that security continue to be counted forliquid assets for a period of one month. Haircuts on equities must be at least 15% with weekly markto market.


Table 12.3Worst scenario lossRisk scenario Price move in Volatility move in Fraction of loss

number multiples of price multiples of considered (%)scan range volatility range

1 0 +1 1002 0 -1 1003 +1/3 +1 1004 +1/3 -1 1005 -1/3 +1 1006 -1/3 -1 1007 +2/3 +1 1008 +2/3 -1 1009 -2/3 +1 100

10 -2/3 -1 10011 +1 +1 10012 +1 -1 10013 -1 +1 10014 -1 -1 10015 +2 0 3516 -2 0 35

All securities deposited for liquid assets are required to be pledged in favor of clearing corporation.The marking to market of securities is carried out weekly for all securities. Debt securities areacceptable only if they are investment grade with haircuts of 10% and weekly mark to market.

The total exposure of the clearing corporation to the debt or equity securities of a company may notexceed 75% of the trade guarantee fund or 15% of the total liquid assets of the clearing corporation,whichever is lower.

12.7.2 Initial margin computation methodology

A portfolio based margining approach has been adopted which takes an integrated view of therisk involved in the portfolio of each individual client comprising of his positions in all derivativecontracts i.e. futures and options. The initial margin requirements are based on worst scenarioloss of a portfolio of an individual client to cover 99% VaR over one day horizon across variousscenarios of price changes and volatility shifts. The parameters for such a model include:

Worst Scenario Loss

The worst case loss of a portfolio is calculated by valuing the portfolio under several scenariosof changes in the underlying and changes in the volatility of the underlying. The scenarios to beused for this purpose are:

The maximum loss under any of the scenario(considering only 35% of the loss in case of


scenarios 15 and 16) is referred to as the worst scenario loss. For the purpose of the calculationof option values Black–Scholes model is used.

For index products the price scan range is specified at three standard deviation(3 sigma) andthe volatility scan range is specified at 4%. Additionally, for index futures contracts the initialmargin may not be less than 5% of the value of the contract. For futures and option contracts onstocks the price scan range is specified at three and a half standard deviation(3.5 sigma) and thevolatility scan range is specified at 10%. The minimum initial margin for stock futures contractis 7.5% of the value of the contract.

12.7.3 Calendar spreads

A calendar spread is a position in an underlying with one maturity which is hedged by anoffsetting position in the same underlying with a different maturity: for example, a short positionin a July futures contract on Reliance and a long position in the August futures contract onReliance is a calendar spread. Calendar spreads attract lower margins because they are notexposed to market risk of the underlying. If the underlying rises, the July contract would make aprofit while the August contract would make a loss.

Margin on calendar spreads is levied at 0.5% per month of spread on the far month contractof the spread subject to a minimum margin of 1% and a maximum margin of 3% on the far monthcontract of the spread.

Margin on calendar spread is calculated on the basis of delta of the portfolio consisting offutures and option contract in each month. Thus, a portfolio consisting of near month futuresand options contracts with a delta of 100 and far month futures and option contracts with a deltaof -100 bears a spread charge equal to the spread charge for a portfolio which is long 100 nearmonth futures and short 100 far month futures. The calendar spread margin is charged in additionto the worst scenario loss of the portfolio. A calendar spread is treated as a naked position in thefar month contract three trading days before the expiry of near month contract.

12.7.4 Short option minimum margin

The short option minimum margin equal to 3% of the notional value of all short index options ischarged if sum of the worst scenario loss and the calendar spread margin is lower than the shortoption minimum margin. For stock options it is equal to 7.5% of the notional value based onthe previous days closing value of the underlying stock. Notional value of option positionsis calculated on the short option positions by applying the last closing price of the relevantunderlying.

12.7.5 Net option value

The net option value is calculated as the current market value of the option times the number ofoption units(positive for long options and negative for short options) in the portfolio.

Net option value is added to the liquid net worth of the clearing member. This means that thecurrent market value of short options are deducted from the liquid net worth and the market value


of long options are added thereto. Thus mark to market gains and losses on option positions getadjusted against the available liquid net worth. Since the options are premium style, mark tomarket gains and losses are not settled in cash for option positions. Net option value is computedbased on the last closing price.

12.7.6 Premium margin

Premium amount due for a client is deducted from the available liquid net worth towardspremium margins on a real time basis till the completion of premium settlement on T+1 day.

12.7.7 Initial margin

Margins in the derivatives markets are based on a 99% Value at Risk (VAR) approach at threesigma limits over a one day horizon. Accordingly, margins are computed based on volatilitycomputations.

