Chapter 1

1.1
INTRODUCTION
A country is termed prosperous if its economy is doing well. There are a large
number of influencing factors which determines the prosperity of the economy,
like Per-capita income of people, GDP, Imports & Exports, Forex Reserves, etc.
In short it can be told that Financial Market is an important contributor to the
economy. In this financial market, capital market plays a significant role. The
capital market always replicates the power and ability of the investors and their
faith in the market. Earlier the capital market was shy. But market deregulations,
growth in global trade and technological development have revolutionized the
financial market place. A by-product of this revolution is increased market
volatility, which has led to a corresponding increase in risk management
products. This demand is reflected in the growth of financial derivatives and
derivatives market. But, question arises, are these derivatives risk free? As
worlds one of the greatest investor once said, Risk is a part of Gods game,
alike for man and nation Thus it can be said that these risk management
instruments are not risk free. This indicates the essence of risk management of
derivatives.

1.2
RATIONALE
In this world of uncertainty risk management has an immense importance for
corporate. Financial derivatives which are introduced with a prime objective of
hedging risk, when used for speculative purposes resulted with increased risk.
Thus, risk management of financial derivatives is a major area of concern. In
case of an exchange, as exchange plays the role of counterparty for both buyer
and seller, it is more exposed to counterparty risk and all other risk associated
with the financial derivatives. This leads to the essence of risk management of
derivatives in exchanges.
The various tools used by the exchanges for risk management includes margins,
position limits, and various rules and regulations laid down by the regulatory
authority for derivative trading. All these process of risk management is done by
wholly computerized process and with specific software. The inclusion of latest
technology has made the risk management process more reliable. The risk
management of derivatives not only secures Stock Exchanges, but also creates
confidence in the minds of the investors. This enhances more investments in the
derivatives market, which leads to business prosperity. Thus the most of the
exchanges have their risk management procedure for risk management of
derivatives.

1.3
OBJECTIVE
On the above outset, the following are the laid down as the objective of this
study,
I. To study the risk associated with derivative market and derivative trading.
II. To study the risk management tools used in Bombay Stock Exchange limited
for mitigating these risks.
III. To study the margining system for derivatives.
IV. To study the software used for margining system.
V. To do comparative analysis of the risk management process of BSE with that
Of NSE
VI. To give suggestion and recommendations for improvement in risk
management process of derivatives in BSE.

1.4
RESEARCH METHODOLOGY
1.4.1
SCOPE
The scope of this project is confined to the study of risk management of
derivatives in BSE, about the margining system. The software used for this
purpose, details about the process and tools of risk management and various
problems faced by them.
1.4.2
TIME FRAME
The project has been undertaken on the basis of information provided by BSEs
derivatives segment which consists of the daily prices and volatility of
derivative segment of BSE for the last ten years. This data consist of details
about the daily prices of derivatives products and proportion of investment in
each and every derivatives instrument.
1.4.3
SOURCES OF DATA
The data has been collected from both primary and secondary sources. The
primary data are collected by interviewing brokers and some officials of BSE.
Some data are collected from personnel of the various departments in BSE, like
Product and Strategy Department, Bank of India Shareholding Limited.
(Clearinghouse of BSE). The secondary data consists of books and journals
provided by BSE, SEBI circulars and Guidelines. This also contains the data of
derivative segment of NSE, which was collected from the website of NSE.

1.4.4
TOOLS AND TECHNIQUES
The data so collected were classified and tabulated for analysis and
interpretation. The tools and techniques used in this project are all computerized
programming. The data are programmed in software like visual basic,
MATLAB, etc, to find the implied volatility and price scan range. Finally all
these implied volatility and price scan range are processed in PC SPAN
(software for calculation of margin) to find out the margin requirement of
different participants of the derivative market. The turnover of derivatives
segment of BSE and NSE is drawn in graphs to compare these two markets.

1.5
LIMITATION
Some of the limitations that are faced during the project are;
1. The information collected is limited by the authenticity and accuracy of
information provided by the interviewees. The data collected from the websites
are limited. Certain information was not disclosed to maintain the secrecy of the
exchange.
2. The time predefined for this project was 8 weeks, which is very short for
covering such a big project.

1.6
CHAPTERISATION
This project is about the risk management of derivatives in BSE. Various
technicalities that are involved in this process has been extensively discussed
and dealt with this report. The report contains the following six chapters, which
are summarized below. Chapter one begins with the introduction to the project
report, stating the importance, objectives and research methodology adopted.
Limitations inherent to the project are also laid down.
Chapter two deals with the history and potentiality of Bombay Stock Exchange
Limited. ,its mission and vision are also laid down. Major events that shaped the
securities market in the country and helped BSE to grow have been mentioned.
The third chapter deals with the conceptual study of derivatives and its
mechanism. A snapshot of international and Indian derivative market was also
laid down. A brief idea about equity derivatives was also mentioned in this
chapter.
Chapter four contains the conceptual idea of risk management process. This
chapter also throws light on the essence of risk management; risk associated
with derivatives trading and risk management of derivatives. The fifth chapter
comprises of analysis and interpretation part. Chapter six contains the
summarized list of all important findings. And finally, the ultimate chapter aims
at providing some relevant suggestions and recommendations to improve the
present market position of BSE.

