DeepakGupta 0348 Risk+Containment+Measure+in+Indian+Stock+Index+Futures+Market

8/6/2019 DeepakGupta 0348 Risk+Containment+Measure+in+Indian+Stock+Index+Futures+Market

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M P Birla Institute of Management

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DECLERATION

I here by declare that, this Project Report entitled Risk Containment MeasureIn Indian Stock Index Futures Market has been undertaken and completed by meunder the valuable guidance of Prof. Santhanam in partial fulfillment of degree of Master of Business Administration (MBA) program.

Place: BangaloreDate: P.K. DEEPAK GUPTA

Reg No. 03XQCM6026


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PRINCIPALS CERTIFICATE

This is to certify that Mr. Deepak Gupta P.K has undertaken Project Work on RiskContainment Measure In Indian Stock Index Futures Market under the ableguidance of Prof. Santhanam,

Place: BangaloreDate: Dr. Nagesh Mallavalli

(Principal)


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GUIDES CERTIFICATE

This is to certify that the Project Work report titled Risk Containment Measure InIndian Stock Index Futures Market has prepared by Mr. Deepak Gupta P.K bearingregistration number 03XQCM6026 , under my guidance.

Place: BangaloreDate: Prof. Santhanam


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ACKNOWLEDGEMENT

I would like to express my sincere gratitude to my project guide Prof.Santhanam, who guided me through the entire project.

Also I would like to thank Bangalore Stock Exchange, my friends and also mycollege who have helped me in completing this project and also for having given me thisopportunity.

DEEPAK GUPTA P.K


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EXECUTIVE SUMMARY

The project starts off with the History of Derivatives in India, which

includes Events that made the launch of Derivatives in India .

Then the project goes on to the Performance of Commondity

Exchanges in India. The initial move is the analysis of Risk Containment

and related issues taking into considerations LC Gupta and Varma

Committee reports.

The project also states some risk management strategies implemented

to manage risk in futures market.


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DERIVATIVES IN INDIA

In the Indian context, the securities contracts (regulation) Act 1956, (SCRA) derivative

includes

A security derived from a debt instrument, share and 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 price or index of prices, of underlyingsecurities.

The Bombay Stock Exchange and National Stock Exchange launched trading in Index

Futures in June 2000. This marked the beginning of exchange traded financial

derivatives in India.

We had a strong Dollar Rupee Forward markets with contracts being traded for 1 to 6

months. The daily trading volume here was approximately US $ 500 million.

Motivation to use derivatives

The real motivation to use derivatives is that they are useful in reallocating risk either

across time or across individuals with different risk bearing preferences.


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Types of Derivatives

Derivatives are basically classified into two based upon the mechanism that is

used to trade on them. They are Over the Counter derivatives and Exchange traded

derivatives. The OTC derivatives are between two private parties and are designed to suit

the requirements of the parties concerned. The Exchange traded ones are standardized

ones where the exchange sets the standards for trading by providing the contract

specifications and the clearing corporation provides the trade guarantee and the

settlement activities

" !"

EVENTS THAT MADE THE LAUNCH OF DERIVATIVES IN INDIA

November 1996, SEBI set up a committee under the chairmanship of Dr. L C

Gupta, the well known economist and former SEBI Board Member.

The Committee submitted its report on the March 17 1998. It advocated the

introduction of derivatives in Indian market in a phased manner, starting with the

Index Futures.

SEBI accepted the report on May 11, 1998 and June 16, 1998, it issued a

circulation allowing exchanges to submit their proposals for introduction of

derivative trading.

Government issued notification delineating the areas of responsibility between

RBI and Market Regulator SEBI.

On June 2000, derivative trading started in NSE and BSE.


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What is the role of commodity futures market and why do we needthem?

One answer that is heard in the financial sector is ` we need commodity futures

markets so that we will have volumes, brokerage fees, and something to trade' ' . I think

that is missing the point. We have to look at futures market in a bigger perspective --

what is the role for commodity futures in India' s economy?

In India agriculture has traditionally been a area with heavy government

intervention. Government intervenes by trying to maintain buffer stocks, they try to fix

prices, they have import-export restrictions and a host of other interventions. Many

economists think that we could have major benefits from liberalization of the agriculturalsector.

In this case, the question arises about who will maintain the buffer stock, how will

we smoothen the price fluctuations, how will farmers not be vulnerable that tomorrow the

price will crash when the crop comes out, how will farmers get signals that in the future

there will be a great need for wheat or rice. In all these aspects the futures market has a

very big role to play.

If you think there will be a shortage of wheat tomorrow, the futures prices will go

up today, and it will carry signals back to the farmer making sowing decisions today. In

this fashion, a system of futures markets will improve cropping patterns.

Next, if I am growing wheat and am worried that by the time the harvest comes

out prices will go down, then I can sell my wheat on the futures market. I can sell my

wheat at a price which is fixed today, which eliminates my risk from price fluctuations.

These days, agriculture requires investments -- farmers spend money on fertilizers, high

yielding varieties, etc. They are worried when making these investments that by the time

the crop comes out prices might have dropped, resulting in losses. Thus a farmer would

like to lock in his future price and not be exposed to fluctuations in prices.


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The third is the role about storage. Today we have the Food Corporation of India

which is doing a huge job of storage, and it is a system which -- in my opinion -- does not

work. Futures market will produce their own kind of smoothing between the present and

the future. If the future price is high and the present price is low, an arbitrager will buy

today and sell in the future. The converse is also true, thus if the future price is low the

arbitrageur will buy in the futures market. These activities produce their own "optimal"

buffer stocks, smooth prices. They also work very effectively when there is trade in

agricultural commodities; arbitrageurs on the futures market will use imports and exports

to smooth Indian prices using foreign spot markets.

In totality, commodity futures markets are a part and parcel of a program for

agricultural liberalization. Many agriculture economists understand the need of liberalization in the sector. Futures markets are an instrument for achieving that

liberalization.

What about futures in bullion?

Futures in gold will be useful, since millions of people in India use gold as a

financial asset and are exposed to fluctuations in the price of gold.

In addition, it' s very easy to start a gold futures market. Gold is a natural

commodity where we should be dealing with warehouse receipts -- banks have already

started giving gold depositories receipts, which clearing corporations would be

comfortable relying upon. A market like NSE could start trading in Gold futures with just

a few weeks of preparation.

Obviously the consent of regulators will be required to getting such trading off the

ground. Remarkably enough, it may not be necessary that we should have a gold futures

market in India. There are several well functioning gold futures market outside India.

Maybe we should just use them


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PERFORMANCE OF COMMONDITY EXCHANGES

Year 2002-03 witnessed a surge in volumes in the commodity futures markets in

India. The 20 plus commodity exchanges clocked a volume of about Rs. 100,000 crore in

volumes against the volume of 34,500 crore in 2001-02 remarkable performance for an

industry that is being revived! This performance is more remarkable because the

commodity exchanges as of now are more regional and are for few commodities namely

soybean complex, castor seed, few other edible oilseed complex, pepper, jute and gur.

Interestingly, commodities in which future contracts are successful are

commodities those are not protected through government policies; and trade constituents

of these commodities are not complaining too. This should act as an eye-opener to thepolicy makers to leave pricing and price risk management to the market forces rather than

to administered mechanisms alone. Any economy grows when the constituents willingly

accept the risk for better returns; if risks are not compensated with adequate or more

returns, economic activity will come into a standstill.