The initial margin is netted with respect to each contract at level of individual client and ison gross basis across all clients for a trading/clearing member. The initial margin for proprietaryposition of a trading/clearing member is done on net basis. Initial margins are required to becollected upfront. Accordingly, the initial margin plus the calendar spread charge is adjustedagainst the available liquid networth of a member. The member is in turn required to collect theinitial margin from his clients upfront.

Method of computation of volatility

The exponential moving average method is used to obtain the volatility estimate every day. Theestimate at the end of day t,�

�

is estimated using the previous day’s volatility estimate��

�

(asat the end of day t-1), and the return�

�

observed in the futures market on day t.

� �

� � � � � �

�

�

�

� ��

� � � � ��

�

where � is a parameter which determines how rapidly volatility estimates change. A value of0.94 is used for� .

12.7.8 Exposure limits

The notional value of gross open positions at any point in time for index futures and short indexoption contracts shall not exceed� �

� (thirty three one by three) times the liquid networth of aclearing member. In case of futures and option contracts on stocks, the notional value of futurescontracts and short option position at any time shall not exceed 20(twenty) times the liquidnetworth of a member.

Therefore, 3% of the notional value of gross open position in index futures and short indexoption contracts, and 5% of the notional value of futures and short option position in stocksis additionally adjusted from the liquid networth of a clearing member on a real time basis.


Notional value of the options contract is calculated on the basis of the previous days closingprice of the underlying. These exposure limits are in addition to the initial margin and calendarspread requirements.

12.7.9 Exposure limit for calendar spreads(only for futures contracts)

For exposure purpose, calendar spreads are regarded as an open position of one third(1/3rd) of themark to market value of the far month futures contract. As the near month contract approachesexpiry, the spread is treated as a naked position in the far month contract three trading days priorto the expiry of the far month contract.

12.7.10 Position limits

Position limits have been specified by SEBI at trading member, client, market and FII levelsrespectively.

Trading member position limits

There is a position limit in derivative contracts on an index of 15% of the open interest or Rs.100Crore, whichever is higher. The position limit in derivative contracts on an individual stock is7.5% of the open interest in that underlying on the exchange or Rs.50 Crore, whichever is higher.Once a member, in a particular underlying reaches the position limit then he is permitted to takeonly offsetting positions(which result in lowering the open position of the member) in derivativecontracts on such underlying.

Client level position limits

On index based derivative contracts, at the client level there is a self–disclosure requirement asfollows: Any person or persons acting in concert who together own 15% or more of the openinterest in all futures and option contracts on the same index are required to report this fact tothe clearing corporation and failure to do so attracts a penalty. This does not mean a ban onlarge open positions but is a disclosure requirement.

On stock based derivative contracts, the gross open position across all such derivativecontracts in a particular underlying of a single customer/client shall not exceed the higher of 1%of the free float market capitalization(in terms of number of shares) or 5% of the open interest ina particular underlying stock(in terms of number of contracts). This position limit is applicableon the combined position in all derivative contracts in an underlying stock at an exchange.

Market wide position limits

The market wide limit of open positions(in terms of the number of units of underlying stock) onall futures and option contracts on a particular stocks is lower of 30 times the average numberof shares traded daily, during the previous calendar month, in the capital market segment of the


exchange, or 10% of the number of shares held by non–promoters i.e. 10% of the free float, interms of number of shares of a company.

This market wide limit is applicable on a particular underlying. When the total open interestin a contract reaches 80% of the market wide limit in that contract, the price scan range andvolatility scan range in SPAN would be doubled.

Position limits for FIIs

The position limits specified for FIIs and their sub-account/s is as under:

� At the level of the FII

– In the case of index related derivative products, the position limit is 15% of open interest inall futures and options contracts on a particular underlying index on an exchange, or Rs.100Crore, whichever is higher.

– In the case of an underlying security, the position limit is 7.5% of open interest, in all futuresand options contracts on a particular underlying security on an exchange or Rs.50 Crore,whichever is higher.

� At the level of the sub-account

– The CM/TM is required to disclose to the clearing corporation details of any person or personsacting in concert who together own 15% or more of the open interest of all futures and optionscontracts on a particular underlying index on the exchange.

– The gross open position across all futures and options contracts on a particular underlyingsecurity, of a sub–account of an FII, should not exceed the higher of 1% of the free floatmarket capitalization (in terms of number of shares) or 5% of the open interest in the derivativecontracts on a particular underlying stock(in terms of number of contracts).

These position limits are applicable on the combined position in all futures and optionscontracts on an underlying security on the exchange.

12.7.11 Real time computation

The computation of worst scenario loss has two components. The first is the valuation of eachcontract under sixteen scenarios. The second is the application of these scenario contract valuesto the actual positions in a portfolio to compute the portfolio values and the worst scenario loss.

