1.1.

Evolution of Financial Derivatives Products

Derivatives may have found their way into the media in very recent times. However, they have

been used by mankind for a very long time. Since the inception of time, humans have not liked

the idea of uncertainty. More so, they did not like the idea of economic uncertainty. Hence, the

need to offset this uncertainty gave rise to the evolution of contracts. Earlier contracts were

verbal agreements and were not as sophisticated as the ones today. However, they were

contracts nonetheless.

Ancient

Derivatives are said to have existed even in cultures as ancient as Mesopotamia. It was said that

the king had passed a decree that if there was insufficient rain and therefore insufficient crop,

the lenders would have to forego their debts to the farmers. They would simply have to write it

off. Thus, the farmers had just been given a put option by the king. If certain events unfolded in

a certain way they had the right to simply walk out of their liabilities!

There have been many such examples that have been quoted during the time. Another famous

example pertains to Greek civilization when one of Aristotle’s followers who was adept at

studying meteorology predicted that there would be a bumper crop of olives that year. He was

so sure that he went ahead and purchased the produce of all the Olive farms in and around

Athens before the crop had been harvested. In the end it did turn out to be a bumper crop and

Aristotle’s disciple made a huge profit from his way ahead of time forwards contract.

19th Century: Chicago Board Of Trade

During the nineteenth century, America was at its pinnacle of economic progress. America was

the center of innovation. One such innovation came in the field of exchange traded derivatives

when farmers realized that finding buyers for the commodities had become a problem. They

created a joint market called the “Chicago Board of Trade”. A few years later, this market

evolved into the first ever derivatives market. Instead of buyers and sellers negotiating their
own customized contracts, there were now standard contracts listed on the exchange which

could be bought and sold by anyone. This idea proved to be a big hit. Soon Chicago Board of

Trade had to create a spinoff called Chicago Mercantile Exchange to handle the growing

business.

Recently Chicago Board of Trade and Chicago Mercantile Exchange have been merged to form

the CME group. It is still one of the foremost derivatives markets in the world. The massive

success witnessed by the members of the Chicago Board of Trade led to the creation of many

such exchanges across the globe. However, during the era of Chicago Board of Trade, derivatives

trading was limited to commodities only. Other financial instruments were largely outside the

realm of such trading.

Modern Day

Innovations in the modern financial market have largely been based on the idea of derivatives.

What started as a simple idea in ancient times was later developed into standard contracts

during the Chicago Board of Trade era has now become a maze of complex financial instruments

and contracts. The asset classes on which the derivative instruments were based have

undergone a rapid expansion. Nowadays, there is a derivative for pretty much everything.

We have derivatives for stocks, indices, commodities, real estate etc. We even have derivatives

that are based on other derivatives creating a Meta structure of sorts. The reason behind this

rapid expansion is that derivatives meet the needs of a large number of individuals and

businesses worldwide.

After the collapse of 2008, derivatives had to take the fall for the entire chain of events. They

were vilified by the media in general. That has come as somewhat of a setback. Barring that the

rise of derivatives in the recent years has been nothing short of extraordinary and this is

expected to continue in the future.

 www.managementstudyguide.com

Definition of Derivatives

Derivative is in Mathematics means a variable derived from another variable. The term

derivative as such has no value of its own, its value is entirely derived from the value of the

underlying asset. The underlying asset can be security, commodity, bullion, curre3ncy, live stock

or anything else. Without the underlying product, derivative do not have any independent

existence in the market.

Raiyani, Jagadish. Financial Derivative in India. New Delhi: New Century Publication. Pg-25,26

“derivative” is defined by the Indian Securities contracts Regulation Act,1956 as— (A) a

security derived from a debt instrument, share, loan, whether secured or unsecured, risk

instrument or contract for differences or any other form of security; (B) a contract which derives

its value from the prices, or index of prices, of underlying securities;]

Securities Contracts (Regulation) Act, 1956 [42 Of 1956]

1.3.Products, Participants and Functions

Products

The most commonly used derivative contracts are forwards, futures and options.

Forwards :

A forward contract is a customized contract between two entities where settlement takes place

on a specific date in the futures at today’s pre-agreed price. Forward contracts offer

tremendous flexibility to the party’s to design the contract in terms of the price, quantity,

quality, delivery, time and place. These have limitations like poor liquidity and default risk.

. It is the simplest form of derivative contract mostly entered by individuals in day to day’s life.

Forward contract is a cash market transaction in which delivery of the instrument is deferred
until the contract has been made. Although the delivery is made in the future, the price is

determined on the initial trade date. One of the parties to a forward contract assumes a long

position (buyer) and agrees to buy the underlying asset at a certain future date for a certain

price. The other party to the contract known as seller assumes a short position and agrees to

sell the asset on the same date for the same price. The specified price is referred to as the

delivery price. The contract terms like delivery price and quantity are mutually agreed upon by

the parties to the contract. No margins are generally payable by any of the parties to the other.

Forwards contracts are traded over-the- counter and are not dealt with on an exchange unlike

futures contract. Lack of liquidity and counter party default risks are the main drawbacks of a

forward contract.

For instance, consider a US based company buying textile from an exporter from England worth

£ 1 million payment due in 90 days. The Importer is short of Pounds- it owes pounds for future

delivery. Suppose the spot (cash market) price of pound is US $ 1.71 and importer fears that in

next 90 days, pounds might rise against the dollar, thereby raising the dollar cost of the textiles.

The importer can guard against this risk by immediately negotiating a 90 days forward contract

with City Bank at a forward rate of say, £ 1= $1.72. According to the forward contract, in 90 days

the City Bank will give the US Importer £ I million (which it will use to pay for textile order), and

importer will give the bank $ 1.72 million (1million ×$1.72) which is the dollar cost of £ I million

at the forward rate of $ 1.72.

Futures:

A futures contract is an agreement between two parties to buy or sell an asset at a specific time

in the future at a particular price. Futures is a standardized forward contact to buy (long) or sell

(short) the underlying asset at a specified price at a specified future date through a specified

exchange. Futures contracts are traded on exchanges that work as a buyer or seller for the

counterparty. Exchange sets the standardized terms in term of Quality, quantity, Price quotation,
Date and Delivery place (in case of commodity).The features of a futures contract may be

specified as follows:

i These are traded on an organised exchange like IMM, LIFFE, NSE, BSE, CBOT etc.

ii These involve standardized contract terms viz. the underlying asset, the time of maturity and
the manner of maturity etc.

iii These are associated with a clearing house to ensure smooth functioning of the market.

iv There are margin requirements and daily settlement to act as further safeguard.

v These provide for supervision and monitoring of contract by a regulatory authority.

vi Almost ninety percent future contracts are settled via cash settlement instead of actual
delivery of underlying asset

There is an expiry date for all Futures Contracts. As in India, All the future contracts are expired

on every month last Thursday. For example: Suppose you buy NIFTY future contract with a lot

size of 50 on 1st February 2016 of one month expiry at Rs. 7200. This means that future

contract will get expire on 25th February 2016 (last Thursday of the Month). Margin required to

buy the future contract is around 11%; which means to buy the future contract you will require

Rs.39,600 (Rs.7200 * 50 (lot size) * 11%). If NIFTY moves 50 points upside and reaches to 7250;

which means that you are making profit of Rs.2,500 (50 * 50 (lot size)). You can sell the future

contract even before expiry. If you sell with rise of 50 points in future market, then you are

making Rs.2,500 as a profit out of it.

Daniel Lazar, & Babu Jose. Financial Derivatives. New Delhi: New Century Publication. Pg 4

http://wikifinancepedia.com/e-learning/definition/trading-terms/what-is-futures-contract-examples-history-and-types-of-future-
contracts
Options:

Options are fundamentally different from forward and future contracts. An option gives the

holder of the option the right to buy or sell. The holder does not have to necessarily exercise

the right. In contrast, in a forward or future contract, the two parties commit themselves to buy

or sell..

Options are of two types; Call options give the buyer the right but not obligation to buy a given

quantity of the underlying asset at a given price on or before a given future date. Put option

gives the buyer the right, but not obligation to sell a given quantity of the underlying asset at a

given price on or before given date. The two basic types of options are call options and put

options. A call option gives the owner the right to buy the underlying security at a specified

price within a specified period of time. A put option gives the owner the right to sell the security

at a specified price within a particular period of time. The right, rather than the obligation, to

buy or sell the underlying security is what differentiates options from futures contracts. In

addition to buying an option, an investor may also sell a call or put option the investor had not

previously purchased, which is often called writing an option. Thus, the two basic option

positions can be expanded into four option positions, as shown below.