With the value of Indias commodity economy being around Rs. 300,000 crore a

year potential for much greater volumes are evident with the expansion of list of

commodities and nationwide availability. Opening up of the world trade barriers would

mean more price risk to be managed. All these factors augur

well for the future of futures.

WAY AHEAD FOR COMMONDITY EXCHANGE

Commodity exchanges in India are expected to contribute significantly in

strengthening Indian economy to face the challenges of globalization. Indian markets are

poised to witness further developments in the areas of electronic warehouse receipts

(equivalent of dematerialized shares), which would facilitate seamless nationwide spot


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market for commodities. Amendments to Essential Commodities Act and implementation

of Value-Added-tax would enable movement of across states and more unified tax

regime, which would facilitate easier trading in commodities. Options contracts in

commodities are being considered and this would again boost the commodity risk

management markets in the country. We may see increased interest from the international

players in the Indian commodity markets once national exchanges become operational.

Commodity derivatives as an industry are poised to take-off which may provide the

numerous investors in this country with another opportunity to invest and diversify their

portfolio. Finally, we may see greater convergence of markets equity, commodities,

forex and debt which could enhance the business opportunities for those have

specialized in the above markets. Such integration would create specialized treasuries and

fund houses that would offer a gamut of services to provide comprehensive risk

management solutions to Indias corporate and trade community.

In short, we are poised to witness the resurgence of Indias commodity trading

which has more than 100 years of great history.

FACTORS DRIVING THE GROWTH OF FINANCIAL

DERIVATIVES IN INDIA

Increased volatility in asset prices in financial markets.

Increased integration of national financial markets with international markets.

Marked improvement in communication facilities and sharp decline in the costs.

Development of more sophisticated risk management tools, providing ecomomic

agents a wider choice of risk management strategies.

Innovation in derivatives market, which optimally combine the risks and return

over a large number of financial assets, leading to higher return, reduced risk as

well as transaction costs as compared to individual financial assets


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POPULARITY OF STOCK INDEX FUTURES

There are many reasons for the wide international acceptance of stock index futures

and for the strong preference for this instrument in India too compared to other forms of

equity derivatives. This is because of the following advantages of stock index futures :

1. Institutional and other large equity holders need portfolio hedging facility. Hence,

index-based derivatives are more suited to them and more cost-effective than derivatives

based on individual stocks. Even pension funds in U.S.A. are known to use stock index

futures for risk hedging purposes.

1. Stock index is difficult to be manipulated as compared to individual stock prices, more

so in India, and the possibility of cornering is reduced. This is partly because anindividual stock has a limited supply which can be cornered. Of course, manipulation of

stock index can be attempted by influencing the cash prices of its component securities.

While the possibility of such manipulation is not ruled out, it is reduced by designing the

index appropriately. There is need for minimizing it further by undertaking cash market

reforms, as suggested by the Committee later in this chapter.

2. Stock index futures enjoy distinctly greater popularity, and are, therefore, likely to be

more liquid than all other types of equity derivatives, as shown both by responses to the

Committees questionnaire and by international experience.

3. Stock index, being an average, is much less volatile than individual stock prices. This

implies much lower capital adequacy and margin requirements in the case of index

futures than in the case of derivatives on individual stocks. The lower margins will

induce more players to join the market.

4. In the case of individual stocks, the positions which remain outstanding on the

expiration date will have to be settled by physical delivery. This is an accepted principle

everywhere. The futures and the cash market prices have to converge on the expiration

date. Since Index futures do not represent a physically deliverable asset, they are cash

settled all over the world on the premise that the index value is derived from the cash


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would exceed 80%. This property holds, regardless of the identity of the securities which

make up the portfolio: whether a person holds index stocks or not, the index is highly

correlated with every portfolio in the country.

This fact is quite apparent when we look back at the experience of 1995 and 1996

-- every single equity investor in the country experienced poor returns in that period,

regardless of the kind of portfolio owned. This widespread correlation of the risk

exposure of investors with the index makes index derivatives very special in their risk

management.

One example will help clarify matters. Suppose a person is long ITC.

Unfortunately, by being long ITC on the cash market, he is simultaneously long ITC and

long index (ITC and the index have a 65% correlation). I.e., if the index should drop, he

will suffer, even though he may have no interest in the index when forming his position.

In this situation, this person can match his ITC exposure with an opposing position using

index futures (i.e. he would be simultaneously long ITC and short index futures) which

effectively strips out his index exposure. Now, he is truly long ITC: whether the index

goes up or down, he is unaffected, he is only taking a view on ITC. This is far closer to

his real interests and objectives, and is much less risky than present market practice (i.e.,

a pure long ITC position).

FUTURES TRADING PROCESS

Any person who wants to trade in futures has to contact a Futures Commission

Merchant (FCM) or a broker. FCM is necessarily a member of the clearing house, An

account has to be opened at his firm. You will be assigned to one of the accounts

executive, who will look after the transactions. Whenever we place an order with the

accounts executive, he will note down the order specifications and immediately transmit

to one of the floor brokers at the exchange. The floor broker will execute the order and


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reports the transaction to the clearing house. Once he received the conformation form the

clearing house, he calls back the accounts executive giving him all the details about the

trade. The accounts executive intern passes on these details to his client.

Other responsibilities of the FCM are maintaining all records and reporting the

trading activity of all his clients to the clearing house and sending the clients monthly

statement about their position and account balances.

If the account is opened with a broker who is not a member of the clearinghouse, he

should necessarily route the order through a member.

FUTURES TRADING STRATEGIES

Arbitrage with Nifty futures

Arbitrage is the opportunity of taking advantage of the price difference between

two markets. An arbitrageur will buy at the cheaper market and sell at the costlier market.

It is possible to arbitraged between NIFTY in the futures market and the cash market. If the futures price is any of the prices given below other than the equilibrium price then the

strategy to be followed is


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Note: The arbitrage opportunity arising when the futures price is underpriced to the cash

price is not feasible if the arbitrageur does not hold the scrip or borrowing of securities is

not possible in the market. This is because the delivery in the spot market comes before

the delivery in the futures market.

Hedging with NIFTY futures .

Case 1

Short Hedge

Let us assume that an investor is holding a portfolio of following scrips as given below

on 1st

May, 2001.

#% $' &) ( 0' 13 2 46 5 79 8 @B AD CF EF G HI CQ PB R C' SU TW VX G Ya `b Vc Ge dF fh g

iG P Cp fr q f s tv uF u w" x6 xF y xF x6 x" x6 x

U ' ' h ' F U W F 6 6 F F 6 " 6

" Q ' % ' ) j k ln m" o ' F 6 " 6

I { z | }n ~ |Q F F 6 " } 6

W Q ' 3 ' c p Q 3 ' ' c U 6 F F 6 F F

Trading Strategy to be followed

The investor feels that the market will go down in the next two months and wants to

protect him from any adverse movement. To achieve this the investor has to go short on 2

months NIFTY futures i.e he has to sell June Nifty. This strategy is called Short Hedge .

Formula to calculate the number of futures for hedging purposes is

Beta adjusted Value of Portfolio / Nifty Index level

Beta of the above portfolio


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=(1.55*400,000)+(2.06*200,000)+(1.95*175,000)+(1.9*125, 000)/1,000,000

=1.61075 (round to 1.61)

Applying the formula to calculate the number of futures contracts

Assume NIFTY futures to be 1150 on 1 st May 2001

= (1,000,000.00 * 1.61) / 1150

= 1400 Units

Since one Nifty contract is 200 units, the investor has to sell 7 Nifty contracts.