For computational ease, the scenario contract values are updated at least 5 times in the day,which may be carried out by taking prices at the start of trading, at 11:00 a.m, at 12:30 p.m , at2:00 p.m., and at the end of the trading session.

12.7.12 Eligibility of stocks for futures and option trading

The stocks which are eligible for futures and option trading, should meet the following criteria:


1. The stock should be amongst the top 200 scrips, on the basis of average market capitalization duringthe last six months and the average free float market capitalization should not be less than Rs.750Crore. The free float market capitalization means the non–promoter holding in the stock.

2. The stock should be amongst the top 200 scrips on the basis of average daily volume(in value terms),during the last six months. Further, the average daily volume should not be less than Rs.5 Crore inthe underlying cash market.

3. The stock should be traded on at least 90% of the trading days in the last six months, with theexception of cases in which a stock is unable to trade due to corporate actions like de–mergers etc.

4. The non promoter holding in the company should be at least 30%.

5. The ratio of the daily volatility of the stock vis–a–vis the daily volatility of the index(either BSE-30 Sensex or S&P CNX Nifty) should not be more than 4, at any time during the previous sixmonths. For this purpose the volatility would be computed as per the exponentially weighted movingaverage(EWMA) formula.

6. The stock on which option contracts are permitted to be traded on one derivative exchange/segmentwould also be permitted to trade on other derivative exchanges/segments.

12.7.13 Adjustments for corporate actions

Adjustments for corporate actions for stock options would be as follows:� The basis for any adjustment for corporate action shall be such that the value of the position of the

market participants on cum and ex-date for corporate action shall continue to remain the same asfar as possible. This will facilitate in retaining the relative status of positions namely in-the-money,at-the-money and out-of-money. This will also address issues related to exercise and assignments.

� Adjustment for corporate actions shall be carried out on the last day on which a security is traded ona cum basis in the underlying cash market.

� Adjustments shall mean modifi cations to positions and/or contract specifi cations namely strike price,position, market lot, multiplier. These adjustments shall be carried out on all open, exercised as wellas assigned positions.

� The corporate actions may be broadly classifi ed under stock benefi ts and cash benefi ts. The variousstock benefi ts declared by the issuer of capital are bonus, rights, merger/de–merger, amalgamation,splits, consolidations, hive–off, warrants and secured premium notes and dividends.

� The methodology for adjustment of corporate actions such as bonus, stock splits and consolidationsis as follows:

– Strike price: The new strike price shall be arrived at by dividing the old strike price by theadjustment factor as under.

– Market lot/multiplier: The new market lot/multiplier shall be arrived at by multiplying the oldmarket lot by the adjustment factor as under.

– Position: The new position shall be arrived at by multiplying the old position by the adjustmentfactor, which will be computed using the pre-specifi ed methodology.


The adjustment factor for bonus, stock splits and consolidations is arrived at as follows:

– Bonus: Ratio - A : B ; Adjustment factor : (A+B)/B

– Stock splits and consolidations : Ratio - A : B ; Adjustment factor : B/A

– Right : Ratio - A : B�

Premium : C�

Face value : D�

Existing strike price : X�

New strike price : ((B * X) + A * (C + D))/(A+B)

– Existing market lot/multiplier/position: Y ; New issue size : Y * (A+B)/B

The above methodology may result in fractions due to the corporate action e.g. a bonus ratio of3:7. With a view to minimizing fraction settlements, the following methodology is proposed to beadopted:

1. Compute value of the position before adjustment.

2. Compute value of the position taking into account the exact adjustment factor.

3. Carry out rounding off for the Strike Price and Market Lot.

4. Compute value of the position based on the revised strike price and market lot.

The difference between 1 and 4 above, if any, shall be decided in the manner laid down by the groupby adjusting strike price or market lot, so that no forced closure of open position is mandated.

� Dividends which are below 10% of the market value of the underlying stock, would be deemed tobe ordinary dividends and no adjustment in the strike price would be made for ordinary dividends.For extra-ordinary dividends, above 10% of the market value of the underlying stock, the strike pricewould be adjusted.

� The exchange will on a case to case basis carry out adjustments for other corporate actions as decidedby the group in conformity with the above guidelines.

12.8 Accounting for futures

The Institute of Chartered Accountants of India (ICAI) has issued guidance notes on accountingof index futures contracts from the view point of parties who enter into such futures contracts asbuyers or sellers. For other parties involved in the trading process, like brokers, trading members,clearing members and clearing corporations, a trade in equity index futures is similar to a tradein, say shares, and does not pose any peculiar accounting problems. Hence in this section weshall largely focus on the accounting treatment of equity index futures in the books of the client.But before we do so, a quick re-look at some of the terms used.

