Project Report On Risk Management Using Future and Option

Shri S.V.
Patel College oI Computer Science & Business Management

CONTENTS
Chapter
No.
Particulars Page
No.
1 Introduction to Derivatives
O Derivatives DeIined........................ 3
O The participants in a derivative market ................. 5
O Types oI Derivatives......................... 5
O History oI Derivatives....................... 8
O Derivative Market in India...................... 11
O Introduction to Forward Contract.................. 14
O Introduction to Futures...................... 16
O Introduction to Option....................... 19
O Pricing oI Iutures ........................ 22
O Pricing oI Options.......................... 22
Clearing & Settlement
O Clearing Banks......................... 24
O Clearing Members............................. 24
O Clearing Mechanism...................... 25
O Settlement Schedule....................... 27
O Settlement Price........................... 27
O Settlement Mechanism...................... 28
O Settlement Procedure......................... 32
Basic Pay-offs
O Pay-oII Ior Buyer oI Call option................... 32
O Pay-oII Ior Writer oI Call option................... 32
O Pay-oII Ior Buyer oI Put option..................... 33
O Pay-oII Ior Writer oI Put option....................... 34
O Pay-oII Ior Buyer oI NiIty Future.................... 35
Shri S.V. Patel College oI Computer Science & Business Management

O Pay-oII Ior Seller oI NiIty Future.................. 35
Trading in Derivative
O Future and Option trading System .................. 37
O Entities in trading System....................... 37
O Corporate hierarchy........................ 38
O Order types and condition....................... 39
The Risk Management System of Derivatives

O

O


INTRODUCTION
The term "Derivative" indicates the value which is entirely "derived" Irom the value oI the assets
such as securities, commodities, bullion, currency, live stock or anything else. In other words,
Derivative means a Iorward, Iuture, option or any other hybrid contract oI pre determined Iixed
duration, linked Ior the purpose oI contract IulIillment to the value oI a speciIied real or Iinancial
asset or to an index oI securities.
Derivatives have been included in the deIinition oI Securities in The Securities Contracts
(Regulations) Act, as a security derived Irom a debt instrument, share, loan, whether secured or
unsecured, risk instrument or contract Ior diIIerences or any other Iorm oI security; a contract
which derives its value Irom the prices, or index oI prices, oI underlying securities.
Derivatives include options and Iutures. Certain options are short-term in nature and are issued
by investors. These options may be long-term in nature and are issued by companies in the
process oI Iinancing their activities. The trading in derivatives are things oI US origin and in US
the Organized exchanges began trading in options on equities in 1973 and on debt Irom 1982.
Derivatives` initially, had its reIerence to the bank transaction when banks created deposits out
oI primary deposits. The primary deposit is received by banks and the same is lent on book
credit. The bank does not give cash to the borrower but provides him with a cheque book and
allows him to draw Ior payment. When these cheques presented in the bank, they create deposits
and they were reIerred to as the derivatives. In a similar Iashion, the stocks are traded in
exchanges either as spot delivery against payment or on Iorward market delivery on Iuture
payment. This may or may not happen, but the purpose is to prevent any Iall in price oI stocks
which is insurance the risk oI volatility in prices. The derivatives market consists oI Iorward
contract, Iutures contract, options trading and swaps market.
Derivatives Defined
Derivative is a product whose value is derived Irom the value oI one or more basic variables,
called bases underlying asset, index, or reIerence rate, in a contractual manner, the underlying
asset can be equity, Iore, commodity or any other asset. For example, wheat Iarmers may wish to
sell their harvest at a Iuture date to eliminate the risk oI a change in prices by that date. Such a

transaction is an example oI derivatives. The price oI this derivative is driven by the spot price oI
wheat which is the 'underlying.

In the Indian context the Securities Contracts Regulation Act, 19SCRA) deIines
'derivative` to include-
1. A security derived Irom a debt instrument, share, and loan whether secured or unsecured,
risk instrument or contract Ior diIIerences or any other Iorm oI security.
. A contract, which derives its value Irom the prices, or index oI prices, oI underlying
securities.

Derivatives are securities under the SCRA and hence the regulatory Iramework under the SCRA
governs the trading oI derivatives.

Structure of Derivative Markets
Derivative trading in India takes place either on a separate and independent Derivative Exchange
or on a separate segment oI an existing Stock Exchange. Derivative Exchange/Segment Iunction
as a Self-Regulatory Organization SRO) and SEBI acts as the oversight regulator. The
clearing & settlement oI all trades on the Derivative Exchange/Segment would have to be
through a Clearing Corporation/House, which is independent in governance and membership
Irom the Derivative Exchange/Segment.
Economic functions of a derivatives market:
The derivatives market perIorms a number oI economic Iunctions:
1. It helps in transIerring risks Irom risk averse people to risk oriented people.
. It helps in the discovery oI Iuture as well as current prices.
. It catalyzes entrepreneurial activity.

. It increase the volume traded in markets because oI participation oI risk averse people in
greater number.
. It increases savings and investment in the long run.
The participants in a derivative market
Hedgers
Use Iutures or options markets to reduce or eliminate the risk associated with price oI an asset.
Speculators
Use Iutures and options contracts to get extra leverage in betting on Iuture movements in the
price oI an asset. They can increase both the potential gains and potential losses by usage oI
derivatives in a speculative venture.
Arbitragers
Arbitragers are in business to take advantage oI a discrepancy between prices in two diIIerent
markets. II, Ior example, they see the Iutures price oI an asset getting out oI line with the cash
price, they will take oIIsetting positions in the two markets to lock in a proIit.
Types of Derivatives
Forwards
A Iorward contract is a customized contract between two entities, where Settlement takes place
on a speciIic date in the Iuture at today`s pre-agreed price.
Futures
A Iutures contract is an agreement between two parties to buy or sell an asset at a certain time in
the Iuture at a certain price. Futures contracts are special types oI Iorward contracts in the sense
that the Iormer are standardized exchange-traded contracts

Options
Options are oI two types - calls and puts. Calls give the buyer the right but not the obligation to
buy a given quantity oI the underlying asset, at a given price on or beIore a given Iuture date.
Puts give the buyer the right, but not the obligation to sell a given quantity oI the underlying
asset at a given price on or beIore a given date.
Warrant
Options generally have lives oI up to one year; the majority oI options traded on options
exchanges having a maximum maturity oI nine months. Longer-dated options are called warrants
and are generally traded over-the-counter.
LEAPS
The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options
having a maturity oI up to three years.
Baskets
Basket options are options on portIolios oI underlying assets. The underlying asset is usually a
moving average or a basket oI assets. Equity index options are a Iorm oI basket options.
Swaps
Swaps are private agreements between two parties to exchange cash Ilows in the Iuture
according to a prearranged Iormula. They can be regarded as portIolios oI Iorward contracts.
There are two types oI Swaps: Interest rate swaps & Currency swaps.
1. Interest rate swaps
These entail swapping only the interest related cash Ilows between the parties in the same
currency.


. Currency swaps
These entail swapping both principal and interest between the parties, with the cash Ilows in one
direction being in a diIIerent currency than those in the opposite direction.
Swaptions
Swaptions are options to buy or sell a swap that will become operative at the expiry oI the
options. Thus a swaption is an option on a Iorward swap. Rather than have calls and puts, the
swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option
to receive Iixed and pay Iloating. A payer swaption is an option to pay Iixed and receive Iloating.