Short Hedge

Stock Market Futures Market

1st May Holds Rs 1,000,000.00 in

stock portfolio

Sell 7 NIFTY futures

contract at 1150.

25 th June Stock portfolio fall by 6%

to Rs 940,000.00

NIFTY futures falls by

4.5% to 1098.25

Profit / Loss Loss: -Rs 60,000.00 Profit: 72,450.00

Net Profit: + Rs 15,450.00

Case 2

Long Hedge

Let us assume that an investor feels that the market is at the beginning of a bull run. He is

expecting to get Rs 1,500,000.00 in two months time. Waiting two months to invest could


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mean that he might miss the bull run altogether. An alternative to missing the market

move is to use the NIFTY futures market. The investor could simply buy an amount of

NIFTY futures contract that would be equivalent to Rs 1,500,000.00. This Strategy is

called long hedge.

Let us assume that on 1 st May 2001 the Nifty futures stand at 1150. He expects to get Rs.

1,500,000.00 by June end. He has to buy 2months June Nifty in May. The number of

contracts he should buy is

1,500,000.00/(1150*200) = 6.52 (round to 7) contracts

Stock Market Futures Market

1st May The investor expects Rs

1,500,000.00 in two

months

Buys 7 Nifty contracts at

1150

25 June 1,500,000.00 becomes

available for investment

The markets have risen and

the June NIFTY futures

stand at 1195

The investor will invest Rs

1,500,000.00 in the market

but will not get the same

amount of shares as on 1 st

May 2001

Futures Profit: Rs

63,000.00


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INTRODUCTION TO INDIAN STOCK INDEX FUTURES MARKET

Index Futures were introduced in June 2000. A future contract is an agreement

between two parties to buy or well an asset at a certain time at a certain price. In this

market the contract is standardized.

Q b ' p D b W D W 6 W ' h { n 6 c 6 W 6

6 c ' e 3 p r c X e p 6 p W 9 I ' I p { D Q Q W ) F 3 3

p % n p e Q c c ' p ' ) ' F c ' 6 F F " !# % $& & $

' ) (" ' 1 02 & 3 4 '6 58 7 9 3 @A B C DE (F G (9 !H $ I '6 (F P 7 Q R S $9 ' T A H $U DV & $U BX WY $U 8 @` Db aG H cd " e a4 $f 7 ) C ' $g ) h 5

i9 pr qA sH t u4 vw i x4 y4 t v E xR v) 4 tF qS T H " & A T " 9 h " # A " h 8 H 9 9 G h " E & ) " & " 2 C " jk U Q A 9 l A mh

" H nA oH g E F G 9 H Y k z9 n3 {` z | }~ z d } |h |" H zR n R nA }e 6 } " nS g }h F " " F } 4 z # nA o% g } % 4 G 4 & S & 4

A % 9 A ~ T h " C R P h " F 4 9 " R F e & d E A H ) h w F g ) " 9 h 3 U & & I

The features of Future Contracts are as follows:

1. Highly liquid

2. Traded in stock exchanges

3. No presence of counter party

4. Margins paid by both buyer and seller

5. Standardized

6. Mode of delivery is cash settlement7. They enable investors/funds to hedge their long/short positions in the market, thus

reducing the risk associated with such stock holdings.

8. Also, they serve as another investment opportunity for investors looking to bet on

the markets in general.


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9. As the futures trading would be on the market index, it will be difficult for a few

operators to manipulate the price of the index futures market.

10. Stock index futures are expected to require lower capital adequacy and margin

requirements and lower brokerage costs.

11. Futures will give a sense of direction to the markets/investors.

12. Contracts are cash settled and hence no paperwork of transferring the stock either

physically or through the depository mode.

Investors can use futures to hedge their portfolio risk. Say, an investor feels that a

particular stock is undervalued. When he buys it, there are two kinds of risks. Either hisunderstanding can be wrong, and the company is really not worth more than its market

price, or the entire market moves against him and generates losses even though his

underlying idea was correct. The second outcome happens most of the time. So now with

Index futures, he will buy the stock and simultaneously short the future.

Consider another investor who had the opposite view. So he shorted the stocks and

bought the futures. If this investor is a portfolio manager, say with the view that the IT

and the Pharma sector will do well, he invests in these sectors and shorts the futures. Onthe other hand, if he feels otherwise, he can short the portfolio of IT and Pharma scrips

and buy futures.

Background

The Securities and Exchange Board of India (SEBI) appointed a committee under

the chairmanship of Dr. L. C. Gupta in November 1996 to "develop appropriate

regulatory framework for derivatives trading in India". In March 1998, the L. C. Gupta

Committee (LCGC) submitted its report recommending the introduction of derivatives

markets in a phased manner beginning with the introduction of index futures. The SEBI


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Board while approving the introduction of index futures trading mandated the setting up

of a group to recommend measures for risk containment in the derivative market in India.

Accordingly, SEBI constituted a group consisting of the following in June, 1998:

1. Prof. J.R. Varma, Chairman

2. Dr. R.H. Patil, The National Stock Exchange

3. Mr. Ravi Narain, The National Stock Exchange

4. Mr. Janak Raj, The Reserve Bank of India

5. Mr. Himanshu Kaji, The Stock Exchange, Mumbai

6. Mr. Ajit Surana, The Stock Exchange, Mumbai

7. Mr. Brian Brown, Indosuez W.I. Carr Securities

8. Mr. K.R. Bharat, Credit Suisse First Boston

9. Mr. Sarosh Irani, Jardine Fleming

10. Mr. O.P. Gahrotra, Member Secretary, SEBI

Badla v/s Futures

Badla is a system in which payment is postponed. A Badla transaction is identical

to a spot transaction in shares, financed by lending against the securities of those shares.

In other words, Badla is akin to lending and borrowing of shares and funds and is not a

variant of futures.

SIMILARITIES

Both Badla and Futures help the investor in leveraging his or her position. Hence,they attract speculative elements into the market.

By allowing for speculation, Badla and Futures improve the liquidity of the cash

markets.


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Several issues arise in the estimation of volatility are:

a. Volatility in Indian market is quite high as compared to developed markets.

b. The volatility in Indian market is not constant and is varying over time.

2. CALANDER SPREADS

In developed markets, calendar spreads are essentially a play on interest rates with

negligible stock market exposure. As such margins for calendar spreads are very low.

However, in India, the calendar basis risk could be high because of the absence of

efficient index arbitrage and the lack of channels for the flow of funds from the organised

money market into the index futures market.