1. Clearing corporation/house: Clearing corporation/house means the clearing corporation/houseapproved by SEBI for clearing and settlement of trades on the derivatives exchange/segment. Allthe clearing and settlement for trades that happen on the NSE’s market is done through NSCCL.

12.8 Accounting for futures 199

2. Clearing member: Clearing member means a member of the clearing corporation and includesall categories of clearing members as may be admitted as such by the clearing corporation to thederivatives segment.

3. Client: A client means a person, on whose instructions and, on whose account, the trading memberenters into any contract for the purchase or sale of any contract or does any act in relation thereto.

4. Contract month: Contract month means the month in which the exchange/clearing corporation rulesrequire a contract to be fi nally settled.

5. Daily settlement price: Daily settlement price is the closing price of the equity index futures contractfor the day or such other price as may be decided by the clearing house from time to time.

6. Derivative exchange/segment: Derivative exchange means an exchange approved by SEBI as aderivative exchange. Derivative segment means segment of an existing exchange approved by SEBIas derivatives segment.

7. Final settlement price: The fi nal settlement price is the closing price of the equity index futurescontract on the last trading day of the contract or such other price as may be specifi ed by the clearingcorporation, from time to time.

8. Long position: Long position in an equity index futures contract means outstanding purchaseobligations in respect of the equity index futures contract at any point of time.

9. Open position: Open position means the total number of equity index futures contracts that have notyet been offset and closed by an opposite position.

10. Settlement date: Settlement date means the date on which the settlement of outstanding obligationsin an equity index futures contract are required to be settled as provided in the Bye-Laws of theDerivatives exchange/segment.

11. Short position: Short position in an equity index futures contract means outstanding sell obligationsin respect of an equity index futures contract at any point of time.

12. Trading member: Trading member means a Member of the Derivatives exchange/segment andregistered with SEBI.

12.8.1 Accounting at the inception of a contract

Every client is required to pay to the trading member/clearing member, the initial margindetermined by the clearing corporation as per the bye-laws/regulations of the exchange forentering into equity index futures contracts. Such initial margin paid/payable should be debitedto “Initial margin - Equity index futures account”. Additional margins, if any, should also beaccounted for in the same manner. It may be mentioned that at the time when the contractis entered into for purchase/sale of equity index futures, no entry is passed for recording thecontract because no payment is made at that time except for the initial margin. At the balancesheet date, the balance in the ‘Initial margin - Equity index futures account’ should be shownseparately under the head ‘current assets’. In those cases where any amount has been paid inexcess of the initial/additional margin, the excess should be disclosed separately as a deposit


under the head ‘current assets’. In cases where instead of paying initial margin in cash, the clientprovides bank guarantees or lodges securities with the member, a disclosure should be made inthe notes to the financial statements of the client.

12.8.2 Accounting at the time of daily settlement

This involves the accounting of payment/receipt of mark-to-market margin money. Paymentsmade or received on account of daily settlement by the client would be credited/debited to thebank account and the corresponding debit or credit for the same should be made to an accounttitled as “Mark-to-market margin - Equity index futures account”.

Some times the client may deposit a lump sum amount with the broker/trading member inrespect of mark-to-market margin money instead of receiving/paying mark-to-market marginmoney on daily basis. The amount so paid is in the nature of a deposit and should be debitedto an appropriate account, say, “Deposit for mark-to-market margin account”. The amount of“mark-to-market margin” received/paid from such account should be credited/debited to “Mark-to-market margin - Equity index futures account” with a corresponding debit/credit to “Depositfor mark-to-market margin account”. At the year-end, any balance in the “Deposit for mark-to-market margin account” should be shown as a deposit under the head “current assets”.

12.8.3 Accounting for open positions

Position left open on the balance sheet date must be accounted for. Debit/credit balance in the“mark-to-market margin - Equity index futures account”, maintained on global basis, representsthe net amount paid/received on the basis of movement in the prices of index futures till thebalance sheet date. Keeping in view ‘prudence’ as a consideration for preparation of financialstatements, provision for anticipated loss, which may be equivalent to the net payment madeto the broker (represented by the debit balance in the “mark-to-market margin - Equity indexfutures account”) should be created by debiting the profit and loss account. Net amount received(represented by credit balance in the “mark-to-market margin - Equity index futures account”)being anticipated profit should be ignored and no credit for the same should be taken in theprofit and loss account. The debit balance in the said “mark-to-market margin - Equity indexfutures account”, i.e., net payment made to the broker, may be shown under the head “currentassets, loans and advances” in the balance sheet and the provision created there-against shouldbe shown as a deduction therefrom. On the other hand, the credit balance in the said account,i.e., the net amount received from the broker, should be shown as a current liability under thehead “current liabilities and provisions in the balance sheet”.