CHAPTER TWO
2.1 COMPANY PROFILE
Bombay Stock Exchange Limited is the oldest stock exchange of Asia and one
of the oldest in World with a rich heritage. As the first stock exchange in India,
the Bombay Stock Exchange Limited is considered to have played a very
important role in the development of countys capital market. The BSE is the
largest stock exchange of 24 exchanges in India, with over 6000 listed
companies. It is also the fifth largest exchange in the world with a market
capitalization of $466 billion. The Bombay Stock Exchange Limited uses BSE
SENSEX, an index of 30 large, developed BSE stocks. This index gives a
measure of overall performance of BSE and is tracked worldwide. In addition
to individual stocks the Bombay Stock Exchange Limited also a market for
derivatives, which was first introduced in India. Listed derivatives on the
exchange include stock futures and options, Index futures and options and
weekly options. The Bombay Stock exchange is also actively involved with the
development of retail debt market.
The Exchange has a nationwide reach with its presence in 417 cities and towns
of India. The systems and processes of the exchange are designed to safeguard
market integrity and enhance transparency in the operations. The Exchange
provides an efficient and transparent market for trading in equity, debt and
derivative instruments. The BSE provides online trading with the BSEs Online
trading System (BOLT), which is a proprietary system of the exchange and is
BS 7799-2-2002 certified. The Surveillance and Clearing Settlement function of
the Exchange are ISO 9001:2000 certified.
VISION
Emerge as the premier Indian stock exchange by establishing global
benchmark

2.2 HISTORY
One of the oldest stock exchanges of the world and the first in the country to be
granted permanent recognition under the Securities Contract (Regulation) Act,
1956, Bombay Stock Exchange Limited has had an interesting rise to
prominence over the past 133 years.
The Bombay Stock Exchange Limited traces its history to the 1850s, when four
Gujarati and one Parsi stock broker would gather under the banyan tree in front
of the Town Hall, where the Horniman Circle is now situated. A decade later,
the brokers moved their venue to another set of foliage, this time under banyan
trees at the junction of Meadows Street and Mahatma Gandhi Road. As the
number of brokers increased, they had to shift from place to place and wherever
they went, through sheer habit, they overflowed to the streets. At last, in 1874,
found a permanent place. The new place was, aptly, called Dalal Street. This
group of brokers in 1875 formed an official organization known as The Native
Share and Stock Brokers Association. In 1956, BSE became the first stock
exchange to be recognized by the Indian Government under the Securities
Contract (Regulation) Act, 1956. In 1979, BSE introduced its Index SENSEX
and from that time it achieved many milestones in the capital market. In 2002,
the name The Exchange, Mumbai was changed to Bombay Stock Exchange.
Subsequently on August 5, 2005, the exchange turned into a corporate entity
from an Association of Persons (AOP), under the provision of Companies Act,
1956, pursuant To BSE (Corporatization and Demutualization) Scheme, 2005
notified by Securities and Exchange Board of India (SEBI). Then it is renamed
as the Bombay Stock Exchange Limited.

2.3 PROMINENT POSITION

The journey of BSE is as eventful and interesting as the history of securities
markets of India. Indias biggest bourse, in terms of listed companies and
market capitalization, BSE has played a pioneering role in Indian securities
market. Much before the actual legislations were enacted, BSE had formulated
comprehensive set of rules and regulations for Indian capital markets. It also
laid down best practices adopted by Indian capital market after India gained its
independence. Perhaps, there would not be any leading corporate in India,
which has not sourced BSEs services in resource mobilization.
2.4 A PIONEER
BSE as brand is synonymous with the capital markets in India. The BSE
SENSEX is the benchmark equity index that reflects the robustness of the
economy and finance. At par with international standards, BSE has been a
pioneer in several areas. It has a several firsts to its credit,
First in India to introduce Equity Derivatives.
First in India to launch a Free Float Index.
First in India to launch US$ version of BSE SENSEX.
First in India to launch Exchange Enable Internet Trading Platform.
First in India to obtain ISO certification for Surveillance, Clearing and Settle.
First to have exclusive facility for financial training.
BSE On-Line Trading System (BOLT) has awarded with the global recognized
Information Security Management System Standard BS7799-2-2002. Moved
from Open Outcry to Electronic Trading within just 50 days. An equal important
accomplishment of BSE is the launch of a nationwide investor awareness
campaign Safe Investing in the Stock Market under which nationwide

awareness campaigns and dissemination of information through print and

electronic medium was undertaken. BSE also actively promoted the securities
market awareness campaign of the Securities and Exchange Board of India
(SEBI).
2.5 AWARDS
Bombay Stock Exchange Limited has many awards to its name for its
excellence in several fields, these are
The World Council of Corporate Governance has awarded the Golden Peacock
Global CSR Award for BSEs initiatives in Corporate Social Responsibility
(CSR).
The Annual Reports and Accounts of BSE for the year ended March 31, 2006
and March 31, 2007 have been awarded the ICAI Awards for excellence in
financial reporting.
The Human Resource Management at BSE has won the Asia Pacific HRM
Award for its efforts in employer branding through talent management at work,
health management at work and excellence in HR through technology.

2.6 BSE SWOT

STRENGHS: BSE has inherent advantages: its history, larger scrip base and a
stronger brand. The SENSEX (BSEs 30-share sensitive index) is one of the
most recognized indexes and tracked worldwide. Apart from lager base of listed
companies, BSE also has a historical perspective. Its online trending system
(BOLT) has awarded with the global recognized Information Security
Management System Standard BS7799-2-2002. It got the ISO certification for
its surveillance and clearing and settlement.
WEAKNESS : The BSE SENSEX, which delivers inferior hedging
effectiveness and higher impact cost. At present BSE has fewer than 12% share
across the cash and derivative market of equity markets. At present, BSE is
almost non-existence in derivatives space. BSE also lacks in terms of providing
better services to its customers and is not proactive.
OPPORTUNITIES : Corporatization will improve internal management systems
and investor relations, and benefit companies that are listed on BSE. Derivatives
market is growing at exponential rate and BSE with its large infrastructure and
long presence in the capital market has the capability to expand its market share
in this segment. If large a private sector bank picks up a strategic stake in BSE,
it could give the exchange access to a large distribution network and promote
new products like derivatives. 30 to 40 percent of the income of exchange like
NASDAQ and NYSE is from vending data. For BSE, its measly 4 percent. The
potential for growth then, is immense.
THREATS : Aggressive competitor like NSE poses major threat to BSEs
future. NSEs top 100 stocks alone account for nearly 80 percent of its cash
segments turnover, indicating that NSE is clearly the preferred destination for
trading in the top stocks.