Suppose an investor buys One European call options on Infosys at the strike price of Rs. 3500 at

a premium of Rs. 100. Apparently, if the market price of Infosys on the day of expiry is more
than Rs. 3500, the options will be exercised. In contrast, a put options gives the holder (buyer/

one who is long put), the right to sell specified quantity of the underlying asset at the strike

price on or before an expiry date. The seller of the put options (one who is short put) however,

has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise

his option to sell. Right to sell is called a Put Options. Suppose X has 100 shares of Bajaj Auto

Limited. Current price (March) of Bajaj auto shares is Rs 700 per share. X needs money to

finance its requirements after two months which he will realize after selling 100 shares after

two months. But he is of the fear that by next two months price of share will decline. He

decides to enter into option market by buying Put Option (Right to Sell) with an expiration date

in May at a strike price of Rs 685 per share and a premium of Rs 15 per shares.

International Research Journal of Finance and Economics - Issue 37 (2010)

Swaps:

Swaps are private agreement between two parties to exchange cash flows in the future

according to the pre-arranged formula. Swap refers to an exchange of one financial instrument

for another between the parties concerned. This exchange takes place at a predetermined time,

as specified in the contract. Swaps are not exchange oriented and are traded over the counter,

usually the dealing are oriented through banks. Swaps can be used to hedge risk of various

kinds which includes interest rate risk and currency risk.

Unlike most standardized options and futures contracts, swaps are not exchange-traded

instruments. Instead, swaps are customized contracts that are traded in the over-the-

counter (OTC) market between private parties. Firms and financial institutions dominate the

swaps market, with few (if any) individuals ever participating. Because swaps occur on the OTC

market, there is always the risk of a counterparty defaulting on the swap.

http://www.investopedia.com/articles/optioninvestor/07/swaps.asp#ixzz4ijbEmIkZ
Interest rare swaps: These entail swapping only the interest related cash flows between the

parties in the same currency.

The first interest rate swap occurred between IBM and the World Bank in 1981. However,

despite their relative youth, swaps have exploded in popularity. In 1987, the International Swaps

and Derivatives Association reported that the swaps market had a total notional value of $865.6

billion. By mid-2006, this figure exceeded $250 trillion, according to the Bank for International

Settlements. The most common and simplest swap is a "plain vanilla" interest rate swap. In this

swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional

principal on specific dates for a specified period of time. Concurrently, Party B agrees to make

payments based on a floating interest rate to Party A on that same notional principal on the

same specified dates for the same specified time period. In a plain vanilla swap, the two cash

flows are paid in the same currency. The specified payment dates are called settlement dates,

and the time between are called settlement periods. Because swaps are customized contracts,

interest payments may be made annually, quarterly, monthly, or at any other interval

determined by the parties.

For example, on Dec. 31, 2006, Company A and Company B enter into a five-year swap with the

following terms:

 Company A pays Company B an amount equal to 6% per annum on a notional principal

of $20 million.
 Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a
notional principal of $20 million.

LIBOR, or London Interbank Offer Rate, is the interest rate offered by London banks on deposits

made by other banks in the eurodollar markets. The market for interest rate swaps frequently

(but not always) uses LIBOR as the base for the floating rate. For simplicity, let's assume the two
parties exchange payments annually on December 31, beginning in 2007 and concluding in

2011.

At the end of 2007, Company A will pay Company B $20,000,000 * 6% = $1,200,000. On Dec. 31,

2006, one-year LIBOR was 5.33%; therefore, Company B will pay Company A $20,000,000 *

(5.33% + 1%) = $1,266,000. In a plain vanilla interest rate swap, the floating rate is usually

determined at the beginning of the settlement period. Normally, swap contracts allow for

payments to be netted against each other to avoid unnecessary payments. Here, Company B

pays $66,000, and Company A pays nothing. At no point does the principal change hands, which

is why it is referred to as a "notional" amount. Figure 1 shows the cash flows between the

parties, which occur annually (in this example).

Currency swaps: These entail swapping both the principal and interest between the parties,

with the cash flows in one direction being in a different currency than those in opposite

direction.
The plain vanilla currency swap involves exchanging principal and fixed interest payments on a

loan in one currency for principal and fixed interest payments on a similar loan in another

currency. Unlike an interest rate swap, the parties to a currency swap will exchange principal

amounts at the beginning and end of the swap. The two specified principal amounts are set so

as to be approximately equal to one another, given the exchange rate at the time the swap is

initiated.
For example, Company C, a U.S. firm, and Company D, a European firm, enter into a five-year

currency swap for $50 million. Let's assume the exchange rate at the time is $1.25

per euro (e.g. the dollar is worth 0.80 euro). First, the firms will exchange principals. So,
Company C pays $50 million, and Company D pays 40 million euros. This satisfies each

company's need for funds denominated in another currency (which is the reason for the swap).

Derivatives contracts can be divided into two general families:

1. Contingent claims, e.g. options

2. Forward claims, which include exchange-traded futures, forward contracts and swaps

A swap is an agreement between two parties to exchange sequences of cash flows for a set

period of time. Usually, at the time the contract is initiated, at least one of these series of cash

flows is determined by a random or uncertain variable, such as an interest rate,

foreign exchange rate, equity price or commodity price. Conceptually, one may view a swap as

either a portfolio of forward contracts, or as a long position in one bond coupled with a short

position in another bond. This article will discuss the two most common and most basic types of

swaps: the plain vanilla interest rate and currency swaps.

The Swaps Market

Unlike most standardized options and futures contracts, swaps are not exchange-traded

instruments. Instead, swaps are customized contracts that are traded in the over-the-

counter (OTC) market between private parties. Firms and financial institutions dominate the

swaps market, with few (if any) individuals ever participating. Because swaps occur on the OTC

market, there is always the risk of a counterparty defaulting on the swap.

The first interest rate swap occurred between IBM and the World Bank in 1981. However,

despite their relative youth, swaps have exploded in popularity. In 1987, the International Swaps
and Derivatives Association reported that the swaps market had a total notional value of $865.6

billion. By mid-2006, this figure exceeded $250 trillion, according to the Bank for International

Settlements. That's more than 15 times the size of the U.S. public equities market.

Plain Vanilla Interest Rate Swap

The most common and simplest swap is a "plain vanilla" interest rate swap. In this swap, Party A

agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific

dates for a specified period of time. Concurrently, Party B agrees to make payments based on

a floating interest rate to Party A on that same notional principal on the same specified dates

for the same specified time period. In a plain vanilla swap, the two cash flows are paid in the

same currency. The specified payment dates are called settlement dates, and the time between

are called settlement periods. Because swaps are customized contracts, interest payments may

be made annually, quarterly, monthly, or at any other interval determined by the parties.

How do companies benefit from interest rate and currency swaps?

For example, on Dec. 31, 2006, Company A and Company B enter into a five-year swap with the

following terms: Company A pays Company B an amount equal to 6% per annum on a notional

principal of $20 million.Company B pays Company A an amount equal to one-year LIBOR + 1%

per annum on a notional principal of $20 million.

LIBOR, or London Interbank Offer Rate, is the interest rate offered by London banks on deposits

made by other banks in the eurodollar markets. The market for interest rate swaps frequently

(but not always) uses LIBOR as the base for the floating rate. For simplicity, let's assume the two

parties exchange payments annually on December 31, beginning in 2007 and concluding in

2011.

At the end of 2007, Company A will pay Company B $20,000,000 * 6% = $1,200,000. On Dec. 31,

2006, one-year LIBOR was 5.33%; therefore, Company B will pay Company A $20,000,000 *
(5.33% + 1%) = $1,266,000. In a plain vanilla interest rate swap, the floating rate is usually

determined at the beginning of the settlement period. Normally, swap contracts allow for

payments to be netted against each other to avoid unnecessary payments. Here, Company B pays

$66,000, and Company A pays nothing. At no point does the principal change hands, which is

why it is referred to as a "notional" amount.