12.8.4 Accounting at the time of fi nal settlement

This involves accounting at the time of final settlement or squaring-up of the contract. At theexpiry of a series of equity index futures, the profit/loss, on final settlement of the contractsin the series, should be calculated as the difference between final settlement price and contractprices of all the contracts in the series. The profit/loss, so computed, should be recognized in

12.8 Accounting for futures 201

the profit and loss account by corresponding debit/credit to “mark-to-market margin - Equityindex futures account”. However, where a balance exists in the provision account created foranticipated loss, any loss arising on such settlement should be first charged to such provisionaccount, to the extent of the balance available in the provision account, and the balance of loss,if any, should be charged to the profit and loss account. Same accounting treatment shouldbe made when a contract is squared-up by entering into a reverse contract. It appears that, atpresent, it is not feasible to identify the equity index futures contracts. Accordingly, if more thanone contract in respect of the series of equity index futures contracts to which the squared-upcontract pertains is outstanding at the time of the squaring of the contract, the contract priceof the contract so squared-up should be determined using First-In, First-Out (FIFO) method forcalculating profit/loss on squaring-up.

On the settlement of an equity index futures contract, the initial margin paid in respect of thecontract is released which should be credited to “Initial margin - Equity index futures account”,and a corresponding debit should be given to the bank account or the deposit account (where theamount is not received).

12.8.5 Accounting in case of a default

When a client defaults in making payment in respect of a daily settlement, the contract is closedout. The amount not paid by the Client is adjusted against the initial margin. In the books ofthe Client, the amount so adjusted should be debited to “mark-to-market - Equity index futuresaccount” with a corresponding credit to “Initial margin - Equity index futures account”. Theamount of initial margin on the contract, in excess of the amount adjusted against the mark-to-market margin not paid, will be released. The accounting treatment in this regard will be thesame as explained above. In case, the amount to be paid on daily settlement exceeds the initialmargin the excess is a liability and should be shown as such under the head ‘current liabilitiesand provisions’, if it continues to exist on the balance sheet date. The amount of profit or loss onthe contract so closed out should be calculated and recognized in the profit and loss account inthe manner dealt with above.

12.8.6 Disclosure requirements

The amount of bank guarantee and book value as also the market value of securities lodgedshould be disclosed in respect of contracts having open positions at the year end, where initialmargin money has been paid by way of bank guarantee and/or lodging of securities.

Total number of contracts entered and gross number of units of equity index futures traded(separately for buy/sell) should be disclosed in respect of each series of equity index futures.

The number of equity index futures contracts having open position, number of units of equityindex futures pertaining to those contracts and the daily settlement price as of the balance sheetdate should be disclosed separately for long and short positions, in respect of each series of equityindex futures.


12.9 Accounting for equity index options and equity stock options

The Institute of Chartered Accountants of India issued guidance note on accounting for indexoptions and stock options from the view point of the parties who enter into such contracts asbuyers/holder or sellers/writers. Following are the guidelines for accounting treatment in case ofcash settled index options and stock options:

12.9.1 Accounting at the inception of a contract

The seller/writer of the option is required to pay initial margin for entering into the optioncontract. Such initial margin paid would be debited to ‘Equity Index Option Margin Account’ orto ‘Equity Stock Option Margin Account’, as the case may be. In the balance sheet, such accountshould be shown separately under the head ‘Current Assets’. The buyer/holder of the option isnot required to pay any margin. He is required to pay the premium. In his books, such premiumwould be debited to ‘Equity Index Option Premium Account’ or ‘Equity Stock Option PremiumAccount’, as the case may be. In the books of the seller/writer, such premium received should becredited to ‘Equity Index Option Premium Account’ or ‘Equity Stock Option Premium Account’as the case may be.

12.9.2 Accounting at the time of payment/receipt of margin

Payments made or received by the seller/writer for the margin should be credited/debited to thebank account and the corresponding debit/credit for the same should also be made to ‘EquityIndex Option Margin Account’ or to ‘Equity Stock Option Margin Account’, as the case may be.Sometimes, the client deposit a lump sum amount with the trading/clearing member in respect ofthe margin instead of paying/receiving margin on daily basis. In such case, the amount of marginpaid/received from/into such accounts should be debited/credited to the ‘Deposit for MarginAccount’. At the end of the year the balance in this account would be shown as deposit under‘Current Assets’.

12.9.3 Accounting for open positions as on balance sheet dates

The ‘Equity Index Option Premium Account’ and the ‘Equity Stock Option Premium Account’should be shown under the head ‘Current Assets’ or ‘Current Liabilities’, as the case may be.