H U H 9 H r S H 3 9 f U " A 9 F F I H 4 & 9 9 G & C V H S G 9 9 G 9 U G S H ) C 9 E H 9

H 9 E U H F U H P H g w P H P H 9 4 H ) % 9 E F R 9 d w ` G A G U 2 " G R G # g H 9 F

H g C g 9 3 A G A 9 E I V F H C S G 4 G C F G ` G C g H F H ) H 4 A F

! # "% $& '! ( 0 )1 ! $& 2 3 ! 46 57 " 48 9 3 2 A @B 'D C! $& 2 F E H G% '9 IP Q G0 $& '9 3 GR '9 0 )S 4T C3 2 U F '9 IP $U (V CU WX C! 48 Y 5` )a '9 % Wb 4c 3 )a W

@ Id WV eR 2 3 $P Ig fh 9 4c ip % q Wr R '9 s Wb e0 ! s 2 t G '9 Iu Q Gv 5a es '9 4T W '9 w )S 4T C3 2 Q F '9 IP $ (b CQ WX C! 48 Y 5` )x '9 s Wb 4c 3 )y W @ e ' 5Y

2 Q $P Ig fh 9 4c ip Iu 5 Iu v 5x I '9 s Wb e3 5

3. MARGIN COLLECTION AND ENFORCEMENT

Margin is:

3 Q s c A t 9 9 a j k lR mD nb oY ! x t x o U nc kT ! Q # m3 nb ! o kT oa 0 ` n b U n nb j0 kX lF D

u D z9 {s |u } ~v }w # b ~% | }Q

% ! t p U U 9 6 s F 9 c u 3 9 A h Y c s # U ! R 9 b a U 9 X ! Q F T p Y b U

p c h D P ! t ! t a ! U c T # 9 U A u p # b % # ! a a U U 9 7


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% s T p F U Q b U D ! Y u 9 a a 9 ! s ! p q g V U U a 9 X ! Q t Q b ! % ` c

a s Q y a U u P A 3 c a 9 t a D S 6 Q b ! % T s s

Buying with borrowed money can be extremely risky because both gains and

losses are amplified. That is, while the potential for greater profit exists, this comes at ahefty price -- the potential for greater losses. Margin also subjects the investor to a

number of unique risks such as interest payments for use of the borrowed money.

9 a ! # % & x 6 u D D F s 9 d b Q X ! 8 Y ` x 9 s b c 3 a b P w v ! Q u 0 3 a x D ! % d 6 3 D Q s h F

0 ! P % V u 0 v a 9 T V ! u 0 ! 3 ! % v D U P R 3 a s ! u U 9 0 s b s ` v 3 c ! ! x D & Q t b s

a 9 % V c Q x V H S Q ! Q !

Apart from the correct calculation of margin, the actual collection of margin is

also of equal importance. Since initial margins can be deposited in the form of bank

guarantee and securities, the risk containment issues in regard to these need to be tackled.

4. CLEARING CORPORATION

It is an organization associated with an exchange to handle the confirmation,

settlement and delivery of transactions, fulfilling the main obligation of ensuring

transactions are made in a prompt and efficient manner. Also referred to as "clearing

firms" or ' clearing houses." In order to make certain that transactions run smoothly,

clearing corporations become the buyer to every seller and the seller to every buyer, or, in

other words, take the off-setting position with a client in every transaction.

The clearing corporation provides novation and becomes the counter party for

each trade. In the circumstances, the credibility of the clearing corporation assumes

importance and issues of governance and transparency need to be addressed.

5. POSITION LIMIT

It is a predetermined position level set by regulatory bodies for a specific contract

or option. Position limits are created for the purpose of maintaining stable and fair


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this recommendation keeping in mind the issues relating to estimation of volatility. It is

decided that SEBI should authorise the use of a particular VAR estimation methodology

but should not mandate a specific minimum margin level.

The specific recommendations of the group are as follows:

1. INITIAL METHODOLOGY

The percentage of the purchase price of securities (that can be purchased on

margin) which the investor must pay for with their own cash or marginable securities.

Also called the initial margin requirement.

According to Regulation T of the Federal Reserve Board, the initial margin iscurrently 50%. This level is only a minimum and some brokerages require you to deposit

more than 50%.

For futures contracts, initial margin requirements are set by the exchange.

2. PERIODIC REPORTING

The committee recommended that the derivatives exchange and clearing

corporation should be required to submit periodic reports (quarterly or half-yearly) to

SEBI regarding the functioning of the risk estimation methodology highlighting the

specific instances where price moves have been beyond the estimated 99% VAR limits.

3 CONTINOUS REFINING

It also recommended that the derivatives exchange and clearing corporation

should be encouraged to refine this methodology continuously on the basis of further

experience. Any proposal for changes in the methodology should be filed with SEBI and

released to the public for comments along with detailed comparative back testing results

of the proposed methodology and the current methodology. The proposal shall specify


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the date from which the new methodology will become effective and this effective date

shall not be less than three months after the date of filing with SEBI. At any time up to

two weeks before the effective date, SEBI may instruct the derivatives exchange and

clearing corporation not to implement the change, or the derivatives exchange and

clearing corporation may on its own decide not to implement the change.

The group recommends that the clearing corporation / clearing house shall be

required to disclose the details of incidences of failures in collection of margin and / or

the settlement dues at least on a quarterly basis. Failure for this purpose means a shortfall

for three consecutive trading days of 50% or more of the liquid net worth of the member.

RISK CONTAINMENT MEASURES

The parameters for risk containment model shall include the following:

1. Initial Margin or Worst Scenario Loss

The Initial Margin requirement shall be based on the worst scenario loss of a

portfolio of an individual client to cover 99% VaR over one day horizon across

various scenarios of price changes, based on the volatility estimates, and volatility

changes. The estimate at the end of day t (SDt) shall be estimated using the previous

volatility estimate i.e., as at the end of t-1 day (SDt), and the return (rt) observed in

the futures market during day t. The formula shall be

6'W A 6'W-1)+(1- UW A

Where:

DSDUDPHWHU ZKLFKGHWHUPLQHVKRZUDSLGO\YRODWLOLW\HVWLPDWHVFKDQJH

YDOXHRI LVIL[HGDW

SD = Standard deviation of daily returns in the interest rate futures contract.


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At the level of the FII

- In the case of index related derivative products, the position limit is 15%

of open interest in all futures and options contract on a particular

underlying index, or Rs. 100 crore, whichever is higher.

- In case of underlying security, the position limit is 7.5 % of open interest,

in all 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 acting in concert who together own 15% or more of the openinterest of all futures and options contracts on a particular underlying

index on the exchange.

- In case of futures and option contracts on securities the gross open

position across all futures and options contracts on a particular underlying

security of a sub account of an FII, should not exceed the higher or 1% of

the free float market capitalization (in terms of number of shares) or 5% of

the open interest in the derivative contracts on a particular underlyingstock (in terms of number of contracts). These position limits are

applicable on the combined position in all futures and options contracts

on an underlying security on the exchange.

-

If people trade on foreign derivatives exchanges, won' t that hurt theinterests of India' s exchanges?


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From the viewpoint of India' s securities industry, it would be great to trade gold

futures -- it would yield revenues and it would raise sophistication. If that can be

achieved, it would be great, but it looks like it will take a while for the regulatory

apparatus to permit gold futures in India.

From the view point of the Indian economy -- and the economy is much more

than the securities industry -- the important point is not the colour of the skin. It does not

matter whether an Indian or a foreigner is running the exchange. The important point is to

have access to these products. There are many situations where we would be better off by

merely giving permissions to Indian to go abroad and trade in these markets.

Why do we take it for granted that we have to wait for India' s markets to develop.

Witness the two year delay in getting an index futures market started -- these delays force

India' s households and companies to continue to live with risk. India' s economy will

benefit from having access to derivatives, whether they are come about through India' s

regulators and exchanges or not. If the Singapore government is friendly to derivatives

markets in a way that India' s government is not, India' s citizens should go ahead and

reduce their risk by using futures markets in Singapore.

Hence we should not approach commodity derivatives looking only at the Indiansecurities industry. The interest of Indian consumers, households and producers is more

important, as these are the people who are exposed to risk and price fluctuations. To the

extent that foreign derivatives markets can reduce the risk for Indians, this is good.

The RBI has recently released the R. V. Gupta committee report on these issues.

It is an excellent piece of work, which paves the way for Indians to benefit from using

foreign commodity futures markets. I think that this report is going to be a milestone in

the history of India' s financial sector.