Cash flows for a plain vanilla interest rate swap

Plain Vanilla Foreign Currency Swap

The plain vanilla currency swap involves exchanging principal and fixed interest payments on a

loan in one currency for principal and fixed interest payments on a similar loan in another

currency. Unlike an interest rate swap, the parties to a currency swap will exchange principal

amounts at the beginning and end of the swap. The two specified principal amounts are set so

as to be approximately equal to one another, given the exchange rate at the time the swap is

initiated.

For example, Company C, a U.S. firm, and Company D, a European firm, enter into a five-year

currency swap for $50 million. Let's assume the exchange rate at the time is $1.25 per euro (e.g.

the dollar is worth 0.80 euro). First, the firms will exchange principals. So, Company C pays $50

million, and Company D pays 40 million euros. This satisfies each company's need for funds

denominated in another currency (which is the reason for the swap).

Cash flows for a plain vanilla currency swap

Then, at intervals specified in the swap agreement, the parties will exchange interest payments

on their respective principal amounts. To keep things simple, let's say they make these

payments annually, beginning one year from the exchange of principal. Because Company C has

borrowed euros, it must pay interest in euros based on a euro interest rate. Likewise, Company

D, which borrowed dollars, will pay interest in dollars, based on a dollar interest rate. For this

example, let's say the agreed-upon dollar-denominated interest rate is 8.25%, and the euro-

denominated interest rate is 3.5%. Thus, each year, Company C pays 40,000,000 euros * 3.50% =

1,400,000 euros to Company D. Company D will pay Company C $50,000,000 * 8.25% =

$4,125,000.

As with interest rate swaps, the parties will actually net the payments against each other at the

then-prevailing exchange rate. If, at the one-year mark, the exchange rate is $1.40 per euro,

then Company C's payment equals $1,960,000, and Company D's payment would be

$4,125,000. In practice, Company D would pay the net difference of $2,165,000 ($4,125,000 -

$1,960,000) to Company C.

Finally, at the end of the swap (usually also the date of the final interest payment), the parties

re-exchange the original principal amounts. These principal payments are unaffected by

exchange rates at the time.

How do companies benefit from interest rate and currency swaps?

An interest rate swap involves the exchange of cash flows between two parties based on

interest payments for a particular principal amount. However, in an interest rate swap, the

principal amount is not actually exchanged. In an interest rate swap, the principal amount is the

same for both sides of the currency and a fixed payment is frequently exchanged for a floating

payment that is linked to an interest rate, which is usually LIBOR.

A currency swap involves the exchange of both the principal and the interest rate in one

currency for the same in another currency. The exchange of principal is done at market rates

and is usually the same for both the inception and maturity of the contract.

In general, both interest rate and currency swaps have the same benefits for a company.

Essentially, these derivatives help to limit or manage exposure to fluctuations in interest rates or

to acquire a lower interest rate than a company would otherwise be able to obtain. Swaps are

often used because a domestic firm can usually receive better rates than a foreign firm.

For example, suppose company A is located in the U.S. and company B is located in England.

Company A needs to take out a loan denominated in British pounds and company B needs to

take out a loan denominated in U.S. dollars. These two companies can engage in a swap in order

to take advantage of the fact that each company has better rates in its respective country. These

two companies could receive interest rate savings by combining the privileged access they have

in their own markets.

Swaps also help companies hedge against interest rate exposure by reducing the uncertainty of

future cash flows. Swapping allows companies to revise their debt conditions to take advantage

of current or expected future market conditions. As a result of these advantages, currency and

interest rate swaps are used as financial tools to lower the amount needed to service a debt.

Currency and interest rate swaps allow companies to take advantage of the global markets more

efficiently by bringing together two parties that have an advantage in different markets.

Although there is some risk associated with the possibility that the other party will fail to meet

its obligations, the benefits that a company receives from participating in a swap far outweigh

the costs.

http://www.investopedia.com/ask/answers/06/benefitsofswaps.asp#ixzz4ijdyca4S
Raiyani, Jagadish. Financial Derivative in India. New Delhi: New Century Publication. Pg-29-30

Participants

There are three main types of participants in the derivative markets. They are identified as

Hedges, Speculators and Arbitrageurs.

1. Hedgers: They use futures and options derivatives to reduce or eliminate the risk associated

with price of an asset in the market. Most producers and trading companies participate in the

derivative market to shift or reduce the price risks in the underlying asset markets to secure

anticipated profits. A Hedger would typically look at reducing his asset exposure to price

volatility and in a derivative market, would usually take up a position that is opposite to the risk

he is otherwise exposed to. Derivative products are used to hedge or reduce their exposures to

market variables such as interest rates, share values, bond prices, currency exchange rates and

commodity prices. This is done by corporations, investing institutions, banks and governments

alike. A classic example is the farmer who sells futures contracts to lock into a price for delivering a
crop on a future date. The buyer could be a food processing company, which wishes to fix a price for

taking delivery of the crop in the future.

2. Speculators: They are risk-seeking traders or investors, they are willing to assure risk by taking

positions with the expectation to earn profits. Speculators are attracted to exchange traded

derivative products because of their high liquidity, high leverage, low impact cost, low

transaction cost and default risk behavior. Futures and options both add to the potential gain

and losses of the speculative venture. It is the speculators who keep the market going because

they bear the risks, which no one else is willing to bear.

3. Arbitrageurs : It is the simultaneous purchase and sale of the same underlying in the two

different markets with an objective of making profit. It is a deal that produces risk free profits

by exploiting a mispricing in the market. A simple arbitrage occurs when a trader purchases an

asset cheaply in one exchange and simultaneously arranges to sell it at another exchange at a

higher price. Such opportunities are unlikely to persist for very long, since arbitrageurs would

rush in to buy the asset in the cheap location and simultaneously sell at the expensive

location, thus reducing the price gap.

International Journal of Marketing, Financial Services & Management Research ISSN 2277- 3622 Vol.2, No. 3, March (2013)

Swain, P. K. (n.d.). Fundamentals of Financial Derivatives. Bangalore: Himalaya Publishing House .

1.1.1. Distinction between Futures and Forwards Contracts

Basis Forwards Futures

A forward contract is an agreement A futures contract is a standardized

between two parties to buy or sell an contract, traded on a futures

asset (which can be of any kind) at a exchange, to buy or sell a certain

1 Definition
pre-agreed future point in time at a underlying instrument at a certain

specified price. date in the future, at a specified

price.
 Customized to customer needs. Standardized. Initial margin

2 Structure & Purpose Usually no initial payment required. payment required. Usually used for

Usually used for hedging. speculation.

Negotiated directly by the buyer and Quoted and traded on the
3 Transaction method
seller Exchange
Not regulated Government regulated market (the

Commodity Futures Trading

4 Market regulation
Commission or CFTC is the

governing body)
Institutional The contracting parties Clearing House
5
guarantee
6 Risk High counterparty risk Low counterparty risk
No guarantee of settlement until the Both parties must deposit an initial

date of maturity only the forward guarantee (margin). The value of

7 Guarantees price, based on the spot price of the the operation is marked to market

underlying asset is paid rates with daily settlement of

profits and losses.

Forward contracts generally Future contracts may not

8 Contract Maturity mature by delivering the commodity. necessarily mature by delivery of

commodity.
9 Expiry date Depending on the transaction Standardized
Opposite contract with same or Opposite contract on the

different counterparty. Counterparty exchange.

Method of pre-
10
termination
risk remains while terminating with

different counterparty.
Depending on the transaction and Standardized

11 Contract size the requirements of the contracting

parties.
12 Market Primary & Secondary Primary

http://www.diffen.com/difference/Forward_Contract_vs_Futures_Contract
FUTURES TERMINOLOGY

• Spot price: The price at which an asset trades in the spot market. In the case of USDINR,

spot value is T + 2.

• Futures price: The price at which the futures contract trades in the futures market.

• Contract cycle: The period over which a contract trades. The currency futures

contracts on the NSE have one-month, two-month, three-month up to twelve-month expiry

cycles. Hence, NSE will have 12 contracts outstanding at any given point in time.

• Value Date/Final Settlement Date: The last business day of the month will be termed

the Value date / Final Settlement date of each contract. The last business day would be taken to

the same as that for Inter-bank Settlements in Mumbai. The rules for Inter-bank

Settlements, including those for ‘known holidays’ and ‘subsequently declared holiday

would be those as laid down by FEDAI (Foreign Exchange Dealers Association of India).