CHAPTER THREE

INTRODUCTION TO DERIVATIVES
3.1 DERIVATIVES
Risk is a characteristic feature of all commodity and capital markets. Over time,
variations in the prices of agricultural and non-agricultural commodities occur
as a result of interaction of demand and supply forces. The last two decades
have witnessed a many-fold increase in the volume of international trade and
business due to the ever growing wave of globalization and liberalization
sweeping across the world. As a result, financial markets have experienced
rapid variations in interest and exchange rates, stock market prices thus
exposing the corporate world to a state of growing financial risk. Increased
financial risk causes losses to an otherwise profitable organization. This
underlines the importance of risk management to hedge against uncertainty.
Derivatives provide an effective solution to the problem of risk caused by
uncertainty and volatility in underlying asset. Derivatives are risk management
tools that help an organization to effectively transfer risk. Derivatives are
instruments which have no independent value. Their value depends upon the
underlying asset. The underlying asset may be financial or non-financial.
The term derivative can be defined as a financial contract whose value is
derived from the value of an underlying asset. Section 2(ac) of Securities
Contract (Regulation) Act, (SCRA), 1956 defines derivatives as,
a) a security derived from a debt instrument, share, loan whether secured or
unsecured, risk instrument or a contract for difference or any other form of
securities;

b) a contract which derives its value from the prices, or index of prices, of
underlying securities. The underlying asset may be a stock, bond, a foreign
currency, commodity or even another derivative security. Derivative securities
can be used by individuals, corporations, and financial institutions to hedge an
exposure to risk.

3.2 DERIVATIVE PRODUCTS

Derivative contracts have several variants. The most common variants are
forwards, futures, options and swaps. Various derivatives contracts are
described below,
3.2.1 FORWARDS
A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at todays pre-agreed
price. A forward contract is an agreement between two parties to buy or sell an
asset at a specific point of time in future and the price which is paid /received by
the parties is decided at the time of entering the contract.
3.2.2 FUTURE
A future contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Future contracts are standardized
forward contracts. Future contracts are traded in exchanges and exchange sets
the standardized terms in term of quantity, quality, price quotation, date and
delivery date (in case of commodities).
3.2.3 OPTIONS
An option contract, as the name suggests, is in some sense an optional contract.
An option is the right, but not the obligation, to buy or sell something at a stated
date at a stated price. Options are of two types;
CALL OPTIONS: A call option gives the buyer of the option the right, but not
the obligation to buy a given quantity of the underlying asset, at a given price
and on or before a given date.

 PUT OPTION: Put options give the buyer the right, but the obligation to sell a
given quantity of underlying asset at a given price on before a given date.
Options can also be European options and American options. This classification
is based on the exercise of the options. European options can be exercised at the
maturity date of the option. On the other hand, American options can be
exercised at any time up to and including the maturity date.
3.2.4 WARRANTS
Options generally have lives of up-to one year. Long dated options are called as
warrants and generally traded over-the-counter.
3.2.5 LEAPS
Long-Term-Equity-Anticipated Securities are options having a maturity of more
than three years or in other words options having a maturity of more than three
years are termed as LEAPS.
3.2.6 BASKETS
Basket options are options on portfolio of underlying assets. Equity index
options are a form of basket options
3.2.7 SWAPS
A swap means a barter or exchange. Thus, a swap is an agreement between two
parties to exchange stream of cash flows over a period of time in future. The
two commonly used swaps are,
i) INTEREST RATE SWAPS: Swaps which entail swapping only the interest
related cash flows between the parties in the same currency.
ii) CURRENCY SWAPS: These entail swapping both principal and interest
between two parities, with cash flows in one direction being in different
currency than those in the opposite direction.

3.3 PARTICIPANTS IN DERIVATIVE MARKET

The reason for which derivatives are so attractive is that they have attracted
different types of investors and have a great deal of liquidity. When an investor
wants to take one side of a contract, there is usually no problem in finding
someone that is prepared to take the other side. Three broad kinds of
participants can be found in derivatives market, namely, hedgers, speculators
and arbitrageurs.
1. Hedgers: They use derivatives markets to reduce or eliminate the risk
associated with price of an asset. Majority of the participants in derivatives
market belongs to this category.
2. Speculators: They transact futures and options contracts to get extra leverage
in betting on future movements in the price of an asset. They can increase both
the potential gains and potential losses by usage of derivatives in a speculative
venture.
3. Arbitrageurs: Their behaviour is guided by the desire to take advantage of a
discrepancy between prices of more or less the same assets or competing assets
in different markets. If, for example, they see the futures price of an asset
getting out of line with the cash price, they will take offsetting positions in the
two markets to lock in a profit.

3.4 CLASSIFICATION OF DERIVATIVES

Broadly derivatives can be classified into two categories, commodity
derivatives and financial derivatives. In case of commodity derivatives, the
underlying asset can be commodities like wheat, gold, silver etc; whereas in
case of financial derivatives the underlying assets are stocks, currencies, bonds
and other interest bearing securities etc. A figure below shows the classification
of derivatives,
Basing on the type of market, derivative market is of two types, exchangetraded derivatives market and over-the-counter derivative market.
In the exchange-traded derivatives, the derivatives which are standardized in
nature are traded. The trading of the derivatives is well regulated by the
exchanges.
The over-the-counter market is an important derivative market and has larger
volume of trade than the exchange-traded market. It is a telephone- and
computer- linked network of dealers.
Traders are done over the phone and are usually between two financial
institutions or between a financial institution and one of its clients. Telephone
conversations in the OTC market are usually taped. If there is a dispute about
what was agreed, the tapes are replayed to resolve the issue. A key advantage of
over-the-counter market is that all the products are customized. Market
participants are free to negotiate any mutually alternative deal. A disadvantage
is that there is usually credit risk in an over-the-counter trade. The over-thecounter market is not regulated by any regulatory body and hence posses a huge
counterparty risk.