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SEBI REGULATIONS OF 1992

(BROKER AND SUB-BROKERS)

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

SEBI Regulations.

BROKERS:

A broker is an intermediary who arranges to buy and sell securities on behalf of

clients. According to section 2 (c) of the SEBI rules, a stock broker means a member of a

recognized stock exchange. No stock broker is allowed to buy or sell or deal in

securities, unless he or she holds a certificate of registration granted by SEBI. A stock

broker applies for registration to SEBI through a stock exchange or stock exchanges of

which he or she is admitted as a member. SEBI may grant a certificate to a stock broker

subject to the condition that:

He holds the membership of any stock exchange.

He shall abide by the rules. Regulations and bye-laws of the stock exchange or

stock exchanges of which he is a member.

In case of any change in the status and constitution, he shall obtain prior

permission of SEBI to continue to buy, sell or deal in securities in any stock

exchange He shall pay the amount of fee for registration in the prescribed manner

He shall take adequate steps for redressal of grievances of the investor with in one

month of the date of the receipt of the complaint and keep SEBI informed about

the member, nature and other particulars of the complaints.


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REGULATION FOR DERIVATIVES TRADING

SEBI setup a 24 member committee under the chairmanship of Dr. L.C. Gupta todevelop the appropriate regulatory framework for derivatives trading in India.

The committee submitted its report in March 1998. On may 11, 1998 SEBI

accepted the recommendations of the committee and approved the phased introduction of

derivatives trading in India beginning with stock index futures. SEBI also approved the

Suggestive by-laws recommended by the committee for regulation and control of

trading and settlement of derivatives contracts.

The provisions for SC( R ) A and regulatory framework developed their undergovern

trading 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 the Act.

Any Exchange fulfilling the eligibility criteria as prescribed in the LC Gupta

committee report may apply to SEBI for grant of recognition under Section 4 of the SC( R)A, 1956 to start trading derivatives. The derivatives exchange/segment

should have a separate governing council and representation of trading/clearing

member shall be limited to maximum of 40% of the total members of the

governing council. The exchange shall regulate the sales practices of its members

and will obtain prior approval of SEBI before start of trading in any derivative

contract.

The exchange shall have minimum 50 members.

The members of an existing segment of the exchange will not automatically

become the members of derivative segment. The embers of the derivative

segment need to fill the eligibility conditions as laid down by the LC Gupta

committee.


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The clearing and settlement of derivatives trades shall be through a SEBI approval

clearing corporation/house. Clearing corporation/house complying with the

eligibility as laid down by the committee have to apply to SEBI grant of approval.

Derivative brokers/dealers and clearing members are required to seek registration

from SEBI. This is in addition to their registration as broker of existing stock

exchange. The minimum net worth for clearing member of the derivatives

clearing corporation/house shall be Rs. 300 lakhs.

The net worth of the member shall be computed as follows:

Capital + Free reserves

Less: non-allowable assets viz.,

(a) Fixed assets

(b) Pledged securities

(c) Members 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

The minimum contract value shall not be less than Rs. 2 lakhs. Exchanges

should also submit details of the futures contract they propose to

introduce.

The initial margin requirement, exposure limits linked to capital adequacy

and margin demands related to the risk of loss on the position shall be

prescribe by SEBI/Exchange from time to time.

The LC Gupta committee report requires strict enforcement of Know

your customer rule and requires that every client shall be registered with

the derivatives broker. The members of the derivatives segment are also


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required to make their clients aware of the risks involved in derivatives

trading by issuing to the client Risk Disclosure Document and obtain a

copy of the same duly signed by the client.

The trading member are required to have qualified approval user and sales

person who have passed a certification program approved by SEBI.

REGULATION FOR RISK MANAGEMENT

The following risk management measures have been prescribed by SEBI:

1. Liquid Networth Requirement:

The clearing members minimum li quid net worth must be at least Rs. 50 lakh at

any point of time.

2. Initial Margin Computation:

A portfolio based margining approach has been adopted which takes an integrated

view of the risk involved in the portfolio of each individual client comprising of hisposition in all derivative contracts. The initial margin requirement are based on worst

scenario loss of a portfolio of an individual client to cover 99% VAR over one day time

horizon. Provided, however, in the case of futures, where it may not be possible to collect

the mark to market settlement value, before the commencement of trading on the next

day, the initial margin may be computed over a two day time horizon, applying the

appropriate statistical formula. The methodology for computation of Value at Risk is as

per recommendation of SEBI from time to time.

Initial margin requirements for a member are as follows:


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a. For client positions It shall be netted at the level of individual client and grossed

across all clients, at the Trading/Clearing Member Level, without any setoffs

between clients.

b. For proprietary position It shall be betted at Trading/Clearing Member Level

without any setoffs between client and proprietary positions.

For the purpose of SPAN margin, various parameters shall be specified hereunder or such

other parameters as may be specified by the relevant authority form time to time:

Calendar Spread Charge: Calendar Spread Charge covers the calendar

(inter-month etc.,) basis risk that may exist for portfolios containing

futures and options with different expirations. In the case of Futures and

Options contracts on Index and Individual securities, the margin on

calendar spread shall be calculated on the basis of delta of the portfolio

consisting of futures and options contracts in each month.

A calendar spread position shall be treated as non spread (naked) positions

in the far month contract, 3 trading days prior to expirations of the near

month contract.

Premium Margin: Premium Margin shall mean and include premiumamount due to be paid to clearing corporation towards premium

settlement, at client level. Premium Margin for a day shall be levied till

the completion of pay in towards the premium settlement.

Position Limit: Position limit have been specified by SEBI at trading

member, client, market and FII level respectively;

Trading Member Position Limit: There is a position limit in derivative

contracts on an index of 15% of the open interest of all derivative

contracts on the same underlying or Rs. 100 crore, whichever is higher, in

all the futures and options contracts on the same underlying. The trading

member positions limits is linked to the market wide position limit is less

than or equal to Rs. 250 crore, the trading member limit in such securities

shall be 20% of the market wide position limit. For securities, in which


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the market wide position limit is greater than Rs. 250 crore, the trading

member position limit in such stocks shall be Rs. 50 crore.

The position of all FII/Sub accounts shall be monitored at the end

of the day for limits of 7.5% of the open interest of all derivative contracts

on the same underlying or Rs. 50 crore, whichever is higher, in all the

futures and option contracts on the same underlying security as per

existing applicable position limits.

For futures contracts open interest shall be equivalent to the open

positions in that futures contract multiplied by its last available closing

price.

Market Wide Position Limits: The market wide limit of open position on

all futures on a particular stocks shall be lower of 30 times the average

number of shares traded daily, during the previous calendar month, in the

relevant underlying security in the underlying segment of the relevant

exchange, or, 10% of the number of shares held by non-promoters in the

relevant underlying security i.e., 10% of the free float, in terms of number

of shares of a company.

RISK MANAGEMENT DEVELOPED BY 16&&/

NSCCL has developed a comprehensive risk containment mechanism for the F&O

segment. The sailent features of risk containment mechanism on the F&O segment are:

The financial soundness of the members is the key to risk management.

Therefore, the requirement for membership in terms of capital adequacy (net

worth, security deposits) are quite stringent.

NSCCL charges an upfront initial margin for all the open positions of a CM. It

specifies the initial margin requirement for each futures contract on a daily basis.

It also follows value at risk (VAR) based margining through SPAN. The CM is

turn collects the initial margin from the TMs and their respective clients.