In the books of the buyer/holder, a provision should be made for the amount by which thepremium paid for the option exceeds the premium prevailing on the balance sheet date. Theprovision so created should be credited to ‘Provision for Loss on Equity Index Option Account’to the ‘Provision for Loss on Equity Stock Options Account’, as the case may be. The provisionmade as above should be shown as deduction from ‘Equity Index Option Premium’ or ‘EquityStock Option Premium’ which is shown under ‘Current Assets’.

In the books of the seller/writer, the provision should be made for the amount by whichpremium prevailing on the balance sheet date exceeds the premium received for that option.This provision should be credited to ‘Provision for Loss on Equity Index Option Account’

12.9 Accounting for equity index options and equity stock options 203

or to the ‘Provision for Loss on Equity Stock Option Account’, as the case may be, with acorresponding debit to profit and loss account. ‘Equity Index Options Premium Account’ or‘Equity Stock Options Premium Account’ and ‘Provision for Loss on Equity Index OptionsAccount’ or ’Provision for Loss on Equity Stock Options Account’ should be shown under‘Current Liabilities and Provisions’.

In case of any opening balance in the ‘Provision for Loss on Equity Stock Options Account’or the ‘Provision for Loss on Equity Index Options Account’, the same should be adjusted againstthe provision required in the current year and the profit and loss account be debited/credited withthe balance provision required to be made/excess provision written back.

12.9.4 Accounting at the time of f i nal settlement

On exercise of the option, the buyer/holder will recognize premium as an expense and debitthe profit and loss account by crediting ‘Equity Index Option Premium Account’ or ‘EquityStock Option Premium Account’. Apart from the above, the buyer/holder will receive favorabledifference, if any, between the final settlement price as on the exercise/expiry date and the strikeprice, which will be recognized as income. On exercise of the option, the seller/writer willrecognize premium as an income and credit the profit and loss account by debiting ‘Equity IndexOption Premium Account’ or ‘Equity Stock Option Premium Account’. Apart from the above,the seller/writer will pay the adverse difference, if any, between the final settlement price as onthe exercise/expiry date and the strike price. Such payment will be recognized as a loss.

As soon as an option gets exercised, margin paid towards such option would be released bythe exchange, which should be credited to ‘Equity Index Option Margin Account’ or to ‘EquityStock Option Margin Account’, as the case may be, and the bank account will be debited.

12.9.5 Accounting at the time of squaring off an option contract

The difference between the premium paid and received on the squared off transactions should betransferred to the profit and loss account. Following are the guidelines for accounting treatmentin case of delivery settled index options and stock options: The accounting entries at the timeof inception, payment/receipt of margin and open options at the balance sheet date will be thesame as those in case of cash settled options. At the time of final settlement, if an option expiresunexercised then the accounting entries will be the same as those in case of cash settled options.If the option is exercised then shares will be transferred in consideration for cash at the strikeprice. For a call option the buyer/holder will receive equity shares for which the call optionwas entered into. The buyer/holder should debit the relevant equity shares account and creditcash/bank. For a put option, the buyer/holder will deliver equity shares for which the put optionwas entered into. The buyer/holder should credit the relevant equity shares account and debitcash/bank. Similarly, for a call option the seller/writer will deliver equity shares for which thecall option was entered into. The seller/writer should credit the relevant equity shares accountand debit cash/bank. For a put option the seller/writer will receive equity shares for which theput option was entered into. The seller/writer should debit the relevant equity shares account andcredit cash/bank. In addition to this entry, the premium paid/received will be transferred to the


profit and loss account, the accounting entries for which should be the same as those in case ofcash settled options.

12.10 Taxation issues: A discussion

The income-tax Act does not have any specific provision regarding taxability from derivatives.Hence we restrict ourselves to a discussion on the topic of taxability of derivatives. The readermay keep track of the developments in this regard as and when they occur.

The only provisions which have an indirect bearing on derivative transactions are sections73(1) and 43(5). Section 73(1) provides that any loss, computed in respect of a speculativebusiness carried on by the assessee, shall not be set off except against profits and gains, ifany, of speculative business. Section 43(5) of the Act defines a speculative transaction as atransaction in which a contract for purchase or sale of any commodity, including stocks andshares, is periodically or ultimately settled otherwise than by actual delivery or transfer of thecommodity or scrips. It excludes the following types of transactions from the ambit of speculativetransactions:

1. A contract in respect of stocks and shares entered into by a dealer or investor therein to guard againstloss in his holding of stocks and shares through price fluctuations;

2. A contract entered into by a member of a forward market or a stock exchange in the course of anytransaction in the nature of jobbing or arbitrage to guard against loss which may arise in ordinarycourse of business as such member.