Types of Derivatives
Derivatives

ICkWAkD IU1UkL C1ICNS
SWA
U1
CALL IN1LkLS1 kA1L CUkkLNC

History of Derivatives

The history oI derivatives is quite colorIul and surprisingly a lot longer than most people think.
Forward delivery contracts, stating what is to be delivered Ior a Iixed price at a speciIied place
on a speciIied date, existed in ancient Greece and Rome. Roman emperors entered Iorward
contracts to provide the masses with their supply oI Egyptian grain. These contracts were also
undertaken between Iarmers and merchants to eliminate risk arising out oI uncertain Iuture prices
oI grains. Thus, Iorward contracts have existed Ior centuries Ior hedging price risk.

The Iirst organized commodity exchange came into existence in the early 1700`s in Japan. The
Iirst Iormal commodities exchange, the Chicago Board of Trade CBOT), was Iormed in 1848
in the US to deal with the problem oI credit risk` and to provide centralized location to negotiate
Iorward contracts. From Iorward` trading in commodities emerged the commodity Iutures`.
The Iirst type oI Iutures contract was called to arrive at`. Trading in Iutures began on the CBOT
in the 1860`s. In 1865, CBOT listed the Iirst exchange traded` derivatives contract, known as
the Iutures contracts. Futures trading grew out oI the need Ior hedging the price risk involved in
many commercial operations. The Chicago Mercantile Exchange CME), a spin-oII oI CBOT,
was Iormed in 1919, though it did exist beIore in 1874 under the names oI Chicago Produce
Exchange` CPE) and Chicago Egg and Butter Board` CEBB).

The Iirst Iinancial Iutures to emerge were the currency in 1972 in the US. The Iirst Ioreign
currency Iutures were traded on May 16, 1972, on International Monetary Market (IMM), a
division oI CME. The currency Iutures traded on the IMM are the British Pound, the Canadian
Dollar, the Japanese Yen, the Swiss Franc, the German Mark, the Australian Dollar, and the Euro
dollar. Currency Iutures were Iollowed soon by interest rate Iutures. Interest rate Iutures
contracts were traded Ior the Iirst time on the CBOT on October 20, 1975. Stock index Iutures
and options emerged in 1982. The Iirst stock index Iutures contracts were traded on Kansas City
Board oI Trade on February 24, 1982.The Iirst oI the several networks, which oIIered a trading

link between two exchanges, was Iormed between the Singapore International Monetary
Exchange SIMEX) and the CME on September 7, 198.
Options are as old as Iutures. Their history also dates back to ancient Greece and Rome. Options
are very popular with speculators in the tulip craze oI seventeenth century Holland. Tulips, the
brightly coloured Ilowers, were a symbol oI aIIluence; owing to a high demand, tulip bulb prices
shot up. Dutch growers and dealers traded in tulip bulb options. There was so much speculation
that people even mortgaged their homes and businesses. These speculators were wiped out when
the tulip craze collapsed in 1637 as there was no mechanism to guarantee the perIormance oI the
option terms.

The Iirst call and put options were invented by an American Iinancier, Russell Sage, in 1872.
These options were traded over the counter. Agricultural commodities options were traded in the
nineteenth century in England and the US. Options on shares were available in the US on the
over the counter OTC) market only until 1973 without much knowledge oI valuation. A group
oI Iirms known as Put and Call brokers and Dealer`s Association was set up in early 1900`s to
provide a mechanism Ior bringing buyers and sellers together.

On April , 197, the Chicago Board options Exchange CBOE) was set up at CBOT Ior the
purpose oI trading stock options. It was in 1973 again that black, Merton, and Scholes invented
the Iamous Black-Scholes Option Formula. This model helped in assessing the Iair price oI an
option which led to an increased interest in trading oI options. With the options markets
becoming increasingly popular, the American Stock Exchange AMEX) and the Philadelphia
Stock Exchange PHLX) began trading in options in 1975.

The market Ior Iutures and options grew at a rapid pace in the eighties and nineties. The collapse
oI the Bretton Woods regime oI Iixed parties and the introduction oI Iloating rates Ior currencies
in the international Iinancial markets paved the way Ior development oI a number oI Iinancial
derivatives which served as eIIective risk management tools to cope with market uncertainties.

The CBOT and the CME are two largest Iinancial exchanges in the world on which Iutures
contracts are traded. The CBOT now oIIers 48 Iutures and option contracts (with the annual
volume at more than 211 million in 2001).The CBOE is the largest exchange Ior trading stock
options. The CBOE trades options on the S&P 100 and the S&P 500 stock indices. The
Philadelphia Stock Exchange is the premier exchange Ior trading Ioreign options.

The most traded stock indices include S&P 500, the Dow Jones Industrial Average, the Nasdaq
100, and the Nikkei 225. The US indices and the Nikkei 225 trade almost round the clock. The
N225 is also traded on the Chicago Mercantile Exchange.


Derivative Market in India
The Iirst step towards introduction oI derivatives trading in India was the promulgation oI the
Securities Laws Ordinance, 1995, which withdrew the prohibition on options in securities. The
market Ior derivatives however did not take oII as there was no regulatory Iramework to govern
trading oI derivatives. SEBI set up a 24-member committee under the Chairmanship oI Dr. L.C.
Gupta on November 18, 1996 to develop appropriate regulatory Iramework oI derivatives trading
in India. The committee submitted its report on March 17, 1998 prescribing necessary pre
conditions Ior introduction oI derivatives trading in India.

The committee recommended that derivatives should be declared as 'securities` so that
regulatory Iramework applicable to trading oI securities` could also govern trading oI securities.
SEBI also set up a group in June 1998 under the Chairmanship oI ProI J.R. Varma, to
recommend measures Ior risk containment in derivatives market in India. The report which was
submitted in October 1998, worked out the operational details oI margining system methodology
Ior charging initial margins, broker net worth deposit requirement and real time monitoring
requirements.

The SCRA was amended in December 1999 to include derivatives within the ambit oI
securities` and the regulatory Iramework were developed Ior governing derivatives trading. The
act also made it clear that derivatives shall be legal and valid only iI such contracts are traded on
a recognized stock exchange thus precluding OTC derivatives. The government also reclined in
March 2000 the three-decade-old notiIication, which prohibited Iorward trading in securities.

Derivatives trading commenced in India in June 2000 aIter SEBI granted the Iinal approval to
this eIIect in May 2000. SEBI permitted the derivative segments oI two stock exchanges NSE
and BSE and their clearing House Corporation to commence trading and settlement in approved
derivatives contracts to begin with SEBI approved trading in index Iutures contracts based on
S&P CNX NiIty and BSE-30 (Sensex) index. This was Iollowed by approval Ior trading inn
options based on theses tow indexes options on individual securities. The trading in index
options commenced June 2001 and the trading in options on individual securities commenced in
July 2001. Futures contracts on individual stocks were launched in November 2001. Trading and

settlement in derivative contract is done in accordance with the rules, bye laws and regulations oI
the respective exchanges ands their clearing house corporation duly approved by SEBI and
notiIied in the oIIicial gazette.

1991

Liberalisation process initiated.

14 December 1995 NSE asked SEBI Ior permission to trade index
Iutures.

18 November 1996 SEBI setup L.C.Gupta Committee to draIt a
policy Iramework Ior index Iutures.

11 May 1998 L.C.Gupta Committee submitted report.

7 July 1999

RBI gave permission Ior OTC Iorward rate
agreements (FRAs) and interest rate swaps.