• Expiry date: It is the date specified in the futures contract. This is the last day on which the

contract will be traded, at the end of which it will cease to exist. The last trading day will be

two business days prior to the Value date / Final Settlement Date.

• Contract size: The amount of asset that has to be delivered under one contract. Also

called as lot size. In the case of USDINR it is USD 1000.

• Basis: In the context of financial futures, basis can be defined as the futures price minus

the spot price. There will be a different basis for each delivery month for each contract. In

a normal market, basis will be positive. This reflects that futures prices normally exceed

spot prices
.• Cost of carry: The relationship between futures prices and spot prices can be summarized

in terms of what is known as the cost of carry. This measures (in commodity markets)

the storage cost plus the interest that is paid to finance or ‘carry’ the asset till delivery less

the income earned on the asset. For equity derivatives carry cost is the rate of interest.

• Initial margin: The amount that must be deposited in the margin account at the time a

futures contract is first entered into is known as initial margin.

• Marking-to-market: In the futures market, at the end of each trading day, the margin

account is adjusted to reflect the investor's gain or loss depending upon the futures closing

price. This is called marking-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. If the balance in the

margin account falls below the maintenance margin, the investor receives a margin call and

is expected to top up the margin account to the initial margin level before trading

commences on the next day.

https://www.nseindia.com/global/content/regulations/NSEFOregulations.pdf

BASIS FUTURES OPTIONS

Options are the contract in which

Futures contract is a binding the investor gets the right to buy

agreement, for buying and selling or sell the financial instrument at a

Meaning
of a financial instrument at a set price, on or before a certain

predetermined price at a future date, however the investor is not

specified date. obligated to do so.

Obligation of buyer Yes, to execute the contract. No, there is no obligation.
Anytime before the expiry of the

Execution of contract On the agreed date. agreed date

 Risk High Limited
Advance payment No advance payment Paid in the form of premiums.
Degree of profit/loss Unlimited Unlimited profit and limited loss.

Options Terminology

At-the-Money: The point at which an option's strike price is the same as the current trading

price of the underlying commodity.

Call: An option contract giving the buyer the right, but not the obligation, to purchase a

commodity or other asset or to enter into a long futures position.

Conversion: A position created by selling a call option, buying a put option and buying the

underlying instrument (for example, a futures contract), where the options have the same strike

price and the same expiration.

Delta: The expected change in an option's price, given a one-unit change in the price of the

underlying futures contract or physical commodity.

Exercise: To elect to buy or sell, taking advantage of the right conferred to the owner of an

option contract.

Expiration: The date on which an option contract automatically expires; the last day an option

may be exercised.

Grantor: The maker, writer, seller or issuer of an option contract who, in return for the premium

paid for the option, stands ready to purchase the underlying commodity (or futures contract) in

the case of a put option, or to sell the underlying commodity (or futures contract) in the case of

a call option.

In-The-Money: The state of an option contract in which it has a positive value if exercised.

Intrinsic Value: A measure of the value of an option if immediately exercised; the extent to

which it is in-the-money.
Out-Of-The-Money: The state of an option contract in which it has no intrinsic value.

Premium: The payment an option buyer makes to the option writer for granting an option

contract. (Note: "Premium" also has the meaning defined above as the amount a price would be

increased to purchase a better quality commodity.

Put: An option contract that gives the holder the right, but not the obligation, to sell a specified

quantity of a particular commodity or other interest at a given, prior to or on a future date.

Spread: The purchase of one futures delivery month against the sale of another futures delivery

month of the same commodity.

Straddle: The purchase of one delivery month of one commodity against the sale of that same

delivery month of a different commodity.

Strangle: An option position consisting of the purchase of put and call options having the same

expiration date, but different strike prices.

Synthetic Futures: A position that mimics a futures contract that is created by combining call

and put options.

Time Value: That portion of an option's premium that exceeds the intrinsic value, reflecting the

probability that the option will move into-the-money.

Writer: The issuer, grantor or seller of an option contract.

Time Decay :Because options have an expiration date, all options are wasting assets whose time

value erodes to zero by expiration. This erosion is known as time decay. Time value varies with

the square root of time, so that as an option approaches its expiration date, the rate of time

decay increases.

Long :To be “long” an option simply means to have purchased it in an opening transaction and

thus to own or hold it.

Short: To be short an option means to have sold the option in an opening transaction. (A short

position is carried as a negative on a statement and must be purchased later to close out.)

http://www.investopedia.com/exam-guide/series-3/studyguide/chapter3/general-options-terminology.asp

The Black-Scholes

The Black-Scholes formula (also called Black-Scholes-Merton) was the first widely used model

for option pricing. It's used to calculate the theoretical value of European-style options using

current stock prices, expected dividends, the option's strike price, expected interest rates, time

to expiration and expected volatility. The formula, developed by three economists – Fischer

Black, Myron Scholes and Robert Merton – is perhaps the world's most well-known options

pricing model, and was introduced in their 1973 paper, "The Pricing of Options and Corporate

Liabilities" published in the Journal of Political Economy. Black passed away two years before

Scholes and Merton were awarded the 1997 Nobel Prize in Economics for their work in finding a

new method to determine the value of derivatives (the Nobel Prize is not given posthumously;

however, the Nobel committee acknowledged Black's role in the Black-Scholes model).

The Black-Scholes model makes certain assumptions:

 The option is European and can only be exercised at expiration

 No dividends are paid out during the life of the option

 Efficient markets (i.e., market movements cannot be predicted)

 There are no transaction costs in buying the option

 The risk-free rate and volatility of the underlying are known and constant

 That the returns on the underlying are normally distributed

Note: While the original Black-Scholes model didn't consider the effects of dividends paid during

the life of the option, the model is frequently adapted to account for dividends by determining

the ex-dividend date value of the underlying stock.

Black-Scholes Formula

The formula takes the following variables into consideration:

 Current underlying price

 Options strike price

 Time until expiration, expressed as a percent of a year

 Implied volatility

 Risk-free interest rates

The model is essentially divided into two parts: the first part, SN(d1), multiplies the price by the

change in the call premium in relation to a change in the underlying price. This part of the

formula shows the expected benefit of purchasing the underlying outright. The second

part, N(d2)Ke-rt, provides the current value of paying the exercise price upon expiration

(remember, the Black-Scholes model applies to European options that can be exercised only on

expiration day). The value of the option is calculated by taking the difference between the two

parts, as shown in the equation.

The Black–Scholes /ˌblæk ˈʃoʊlz/[1] or Black–Scholes–Merton model is a mathematical model of

a financial market containing derivative investment instruments. From the model, one can
deduce the Black–Scholes formula, which gives a theoretical estimate of the price of

European options. The formula led to a boom in options trading and provided mathematical

legitimacy to the activities of the Chicago Board Options Exchange and other options markets

around the world.[2] lt is widely used, although often with adjustments and corrections, by

options market participants.[3]:751 Many empirical tests have shown that the Black–Scholes price

is "fairly close" to the observed prices, although there are well-known discrepancies such as the

"option smile".

Based on works previously developed by market researchers and practitioners, such as Louis

Bachelier, Sheen Kassouf and Ed Thorpamong others, Fischer Black and Myron Scholes came to

the formula in the late 1960s. In 1970, after they attempted to apply the formula to the markets

and incurred financial losses due to lack of risk management in their trades, they decided to

focus in their domain area, the academic environment. After three years of efforts, the formula

named in honor of them for making it public, was finally published in 1973 in an article entitled

"The Pricing of Options and Corporate Liabilities", in the Journal of Political Economy. Robert C.

Merton was the first to publish a paper expanding the mathematical understanding of the

options pricing model, and coined the term "Black–Scholes options pricing model". Merton and

Scholes received the 1997 Nobel Memorial Prize in Economic Sciences for their work. Though

ineligible for the prize because of his death in 1995, Black was mentioned as a contributor by

the Swedish Academy.

They derived a partial differential equation, now called the Black–Scholes equation, which

estimates the price of the option over time. The key idea behind the model is to hedge the

option by buying and selling the underlying asset in just the right way and, as a consequence, to

eliminate risk. This type of hedging is called delta hedging and is the basis of more complicated

hedging strategies such as those engaged in by investment banks and hedge funds.
The model's assumptions have been relaxed and generalized in many directions, leading to a

plethora of models that are currently used in derivative pricing and risk management. It is the

insights of the model, as exemplified in the Black–Scholes formula, that are frequently used by

market participants, as distinguished from the actual prices. These insights include no-arbitrage

bounds and risk-neutral pricing. TheBlack–Scholes equation, a partial differential equation that

governs the price of the option, is also important as it enables pricing when an explicit formula

is not possible.