3.5 ECONOMIC SIGNIFICANCE OF DERIVATIVES

Some of the significance of financial derivatives can be enumerated as follows;
1) The most important function of derivatives is risk management. Financial
derivatives provide a powerful tool for limiting risks that individuals and
organizations face in ordinary conduct of their business.
2) The prices of derivatives converge with the prices of underlying at the
expiration of derivative contract. Thus, derivatives help in discovering the
future as well as current prices.
3) As derivatives are closely linked with the underlying cash market, with the
introduction of derivatives, the underlying cash markets witness higher trading
volumes. This is because; more people participate in stock market due to the
risk transferring nature of derivatives.
4) Speculative trade shift to a more controlled environment of derivative
market. In the absence of an organized derivatives market, speculators trade in
the cash markets. Margining, monitoring and surveillance of various
participants become extremely difficult in these kinds of mixed markets.
5) Derivatives trading acts as a catalyst for new entrepreneurial activities. In a
nut shell, derivatives markets encourage investment in long run. Transfer of risk
enables market participants to expand their volume of activity.

3.6 INTERNATIONAL DERIVATIVE MARKET

The financial derivatives which were meant to address the needs of farmers and
merchants have now a major share in the financial market place. Started with he
establishment of Chicago Board of Trade (CBOT), derivatives are now traded in
almost all major stock exchanges of the world. Boosted with the breakdown of
Brettonwoods system, the derivatives got the recognition of risk management
instruments and are used by all investors starting from individual investor to
institutional investor.
Thus, the global derivative market is now a wide spread market with a potential
of further growth. In last two decades derivatives has shown a tremendous
growth and also continuing to grow in future.
Major stock exchanges of derivatives trading are Chicago Mercantile Exchange
(CME), Eurex, Hongkong Futures Exchange, The London International
Financial Futures and Options Exchange (LIFFE), Singapore Exchange, Sydney
Futures Exchange etc. Apart from these stock exchanges other stock exchanges
of various countries has shown a huge growth in derivatives trading.
3.7 INDIAN DERIVATIVE MARKET
Derivatives markets in India have been in existence in one form or the other for
a long time. In the area of commodities, the Bombay Cotton Trade Association
started futures trading way back in 1875. In 1952, the Government of India
banned cash settlement and options trading. Derivatives trading shifted to
informal forwards markets. In recent years, government policy has shifted in
favour of an increased role of market-based pricing and less suspicious
derivatives trading. The first step towards introduction of financial derivatives
trading in India was the promulgation of the Securities Laws (Amendment)
Ordinance, 1995. It provided for withdrawal of prohibition on options in
securities. The last decade, beginning the year 2000, saw lifting of ban on

futures trading in many commodities. Around the same period, national

electronic commodity exchanges were also set up.
Derivatives trading commenced in India in June 2000 after SEBI granted the
final approval to this effect in May 2001 on the recommendation of L. C Gupta
committee. Securities and Exchange Board of India (SEBI) permitted the
derivative segments of two stock exchanges, NSE and BSE, and their clearing
house/corporation to commence trading and settlement in approved derivatives
contracts. Initially, SEBI approved trading in index futures contracts based on
various stock market indices such as, S&P CNX, Nifty and SENSEX.
Subsequently, index-based trading was permitted in options as well as
individual securities.
The trading in BSE SENSEX options commenced on June 4, 2001 and the
trading in options on individual securities commenced in July 2001. Futures
contracts on individual stocks were launched in November 2001. The
derivatives trading on NSE commenced with S&P CNX Nifty Index futures on
June 12, 2000. The trading in index options commenced on June 4, 2001 and
trading in options on individual securities commenced on July 2, 2001. Single
stock futures were launched on November 9, 2001. The index futures and
options contract on NSE are based on S&P CNX. In June 2003, NSE introduced
Interest Rate Futures which were subsequently banned due to pricing issue.
Since the scope of this project is limited to equity derivatives only, so the
further discussion will be confined to equity derivatives only.
Equity derivatives market in India has registered an "explosive growth" and is
expected to continue the same in the years to come. Introduced in 2000,
financial derivatives market in India has shown a remarkable growth both in
terms of volumes and numbers of traded contracts. NSE alone accounts for 99
percent of the derivatives trading in Indian markets. The introduction of

derivatives has been well received by stock market players. Trading in

derivatives gained popularity soon after its introduction. In due course, the
turnover of the NSE derivatives market exceeded the turnover of the NSE cash
market. For example, in 2008, the value of the NSE derivatives markets was Rs.
130, 90,477.75 Cr. whereas the value of the NSE cash markets was only Rs.
3,551,038 Crore. If I compare the trading figures of NSE and BSE, performance
of BSE is not encouraging both in terms of volumes and numbers of contracts
traded in all product categories.
NSES DERIVATIVE SEGMENT
The National Stock Exchange accounts almost 99% of the Indian derivatives
market in terms of turnover, volume etc. Its equity derivatives market is most
boosted one and in turnover it is a major stock exchange. All products in equity
derivative segment i.e. Index Futures and Options and Stock Futures and
Options have marked a tremendous growth over the last decade. The graph
below shows the average yearly turnover in each equity derivative products and
average daily turnover of derivative segment of NSE.