24 May 2000

SIMEX chose NiIty Ior trading Iutures and
options on an Indian index.

25 May 2000

SEBI gave permission to NSE and BSE to do
index Iutures trading.

9 June 2000

Trading oI BSE Sensex Iutures commenced at
BSE.
12 June 2000 Trading oI NiIty Iutures commenced at NSE.

25 September 2000 NiIty Iutures trading commenced at SGX.

2 June 2001 Individual Stock Options & Derivatives


Recommendations of L.C.Gupta Committee on Derivatives

The committee was set up by SEBI in November 1996 to develop the appropriate regulatory
Iramework Ior the derivatives trading in India. The committee concern was with the Iinancial
derivatives in general and in particular about the equity derivatives. The committee consisted oI
24 members which were Irom various Iields oI Iinancial sector. The Iollowing were the main
recommendations oI the committee:
1. The committee strong Iavored the introduction oI the derivatives trading in India with a view
to provide the hedging to the institutions and the general investors.

. The committee recommended that there should be two level oI regulatory Iramework, one is
at the exchange level and the second level is that oI the SEBI level.

. The committee observed that the regulation oI SEBI was oI overlapping nature and that they
should be studied in detail and then made applicable to the derivatives segment.

. The committee observed that Mutual Iunds which are the big players in the capital market
should be allowed to work in the derivatives segment but made it clear that they can use the
derivatives market only Ior the purpose oI hedging and not Ior speculation.

. The committee Iavored the introduction oI the simple variants oI the derivatives Iirst so that
the market players can understand the product and then proceed with the gradual introduction
oI the complex products oI derivatives.

. The committee Iurther recommended that 'derivatives to be included in the deIinition oI
securities under the Securities Contract Regulations Act (SCRA) to enable the trading in
derivatives in its products oI options and Iutures.


Introduction to Forward Contract
A Iorward contract is an agreement to buy or sell an asset on a speciIied date Ior a speciIied
price. One oI the parties to the contract assumes a long position and agrees to buy the
underlying asset on a certain speciIied Iuture date Ior a certain speciIied price. The other party
assumes a short position and agrees to sell the asset on the same date Ior the same price. Other
contract details like delivery date, price and quantity are negotiated bilaterally by the parties to
the contract. The Iorward contracts are normally traded outside the exchanges.
The salient features of forward contracts are:

O They are bilateral contracts and hence exposed to counter-party risk.

O Each contract is custom designed, and hence is unique in terms oI contract size, expiration date
and the asset type and quality.

O The contract price is generally not available in public domain.

O On the expiration date, the contract has to be settled by delivery oI the asset.

O II the party wishes to reverse the contract, it has to compulsorily go to the same counter-party,
which oIten results in high prices being charged.

However Iorward contract in certain markets have become very standardized as in the case oI
Ioreign exchange thereby reducing transaction costs and increasing transaction volume. This
process oI standardization reaches its limit in the organized Iutures market.

Forward contract are very useIul heeding and speculation. The classic hedging application would
be that oI an exporter who expects to receive payment in dollar three months later. He is exposed
to the risk oI exchange rate Iluctuations. By using the currency Iorward market to sell dollars
Iorward he can lock on to a rate today and reduce his uncertainty. Similarly an importer who is

required to make a payment in dollars two months hence can reduce his exposure to exchange
rate Iluctuations by buying dollars Iorward.

II a speculator has inIormation or analysis, which Iorecasts an upturn in a price then he can go
long on the Iorward market instead oI the cash market. The speculator would go long on the
Iorward, wait Ior the price to raise and then take a reversing transaction to book proIits.
Speculators may well be required to deposit a margin upIront. Hoverer this is generally a
relatively small proportion oI the value oI the assets underlying the Iorward contract. The use oI
Iorward markets here supplies leverage to the speculator.

Limitations of Forward Markets
O Lack oI centralization oI trading

O Liquidity and
O Counter party risk.

In the Iirst two oI these the basic problem is that oI too much Ilexibility and generally. The
Iorward markets like a real estate market in that any two consenting adults can Iorm contracts
against each other. This oIten makes them design terms oI the deal which are very convenient
that speciIic situation, but makes the contract non tradable.

Counter party risk arises Irom the possibility oI deIault by nay on party to the transactions. When
one oI the two sides to the transaction declares bankruptcy the other suIIers. Even when Iorward
markets trade standardized contracts and hence avoid the problem oI illiquidity, still the counter
party risk remains a very serious issue.

Introduction to Futures
Futures markets were designed to solve the problems that exist in Iorward markets. A Iutures
contract is an agreement between two parties to buy or sell an asset at a certain time in the Iuture
at a certain price. But unlike Iorward contracts the Iutures contracts are standardized and
exchange traded. To Iacilitate liquidity in the Iutures contracts, the exchange speciIies certain
standard Ieatures oI the contract. It is a standardized contract with standard underlying
instrument a standard quantity and quality oI the underlying instrument that can be delivered,
(which can be used Ior reIerence purposes in settlement) and a standard timing oI such
settlement. A Iutures contract may be oIIset prior to maturity by entering into an equal and
opposite transaction. More than 99 oI Iutures transactions are oIIset this way.

The standardized items in Iutures contract are;
O "uantity oI the underlying
O "uality oI the underlying

The Iirst exchange that traded Iinancial derivatives was launched in Chicago in the year1972. A
division iI the Chicago Mercantile exchanges it was called the International Monetary Market
IMM) and traded currency Iutures.

The brain behind this was a man called Leo Melamed acknowledged as the Father oI Iinancial
Iutures who was then the Chairman oI the Chicago Mercantile Exchange.

Future Terminology

Spot price: The price at which an asset trades in the spot market.

Future price: The price at which the Iuture contract trades in the Iutures market.


Contract cycle: The period over which a contract trades. The index Iutures contacts on the NSE
have one month, two months and three months expiry cycle s, which expire on the last Thursday
oI the month. Thus a January expiration contract expires on the last Thursday oI January and
February expiration contract ceases trading on the last Thursday oI February. On the Friday
Iollowing the last Thursday a new contract having a three-month expiry is introduced Ior trading.

Expiry date: It is the date speciIied in the Iutures contract. This is the last day on which the
contract will be traded, at the end oI which it will cease to exist.

Contract size: The amount oI asset that has to be delivered under on contract. For instance, the
contract size on NSE`s Iutures markets is 200 NiIties.

Basis: In the context oI Iinancial Iutures, basis can be deIined as the Iutures price minus the spot
price. The will be d diIIerent basis Ior each delivery month Ior each contract. In a normal market,
basis will be positive. This reIlects that Iutures prices normally exceed spot prices.

Cost of carry: The relationship between Iutures prices and spot prices can be summarized in
terms oI what is known as the cost oI carry. This measures the storage cost plus the interest that
is paid to Iinance the asset less the income earned on the asset.

Initial margin: The amount that must be deposited in the margin account at the time a Iuture a
contract is Iirst entered into is known as initial margin.

Mark to market: In the Iutures market at the end oI each trading day the margin account
adjusted to reIlect the investor gain or loss depending upon the Iutures closing price. This is
called mark to market.