The Black–Scholes formula has only one parameter that cannot be observed in the market: the

average future volatility of the underlying asset. Since the formula is increasing in this

parameter, it can be inverted to produce a "volatility surface" that is then used to calibrate

other models, e.g. for OTC derivatives.

The Black-Scholes model is used to calculate a theoretical call price (ignoring dividends paid

during the life of the option) using the five key determinants of an option's price: stock price,

strike price, volatility, time to expiration, and short-term (risk free) interest rate.

The original formula for calculating the theoretical option price (OP) is as follows:

Where:

The variables are:

S = stock price
X = strike price
t = time remaining until expiration, expressed as a percent of a year
r = current continuously compounded risk-free interest rate
v = annual volatility of stock price (the standard deviation of the short-term returns over one
year). See below for how to estimate volatility.
ln = natural logarithm
N(x) = standard normal cumulative distribution function
e = the exponential function

THE GREEKS

Delta is the rate of change of option price with respect to the price of the underlying asset. For

example, the delta of a stock is 1. It is the slope of the curve that relates the option

price to the price of the underlying asset. Suppose the of a call option on a stock is 0.5. This

means that when the stock price changes by one, the option price changes by about 0.5,

or 50% of the change in the stock price. Expressed differently, is the change in the call price per

unit change in the spot.

Gamma is the rate of change of the option's Delta with respect to the price of the underlying

asset. In other words, it is the second derivative of the option price with respect to price of the

underlying asset.

3.26.3 Theta of a portfolio of options, is the rate of change of the value of the portfolio with

respect to the passage of time with all else remaining the same. Is also referred to as the time

decay of the portfolio. is the change in the portfolio value when one day passes with all else

remaining the same. We can either measure "per calendar day" or "per trading day". To obtain

the per calendar day, the formula for Theta must be divided by 365; to obtain Theta per

trading day, it must be divided by 250.

Vega of a portfolio of derivatives is the rate of change in the value of the portfolio with respect

to volatility of the underlying asset. If is high in absolute terms, the portfolio's value is very
sensitive to small changes in volatility. If is low in absolute terms, volatility changes have

relatively little impact on the value of the portfolio.

Rho of a portfolio of options is the rate of change of the value of the portfolio with respect to

the interest rate. It measures the sensitivity of the value of a portfolio to interest rates.

Option Greeks help us to understand Option behaviour better. They measure the extent of the

impact of various factors on Option Prices. Delta stands for the change in Option

Premium for a unit change in the Price of the Underlying Share or Index (also stands for Hedge

Ratio). Gamma stands for the change in Delta for a unit change in the Price of the Underlying

Share or Index. Vega stands for the change in Option Premium for a unit change in the

Volatility of the Underlying Share or Index. Theta stands for the change in Option Premium for

a unit change in the Time to expiry. Rho stands for the change in Option Premium for a

unit change in the Interest Rates.

www.bseindia.com/downloads/Training/file/BCDE.pdf

Binomial Option Pricing Model

The binomial option pricing model is an options valuation method developed in 1979.

The binomial option pricing model uses an iterative procedure, allowing for the specification of

nodes, or points in time, during the time span between the valuation date and the

option's expiration date. The model reduces possibilities of price changes, and removes the

possibility for arbitrage. A simplified example of a binomial tree might look something like this:
The binomial option pricing model assumes a perfectly efficient market. Under this assumption,

it is able to provide a mathematical valuation of an option at each point in the timeframe

specified. The binomial model takes a risk-neutral approach to valuation and assumes

that underlying security prices can only either increase or decrease with time until the option

expires worthless.

A simplified example of a binomial tree has only one time step. Assume there is a stock that is

priced at $100 per share. In one month, the price of this stock will go up by $10 or go down by

$10, creating this situation:

Stock Price = $100

Stock Price (up state) = $110

Stock Price (down state) = $90

Next, assume there is a call option available on this stock that expires in one month and has a

strike price of $100. In the up state, this call option is worth $10, and in the down state, it is

worth $0. The binomial model can calculate what the price of the call option should be today.

For simplification purposes, assume that an investor purchases one-half share of stock and

writes, or sells, one call option. The total investment today is the price of half a share less the

price of the option, and the possible payoffs at the end of the month are:

Cost today = $50 - option price

Portfolio value (up state) = $55 - max ($110 - $100, 0) = $45

Portfolio value (down state) = $45 - max($90 - $100, 0) = $45

The portfolio payoff is equal no matter how the stock price moves. Given this outcome,

assuming no arbitrage opportunities, an investor should earn the risk-free rate over the course
of the month. The cost today must be equal to the payoff discounted at the risk-free rate for

one month. The equation to solve is thus:

Option price = $50 - $45 x e ^ (-risk-free rate x T), where e is the mathematical constant 2.7183

Assuming the risk-free rate is 3% per year, and T equals 0.0833 (one divided by 12), then the

price of the call option today is $5.11.

Due to its simple and iterative structure, the binomial option pricing model presents certain

unique advantages. For example, since it provides a stream of valuations for a derivative for

each node in a span of time, it is useful for valuing derivatives such as American options.

Each of the approaches has its advantages and disadvantages for pricing different types of

options. However, they all involve a similar three step process.

1. Calculate potential future prices of the underlying asset(s) at expiry (and possibly at

intermediate points in time too).

2. Calculate the payoff of the option at expiry for each of the potential underlying prices.

3. Discount the payoffs back to today to determine the option price today.

Each of those steps is discussed in the following sections.

Calculating a Tree for the Underlying Asset Price

The first step in pricing options using a binomial model is to create a lattice, or tree, of potential

future prices of the underlying asset(s). This section discusses how that is achieved.

The One Step Binomial Model

A one-step binomial model is shown in Figure 1. The notation used is,

S0: The stock price today.

p: The probability of a price rise.

u: The factor by which the price rises (assuming it rises).

d: The factor by which the price falls (assuming it falls).

Note that the model assumes that the price of the equity underlying the option follows a

random walk.

Figure 1: One Step Binomial Model

The essence of the model is this: assume the price of an asset today is S0 and that over a small

time interval Δt it may move to one of only two potential future values S0u or S0d. The

underlying price is assumed to follow a random walk and a probablity p is assigned to the

likelihood that the price will rise. Hence the probability of a fall in the stock price is 1-p.

Conceptually any values for the three parameters, p, u and d may be used. (Subject to 0 < p < 1

and S0d > 0.) There are many different approaches to calculating values for p, u and d. These

include methods developed by,

Cox-Ross-Rubinstein: This is the method most people think of when discussing the binomial

model, and the one discussed in this tutorial.

Jarrow-Rudd: This is commonly called the equal-probability model.

Tian: This is commonly called the moment matching model.

Jarrow-Rudd Risk Neutral: This is a modification of the original Judd-Yarrow model that

incorporates a risk-neutral probablity rather than an equal probability.

Cox-Ross-Rubinstein With Drift: This is a modification of the original Cox-Ross-Runinstein model

that incorporates a drift term that effects the symmetry of the resultant price lattice.

Leisen-Reimer: This uses a completely different approach to all the other methods, relying on

approximating the normal distrbution used in the Black-Scholes model.

Of the above approaches the Cox-Ross-Rubinstein method is perhaps the best known, with

the Jarrow-Rudd method close behind. The remaining methods have been developed to address

perceived (and perhaps real) deficiencies in those two methods.

A Risk-Neutral World

Three equations are required to be able to uniquely specify values for the three parameters of

the binomial model. Two of these equations arise from the expectation that over a small period

of time the binomial model should behave in the same way as an asset in a risk neutral world.

This leads to the equation

Equation 1: Matching Return which ensures that over the small period of time Δt the expected

return of the binomial model matches the expected return in a risk-neutral world, and the

equation,

Equation 2: Matching Variance which ensures that the variance matches.