CHAPTER FOUR
RISK AND RISK MANAGEMENT
4.1 RISK
Over the past two decades and so, the markets have seen debacle after another,
each of which has brought its lessons from some of which the markets have
learned and from many of which markets still need to learn. The Great
Depression of 1930s has brought remainder to all financial markets or the
economies as a whole. The 1987 crash taught markets the dangers of automated
trading models and the second and third-order effects of credit crisis. In 1990,
Wall Street learned the horrors of holding huge illiquid investments. In 1994s
spectacular bond market collapse, financial executives saw for the first time
how correlated global markets had become as the fallout from Federal Reserve
Board rate hikes swept from the US through Europe, before devastating Mexico
and other emerging markets. The Russian meltdown in August 1998 was
widespread and mounting. Banks and brokerage firms took turns announcing
trading losses from emerging markets, high yield, equities, or dealings with
hedge funds. Most recently, the Global Financial Meltdown, which was started
with the US sub-prime mortgage crisis, has captured almost all economies of
the world. Many banks become bankrupt, many loss their job, increased
budgetary deficits are the result of this crisis. Thus, it can be said that, the
financial market is full of risk and uncertainties. Finance has never been so
competitive, so far-flung, and so quantitative. Information flow has never been
so fast. But with the passage of time, financial markets are becoming more
sophisticated in pricing, isolating, repackaging, and transferring risks. Tools
such as derivatives and securitization contribute to this process, but they pose
their own risks. The failure of accounting and regulation to keep abreast of
developments includes yet more risks, with occasionally spectacular

consequences. Practical applications including risk limits, trader performancebased compensation, portfolio optimization, and capital calculations all
depend on the measurement of risk. In the absence of a definition of risk, it is
unclear what, exactly, such measurements reflect.
Charles Tschampion, the MD of the $50 bn GM Pension fund, once said
Investment management is not an art, not science, it is engineering. We are in
the business of managing and engineering financial investment risk; the
challenge is to first not take more risk than we need to generate the returns that
is offered. It is a profound statement that well captures the philosophical and
mathematical connotation of Risk.
The terms risk and uncertainty are often used interchangeably though there is a
clear distinction between them. Certainty is a state of being completely
confident, having no doubts of whatever being expected. Uncertainty is just
opposite of that. Risk is situation where there are a number of specific, probable
outcomes, but it is not certain as to which one of them will actually happen. In
that context risk is not an abstract concept. It is a variable, which can be
calibrated, measured and compared. So to define risk, risk entails two essential
components; exposure and uncertainty. Thus, risk is the exposure to uncertainty.
4.2 RISK MANAGEMENT PROCESS
Market integration, liberalization, globalization and technical advancement has
resulted with an increased competition in the market and the corporate are hence
exposed to risk. Thus a proper and unbiased assessment of risk is a prerequisite
for a sound management process. Moreover, with the advancement of
communication system and technology, the markets over the world are getting
interconnected. Thus making an effective risk management system is the need
of the hour. Risk management is the process in which risk is minimized with the
application of certain tools. The risk management process essentially comprises

of certain steps, such as, identification, assessment, prioritization, followed by

coordinated and economical application of resources to minimize, monitor and
control it. These steps are described below,
4.2.1 IDENTIFICATION
The risk management process starts with the identification of the factors which
are exposed to risk. It is always of primary concerns to identify the factors
which are more vulnerable and weak points in the system.
4.2.2 ASSESSMENT
After identifying the risk exposure points, it then to be assessed, i.e. to what
extent it is susceptible to that particular risk that has to be measured.
Assessment of risk helps in knowing the extent of vulnerability of a particular
factor which is risk exposed.
4.2.3 PRIORITIZATION
The next step of risk management process is the prioritization of factors which
are more vulnerable. The assessment of risk results in identifying the factors
which are more risk exposed and then these factors are prioritized from risk
management point of view.
4.2.4 APPLICATION OF RESOURCES TO MINIMIZE RISK
After identifying the most vulnerable factor, the management team applies
economic resources to minimizing the risk. This is the most important stage of
risk management as any wrong step can result a more susceptible situation.
4.2.4 MONITOR
The final step of risk management is monitoring the risk management process.
Simply applying the resources to minimize the risk is not the last step of risk
management, as it is needed to analyze the success of the risk management

process. For this reason the entire process is monitored and if anything goes
wrong, it is rectified.
4.3 RISK ASSOCIATED WITH DERIVATIVES TRADING
The continuing discussion of risks and its management in derivative markets
illustrates that there is little agreement on what the risks are and how to control
it. One source of confusion is the sheer profusion of names describing the risks
arising from derivatives. Besides the price risk of losses on derivatives from
change in underlying asset values, there is default risk, settlement risk, and
operational risk. Last, but certainly not the least, is the specter of systemic
risk that has captured so much congressional and regulatory attention. All these
risks associated with derivatives market are described below,
4.3.1 PRICE RISK
Price arises for the simple reason that the price of the underlying and price of
the derivatives are correlated. If the prices of the underlying increases, the
impact is seen in corresponding prices of derivatives products i.e. their prices
also increase. For an investor who is short in a futures contract or long in a put
option or short in a call option, there are potential losses. Thus, he or she may
default in the obligation of the derivative contract. This is price risk associated
with the derivatives. Default due to Price risk is mitigated by imposing some
risk management tools in exchange-traded derivatives, but in case of over-thecounter market, since it is largely unregulated, default is more due to price risk.
4.3.2 DEFAULT RISK
This may the most popular and hazardous risk associated with the derivatives.
As derivatives are contracts or agreements, they need the obligations to be
performed. If any party default from the contract, then the contract is
meaningless. The risk that arises from the default of any party in derivatives is