Maintenance margin:This is somewhat lower than the initial margin. This is set to ensure that
the balance in the margin account never becomes negative. II the balance in the margin account

Ialls below the maintenance margin the investor receives a margin call and is expected to top up
the margin account to the initial margin level beIore trading commences on the next day.

Distinction between Futures and Forwards Contracts

FEATURES FORWARD CONTRACT FUTURE CONTRACT
Operational Mechanism

Traded directly between two
parties (not traded on the
exchanges).
Traded on the exchanges.

Contract Specifications

DiIIer Irom trade to trade.

Contracts are standardized
contracts.

Counter-party risk Exists.

Exists.

However, assumed by the
clearing corp., which becomes
the counter party to all the
trades or unconditionally
guarantees their settlement.
Liquidation Profile

Low, as contracts are tailor
made contracts catering to the
needs oI the needs oI the
parties.
High, as contracts are
standardized exchange traded
contracts.

Price discovery

Not eIIicient, as markets are
scattered.

EIIicient, as markets are
centralized and all buyers and
sellers come to a common
platIorm to discover the price.
Examples

Currency market in India.

Commodities, Iutures, Index
Futures and Individual stock
Futures in India


Introduction to Options
A derivative transaction that gives the option holder the right but not the obligation to buy or sell
the underlying asset at a price, called the strike price, during a period or on a speciIic date in
exchange Ior payment oI a premium is known as option`. Underlying asset reIers to any asset
that is traded. The price at which the underlying is traded is called the strike price`.
There are two types oI options i.e., CALL OPTION & PUT OPTION.
Call Option
A contract that gives its owner the right but not the obligation to buy an underlying asset- stock
or any Iinancial asset, at a speciIied price on or beIore a speciIied date is known as a Call
option`. The owner makes a proIit provided he sells at a higher current price and buys at a lower
Iuture price.
Put Option
A contract that gives its owner the right but not the obligation to sell an underlying asset- stock
or any Iinancial asset, at a speciIied price on or beIore a speciIied date is known as a Put
option`. The owner makes a proIit provided he buys at a lower current price and sells at a higher
Iuture price. Hence, no option will be exercised iI the Iuture price does not increase.
Put and calls are almost always written on equities, although occasionally preIerence shares,
bonds and warrants become the subject oI options.
Option Terminology

Index options: Theses options have the index as the underlying some options are European
while others are American like index Iutures contract index options contracts are also cash
settled.

Stock options: Stock options are options on individual stock. Options currently trade on over
500 stocks in Untied States. A contract gives the holder the right to buy or sell shares at the
speciIied price.

Buyer of an option: The buyer oI an option is the one who by paying the options premium buys
the right but not the obligation to exercise his options on the seller writers.

Writer of an option: The writer oI a call put options is the one who receives the options
premium ands is there by obliged to sell buy the asset iI the buyer exercises on him.

Option price: Option price is the price, which the option buyer pays to the option seller. It is
also reIerred to as the option premium.

Expiration date: The date speciIied in the options contract is known as the expiration date the
exercise date, the strike date or the maturity

Strike price: The price speciIied in the options contract is known as the strike price or the
exercise price.

American options: American options are options that can be exercised at any time up to the
expiration date most exchange-traded options are American.

European options: European options are options that can be exercised only on the expiration
date itselI. Index options are European options.

In The Money option: An In The Money (ITM) option is an option that would lead to a positive
cash Ilow to the holder iI the were exercised immediately a call option on the index is said to be
in the money when the current index stand at la level higher than the strike price is spot price
strike price. II the index is much higher than the strike price, the call is said to be deep ITM. In
the case oI a put, the put is ITM iI the index is below the strike price.

At The Money option: An At the Money (ATM) option is an option that would lead to zero
cash Ilow iI it were exercised immediately. An option on the index is at the money when the
current index equals the strike price (I.E. spot pricestrike price).


Out of The Money option: An Out oI The Money (OTM) option is an option that would lead to
a negative cash Ilow it was exercised immediately. A call option on the index is out oI the money
when the current index stands at a level, which is less than the strike price. I.e. spot priceStrike
price. II the index is much lower than the strike price the call is said to be deep OTM. In the case
oI a put the put is OTM iI the index is above the strike price.

Intrinsic value of an option: The option premium can be broken down into two components
intrinsic value a time value. The intrinsic value oI a call is the mount the option is ITM iI it is
ITM. II the call is OTM, its intrinsic value is zero. Putting it another way the intrinsic value oI a
call is Max O, St-K), which means the intrinsic value oI call is the greater oI O or St) K is the
strike priced St is the spot price.

Time value of an option: The time value oI an option is the diIIerence between its premium
and its intrinsic value. Both calls and puts have time value an option OTM or ATM has only time
value. Usually the maximum time value exists when the options Atm. The longer the time to
expiration the greater is an options time value alleles` equal at expiration an option should have
no time value.


Pricing of futures
Pricing oI a Iuture contract is very simple. Using the cost-oI-carry logic, we calculate the Iair
value oI the Iuture contract. Every time the observed price deviates Irom the Iair value,
arbitragers would enter into trades to capture the arbitrage proIit. This in turn would push the
Iuture price back to its Iair value. The cost oI carry model used Ior pricing Iuture given below:

F S ` e
rt
Where: F theoretical Iutures price
S value oI the underlying index
r Cost oI Iinancing (using continuously compounded interest rate)
t time till expiration in year
e 2.71828

Example:
Security XYZ Ltd. Trades in the spot market at Rs. 1150. Money can be invested 11 p.a. the
Iair value oI one-month Iuture contract on XYZ is calculated as Iollows:

F S ` e
rt
11`e
.11`1/1
11

Pricing of Options
An option gives the buyer a right but not an obligation to exercise on the seller. The worst that
can happen to a buyer is the loss oI the premium paid by him. His down side is limited to this
premium, but his upside is potentially unlimited. This optionality is precious and has a value,
which is expressed in term oI an option price. Just like in order Iree market, it is the supply and
demand in the secondary market that drives the price oI an option.


There are various models which help us get close to the true price oI an option. Most oI these are
variants oI the celebrated Black-Scholes model Ior pricing European options. Today most
calculators and spread-sheets come with a built-in Black-Scholes options pricing Iormula.

The Black-Scholes Iormulas Ior the prices oI European calls and puts on a non-dividend paying
stock are:
C SN d
1
) - Xe
-rT
N d
)
P Xe
-rT
N -d
) - SN -d
1
)
Where d
1
ln S/X + r + 9
/) T
d

d
1
- 9bT

O The Black-Scholes equation is done in continuous time. This required continuous
compounding. Example: iI the interest rate per annum is 12 , you need to use ln 1.12.
O N () is the cumulative normal distribution. N(d
1
) is called the delta oI the option which is a
measure oI change in option price with respect to change in the price oI the underlying
assets.
O 9 a measure oI volatility is the annualized standard deviation oI continuously compounded
returns on the underlying. When daily sigma is given, that need to be converted into
annualized sigma.
O Sigma
annual
Sigma
daily
*

b Number oI trading days per year. On an average there are 250
trading days in a year.
O X is the exercise price, S the spot price and T the time to expiration measured in a year.


Clearing & Settlement

National Securities Corporation Limited (NSCCL) undertakes clearing and settlement oI all
trades executed on the Iutures and options (F&O) segment oI the NSE. It also acts as legal
counter party to all trades on the F&O segment and guarantees their Iinancial settlement.