From the above, it appears that a transaction is speculative, if it is settled otherwise thanby actual delivery. The hedging and arbitrage transactions, even though not settled by actualdelivery are considered non-speculative. A transaction to be speculative therefore requires that:

1. The transaction is in commodities, shares, stock or scrips

2. The transaction is settled otherwise than by actual delivery

3. The participant has no underlying position

4. The transaction is not for jobbing/arbitrage

In the absence of a specific provision, it is apprehended that the derivatives contracts,particularly the index futures which are essentially cash-settled, may be construed as speculativetransactions and therefore the losses, if any, will not be eligible for set off against other incomeof the assessee and will be carried forward and set off against speculative income only up tomaximum of eight years.

The fact, however, is that derivative contracts are not for purchase/sale of anycommodity,stock,share or scrip. Derivatives are a special class of securities under the SC(R)A,1956 and do not any way resemble any other type of securities like share,stocks or scrips.Derivative contracts, particularly index futures are cash-settled, as these cannot be settledotherwise. As explained earlier, derivative contracts are entered into by hedgers,speculators

12.10 Taxation issues: A discussion 205

and arbitrageurs. A derivative contract has any of these two parties and hence some of thederivative contracts, not all, have an element of speculation. At least one of the parties to aderivative contract is a hedger or an arbitrageur. It would, therefore, be unfair to treat derivativetransactions as speculative. Otherwise it would be a penalty on hedging which the SecuritiesLaws (Amendment) Act, 1999 seeks to promote. In view of these difficulties in applying theexisting provisions, it is desirable to clarify or make special provision for derivatives of securities.

Section 43 is relevant in case of contracts where actual delivery is possible, but these aresettled otherwise than by actual delivery. This provision cannot be applied to derivatives,particularly index futures, which can be settled only by cash. There cannot be actual delivery.Hence the actual delivery for a contract to be non-speculative cannot be applied to derivativescontracts.

As emphasized earlier by the L C Gupta Committee, the futures market should havespeculative appeal. This means, the speculators have to be treated equitably, that is at leastat par with hedgers, if not better. All types of participants need to be provided level playingfield so that the market is competitive and efficient. As regards taxability, the law should nottreat income of the hedger,speculators and arbitrageurs differently. Income of all the participantsfrom derivatives needs to be treated uniformly.

Further, a transaction is considered speculative, if a participant enters into a hedgingtransaction in scrips outside his holdings. It is possible that an investor does not have all the 30or 50 stocks represented by the index. As a result an investor’s losses or profits out of derivativestransactions, even though they are of hedging nature in real sense, it is apprehended, may betreated as speculative. This is contrary to capital asset pricing model which states that portfoliosin any economy move in sympathy with the index although the portfolios do not necessarilycontain any security in the index. The index futures are, therefore, used even for hedging theportfolio risk of non-index stocks. An investor who does not have the index stocks can also usethe index futures to hedge against the market risk as all the portfolios have a correlation with theoverall movement of the market (i.e. the index).

In view of the practical difficulties in administration of tax for different purposes of the sametransaction, inherent nature of derivative contract requiring its settlement otherwise than by actualdelivery, need to promote level playing field to all parties to derivatives contracts, and the needto promote derivatives markets, it is suggested that the exchange-traded derivatives contracts areexempted from the purview of speculative transactions. These must, however be taxed as normalbusiness income. This would be fiscally more prudent.


Solved problems

Q: The Securities and Exchange Board of India Act, 1992 was an act to provide for the establishment ofa Board

1. To protect the interests of investors

2. To promote the development of securitiesmarket

3. To regulate the securities market

4. All of the above


Q: The regulatory framework for the derivatives market in India has been developed by the

1. L.C.Gupta committee

2. J.R.Varma committee

3. A.C.Gupta committee



Q: A member is short 400 March futures contracts and long 200 April futures contracts. A calendar spreadin this case will be

1. Long 200 futures contracts

2. Short 200 futures contracts

3. Long 400 futures contracts

4. Short 400 futures contracts


Q: As per the requirements of SEBI, a derivatives exchange must have a minimum of members

1. 100

2. 50

3. 75

4. 25


Q: The minimum networth for clearing members of the derivatives clearing corporation/house shall be

1. Rs.300 Lakh

2. Rs.250 Lakh

3. Rs.500 Lakh




Q: Which of the following persons are eligible to become trading members in the F&O segment of NSE?

1. Individuals

2. Registered fi rms

3. Companies

4. Any of the above


Q: The dealer/broker and sales persons in the F&O segment shall be required to pass which of thefollowing examinations?

1. MBA (Finance)

2. Chartered Accountancy

3. Certifi ed Financial Analyst

4. NCFM


Q: Which of the following Acts governs trading of derivatives in India?