called as default risk. This is common risk that is found in over-the-counter

derivative market, but in exchange-traded market, this type of risk is minimized
by regulating the transactions. Default risk is the risk that losses will be incurred
due to default by the counterparty. As noted above, part of the confusion in the
current debate about derivatives stems from the profusion of names associated
with the default risk. Terms such as credit risk and counterparty risk are
essentially synonyms for default risk. Legal risk refers to the enforceability of
the contract. Terms such as Settlement risk and Herstatt risk refer to
defaults that occur at a specific point in the life of the contract: date of
settlement. These terms do not represent independent risks; they just describe
different occasions or causes of default. Default risk has two components: the
expected exposure and the probability that default will occur. The expected
exposure measures how much capital is likely to be at risk should the
counterparty defaults. The probability of default is the measure of the possibility
that the counterparty will default.
4.3.3 SYSTEMATIC RISK
One of the prominent concerns of regulators is systematic risk arising from
derivatives. Although this risk is rarely defined and almost never quantified, the
systemic risk associated with the derivative contracts is often envisioned as a
potential domino effect in which default in one derivative contract spreads to
other contracts and markets, ultimately threatening the entire financial system.
For the purpose of this paper, systemic risk can be defined as widespread default
in any set of financial contracts associated with default in derivatives. If
derivative contracts are to cause widespread default in other markets, there first
must be large defaults in derivative markets. In other words, significant
derivative defaults are a necessary condition for systematic problems. It is
argued that widespread corporate risk management with derivatives increases
the correlation of default among financial contracts. What this argument fails to

recognize, is that the adverse effects of stocks on individual firms should be

smaller precisely because the same shocks are spread more widely. Moe
important, to the extent firms use derivatives to hedge their existing exposures,
much of impact of stocks is being transferred from corporations and investors
less able to bear them to counterparties better able to absorb them. It is
conceivable that financial markets could be hit by a large disturbance. The
effect of such disturbances depends, in particular, on the duration of the
disturbances and whether firms suffer common or independent shocks. If the
disturbance were large but temporary many outstanding derivatives would be
essentially unaffected because they specify only relative infrequent payment.
Therefore, a tempore disturbance would primarily affect contracts with required
settlements during this period. If the shock were permanent, it would affect the
derivatives in a much hazardous way.
4.4 RISK MANAGEMENT OF DERIVATIVES
Derivatives, which come to light as a hedging instrument against volatility of
market and market related risk, created risk when there is a default. This gave
rise to the essence of risk management of derivatives and derivatives trading. In
case of OTC derivatives, as it is not regulated, it is more risky and there is no
risk management at all. But in case of exchange traded derivatives, several risk
management tools are applied to ensure the integrity of the market. The tools
used for risk management of derivatives are described below;
4.4.1 MARGINS
Margins are upfront payment by the participants of the derivatives market to the
exchanges. This upfront payment is collected to ensure that none will default in
future in obliging his obligation. If someone defaults then the clearinghouse
settles the contract from this margin account. Exchanges clearinghouse collects
the margin from the clearing member, the clearing member collects the margin

from the trading member or the brokers and it is the responsibility of the trading
members to collect the same from its clients.
4.4.2 MARK-TO-MARKET MARGIN
In case of futures contracts, the margin is mark-to-market on daily basis i.e. the
gain or loss of a day is settled to the margin account on a daily basis. If the long
position gains, then the amount he gained will be transferred to his account in
the end of the day. Similarly, if the investor losses, the amount that he lost is
withdrawn from his account.
4.4.3 EXPOSURE LIMITS
If an investor holds quite a large position than his capacity, then the probability
that he will default is more. For this reason, the regulatory body of the
derivative market put an exposure limit for the participants beyond which one
cannot take position in the market. This will ensure the integrity in term that
nobody will default.
4.4.4 POSISTION LIMITS
Position limit is more applicable for the high net worth individuals, the FIIs and
the mutual funds. This is because, these people have huge investible cash and
they can direct the market as their wish. This will harm the market and other
participants of the market. Thus a position limit is introduced for this type of
risk by the regulators for the sound running of the market.
4.4.5 FINAL SETTLEMENT
Final settlement is the last part of risk management in case of derivatives. The
settlement is done by the clearing house of the exchange. On exercise the
settlement is done on the closing price of the derivative product and final
settlement takes place on T+1 basis. If the long position exercises his right, then

the settlement is done by randomly assigning the obligation on a short position

at the end of the day. Frankly speaking risk management of derivatives
comprises of two things i.e. margining requirement and the regulatory
requirement. Thus risk management of derivatives is nothing but, complying the
rules and regulation laid down by the regulator and satisfying the margin
requirement.

CHAPTER FIVE

INTERPRETATION AND ANALYSIS

In the course of study of the risk management process used in BSE for
derivative segment, the following things are observed. The risk management of
derivatives in BSE has two parts; one is the margining system and the
regulatory requirement. The details of these are explained below, For margining
the BSE is following portfolio based margining system and the margin
calculation is done by software known as PC SPAN. The portfolio based
margining model adopted by the exchange takes an integrated view of the risk
involved in the portfolio of each and every individual client comprising of his
positions in all derivatives contract traded on derivative segment. The SPAN
(Standard Portfolio Analysis of Risk System) is a portfolio based margining
system developed by Chicago Mercantile Exchange and it is being used by
almost all stock exchanges now. For setting the margin the exchange has a
margin committee, which decides about various factors to be considered while
calculating the margin requirements.
5.1 THE SPAN MARGINING SYSTEM
The SPAN margins are estimates of changes in futures and futures-options
contract prices that would occur under various next-day realizations of futures
prices and implied volatility. The inputs into SPAN are; the futures price scan
range, the implied volatility scan range, the minimum short option charge, the
calendar spread charge, the inter-commodity spread charge. These are described
below;