1. Clearing Banks
NSCCL has empanelled 13 clearing banks namely Axis Bank Ltd., Bank oI India, Canara Bank,
Citibank N.A, HDFC Bank, Hongkong & Shanghai Banking Corporation Ltd., ICICI Bank, IDBI
Bank, IndusInd Bank, Kotak Mahindra Bank, Standard Chartered Bank, State Bank oI India and
Union Bank oI India.

Every Clearing Member is required to maintain and operate clearing accounts with any oI the
empanelled clearing banks at the designated clearing bank branches. The clearing accounts are to
be used exclusively Ior clearing & settlement operations.
. Clearing Members
A Clearing Member (CM) oI NSCCL has the responsibility oI clearing and settlement oI all
deals executed by Trading Members (TM) on NSE, who clear and settle such deals through
them. Primarily, the CM perIorms the Iollowing Iunctions:
Clearing: Computing obligations oI all his TM's i.e. determining positions to settle.
Settlement: PerIorming actual settlement. Only Iunds settlement is allowed at present in Index
as well as Stock Iutures and options contracts
Risk Management: Setting position limits based on upIront deposits / margins Ior each TM and
monitoring positions on a continuous basis.

Types of Clearing Members
O Trading Member-Clearing Member TM-CM)
A Clearing Member who is also a TM. Such CMs may clear and settle their own proprietary
trades, their clients` trades as well as trades oI other TM`s & Custodial Participants.
O Professional Clearing Member PCM)
A CM who is not a TM. Typically banks or custodians could become a PCM and clear and settle
Ior TM`s as well as oI the Custodial Participants
O Self Clearing Member SCM)
A Clearing Member who is also a TM. Such CMs may clear and settle only their own proprietary
trades and their clients` trades but cannot clear and settle trades oI other TM`s.

Clearing Member Eligibility Norms
O Net worth oI at least Rs.300 lakhs. The net worth requirement Ior a CM who clears and
settles only deals executed by him is Rs. 100 lakhs.
O Deposit oI Rs. 50 lakhs to NSCCL which Iorms part oI the security deposit oI the CM.
O Additional incremental deposits oI Rs.10 lakhs to NSCCL Ior each additional TM in case the
CM undertakes to clear and settle deals Ior other TMs.

. Clearing Mechanism
The clearing mechanism essentially involves working out open positions and obligations oI
clearing (selI-clearing/trading-cum-clearing/proIessional clearing) members. This position is
considered Ior exposure and daily margin purpose. The open positions oI CMs are arrived at by
aggregating the open positions oI all the TMs and all custodial participants clearing through him,
in contracts in which they have traded. A TMs open position is arrived at as the summation oI his

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 identity the orders, whether
proprietary (iI they are their own trades) or client (iI entered on behalI oI clients) through
Pro/Cli` indicator provided in the order entry screen. Proprietary positions are calculated on the
basis (buy-sell) Ior each contract. Clients` positions are arrived a by summing together net (buy
sell) positions oI each individual client. A TMs open position is the sum oI proprietary open
position, client open long position and client open short position.

1. Proprietary position of trading member Madanbhai on day 1
Trading member Madanbhai trades in the Iutures & options segment Ior himselI and two oI his
clients. The table shows his proprietary position.
Note: A buy position 2001000` means 200 units bought at the rate oI Rs.1000.
Trading member Madanbhai
Buy Sell
Proprietary positions 2001000 4001010

. Client position of trading member Madanbhai on day 1
Trading member Madanbhai trades in the Iutures & options segment Ior himselI and two oI his
clients. The table shows his clients positions.

Buy Open Sell Close Sell Open Buy Close

Client position
Client A 4001109 2001000
Client B 6001100 2001099

. Proprietary position of trading member Madanbhai on Day
Assume that the position on Day 1 is carried Iorward to the next trading day and the Iollowing
trades are also executed.
Buy Sell
Proprietary positions 2001000 4001010

. Client position of trading member Madanbhai on day
Trading member Madanbhai trades in the Iutures and options segment Ior himselI and two oI his
clients. The table shows his client position on Day 2

The proprietary open position on day 1 is simply Buy - Sell - short. The
open position Ior client A Buy O) - Sell C) - long, i.e. he has a long
position oI 200 units. The open position Ior Client B shell O) - Buy C) -
short, i.e. he has a short position oI 400 units. Now the total open position oI the trading member
Madanbhai at end on day 1 is 200 (his proprietary open position on net basis) plus 600 (the
Client open positions on gross basis) i.e. 800.

The proprietary open position at end oI day 1 is 200 short. The end oI day open position Ior
proprietary trades undertaken on day 2 is 200 short. Hence the net open proprietary position at
the end oI day 2 is 400 short. Similarly, Client A`s open position at the end oI day 1 is 200 long.
The end oI day open position Ior trades done by Client A on day2 is 200 long. Hence the net
open position Ior Client A at the end oI day 2 is 400 long. Client B`s open position at the end oI
Buy Open Sell Close Sell Open Buy Close

Client position
Client A 4001109 2001000
Client B 6001100 4001099

day 1 is 400 short. The end oI day open position Ior trades done by Client B on day 2 is 200
short. Hence the net open position Ior Client B at the end oI day 2 is 600 short. The net open
position Ior the trading member at the end oI day 2 is sum oI the proprietary open position and
client open positions. It worked out to be 400 400 600, i.e. 1400.

. Settlement Schedule
The settlement oI trades is on T1 working day basis.

Members with a Iunds pay-in obligation are required to have clear Iunds in their primary clearing
account on or beIore 10.30 a.m. on the settlement day. The payout oI Iunds is credited to the
primary clearing account oI the members thereaIter.
. Settlement Price
Product Settlement Schedule
Futures Contracts
on Index or
Individual Security
Daily
Settlement
Closing price oI the Iutures contracts on the trading
day. (closing price Ior a Iutures contract shall be
calculated on the basis oI the last halI an hour
weighted average price oI such contract)
Un-expired illiquid
Iutures contracts
Daily
Settlement
Theoretical Price computed as per Iormula FS * ert
Futures Contracts
on Index or
Individual
Securities
Final
Settlement
Closing price oI the relevant underlying index /
security in the Capital Market segment oI NSE, on
the last trading day oI the Iutures contracts.
Options Contracts
on Index and
Individual
Securities
Final Exercise
Settlement
Closing price oI such underlying security (or index)
on the last trading day oI the options contract.


. Settlement Mechanism
The entire Iuture and option contract are cash settled, i.e. through exchange oI cash. The
underlying Ior index Iuture/option oI the niIty index cannot be delivered. These contracts,
thereIore, have to be settled in cash. Future and option on individual securities can be delivered
as in the spot market. However, it has been currently mandated that stock option and Iuture
would also be cash settled. The settlement amount Ior a CM is netted across all their TMs/clients,
with respect to their obligations on MTM, premium and exercise settlement.

Settlement of future contract
Future contract have two types oI settlements, the MTM settlement which happen on a
continuous basis at the end oI each day, and the Iinal settlement which happens on the last
trading day oI the Iuture contract.

MTM settlement
All Iuture contracts Ior each member are marked-to-market (MTM) to the daily settlement price
oI the relevant Iutures contract at the end oI each day. The proIit or losses are computed as the
diIIerence between:

1. The trade price and the day`s settlement price Ior contracts executed during the day but not
squared up.
2. The previous day`s settlement price and the current day`s settlement price Ior bought
Iorward contract.
3. The buy price and the sell price Ior contracts executed during the day and squared up.