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The stock should be amongst the top 200 scrips, on the basis of average market

capitalization during the last six months and the average free float market

capitalization should not be less than Rs. 750 crore. The free float market

capitalization means the non-promoter holding in the stock.

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 in the underlying cash market.

The stock should be traded on atleast 90% of the trading days in the last six

months, with the exception of cases in which a stock is unable to trade due to

corporate actions like de-mergers etc.,

The non promoter holding in the company should be at least 30%. The ratio of the daily volatility of the stock vis--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 six months. For this purpose the volatility would be

computed as per the exponentially weighted moving average formula.

The stock on which options contracts are permitted to be traded on one derivative

exchange/segment would also be permitted to trade on other derivative

exchange/segments.

VALUE AT RISK MODELS IN THE INDIAN STOCK MARKET

1. The Exponentially Weighted Moving Average Method

The successful use of value at risk models is critically dependent upon estimates of

the volatility of underlying prices. The principal difficulty is that the volatility is not

constant over time - if it were, it could be estimated with very high accuracy by using a


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sufficiently long sample of data. Thus models of time varying volatility become very

important. Practitioners have often dealt with time varying parameters by confining

attention to the recent past and ignoring observations from the distant past.

Econometricians have on the other hand developed sophisticated models of time varying

volatility like the GARCH (Generalised Auto-Regressive Conditional Heteroscedasticity)

model.

Straddling the two are the exponentially weighted moving average (EWMA) methods

popularised by J. P. Morgans Risk Metrics system. EWMA methods can be regarded as

a variant of the practitioners idea of using only the recent past because the practitioners

idea is essentially that of a simple moving average where the recent past gets a weight of

one and data before that gets a weight of zero. The variation in EWMA is that the

observations are given different weights with the most recent data getting the highest

weight and the weights declining rapidly as one goes back. Effectively, therefore,

EWMA is also based on the recent past, in fact, it is even more responsive than the

simple moving average to sudden changes in volatility. EWMA can also be regarded as a

special case of GARCH in which the persistence parameter is set to unity. This means

that unlike GARCH, EWMA does not have a notion of long run volatility at all and is

therefore more robust under regime shifts.

EWMA is computationally very simple to implement (even simpler than a simple

moving average). The volatility at the end of day t, W LVHVWLPDWHGXVLQJWKHSUHYLRXV

volatility estimate SDt-1 (as at the end of day t-1), and the return rt observed in the index

during day t:

6'W A 6'W-1)^2 + (1 - UW A

ZKHUH LVDSDUDPHWHU ZKLFKGHWHUPLQHVKRZUDSLGO\YRODWLOLW\HVWLPDWHVFKDQ


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2. Empirical Tests on the Indian Stock Market

3.

Whatever intuitive or theoretical merits a value at risk model may have, the

ultimate test of its usability is how well it holds up against actual data. For example,

tentative results3 indicate that foreign exchange markets in India are best modelled by

processes that allow jumps and that EWMA methods do not perform well in that market

at all. Empirical tests of the EWMA model in the Indian stock market are therefore of

great importance. The EWMA model was therefore tested using historical data on the

Indian stock market indices - the NSE-50 Index (Nifty) and the BSE-30 Index (Sensex).

2.1 Sample Period

The data period used is from July 1, 1990 to June 30, 1998. The long sampleperiod reflects the view that risk management studies must attempt (wherever possible) to

cover at least two full business cycles (which would typically cover more than two

interest rate cycles and two stock market cycles). It has been strongly argued on the other

hand that studies must exclude the securities scam of 1992 and must preferably confine

itself to the period after the introduction of screen based trading (post 1995).

The view taken in this study is that the post 1995 period is essentially half a

business cycle though it includes complete interest rate and stock market cycles. The post

1995 period is also an aberration in many ways as during this period there was a high

positive autocorrelation in the index which violates weak form efficiency of the market.

(High positive autocorrelation is suggestive of an administered market; for example, we

see it in a managed exchange rate market). The autocorrelation in the stock market was

actually low till about mid 1992 and peaked in 1995-96 when volatility reached very low

levels. In mid-1998, the autocorrelation dropped as volatility rose sharply. In short there

is distinct cause for worry that markets were artificially smoothed during the 1995-97

periods.

Similarly, this study takes the view that the scam is a period of episodic volatility

(event risk) which could quite easily recur. If we disregard issues of morality and legality,


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the scam was essentially a problem of monetary policy or credit policy. Since both the

bull and bear sides of the market financed themselves through the scam in roughly equal

measure, the scam was roughly neutral in terms of direct buy or sell pressure on the

market. What caused a strong impact on stock prices was the vastly enhanced liquidity in

the stock market. The scam was (in its impact on the stock market) essentially equivalent

to monetary easing or credit expansion on a large scale. The exposure of the scam was

similarly equivalent to dramatic monetary (or credit) tightening. Any sudden and sharp

change in the stance of monetary policy can be expected to have an impact on the stock

market very similar to the scam and its exposure. A prudent risk management system

must be prepared to deal with events of this kind.

2.2 Logarithmic ReturnThe usual definition of return as the percentage change in price has a very serious

problem in that it is not symmetric. For example, if the index rises from 1000 to 2000, the

percentage return would be 100%, but if it falls back from 2000 to 1000, the percentage

return is not -100% but only -50%. As a result, the percentage return on the negative side

cannot be below - 100%, while on the positive side, there is no limit on the return. The

statistical implication of this is that returns are skewed in the positive direction and the

use of the normal distribution becomes inappropriate.

For statistical purposes, therefore, it is convenient to define the return in

logarithmic terms as rt = ln(It/It-1) where It is the index at time t. The logarithmic return

can also be rewritten as rt = ln(1+Rt) where Rt is the percentage return showing that it is

essentially a logarithmic transformation of the usual return. In the reverse direction, the

percentage return can be recovered from the logarithmic return by the formula, Rt =

exp(rt)-1. Thus after the entire analysis is done in terms of logarithmic return, the results

can be restated in terms of percentage returns. It is worth pointing out that the percentage

return and the logarithmic return are very close to each other when the return is small in

magnitude. However, when there is a large return (positive or negative) the logarithmic

return can be substantially different from the percentage return. For example, in the

earlier illustration of the index rising from 1000 to 2000 and then dropping back to 1000,


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the logarithmic returns would be +69.3% and -69.3% respectively as compared to the

percentage returns of +100% and -50% respectively.

2.3 Maximum Likelihood Estimation

7KH(:0$PHWKRGUHTXLUHVWKHVSHFLILFDWLRQRI WKHYDOXHRI 2QHFDQHVWLPDWHitself statistically by the method of maximum likelihood. This process yielded an estimate

for RI IRU WKH1Lfty and 0.929 for the Sensex. These values are not statisticallyVLJQLILFDQWO\GLIIHUHQW IURPWKHYDOXHRI IRU XVHGLQ- 3 0RUJDQV5LVN0HWULFV

V\VWHPIRU GDLO\KRUL]RQV 7KHOLNHOLKRRGUDWLRWHVW JLYHVFKL-squares with 1 df of 1.89for the Sensex and 4.46 for the Nifty which are not significant at the 1% level even

though we have a sample size of over 1750). The analysis was therefore carried out using

D RI WRSHUPLW HDVLHU FRPSDUDELOLW\DQGIDFLOLWDWHIXUWKHU H[WHQVLRQVW. 2.4 Conditional Normality

It is well known that stock market returns are not normally distributed even if one

uses logarithmic returns to induce symmetry. However, the time varying volatility itself

is one major cause for non-normality. It is to be expected therefore that the conditional

distribution of the return given the volatility estimate is approximately normal. In other

words, the returnon each day divided by the estimated standard deviation for that day

should be roughly normally distributed. The results do indicate significant reduction in

non normality. The unconditional distribution has an excess kurtosis6 of 5.42 for Nifty

and 4.77 for Sensex while the conditional distribution has an excess kurtosis of only

1.75 for Nifty and 1.13 for Sensex. Thus over two-thirds of the excess kurtosis is

eliminated by the time varying volatility estimation process.