5.1.1 THE FUTURES PRICE SCAN RANGE:

The price scan range inputs sets the maximum underlying price movement that
the margin committee chooses to consider in setting margin collateral
requirements. The futures price scan range is the clearinghouse margin
requirement on a naked future position and controlling input into the option
pricing model simulation that ultimately determines the margin requirements.
The future scan range is set by the margin committee after examining historical
price movements and applying subjective judgments.
5.1.2 THE IMPLIED VOLATILITY SCAN RANGE:
The implied volatility scan range is the largest movement in implied volatility
that margin committee chooses. The margin committee sets input scan ranges
after analyzing histograms of absolute value of day-to-day changes in the
implied volatility of traded futures-option contracts. The underlying average
implied volatility estimate that is analyzed is a simple average of eight contracts
implied volatility on a given maturity: the first is in-the-money and first three
out-of-the-money implied volatility estimates for both calls and puts.
5.1.3 THE MINIMUM SHORT OPTION CHARGE:
The minimum short option charge or minimum margin on an option contract is
set at 2.5% of the clearing members futures price scan range.
5.1.4THE CALENDAR SPREAD CHARGE:
The calendar spread charge is put into the SPAN is a parameter that sets the
amount of margin collateral, the clearinghouse collects against calendar spread
basis risk in portfolios. The calendar spread basis is the difference between
prices of contracts with different maturities. The basis between nearest quarterly
and next quarterly futures contract is calculated. Histograms of the absolute
value changes in basis series are constructed for different windows periods, and

the histograms are considered by the margin committee while calculating

margin.
5.1.5 THE INTER-COMMODITY SPREAD CHARGE:
The inter-commodity spread charge is an input that sets the collateral
requirement that must be posted to protect against correlation risk in intercommodity spread positions.
In SPAN, futures and futures options changes are estimate under alternative
scenario that are determined by the values chosen for the price and implied
volatility scan range inputs. In the simulation analysis, the value of each option
contract is estimated for following day using Black Option Pricing Model. The
next-day contract prices are determined under alternative scenarios in which
underlying futures contracts price and implied volatility move by
predetermined function of their scan range. The futures price and implied
volatility scan inputs are translated into 16 different scenarios that represent
alternative combinations of futures price and implied volatility changes. For
each scenario simulated, the contracts value is reported as an element called
SPAN risk array. This average implied volatility is then shocked by the
implied volatility scan range in the SPAN simulations. The next day simulated
contract prices are compared with the prior days theoretical settlement price
and contract gains and losses are calculated as the difference in these prices. In
extreme price move scenarios, the CMEs margin committee has decided to
margin 35% of the simulated price move gain or loss is the value reported in
these extreme price move SPAN array entries. The SPAN risk array is given
below,

1. Underlying unchanged; volatility up

2. Underlying down; volatility down
3. Underlying up by 1/3 of price scan range; volatility up
4. Underlying down by 1/3 of price scan range; volatility down
5. Underlying down by 1/3 of price scan range; volatility up
6. Underlying up by 1/3 of price scan range; volatility down
7. Underlying up by 2/3 of price scan range; volatility up
8. Underlying down by 2/3 of price scan range; volatility down
9. Underlying down by 2/3 of price scan range; volatility up
10. Underlying up by 2/3 of price scan range; volatility down
11. Underlying up by 1 of the price scan range; volatility up
12. Underlying down by 1 of the price scan range; volatility down
13. Underlying down by 1of price scan range; volatility up
14. Underlying up by 1 of price scan range; volatility down
15. Underlying up extreme move, double the price scanning range
16. Underlying down extreme move, double the price scanning range

5.2 WORKING OF SPAN MARGIN SYSTEM

The clearinghouse of the exchange electronically distributes a SPAN risk array
for every derivative product that it clears and settles. Clearing members firms
receive these arrays and use them to calculate their margin requirements for
their customers account. The maximum loss across the 16 scenarios becomes
the Preliminary SPAN margin for that account. The final margin requirements
may differ from this preliminary margin owing to additional margin
requirements that resulted from margin requirement on calendar spreads and
minimum margin requirement for written options contracts. Inter-commodity
spread charges also enter into the final margin calculation. Each written option
contract is subjected to minimum margin requirement. For a portfolio, this
margin requirement is the product of the number of written options times the
minimum short option charge.
5.4 MARK-TO-MARKET OF MARGIN
o For all stock futures and index futures contract, the clients position is
marked-to-market on a daily basis at portfolio level. The mark-to-market margin
is paid in/out in T+1 day in cash. For determining the mark-to-market margin,
the closing price is taken into consideration.
5.5 EXPOSURE LIMITS
The exposure limit for different equity derivatives products are given below;
o In case of stock futures contracts, the notional value of gross open positions at
any point in time should not exceed 20 times the available liquid net-worth of a
member, i.e. 10% of the notional value of gross open position in single stock
futures or 1.5 of the notional value of gross open position in single stock
futures, whichever is higher. However BSE charges exposure margin for better
risk management.

o For stock options contracts, the notional value of gross short open position at
any time would not exceed 20 times of the available liquid net-worth of the
member, i.e. 5% of the notional value of gross short open position in single
stock options or 1.5 of notional value of gross short open position in single
stock options whichever is higher.
o In case of index products, the notional value of gross open positions at ant
time would not exceed 33 1/3 times of the available liquide networth of the
member. for index products, 3% of the notional value of gross open position
would be collected from the liquide networth of a member on a real time basis.
5.6 POSITION LIMITS
o A market wide limit on the open position on stock options and futures
contracts of a particular underlying stock is 20% of the number of shares held
by non-promoters i.e. 20% of the free float, in terms of number of shares of a
company.
o In case of stock futures and options, the stock having applicable market wide
position limit (MWPL) of Rs. 500 crores or more, the combined futures and
options position limits shall be 20% of market wide position limit or Rs. 300
crores, whichever is lower and within which shock futures position cannot
exceed 10% of applicable market wide position limit or Rs. 150 crores,
whichever is lower. This is the position limit for trading members, FII and
mutual funds.
o For stocks having applicable market wide position limit less than Rs. 500
crores, the combined futures and options position limit would be 20% of
applicable market wide position limit or Rs. 50 crore whichever is lower. This is
applicable for trading members, FII and mutual funds.

o For futures and options contracts, the trading members, FII and mutual funds
position limits shall be higher of; Rs. 500 crores or 15% of total open interest in
the market in equity index futures contracts or equity index options contract
respectively.
o The gross open position of clients, sub-accounts, NRI level and for each
scheme of mutual funds across all derivatives contracts on a particular
underlying shall not exceed higher of; 1% of the free float market capitalization
or 5% of the open interest in underlying stock.
o Any person who holds 15% or more of the open interest in all derivatives
contracts on the index shall be required to disclose the fact to the exchange and
failure of which will attract a penalty.