F S ` e
rt
Where: F theoretical Iutures price
S value oI the underlying index
r rate oI interest (MIBOR)
t time to expiration
e 2.71828


Final settlement for futures
On the expiry day oI the Iuture contracts, aIter the close oI the trading hours, NSCCL marks all
positions oI a CM to the Iinal settlement price and the resulting proIit or loss is settled in cash.
Final settlement proIit or loss amount is debited or credited to the relevant CM`s clearing bank
account on the day Iollowing expiry day oI the contract.

Settlement of future contract
Option contracts have three types oI settlements, daily premium settlement, exercise settlement,
interim exercise settlement in case oI option contracts on securities and Iinal settlement.

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

Exercise settlement
Although most option buyer and seller close out their options positions by an oIIsetting closing
transaction, an understanding oI exercise can help an option buyer determine whether exercise
might be more advantageous than an oIIsetting sale oI an option. There is always a possibility oI
an option seller being assigned an exercise. Once an exercise oI an option has been assigned to
an option seller, the option seller is bound to IulIill his obligation (meaning, pay the cash
settlement amount in the case oI cash-settled option) even though he may not yet have been
notiIied oI the assignment.

Interim exercise settlement
Interim exercise settlement takes place only Ior option contracts on securities. An investor can
exercise his in-the-money options at any time during trading hours, through his trading member.
Interim exercise settlement is eIIected Ior such options at the close oI the trading hours, on the
day oI exercise. Valid exercised option contract are assigned to short position in the option

contract with the same series (i.e. having the same underlying, same expiry date and same strike
price), on a random basis, at the client level. The CM who has exercised the option receives the
exercise settlement value per unit oI the option Irom the CM who has been assigned the option
contract.

Final exercise settlement
Final exercise settlement is eIIected Ior all open long in-the-money strike price options existing
at the close oI trading hours, on the expiration day oI the option contract. All such long positions
are exercised and automatically assigned to short positions in option contract with the same
series, on a random basis. The investor who ha long in the money options on the expiry date will
receive the exercise settlement value per unit oI the option Irom the investor who has been
assigned the option contract.

. Settlement Procedure
Clearing members who opt to pay the Daily MTM settlement on a T0 basis would compute
such settlement amounts on a daily basis and make the amount oI Iunds available in their
clearing account beIore the end oI day on T0 day. Failure to do so would tantamount to non
payment oI daily MTM settlement on a T0 bases. Further, partial payment oI daily MTM
settlement would also be considered as non payment oI daily MTM settlement on a T0 basis.
These would be construed as non compliance and penalties applicable Ior Iund shortages Irom
time to time would be levied.
A penalty oI 0.07 oI the margin amount at end oI day on T0 would be levied on the clearing
members. Further, the beneIit oI scaled down margins shall not be available in case oI non
payment oI daily MTM settlement on a T0 basis Irom the day oI such deIault to the end oI the
relevant quarter.


Basic Pay-off
Option pays-offs
1. Pay-off for Buyer of call option
Pay-oII diagram below represents the eIIective pay-oII oI a long call position oI an option at the
time oI the expiry date. It looks at the option Irom the point oI view oI buyer.

The Iigure shows the proIits or losses Ior the buyer oI the call option oI NiIty at the strike oI
6000. As can be seen, as the spot NiIty raises, the call option in in-the-money. It will generate
positive cash Ilow and the investor will get proIit to the extent oI the diIIerence between the spot
and the strike price.
However iI niIty Ialls below the strike price oI 6000, he let the option expire. His losses are
limited to the extent oI the premium he paid Ior buying the option.
. Pay-off for writer of call option
Option seller has limited proIit potential and potentially unlimited risk. Pay-oII diagram below
represents the eIIective pay-oII oI a short call position oI an option at the time oI the expiry date.
It looks at the option Irom the point oI view oI seller.
rof|t
Loss
N|fty

The Iigure shows the proIits or losses Ior the seller oI NiIty 6000 call option. As the spot NiIty
rises, the call option is in-the-money and the writer starts making losses. II NiIty closes above the
strike oI 6000, the buyer would exercise his option on the writer who would suIIer a loss to the
extent oI the diIIerence between the NiIty close and the strike price.

The loss that can be incurred by the writer oI the option is potentially unlimited; whereas the
maximum proIit is limited to the extent oI the up-Iront option premium is charged by him.
. Pay-off for buyer of put option
Loss
N|fty
Loss
N|fty
rof|t
rof|t

The Iigure shows the proIits or losses Ior the buyer oI a NiIty 6000 put option. As can be seen, as
the spot NiIty Ialls, the put option in-the-money. II NiIty closes below the strike oI 6000, the
buyer would exercise his option and proIit to the extent oI the diIIerence between the strike price
and NiIty-close. The proIit possible on this option can be high as the strike price.
However iI niIty rises above the strike price oI 6000, he let the option expire. His losses are
limited to the extent oI the premium he paid Ior buying the option.
. Pay-off for writer of put option
The Iigure shows the proIits or losses Ior the seller oI a NiIty 6000 put option. As can be seen,
as the spot NiIty Ialls, the put option in-the-money and the writer starts making losses. II NiIty
closes below the strike oI 6000, the buyer would exercise his option on the writer who would
suIIer a loss to the extent oI the diIIerence between the strike price and NiIty-close.

The loss can be incurred by the writer oI the option is a maximum extent oI the strike price
whereas the maximum proIit is limited to the extent oI the up-Iront option premium is charged
by him.

Loss
N|fty
rof|t

Future pay-offs
1. Payoff for a buyer of the Nifty future

The Iigure shows the proIit or loss Ior a long Iuture position. The investors buy Iutures when the
index was at 5800. II the index goes up, his Iuture position starts making proIit. II index Ialls, his
Iuture position starts showing losses.

. Payoff for a Seller of the Nifty future
1111

rof|t
Loss
N|fty
rof|t
Loss
N|fty

The Iigure shows the proIit or loss Ior a short Iuture position. The investors sold Iutures when the
index was at 5800. II the index goes down, his Iuture position starts making proIit. II index rises,
his Iuture position starts showing losses.


Trading in Derivative
Future and Option trading system

The Iutures and options trading system oI NSE, called NEAT-F&O trading system, provides a
Iully automated screen based trading Ior NiIty Iutures and options and stock Iutures and options
on a nation wide basis as well as an online monitoring and surveillance mechanism. It supports
an order driven market and provides complete transparency oI trading operations. It is similar to
that oI trading oI equities in the cash market segment.

The soItware Ior the F&O market has been developed to Iacilitate eIIicient and transparent
trading in Iutures and options instruments. Keeping in view the Iamiliarity oI trading members
with the current capital market trading system, modiIications have been perIormed in the existing
capital market trading system so as to make it suitable Ior trading Iutures and options.

Entities in the trading system
There are Iour entities in the trading system. Trading members, clearing members, proIessional
clearing members and participants.
. Trading members
Trading members are members oI NSE. They can trade either on their own account or on behalI
oI their clients including participants. The exchange assigns a trading member ID to each
trading member. Each member can have more than one use. The number oI users allowed Ior
each trading member is notiIied by the exchange Irom time to time. Each user oI a trading
member must be registered with the exchange and is assigned a unique user ID. The unique
trading member ID Iunctions as a reIerence Ior all orders, trades oI diIIerent users. This ID is

common Ior all users oI a particular trading member. It is the responsibility oI the trading
member to maintain adequate control over persons having access to the Iirms User ID.
. Clearing members
Clearing members are members oI NSCCL. They carry out risk management activities and
conIirmation inquiry oI trades through the trading system.