1. Securities Contracts (Regulation) Act, 1956

2. SEBI Act, 1992

3. Capital Issues (Control) Act, 1947

4. Depositories Act, 1956


Q: The open position for the proprietary trades will be on a

1. Net basis 2. Gross basis


Q: The computation of open position for client trades would be carried out on a

1. Gross basis i.e.long minus short. 2. Net basis i.e. long and short separately.


Q: A clearing member of F&O segment is required to have a networth of and keep collateralsecurity deposit of

1. Rs.3 Crore, 50 Lakh.






Q: The clearing member has to maintain a minimum liquid networth of .

1. Rs.35 Lakh

2. Rs.50 Lakh

3. Rs.80 Lakh

4. Rs.20 Lakh


Q: Initial margin paid/payable should be debited to

1. “Initial margin - Equity index futures ac-count”

2. “Initial margin - Equity index futures broker’saccount”

3. “Initial margin - Equity index futures client’saccount”



Q: At the year-end, any balance in the “Deposit for mark-to-market margin account” should be shown asa deposit under the head

1. “current assets”.

2. “current liabilities”

3. “pre-paid expenses”



Q: The sum of percent of the notional value of gross open position in index futures and short indexoption contracts and percent of the notional value of futures and short option position in stocks shallnot exceed liquid networth.

1. 3,5

2. 5,3

3. 8,16

4. 5,10


Q: The CM/TM is required to disclose to the clearing corporation details of any person or persons acting inconcert who together own percent or more of the open interest of all futures and options contractson a particular underlying index on the exchange.

1. 20

2. 12

3. 15

4. 25



Q: In which of the following cases will the futures and options contracts be adjusted for dividends?

1. aggregate dividend is more than 10% of themarket value

2. aggregate dividend is more than 1% of themarket value

3. aggregate dividend is 5% of the face value

4. aggregate dividend is 10% of the face value


Q: Margins may be deposited in the form of

1. Cash only

2. Cash + bank guarantee + fi xed deposit + se-curities

3. Cash + fi xed deposits only

4. 30% cash and fi xed deposits + 70% bankguarantee and securities

A: The correct answer 2. ��


References/suggested readings

The readings suggested here are supplementary in nature and would prove to be helpful for thoseinterested in learning more about derivatives.

1. Derivatives FAQby Ajay Shah and Susan Thomas

2. Escape to the futuresby Leo Melamed

3. Futures and optionsby Hans R.Stoll and Robert E. Whaley.

4. Futures and options in risk managementby Terry J. Watsham.

5. Futures, options and swapsby Robert W. Kolb.

6. Indian Securities Market Review,2001, National Stock Exchange

7. Introduction to futures and options marketsby John Kolb

8. NSENEWS, National Stock Exchange

9. Options and financial future: Valuation and usesby David A. Dubofsky.

10. Regulatory framework for financial derivatives in Indiaby Dr.L.C.Gupta Committee

11. Risk containment in the derivatives marketby Prof.J.R.Varma group

12. Rubinstein on derivativesby Mark Rubinstein.

13. Rules, regulations and bye– laws, (F &O segment)of NSE & NSCCL

14. Understanding futures marketsby Robert W. Kolb.

15. http://www.derivativesindia.com

16. http://www.derivatives-r-us.com

17. http://www.igidr.ac.in./� ajayshah

18. http://www.mof.nic.in

19. http://www.nseindia.com

20. http://www.rediff/money/derivatives

21. http://www.sebi.gov.in

Index

arbitragetransactions costs in, 86

arbitrageurs, 8

basis, 32basket trading, 158baskets, 9beta

portfolio, 70security, 61

clearing member, 151trading, 14professional, 14self, 14

contract cyclefutures, 159

cost-of-carry, 49

derivativesexchange traded, 12OTC, 12

Exchange Traded Fund, 26

financial derivatives, 29forwards, 29futures, 8

commodity, 50index, 51individual security, 54

hedgers, 8

impact cost, 24on futures market, 86

indexequally weighted, 20

funds, 25Market capitalization weighted, 20price weighted, 20S&P CNX Nifty, 23

inquiry window, 156inter-futures trading, 90

LEAPS, 9

market by price, 156market watch, 156

optionamerican, 33at-the-money, 33buyer, 33call, 33european, 33in-the-money, 33index, 33intrinsic value, 34out-of-money, 33premium, 33put, 33stock, 33time value, 34writer, 33

orderday, 155GTC, 155GTD, 155IOC, 155stop–loss, 155

pricelimit, 155trigger, 155

212 INDEX

pricingindex options, 101options on individual security, 102

put-call parity, 131

speculators, 8spot price, 31spreads trading, 90strike price, 102swaps, 9

currency, 9interest rate, 9

swaptions, 9

warrants, 9

151-212

Documents

Transcript of 151-212