Synopsis

In this project “Risk Management of Derivatives Market”, the major objective was to find out the
effectiveness and efficiency of the risk management process of derivatives segment. For
achieving this objective secondary Data was gathered and the details of the risk management
process of derivatives in Indian Market were analyzed. SEBI guidelines and circulars are also
referred for this purpose. During the Research it was found that the risk management process of
Derivatives Market in India is efficient and can be compared with any of the major stock
exchange of the world. The SPAN margining system that BSE follows for margin calculation is
an effective system of risk management and most of the exchanges of the world follow this
method for margin calculation. The software PC SPAN®, used by BSE for SPAN margin
calculation is reliable and user friendly software. In case of risk management, BSE lags behind
NSE in one area i.e. monitoring. NSE has an integrated system (PRISM) for monitoring the risk,
whereas BSE does not have such facility thus the recommendation in accordance with this
project would be that BSE should take aggressive steps for expansion of its derivatives segment.
This coupled with a few with the risk management process such as providing real time
information about the parameters; especially the risk array and the trading information in tabular
form rather than graphical form, use of better monitoring system for risk management would
help BSE to improve its market position in derivatives As Compared to NSE.

Risks 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 study attempts to discuss the genesis of derivatives trading by tracing its historical
development, types of traded derivatives products, regulation and policy developments, trend and
Growth, future prospects and challenges of derivative market in India
The Study also attempts to understand the risks which are present in trading with derivative
Products and the tools which are used to mitigate the risk by the regulatory bodies in India.
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;
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.
Exchange’s 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.

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.
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.

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.
MARK-TO-MARKET OF MARGIN o For all stock futures and index futures contract, the
client’s 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.

FINAL SETTLEMENT

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. 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-the money 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.