5.7 FINAL SETTLEMENT

o On expiry of a stock futures or index futures contract, the contract is settled in
cash at the final settlement price. The final settlement price is the closing price
of the underlying stock or the index respectively. The profit or loss is paid in or
out in T+1 day.
o On exercise or assignment of options, the settlement takes place on T+1 basis
and in cash. On expiry, if the options are not exercised or closed out, all in-themoney options are settled by the exchange at the settlement price. The
settlement price is the closing price of the stock or index in the cash segment.
On exercise of options, the assignment takes place on a random basis at client
level. At present there would not be any exercise limit for trading in options, but
the exchange can specify the limit as per its convenience.

CHAPTER SIX
6.1 MAJOR FINDINGS
On course of study of the risk management process of derivatives in BSE, the
following observations are pointed out. Since the study is focused on equity
derivatives only, the findings are concerned only about equity derivatives.
6.1.1 SPAN MARGINING SYSTEM
The SPAN (Standard Portfolio Analysis of Risk) is a portfolio based margining
approach for calculation of margin requirement of derivatives. This is an
integrated system of margining that reduces margining requirement on
derivatives than any other system of margining. The SPAN margining system in
BSE is an efficient system of margin calculation. The procedure in which the
SPAN is calculated in BSE can be compared to any major exchange of the
world and covers almost 99% of risk exposure of the exchange.
6.1.3 RISK MANAGEMENT
o The risk management process for derivatives used by BSE is efficient and
effective system.
o It covers about 99% Vary at any time.
o This also helps in protecting the market and helps in increasing the market
integration.
o On comparing the risk management process of BSE with that of NSE, it is
found that it is almost same. But NSE has an added advantage for the
information related services that it provides.
o BSE provides its data on a graphical format, whereas NSE provides the same
on a tabular format, which is easy to understand.

o The NSE uses PRISM (Parallel Risk Management System), which monitors
the derivatives segment of NSE on a real time basis. But BSE do not have, this
system.
6.2 SUGGESTIONS
Based on the interaction with different broking firms, it is observed that BSE is
comparable to NSE in technical terms. However, BSE lacks in providing better
services and information to the investors, which leads to poor market position in
derivatives.
o During our interaction with the brokers we come to know that, the services
provided by NSE are more reliable than that of BSE. So BSE should try to
provide integrated services to its members to improve its derivatives segment.
o Regarding the risk management procedure, as there is no difference between
NSE and BSE, it can be said that, BSE should continue with this process.
o BSE should improve its monitoring system for better risk management of the
exchange.
o Another major cause for BSEs lost market share is the failure in providing
data. BSE can focus on this part in particular. It should also provide data in
tabular format rather than graphical format, so that it can be easily understood
by the investors.
o To improve its derivatives segment, BSE has to constantly innovate in terms
of services, products and technology, otherwise it cannot compete with NSE.
o BSE charges more margins for better risk management, which in terms harms
its market position. Thus, a reasonable margin should be charged on the
members for development of derivatives market and better risk management.

6.3 CONCLUSION
BSE with its distinctive feature has a long, colorful and chequered history. It
enjoys a pre-eminent position by having a permanent recognition from the
Securities Contract (Regulation) Act, 1956. It can be considered as an essential
concomitant of the Indian economy. It is performing all the important functions
of an ideal stock exchange by providing a ready and continuous market with
negotiability and safety to investment of investors; redressing their grievance,
minimizing risk, and providing a forum to ensure liquidity and attracting capital
from the investors, etc.
Despite the efficiency and transparency, BSE still lags behind NSE and faces a
stiff competition from it. Particularly, NSE holds about 99% of the derivatives
market of India, whereas BSEs position is negligible. This can be attributed to
the following reasons.
Firstly, lack of detail and timely information of derivative segment and its risk
management is one of the main reasons for the falling market share of the BSEs
derivatives segment.
Secondly, the data files for margin calculation are not precious as NSE has. This
is also one of the key obstacles in the development of derivative segment of
BSE.
When BSE losses NSE gains.
Thirdly, the lack of monitoring system for risk management is another problem
with BSE. NSE has PRISM as the monitoring system which enables it for better
risk management of derivatives. Coming to risk management of derivatives in
BSE, BSE has an efficient and effective risk management system, which can be
compared with any of the exchange of the world. The SPAN margining system
followed by BSE for margin calculation is one of the most efficient systems of

margining. Along with this the regulatory requirement of BSE makes the risk
management system stronger and effective. Though the margin with which BSE
lags behind NSE is too much for derivatives market, but a committed effort can
help BSE to gain supremacy in this segment. This can be done by making itself
more informative, monitoring the risk management process and taking some
aggressive steps for the improvement of the derivatives segment. All it needs to
do is to take quick and timely decisions for the improvement of the derivatives
segment.

BIBLIOGRAPHY
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www.moneycontrol.com
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http://www.cboe.com/learncenter/glossary.aspx
http://www.cme.com/SPAN/
http://www.sgx.com/
http://www.asx.com/
http://www.sebi.gov/
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