7. Professional clearing members
A proIessional clearing members is a clearing member who is not a trading member. Typically
banks and custodian become proIessional clearing members and clear and settle Ior their trading
members.

8. Participants
A participant is a client oI trading members like Iinancial institutions. These clients may trade
through multiple trading members but settle through a single clearing member.

Corporate hierarchy
In the F&O trading soItware, a trading member has the Iacility oI deIining a hierarchy amongst
users oI 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 highest level in a trading Iirm.
Such a user can perIorm all the Iunctions such as order and trade related activities, receiving
reports Ior all branches oI the trading member Iirm and also all dealers oI the Iirm. Additionally,

a corporate manager can deIine exposure limits Ior the branches oI the Iirm. This Iacility is
available only to the corporate manager.

. Branch manager
The branch manager is a term assigned to a user who is placed under the corporate manager.
Such a user can perIorm and view order and trade related activities Ior all dealers under that
branch.

. Dealer
Dealers are users at the lower most level oI the hierarchy. A Dealer can perIorm view order and
trade related activities only Ior one selI and dose not have access to inIormation on other dealers
under either the same branch or other branches.
Order types and conditions
The system allows the trading members to enter orders with various conditions attached to them
as per their requirements. These conditions are broadly divided into the Iollowing categories;
1. Time conditions
. Price conditions
. Other conditions
Several combinations oI the above are allowed thereby providing enormous Ilexibility to the
uses. The order types and conditions are given below.
1. Time conditions
Day order
A day order, as the name suggest is an order which is valid Ior the day on which it is entered. II
the order is not executed during the day, the system cancels the order automatically at the end oI
the day.

Immediate or Cancel IOC)
An IOC order allows the user to buy or sell a contract as soon as the order is released into the
system Iailing which the order is cancelled Irom the system. Partial match is possible Ior the
order, and the unmatched portion oI the order is cancelled immediately.

. Price conditions
Stop loss
This Iacility allows the user to release an order into the system, aIter the market price oI the
security reaches or crosses a threshold price E. G. iI Ior stop loss buy order, the trigger is
1027.00, the limit price is 1030.00, and the market last traded price is 1023.00, then this order is
released into the system once the market price reaches or exceeds 1027.00, This order is added to
the regular lot book with time or triggering as the time stamp as a limit order oI 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 Ior which no price is speciIied at the time the order is entered i.e. price
is market price} Ior such orders, the system determines the price.
Trigger price
Price at which an order gets triggered Irom the stop loss book.
Limit price
Price oI the orders aIter triggering Irom 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 behalI oI a client.

Placing order on the trading system

For both the Iuture and the option market, while entering orders on the trading system, members
are required to identiIy order as being proprietary or client order. Proprietary order should be
identiIied as Pro` and those oI client should be identiIied as Cli`. Apart Irom this, in the case oI
Cli` trades, the client account number should also be provided.


Risk Management system of Derivative

Margin system adopted by Exchanges in India

The initial margin is required to be paid by the person taking the risk. However, an option buyer
risk is limited to the amount oI the premium. Thus, as a rule, an option buyer does not pay the
margin. He only pay the premium to the options seller at the time oI buying the option. Options
sellers, Iutures buyers and Iutures sellers have potentially unlimited risk and hence have to pay
the initial margin. Options traders trading in vertical spreads and time spreads have to pay a
much lower margin than normal options writers.

In India, NSE and BSE use the margin system called as the Standardized PortIolio Analysis
(SPAN) developed by the Chicago Mercantile Exchange (CME), Chicago, USA. The objective
oI SPAN is to identiIy the overall risk in a portIolio oI Iutures and options contracts Ior each
member. The system treats Iutures and options contracts uniIormly, while recognizing the non-
linearity oI the payoIIs oI options portIolios and the consequential unique exposures associated
with them. SPAN is used to determine margin requirements. Its main objective is to determine
the largest loss that a portIolio might reasonably suIIer Irom one day to the next.

The underlying market price, the volatility oI the underlying instrument and the time to
expiration are important Iactors that directly aIIect the value oI options at a given point in time.
A change in these Iactors aIIects the value oI the Iutures and options in a portIolio. This system
is scientiIic and takes into consideration traders total long and short positions. It takes into the
market price oI the underlying asset, the volatility o I the underlying asset, and the time to
expiration oI the contract entered into. It also considers whether it is a long or short position.
The options and Iutures portIolio is analyzed as a whole and the net risk taken by the trader is
considered. Thus a naked options seller will have to pay much more margin than a trader who
has short options positions and also long options positions oI a diIIerent strike price.


The calculation process is deIinitely much more systematic than an arbitrary margin rate system.
Derivatives contracts oI a more volatility underlying asset have larger margin requirements, and
a derivatives contract on the same underlying with more time to expiry will also have a higher
margin requirement. There are a series oI complex steps and procedures Ior calculating the Iinal
margin amount. However, CME PC-SPAN soItware makes the calculations oI margins very
simple. All that the broker back oIIice has to do is to Ieed in the investors` position at the end oI
the day into the computer and they can get the Iinal net margin requirement oI the trader with the
click oI the button. Initial margin is also payable in the Iorm oI speciIied securities. The list oI
such securities is approved by SEBI and is updated regularly. A haircut speciIied by the
regulatory authorities` sis applied to the value oI the securities. This is very beneIicial as the
investor paying the margin in the Iorm oI money will not earn interest, whereas iI he deposits
securities like the government bonds as margin he will keep earning interest on them.

The objective oI NSE-SPAN is to identiIy over all risk on a portIolio oI all Iutures and options
contracts Ior each member. The system treats Iutures and options contracts uniIormly, while at
the same time recognizing the unique exposures associated with options portIolios. Like
extremely deep out oI the money short position and inter month risk. Its over riding objective is
to determine the largest loss that a portIolio might reasonably to expected to suIIer Irom one day
to the next day based on 99 VaR methodology. SPAN considers uniqueness oI option
portIolios.

The Iollowing Iactors aIIect the value oI an option

O Underlying market price
O Strike price
O Volatility oI underlying instrument
O Time to expiration
O Interest rate


As these Iactors change, the value oI options maintained within a portIolio also changes. Thus,
SPAN constructs scenarios oI probable changes underlying prices and volatilities in order to
identiIy the largest loss a portIolio might suIIer Iro one day to the next. It then sets the margin
requirement to cover his one-day loss. The complex calculations (e.g. the pricing oI options) in
SPAN are executed by NSCCL. The results oI these calculations are called risk arrays. Risk
arrays, and other necessary data inputs Ior margin calculation are provided to members daily in a
Iile called the SPAN risk parameter Iile. Member can apply the data contained in the risk
parameter Iiles, to their speciIic portIolios oI Iutures and options contracts, to determine their
SPAN margin requirements. Hence, members need not execute complex option pricing
calculations, which are perIormed by NSCCL. SPAN has the ability to estimate risk Ior
combined Iutures and options portIolios, and also re-value the same under various scenarios oI
change in market conditions.