Nevertheless, the kurtosis (which is a measures the fat tails) is still too large for

use of the normal distribution values without modification. For example, the normal

distribution would imply applying a value of 2.58 SD IRU DWZRVLGHGYDOXHDW ULVNOLPLWof 1%. However, the presence of fat tails even in the conditional stock market returns

implies that it is necessary to use a higher value to get the same degree of protection. A


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tabulated below while year by year details of the sell side and buy side margins are given

in Tables 1 and 2.

REGULATORY FRAMEWORK FOR DERIVATIVES

REGULATORY OBJECTIVE

(a). Investor protection: Attention needs to be given to the following four aspects:

(i) Fairness and Transparency: The trading rules should ensure that trading isconducted in a fair and transparent manner. Experience in other countries shows that in

many cases, derivatives brokers/dealers failed to disclose potential risk to the clients. In

this context, sales practices adopted by dealers for derivatives would require specific

regulation. In some of the most widely reported mishaps in the derivatives market

elsewhere , the underlying reason was inadequate internal control system at the user firm

itself so that overall exposure was not controlled and the use of derivatives was for

speculation rather than for risk hedging. These experiences provide useful lessons for us

for designing regulations.

(ii) Safeguard for clients money:

Moneys and securities deposited by clients with the trading members should not only be

kept in a separate clients account but should also not by attachable for meeting the

brokers own debts. It should be ensured that trading by dealers on account is totally

segregated from that for clients.

(iii) Competent and honest service:

The eligibility criteria for trading members should be designed to encourage competent

and qualified personnel so that investors/clients are served well. This makes it necessary


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BSE can square his position on that exchange on or before Friday and simultaneously buy

on NSE. Since he has squared up on BSE, he does not have to take delivery there. On or

before Tuesday, he can square up on NSE and buy on BSE avoiding delivery at NSE. He

can keep repeating this cycle as long as he likes. Since this is very similar to carry

forward trading (or rolling a futures contract), it is clear that this person would implicitly

pay a carry forward charge (contango or backwardation) in the form of a price difference

between the two exchanges.

To model this, this study assumes that a trade in the BSE could be regarded as a

futures contract for Friday expiry while a trade on the NSE could be regarded as a futures

contract for Tuesday expiry. The cost of carry model of futures prices tells us that the

futures price equals the cash price plus the cost of carry till the expiry date. Two futurescontract with different expiry dates will be priced to yield a price difference equal to the

cost of carry for the difference between the two expiry dates.

The table below summarises the impact of the differing settlement cycles.

(Throughout this study, day means trading day and yesterday means last trading day).

Days of week YesterdayDays to expiry

TodayDays to expiry

Change indifferential

BSE NSE DIFF. BSE NSE DIFF Days to expiry

Monday 0 2 -2 4 1 3 5

Tuesday 4 1 3 3 0 3 0

Wednesday 3 0 3 2 4 -2 -5

Thursday 2 4 -2 1 3 -2 0

Friday 1 3 -2 0 2 -2 0

The last column of this table is crucial. It tells us that the relation between BSE and NSE

undergoes a change on Monday and Wednesday.


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From Friday close to Monday close the BSE contract changes from an expiry 2 days

ahead of NSE to an expiry 3 days after NSE - a net positive change of 5 trading days or

one week. From being priced two days carry below NSE, the BSE contract will now be

priced three days carry above the NSE price causing a net change of 5 trading days or

one weeks cost of carry in the difference between the two prices. Therefore Monday' s

return on BSE should exceed that in NSE by one weeks cost of carry

Similarly from Tuesday close to Wednesday close the BSE contract changes from an

expiry 3 days after NSE to an expiry 2 days ahead of NSE - a net negative change of 5

trading days or one week. This is the reverse of the above situation and therefore

Wednesday' s return on BSE should be lower than that in NSE by one weeks cost of

carry.

To estimate the cost of carry, the Nifty index was used. The Nifty Index based on Last

Traded Prices (LTP) at the NSE was obtained from the NSE and the returns on this index

were computed. The returns on the Nifty Index was computed separately using BSE

prices for the period from January 1, 1998 to June 30, 1998.

It turns out that on average on Mondays, the return in BSE exceeds that in NSE by 0.61%while on Wednesdays, it is the other way around - the return in NSE exceeds that in BSE

by 0.71%. This implies that one weeks cost of carry is approximately 0.6 -0.7% or that

the annual cost of carry is about 30-35% on a simple interest basis or 35-45% on a

compound interest basis. These rates are far above any money market rate and indicates

very strong barriers to the flow of money into financing stock market transactions.

A closer look at Table 1 suggests a way of measuring the volatility of the cost of carry as

well:

Both on Monday close and on Tuesday close the BSE contract is for expiry 3 days after

NSE. The difference in the returns between the two exchanges is therefore only due to the

change in the cost of carry during Tuesday. Standard deviation of the differential return is


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therefore the standard deviation of daily change in 3 days' cost of carry.

Similarly the standard deviation of the differential return on Thursday and Fridays is

equal to the standard deviation of daily change in 2 days' cost of carry of carry.

The critical assumption in the above is that the differences in prices between the BSE and

NSE is due only to the difference in the two expiry dates and that various other

differences in market microstructure in the two exchanges do not have any impact. In

reality perhaps a lot of the fluctuation in the price differences is attributable to these

microstructure differences.

MARKET OUTCOME

In India derivatives are traded only on two exchanges. The details of trades on these

exchanged during 2002-03 are presented in the table below. The total exchange traded

derivatives witnessed a volume of Rs. 4423333 million during the current year as against

Rs. 1038480 million during the preceding year. While NSE accounted for about 99.4%

of total turnover, BSE accounted for less than 1%. It is believed that India is the second

largest market in the world for stock futures.

TRADE DETAILS OF DERIVATIVES MARKET

NSE BSE TOTALMonth/year

No. of

Contracts

Traded

Turnover

( Rs. mn.)