Cox-Ross-Rubinstein

Cox, Ross and Rubinstein proposed the third equation

Equation 3: Third Equation for the Cox-Ross-Rubinstein Binomial Model

Rearranging the above three equations to solve for parameters p, u and d leads to,

Equation 4: Equations for the Cox-Ross-Rubinstein Binomial Model

The unique solution for parameters p, u and d given in Equation 4 ensures that over a short

period of time the binomial model matches the mean and variance of an asset in a risk free

world, and as will be seen shortly, ensures that for a multi-step model the price of the

underlying asset is symmetric around the starting price S0.

The Multi-Step Model

Before considering the more general case of a many-step model, consider the two-step model

shown below.
A Two-Step Binomial Model

As with the one-step model of Figure 1, over the first period of time in the two-step model the asset

price may move either up to Su or down to Sd. Over the second period, if the price moved up to Su in the

first period then the price may move to either Suu or Sud. However if the price moved down in the first

period to Sd then in the second period it may move to either Sdu or Sdd.

If Sud=Sdu then the price tree is said to be recombining. However if they are not equal then the price tree

is said to be non-recombining (or bushy).

Since there are typically tens if not hundred or thousands of time steps taken when pricing an option the

amount of data (and hence computer memory, and computation time) required to calculate a non-bushy

tree is typically prohibitively and hence they are rarely used. The third

equation of the CRR model ensures that it generates a recombining tree that is centred around the
original stock price S0. Taking multiple time steps leads to the tree shown in Figure3.

Figure 3: A Multi-Step Binomial Model

In general the time period between today and expiry of the option is sliced into many small time

periods. A tree of potential future asset prices is then calculated. Each point in the tree is

refered to as a node. The tree contains potential future asset prices for each time period from

today through to expiry.

Calculating the Payoffs at Expiry

The second step in pricing options using a binomial model is to calculate the payoffs at each

node corresponding to the time of expiry. This corresponds to all of the nodes at the right hand

edge of the price tree.

In general the payoff may depend on many different factors. As an example, the payoffs of

simple put and call options will use the standard formulae
 Type Payoff

Put VN = max(X-SN,0)

Call VN = max(SN-X,0)

where

 N designates a node at expiry.

 VN is the option value.

 X is the strike.

 SN is the price of the underlying asset.

Discounting the Payoffs

The third step in pricing options using a binomial model is to discount the payoffs of the option

at expiry nodes back to today. This is achieved by a process called backwards induction, and

involves stepping backwards through time calculating the option value at each node of the

lattice in a sequential manner.

This is achieved using the appropriate following formulae

Type Backwards Induction Formula

European Put or Call Vn = e-rΔt(pVu+(1-p)Vd)

American Put Vn = max(X-Sn,e-rΔt(pVu+(1-p)Vd))

American Call Vn = max(Sn-X,e-rΔt(pVu+(1-p)Vd))

where

 n designates a node prior to expiry.

 Vn is the option value.

  X is the strike.

 Sn is the price of the underlying asset.

 p is the probability of an upwards price movement.

 Vu is the option value from node upper node at n+1.

 Vu is the option value from the lower node at n+1.

 r is the risk-free interest rate.

 Δt is the step size between time slices of the model.

It is critical to notice that with backwards inducton the counter n starts at N (i.e. expiry) and

decreases down to 0 (i.e. today).

DEVELOPMENT OF EXCHANGE-TRADED DERIVATIVES

Derivatives have probably been around for as long as people have been trading with one

another. Forward contracting dates back at least to the 12th century, and may well have been

around before then. Merchants entered into contracts with one another for future delivery of

specified amount of commodities at specified price. A primary motivation for pre-arranging a

buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility

that large swings would inhibit marketing the commodity after a harvest.

Although early forward contracts in the US addressed merchants’ concerns aboutensuring that

there were buyers and sellers for commodities, “credit risk” remained aserious problem. To deal

with this problem, a group of Chicago businessmen formed the

Chicago Board of Trade

(CBOT) in 1848. The primary intention of the CBOT was to provide a centralized location known

in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one

step further and listed the first “exchangetraded” derivatives contract in the US; these contracts

were called “futures contracts”. In1919, Chicago Butter and Egg Board, a spin-off of CBOT, was

reorganized to allow futures trading. Its name was changed to Chicago Mercantile

Exchange(CME). The CBOT and the CME remain the two largest organized futures exchanges,

indeed the two largest “financial” exchanges of any kind in the world today. The first stock index

futures contract was traded at Kansas City Board of Trade. Currently the most popular index

futures contract in the world is based on S&P 500index, traded on Chicago Mercantile Exchange.

During the mid eighties, financial futures became the most active derivative instruments

generating volumes many times more than the commodity futures. Index futures, futures on T-

bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other

popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany,

SGX in Singapore, TIFFEin Japan, MATIF in France, etc

The following factors have been driving the growth of fi nancial derivati ves:

 Increased volatility in asset prices in financial markets, Increased integration of national

financial markets with the international markets,

 Marked improvement in communication facilities and sharp decline in their costs,

 Development of more sophisticated risk management tools, providing economic agents a

wider choice of risk management strategies, and Innovations in the derivatives markets,

which optimally combine the risks and returns over a large number of financial assets leading

to higher returns, have reduced risk as well as transactions costs as compared to individual

financial assets.

 Increased integration of national financial markets with the international markets,

 Marked improvement in communication facilities and sharp decline in their costs,

 Development of more sophisticated risk management tools, providing economic agents a

wider choice of risk management strategies, and

 Innovations in the derivatives markets, which optimally combine the risks and returns over a

large number of financial assets leading to higher returns, reduced risk as well as transactions

costs as compared to individual financial assets

http://nikhil-barjatya.tripod.com/ncfm/derivative/7-46.pdf

http://shodhganga.inflibnet.ac.in/bitstream/10603/12562/6/06_chapter%201.pdf

Development of Derivatives Markets in India

Indian Derivatives markets 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 in 1875.

In 1952, with the ban on cash settlement and option trading by the Government of India,

derivatives trading shifted to informal forwards markets. In recent years, government policy has

shifted in favor of an increased role of market-based pricing and less suspicious derivatives

trading. The first step towards the introduction of financial derivatives trading in India was the

promulgation of the Securities Laws (Amendment) Ordinance, 1995. This provided for

withdrawal of prohibition on options in securities. In the last decade, beginning the year 2000,

ban on futures trading in many commodities was lifted out. During 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.

Derivatives Products Traded in Derivatives Segment of BSE

The Bombay Stock Exchange (BSE) created history on June 9, 2000 when it launched trading in

Sensex based futures contract for the first time. It was then followed by trading in index options

on June 1, 2001; in stock options and single stock futures (31 stocks) on July 9, 2001 and

November 9, 2002, respectively. It permitted trading in the stocks of four leading companies

namely; Satyam, State Bank of India, Reliance Industries and TISCO (renamed now Tata Steel).

Chhota (mini) SENSEX7 was launched on January 1, 2008. With a small or 'mini' market lot of 5,

it allows for comparatively lower capital outlay, lower trading costs, more precise hedging and

flexible trading. Currency futures were introduced on October 1, 2008 to enable participants to

hedge their currency risks through trading in the U.S. dollar rupee future platforms. Table 1

summarily specifies the derivative products and their date of introduction on the BSE.
Derivatives Products Traded in Derivatives Segment of NSE

NSE started trading in index futures, based on popular S&P CNX Index, on June 12, 2000 as its

first derivatives product. Trading in index options was introduced on June 4, 2001. On November

9, 2001, Futures on individual securities started. As stated by the Securities & Exchange Board of

India (SEBI), futures contracts are available on 233 securities. Trading in options on individual

securities commenced w.e.f. July 2, 2001. The options contracts, available on 233 securities, are

of American style and cash settled. Trading in interest rate futures was started on 24 June 2003

but it was closed subsequently due to pricing problem. The NSE achieved another landmark in

product introduction by launching Mini Index Futures & Options with a minimum contract size

of Rs 1 lac. NSE created history by launching currency futures contract on US Dollar-Rupee on

August 29, 2008 in Indian Derivatives market. Table 2 presents a description of the types of

products traded at F& O segment of NSE.

 www.bseindia.com/downloads/faqsrs.pdf

1.7 EXCHANGE-TRADED VS. OTC DERIVATIVES

Derivatives have probably been around for as long as people have been trading with one

another. Forward contracting dates back at least to the 12th century, and may well have

been around before then. Merchants entered into contracts with one another for future

delivery of specified amount of commodities at specified price. A primary motivation for pre-

arranging a buyer or seller for a stock of commodities in early forward contracts was to

lessen the possibility that large

swings would inhibit marketing the commodity after a harvest. As the name suggests,

derivatives that trade on an exchange are called exchange traded derivatives, whereas privately

negotiated derivative contracts are called OTC contracts. The OTC derivatives markets have

witnessed rather sharp growth over the last few years, which has accompanied the

modernization of commercial and

investment banking and globalisation of financial activities. The recent developments

in information technology have contributed to a great extent to these developments.