Margins
Derivatives segment uses margins as one oI the important measures Ior the risk management
purpose. In order to control the trading activities and to prevent the speculative activities the
exchange imposes several types oI margins to saIe guard the interest oI the genuine investors and
Ior the proper development oI the overall market. The Iollowing types oI margins are imposed
Ior the purpose oI risk management:-

1. Initial margin
This is the amount oI money taken Iirst time to saIe guard the interest oI the trading member.
The initial margin is charged at the time oI opening oI account in the options and Iutures
segment. The usual practice Iollowed by the investment solution providers is to charges
Rs.10,000 in case oI opening oI an options account and Rs. 50,000 in case oI opening a Iutures
account.

. Maintenance margin
This is the minimum amount oI margin required in the client account at all the times. When the
margin in the client account goes beyond the maintenance margin a call is made to the client by
the broker that the margin needs to be brought back to the original level oI initial margin and the

client is required to provide the required margin immediately to the broker otherwise the broker
will close the account oI the client and will not allow him to operate him anymore. It is a usual
practice to charge 75 per cent oI the initial margin as the maintenance margin. For example iI the
initial margin is Rs. 10,000 then its 75 per cent i.e. Rs. 7500 is considered as the maintenance
margin and iI the margin money goes below Rs. 7500 then the client is required to bring the
required amount oI money.

. Value at Risk Margin
This is the margin which the exchange calculates on the basis oI the volatility oI the stock price
movement and it is decided on the movement oI the stock prices during a particular day. This
margin is sent by the Iile to all the brokers three times a day or Iive times a day depending upon
the volatility oI the stock. The value at risk margin may vary Irom 15 per cent to say 25 per cent.
When there is high volatility in the stock prices the value at risk margin is also charged at a high
level. This margin is imposed to have control over the speculative activities and to prevent the
traders Irom the over trading.

. Special margin
This margin is charged when the exchanges observed some abnormal movement in the prices oI
the stock prices. This type oI margin is imposed by the exchange by giving notice in the
newspaper and by inIorming the clients through the Iile sent through the internet to the brokers.
Recently on 9
th
December 2003 the Bombay stock exchange and the National Stock Exchange
imposed at special margin oI 10 per cent on 35 scripts oI A group while 71 scripts oI B1, B2 and
Z group has been imposed a margin 25 per cent.

. Mark to Market margin
The proIit or loss oI the investor open position is calculated on a daily basis and the is called as
mark to market (MTM). The daily proIit/loss is credited or debited to the investors account on a
daily basis. A penalty is levied by the exchange on the clearing member in case oI non-collection
oI the initial or MTM margin and the open position oI the investor is closed, irrespective oI
whether he makes a proIit or loss. The penalty is charged even iI the client brings in the margin
later. The clearing member collects these penalties levied by the exchange Irom such a client. To

avoid such situations, the investors generally pay 10 to 15 per cent more than the margin
requirement. This practice not only precludes the possibility oI a penalty being levied but also
meets the possibility oI an additional margin requirement in the case oI an increase by the
clearing house or daily MTM requirement.

. Exposure Margin
Exchanges may levy an exposure margin over and above the initial margin as a second line oI
deIense. This margin may vary Irom 5 per cent to 20 per cent depending on the stock. This may
be increased by the exchanges as and when necessary by giving notices to the clearing members.
The clearing members in turn have to collect the same Irom the trading members and the clients
and pass them on to the exchanges. The exchanges do take such actions in time oI volatility. The
main purpose oI such an exercise is to reduce any excessive speculation in the market. However,
the negative eIIect oI increasing the margins is that it results in the Iorced liquidations oI
positions, thereby bringing down the market, at least temporarily.

7. Ad hoc margin
The exchanges may levy an adhoc margin on investors who have large positions in the
derivatives segment. The exchanges send notices to the clearing members to collect such margins
Irom these investors.

The above margins are collected upIront Irom the clients so that there is no excess position
taking by the clients and the liquidity oI the members is also saIeguarded. Whenever the market
wide limit on a particular stock touches 80 per cent oI the total limit allowed on that particular
day then the margins are doubled that is iI the margins comes to Rs. 25000 then it is doubled and
becomes Rs. 50,000. On 14
th
October 2003 the Iollowing scripts had touched 80 per cent market
wide limit and so the margins were doubled.

1. Arvind Mills (98)
2. ACC (82)
3. Digital Global (85)
4. IPCL (84)

5. Mastek (100)
6. Nalco (91)
7. NIIT (84)
8. PNB (83)
9. Polaris (93)
10. SCI (96)

POSITION LIMITS
Position limits have been speciIied by SEBI at the trading member, client, market and the FII
levels to prevent any manipulation and excess position taking.

Trading Member position limits
There is a position limit in derivative contracts on an index oI 15 oI the open position or Rs.
100 crores whichever is higher. The position limit in derivative contracts on an individual stock
is 7.5 oI the open interest in that underlying on the exchange or Rs. 50 crores whichever is
higher.

Client level position limit
Any client either individually or in group with other investor iI acquires more than 15 oI the
total open interest in all the Iutures and options contract taken together then he has to inIorm the
Clearing Corporation and iI he does not do so then it would attract penalty in the Iorm oI Iine.

Market wide position limits
The market wide limit oI open position in terms oI the number oI units oI underlying stock on all
the Iutures and options contract on particular stocks is lower oI 30 times the average number oI
shares traded daily, during the previous calendar month, in the capital market segment oI the
exchange or 10 oI the number shares held by the non-promoters that is 10 oI the Iree Iloat in
terms oI the number oI shares oI the company.


Position limit for FIIs
In case oI the index related derivative products the position limit is 15 oI open interest in all
Iutures and option contract or Rs. 100 crores whichever is higher. In case oI stock related
derivative products the position limit is 7.5 oI open interest in all the Iutures and options
contracts or Rs. 50 crores whichever is higher.

Margin collection and violations
Clearing members are provided with terminals oI the Iutures and options segment to monitor the
trades oI all the trading members and clients. Through this, clearing members can set the
exposure limits Ior trading members and clients; the trading Iacility is withdrawn whenever a
trading member exceeds exposure limits. The initial margin amount on the positions taken by the
clearing member is computed Ior the each trade. The initial margin amount is reduced Irom the
eIIective deposits oI the clearing member with the Clearing Corporation. Once 70, 80 and 90 per
cent oI the eIIective deposits are consumed; the member receives a warning message on his
terminal. The clearing Iacility is withdrawn the moment 100 per cent is consumed. The liquid net
worth oI the clearing member at any point oI time should not be less than Rs. 50 lakhs. The
withdrawal oI the clearing Iacility in case oI violations will apply to the trading Iacility oI all
trading members clearing and settling through that clearing member.

The margin amount on the positions taken by the trading member is also computed on a real time
basis and compared with the trading member limit set by his clearing member. Here also the
initial margin amount is reduced Irom the trading member limit, set by the clearing member.
Having consumed 70 per cent, 80 per cent and 90 per cent oI the limit, the member receives a
warning message on his terminal, and once 100 per cent is consumed the trading Iacility
provided to the trading member is withdrawn.

Project Report On Risk Management Using Future and Option

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Project Report On Risk Management Using Future and Option

Uploaded by

Copyright:

Available Formats

Shri S.V.

Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

O Lack oI centralization oI trading

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

Shri S.V. Patel College oI Computer Science & Business Management

You might also like