No. of

Contracts

Traded

Turnover

( Rs.

mn)

No. of

Contracts

Traded

Turnover

(Rs. mn)

OCT 02 1378088 34413 618 140 1378706 334553

NOV 02 1554551 398360 546 132 1555097 398492

DEC 02 1966839 556201 611 160 1967450 556361

JAN 03 2061155 591400 36470 6471 2097625 597871


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FEB 03 1863217 493948 39513 6848 1902730 500796

MAR 03 1950004 493317 43648 7182 1993652 500499

TOTAL

02-0316768909 4398548 138037 24785 16906946 4423333

The product wise distribution of turnover in F&O segment for the year 2002-03 is

presented in the chart below

Produ ct wise distribu tion of turnoverof F&O segm ent of NSE 2002-03

Stockoptions

23%

Stockfutures

65% Indexoptions 2%

Indexfutures

10%


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CITYWISE DISTRIBUTION OF TURNOVER OF F&O SEGMENT OF NSE 2002-03

Sl No.Location Share in Turnover

(%)

2001-02 2002-03

1 Mumbai 49.08 41.202 Delhi/Ghaziabad 24.28 20.313 Calcutta/Howrah 12.6 15.64 Cochin/Ernakulam/Parur/Kalamserry/Alwaye 2.44 .635 Ahamedabad 2.25 2.16 Chennai 2.01 2.247 Hydrabad/Secundrabad/Kukatpally 1.54 .978 Others 5.2 9.38

TOTAL 100 100

TAXABILITY OF INCOME ARISING FROM DERIVATIVE CONTRACTS

The Income Tax Act does not have any specific provision regarding taxability of

income from derivatives. Only provisions, which have an indirect bearing on derivative

transaction, are section 73(1) and 43(5). Section 73(1) provides that any loss, computed

in respect of a speculative business carried on by the assessee, shall not be set off expect

against profits and gains, if any, of any speculative business. Section (43) of the Act

defines a speculative transaction as a transaction in which contract for purchase or sale of

any commodity, including stocks and shares, is periodically or ultimately settled

otherwise than by actual delivery or transfer of the commodity or scrips. It excludes the

following types of transactions from the ambit of speculative transaction:

1. A contract in respect of stocks and shares entered into by a dealer or investor

therein to guard against loss in his holding of stocks and shares through pricefluctuations;

2. A contract entered into by a member of a forward market or a stock exchange in

the course of any transaction in the nature of jobbing or arbitrage to guard against

loss, which arise in ordinary course of business as such member.

A transaction is thus considered speculative if


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An investor who does not have the index stocks can also se the index derivatives to hedge

against the market risk as all the portfolios have a correlation with the overall movement

of the market (i.e, index).

In view of

i. practical difficulties in administration of tax for different purpose of the same

transaction,

ii. inherent nature of a derivative contract requiring its settlement otherwise than

by actual delivery,

iii. need to provide level playing field to all the parties to derivatives contracts,

and

iv. need to promote derivatives markets, the exchange-traded derivatives

contracts need to be exempted from the purview of speculative transactions.Thus must, however, be taxed as normal business income.

EFFECT OF INTRODUCTION OF INDEX FUTURES ON STOCKMARKET

VOLATILITY: THE INDIAN EVIDENCE

The Indian capital market has witnessed a major transformation and structural

change during the past one decade or so as a result of on going financial sector reforms

initiated by the Government of India since 1991 in the wake of policies of liberalization

and globalization. The major objectives of these reforms have been to improve market

efficiency, enhancing transparency, checking unfair trade practices, and bringing the

Indian capital market up to international standards. As a result of the reforms several

changes have also taken place in the operations of the secondary markets such as

automated on-line trading in exchanges enabling trading terminals of the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) to be available across the country

and making geographical location of an exchange irrelevant; reduction in the settlement

period, opening of the stock markets to foreign portfolio investors etc. In addition to

these developments, India is perhaps one of the real emerging markets in South Asian

region that has introduced derivative products on two of its principal existing exchanges


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viz., BSE and NSE in June 2000 to provide tools for risk management to investors. There

had, however, been a considerable debate on the question of whether derivatives should

be introduced in India or not. The L.C. Gupta Committee on Derivatives, which

examined the whole issue in details, had recommended in December 1997 the

introduction of stock index futures in the first place (1). The preparation of regulatory

framework for the operations of the index futures contracts took another two and a

halfyear more as it required not only an amendment in the Securities Contracts

(Regulation) Act, 1956 but also the specification of the regulations for such contracts.

Finally, the Indian capital market saw the launching of index futures on June 9, 2000 on

BSE and on June 12, 2000 on the NSE. A year later options on index were also

introduced for trading on these exchanges. Later, stock options on individual stocks were

launched in July 2001.

The latest product to enter in to the derivative segment on these exchanges is

contracts on stock futures in November 2001. Thus, with the launch of stock futures, the

basic range of equity derivative products in India seems to be complete.

Despite the existence of a well-developed stock market for over a hundred years,

trading on derivative contracts in India (index futures) started only in June 2000. It is but

natural that the market players took time to understand the intricacies involved in the

operations of these new instruments. This is clearly reflected in the growth of business in

the index futures contracts during the period June 2000 to June 2002. The growth can at

the best be said to be modest not only in terms of the number of contracts involved but

also in terms of value of such contracts.

As far as developed capital markets are concerned, a number of in-depth studies

have been carried out to examine various issues relating to financial derivatives. In recent

years, some attempts have also been made to study various aspects of index futures

relating to emerging markets . Since the introduction of index futures in India is a

recent phenomenon, there has hardly been any attempt to examine the impact of their

introduction on the underlying stock market volatility .


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3. MARGINING FOR CALENDER SPREADS:

International Markets levy very low margins on calendar spreads. A calendar

spread is a position at one maturity which hedged by an offsetting position at different

maturity like a short position in six month contract coupled with a long position in the

nine month contract. The justification for low margins is that a calendar spread is not

exposed to the market risk in underlying at all in India. However, unless banks and

institutions enter the calendar spread in a bigway, it would be possible that the cost of

carry would be driven by an unorganized money market rate as in the case of badla

market. These interest rate could be highly volatile.

4. MARGIN COLLECTION AND ENFORCEMENT:

A part from correct calculation, the actual collection of margin is also of equal

importance. The group recommended that the clearing corporation should lay down

operational guidelines on collection of margins and standard guidelines for back

office accounting at the clearing member and trading member level to facilitate the

detection of non compliance at each level.

OTHER RECOMMENDATION

From the purely regulatory angle, a separate exchange for futures trading seems to

be a neater arrangement. However, considering the constraints in infrastructure facilities,

the existing stock exchanges having cash trading may also be permitted to trade

derivatives provided they meet the minimum eligibility conditions as indicated below:

1. The trading should take place through an online screen based trading system

which also has a disaster recovery site. The per half hour capacity of the

computers and the network should be atleast 4 to 5 times of the anticipated

peak load in any half hour or of the actual peak load seen in any half hour


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TECHNICAL ANALYSIS OF TITAN INDUSTRIES LTD

This study is for making the real Futures contracts taking Titan Industries asunderlying. These contracts are mainly based on the information provided by technical

analysis. Fundamental analysis is not included as these contracts for only one month and

only technical analysis can be provided buying and selling points and the movement of

this stock in one month. Where as fundamental analysis cannot predict the market

The above Graph which indicates the price movement of Titan shows that it is in

bullish trend. This bullish is also supported by the huge volume of shares traded.

Volume generally moves along with prices, and is indicative of the intensity of a price

reaction. Both the price and volume are on the rise.


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Thus above are the indicative signs for an investor to go bullish on Titan

Industries Ltd., But whether to trade in Futures and Options of this underlying is yet to be

seen on further evaluation through technical analysis.

Simple Moving Average of Titan Industries Ltd

All simple moving averages 13 days, 34days and 89days does not predict any

reversal in the bullish trend. All the Moving Averages are below the price line and are

moving in the same direction as the price line there fore showing no signs of trend

reversal in near future and conforming bullishness of the stock in near future also.

As far as these simple moving averages move in the same direction and are below

the price line you can safely bet on the contracts. All this based on simple logic that as

long as price at the end of a period is above the average that prevailed in the immediate

past, prices are on an up trend. The converse is true for conforming end or a bear market.


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DeepakGupta 0348 Risk+Containment+Measure+in+Indian+Stock+Index+Futures+Market

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