While both exchange-traded and OTC derivative contracts offer many benefits, the former

have rigid structures compared to the latter.

The OTC derivatives markets have the following features compared to exchange-

traded derivatives:

1. The management of counter-party (credit) risk is decentralized and located within

individual institutions,

2. There are no formal centralized limits on individual positions, leverage, or margining,

3. There are no formal rules for risk and burden-sharing,

4. There are no formal rules or mechanisms for ensuring market stability and integrity,
and for safeguarding the collective interests of market participants, and
5. The OTC contracts are generally not regulated by a regulatory authority and the

exchange's self-regulatory organization, although they are affected indirectly by national

legal systems, banking supervision and market surveillance. Some of the features of OTC

derivatives markets embody risks to financial market stability. The following features of OTC

derivatives markets can give rise to

instability in institutions, markets, and the international financial system:

(i) the dynamic nature of gross credit exposures;

(ii) information asymmetries;

(iii) the effects of OTC derivative activities on available aggregate credit;

(iv) the high concentration of OTC derivative activities in major institutions; and

(v) the central role of OTC derivatives markets in the global financial system.

Instability arises when shocks, such as counter-party credit events and sharp movements in

asset prices that underlie derivative contracts occur, which significantly alter the

perceptions of current and potential future credit exposures. When asset prices change

rapidly, the size and configuration of counter-party exposures can become unsustainably large

and provoke a rapid unwinding of positions.

There has been some progress in addressing these risks and perceptions. However, the

progress has been limited in implementing reforms in risk management, including

counter-party, liquidity and operational risks, and OTC derivatives markets continue to

pose a threat to international financial stability. The problem is more acute as heavy

reliance on OTC derivatives creates the possibility of systemic financial events, which fall

outside the more formal clearing house structures. Moreover, those who provide OTC

derivative products, hedge their risks through the use of exchange traded derivatives.

GLOBAL DERIVATIVES MARKETS

Early forward contracts in the US addressed merchants' concerns about ensuring that there

were buyers and sellers for commodities. However "credit risk" remained a serious problem. To

deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade

(CBOT) in 1848. The primary intention of the CBOT was to provide a centralized location known

in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one

step further and listed the first "exchange traded" derivatives contract in the US; these contracts

were called "futures contracts". In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was

reorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange

(CME). The CBOT and the CME remain the two largest organized futures exchanges, indeed the

two largest "financial" exchanges of any kind in the world today. The first stock index futures

contract was traded at Kansas 10 City Board of Trade. Currently the most popular stock index

futures contract in the world is based on S&P 500 index,_ traded on Chicago Mercantile

Exchange. During the mid eighties, financial futures became the most active derivative

instruments generating volumes many times more than the commodity futures. Index futures,

futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded

today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in

Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc. Derivative products

initially emerged as hedging devices against fluctuations in commodity prices, and commodity-

linked derivatives remained the sole form of such products for almost three hundred years.

Financial derivatives came into spotlight in the post-1970 period due to growing instability in

the financial markets. However, since their emergence, these products have become very

popular and by 1990s, they accounted for about two-thirds of total transactions in derivative

products. In recent years, the market for financial derivatives has grown tremendously in terms

of variety of instruments available, their complexity and also turnover. In the class of equity

derivatives the world over, futures and options on stock indices have gained more popularity

than on individual stocks, especially among institutional investors, who are major users of index-
linked derivatives. Even small investors find these useful due to high correlation of the popular

indexes with various portfolios and ease of use. The lower costs associated with index 11

derivatives vis—a—vis derivative products based on individual securities is another reason for

their growing use.

http://shodhganga.inflibnet.ac.in/bitstream/10603/12562/6/06_chapter%201.pdf

DERIVATIVES MARKET IN INDIA

Approval for derivatives trading: The first step towards introduction of derivatives trading in

India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which

withdrew the prohibition on options in securities. The market for derivatives, however, did not

take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24

—member committee under the Chairmanship of Dr. L. C. Gupta on November 18, 1996 to

develop appropriate regulatory framework for derivatives trading in India. The committee

submitted its report on March 17, 1998 prescribing necessary preconditions for introduction of

derivatives trading in India. The committee 21 recommended that derivatives should be

declared as 'securities' so that regulatory framework applicable to trading of 'securities' could

also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship

of Prof. J. R. Varma, to recommend measures for risk containment in derivatives market in India.

The report, which was submitted in October 1998, worked out the operational details of

margining system, methodology for 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 of 'securities' and the regulatory framework was

developed for governing derivatives trading. The act also made it clear that derivatives shall be

legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding

OTC derivatives. The government also rescinded in March 2000, the three—decade - -V old
naili"Cation, which prohibited forward trading in securities. Derivatives trading commenced in

India in June 2000 after SEBI granted the final approval to this effect in May 2000. 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. To

begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE-30

(Sensex) index. This was followed by approval for trading in options based on these two indexes

and options on individual securities. The trading in index options commenced in June 2001 and

the trading in options on individual securities commenced in July 2001. Futures contracts on J

22 individual stocks were launched in November 2001. Trading and settlement .in derivative

contracts is done in accordance with the rules, byelaws, and regulations of the respective

exchanges and their clearing house/corporation duly approved by SEBI and notified in the

official gazette.

Trading Mechanism

Trading system of derivatives at NSE, known as NEAT-F&O trading system, provides a fully

automated screen-based trading for all kinds of derivatives products available on NSE on a

national wide basis. It supports an anonymous order driven market, which operates on a time

priority/strict price basis. It offers great flexibility to users in terms of kinds of orders that can be

placed on the terminal. Various time and price-related conditions like Immediate/Cancel,

Limit/Market Price, Stop Loss, etc. can be built into an order. The trading in derivatives is

essentially similar to that of trading of securities in the Capital Market segment.

There are four entities in the trading system of a derivative market:

1.Trading members: Trading members can trade either on their own account or on behalf of

their clients including participants. They are registered as members with NSE and are assigned

an exclusive trading member ID.

2. Clearing members: Clearing members are members of NSCCL. They carry out

confirmation/inquiry of trades and the risk management activities through the trading system.

These clearing members are also trading members and clear trade for themselves or/and

other.

3. Professional clearing members: A clearing member who is not a trading member is known as

a professional clearing member (PCM). Typically, banks and custodian become PCMs and clear

and settle for their trading members.

4. Participants: A participant is a client of trading members like financial institutions. These

clients may trade through multiple trading members, but settle their trades through a single

clearing member only.

Membership Criteria

NSE admits members on its derivatives segment in accordance with the rules and regulations of

the exchange and the norms specified by SEBI. NSE follows 2—tier membership structure

stipulated by SEBI to enable wider participation. Those interested in taking membership on F&O

segment are required to take membership of CM and F&O segment or CM, WDM and F&O

segment. Trading and clearing members are admitted separately. Essentially, a clearing member

(CM) does clearing for all his trading members (TMs), undertakes risk management and

performs actual settlement. There are three types of CMs

Self Clearing Member: A SCM clears and settles trades executed by him only either on his own

account or on account of his clients.

Trading Member Clearing Member: TM—CM is a CM who is also a TM. TM— CM may clear and

settle his own proprietary trades and client's trades as well as clear and settle for other TMs.

Professional Clearing Member PCM is a CM who is not a TM. Typically, banks or custodians

could become a PCM and clear and settle for TMs.

https://www.nseindia.com/content/us/fact2010_sec6.pdf

BSE created history on June 9, 2000 by launching the first Exchange-traded Index Derivative

Contract in India i.e. futures on the capital market benchmark index - the BSE Sensex. The

inauguration of trading was done by Prof. J.R. Varma, member of SEBI and Chairman of the

committee which formulated the risk containment measures for the derivatives market.

In sequence of product innovation, BSE commenced trading in Index Options on Sensex on June

1, 2001, Stock Options were introduced on 31 stocks on July 9, 2001 and Single Stock Futures

were launched on November 9, 2002.

Long Dated Options

BSE also introduced 'Long Dated Options' on its flagship index - Sensex -on February 29, 2008,

whereby the Members can trade in Sensex Options contracts with an expiry of up to 5 years.

Currency Derivatives :

Going ahead, on October 1, 2008 BSE launched its currency derivatives segment in dollar-rupee

currency futures as the exchange traded currency futures contracts facilitate easy access,

increased transparency, efficient price discovery, better counterparty credit risk management,

wider participation and reduced transaction costs.

Futures on BOLT
BSE re-launched its Derivatives Segment by enabling trading of Index and Stock Futures on its

BOLT Terminal. The change was in response to requests from trading members for a common

front end from which equities and equity derivatives could be traded. The change will enable a

trader to trade in cash Securities and futures products through BOLT TWS/ IML while Option

products would continue to trade through the DTSS TWS/DIML. The risk management and

settlement of futures and option trades will continue to take place on DTSS.

The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with the

launch of index futures on June 12, 2000. The futures contracts are based on the popular

benchmark Nifty 50 Index.

The Exchange introduced trading in Index Options (also based on Nifty 50) on June 4, 2001. NSE

also became the first exchange to launch trading in options on individual securities from July 2,

2001. Futures on individual securities were introduced on November 9, 2001. Futures and

Options on individual securities are available on 175 securities stipulated by SEBI.

The Exchange has also introduced trading in Futures and Options contracts based on Nifty IT,

Nifty Bank, and Nifty Midcap 50, Nifty Infrastructure, Nifty PSE, Nifty CPSE indices.

http://www.academia.edu/814173/A_STUDY_ON_EFFECTIVENESS_OF_EQUITY_DERIVATIVES_IN_CASH_MARKET_SEGMENT_IN_INDIA

HISTORICAL DEVELOPMENT OF DERIVATIVE MARKET IN INDIA

The origin of derivatives can be traced back to the need of farmers to protect themselves against

fluctuations in the price of their crop. From the time it was sown to the time it was ready for harvest,

farmers would face price uncertainty. Through the use of simple derivative products, it was possible for

the farmer to partially or fully transfer price risks by locking-in asset prices. These were simple contracts

developed to meet the needs of farmers and were basically a means of reducing risk. Derivative 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 future trading way back in 1875. This was the first organized

futures market. Then Bombay Cotton Exchange Ltd. in 1893, Gujarat Vyapari Mandall in 1900, Calcutta
Hesstan Exchange Ltd. in 1919 had started future market. After the country attained independence,

derivative market came through a full circle from prohibition of all sorts of derivative trades to their

recent reintroduction. 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 at market based pricing and less suspicious derivatives trading. The first step

towards introduction of financial derivatives trading in India was the promulgation at the securities laws

(Amendment) ordinance 1995. It provided for withdrawal at prohibition on options in securities. The last

decade, beginning the year 2000, saw lifting of ban of futures trading in many commodities. Around the

same period, national electronic commodity exchanges were also set up.

REGULATION OF DERIVATIVES TRADING IN INDIA

The regulatory frame work in India is based on L.C. Gupta Committee report and J.R. Varma Committee

report. It is mostly consistent with the international organization of securities commission (IUSCO). The

L.C. Gupta Committee report provides a perspective on division of regulatory responsibility between the

exchange and SEBI. It recommends that SEBI‟s role should be restricted to approving rules, bye laws and

regulations of a derivatives exchange as also to approving the proposed derivatives contracts before

commencement of their trading. It emphasizes the supervisory and advisory role of SEBI. It also suggests

establishment of a separate clearing corporation.

DERIVATIVES MARKET IN INDIA

In India, there are two major markets namely National Stock Exchange (NSE) and Bombay Stock

Exchange (BSE) along with other Exchanges of India are the market for derivatives. Here we may discuss

the performance of derivatives products in Indian market.

DERIVATIVE PRODUCTS TRADED

AT BSE The BSE started derivatives trading on June 9, 2000 when it launched “Equity derivatives (Index

futures-SENSEX) first time. It was followed by launching various products which are shown in table no.2.

They are index options, stock options, single stock futures, weekly options, stocks for: Satyam, SBI,

Reliance Industries, Tata Steel, Chhota (Mini) SENSEX, Currency futures, US dollar-rupee future and
BRICSMART indices derivatives. The table No.2 summarily specifies the derivative products and their

date of introduction at BSE.

DERIVATIVE PRODUCTS TRADED AT NSE

The NSE started derivatives trading on June 12, 2000 when it launched “Index Futures S & P CNX Nifty”

first time. It was followed by launching various derivative products which are shown in table no.3. They

are index options, stock options, stock future, interest rate, future CNX IT future and options, Bank Nifty

futures and options, CNX Nifty Junior futures and options, CNX100 futures and options, Nifty Mid Cap-50

future and options, Mini index futures and options, Long term options. Currency futures on USD-rupee,

Defty future and options, interest rate futures, SKP CNX Nifty futures on CME, European style stock

options, currency options on USD INR, 91 days GOI T.B. futures, and derivative global indices and

infrastructures indices

Structure of Derivative Markets in India

Derivative trading in India takes can place either on a separate and independent Derivative Exchange or

on a separate segment of an existing Stock Exchange. Derivative Exchange/Segment function as a Self-

Regulatory Organisation (SRO) and SEBI acts as the oversight regulator. The clearing & settlement of all

trades on the Derivative Exchange/Segment would have to be through a Clearing Corporation/House,

which is independent in governance and membership from the Derivative Exchange/Segment.

Regulatory Objectives

The LCGC outlined the goals of regulation admirably well in Paragraph 3.1 of its report. We therefore

reproduce this paragraph of the LCGC Report:

"The Committee believes that regulation should be designed to achieve specific, well-defined goals. It is

inclined towards positive regulation designed to encourage healthy activity and behaviour. It has been

guided by the following objectives:

A. Investor Protection: Attention needs to be given to the following four aspects:

i. Fairness and Transparency:

 The trading rules should ensure that trading is conducted in a fair and transparent manner.

Experience in other countries shows that in many cases, derivatives-brokers / dealers failed to

disclose potential risk to the clients. In this context, sales practices adopted by dealers for

derivatives would require specific regulation. In some of the most widely reported mishaps in

the derivatives market elsewhere, the underlying reason was inadequate internal control system

at the user-firm itself so that overall exposure was not controlled and the use of derivatives was

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

designing regulations.

ii. Safeguard for clients' moneys:

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

a separate clients' account but should also not be attachable for meeting the broker's own debts.

It should be ensured that trading by dealers on own account is totally segregated from that for

clients.

iii. Competent and honest service:

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

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

qualification for derivatives brokers/dealers and the sales persons appointed by them in terms of

a knowledge base.

iv. Market integrity:

The trading system should ensure that the market's integrity is safeguarded by minimising the

possibility of defaults. This requires framing appropriate rules about capital adequacy, margins,

clearing corporation,etc.

B. Quality of markets:

The concept of "Quality of Markets" goes well beyond market integrity and aims at enhancing important

market qualities, such as cost-efficiency, price-continuity, and price-discovery. This is a much broader

objective than market integrity.

C. Innovation:

While curbing any undesirable tendencies, the regulatory framework should not stifle innovation which

is the source of all economic progress, more so because financial derivatives represent a new rapidly

developing area, aided by advancements in information technology.

Derivatives Trading - Regulatory Framework

With the amendment in the definition of 'securities' under SC(R)A (to include derivative contracts in the

definition of securities), derivatives trading takes place under the provisions of the Securities Contracts

(Regulation) Act, 1956 and the Securities and Exchange Board of India Act, 1992. Dr. L.C Gupta

Committee constituted by SEBI had laid down the regulatory framework for derivative trading in India.

SEBI has also framed suggestive bye-law for Derivative Exchanges/Segments and their Clearing

Corporation/House which lay's down the provisions for trading and settlement of derivative contracts.

The Rules, Bye-laws & Regulations of the Derivative Segment of the Exchanges and their Clearing

Corporation/House have to be framed in line with the suggestive Bye-laws. SEBI has also laid the

eligibility conditions for Derivative Exchange/Segment and its Clearing Corporation/House. The eligibility

conditions have been framed to ensure that Derivative Exchange/Segment & Clearing

Corporation/House provide a transparent trading environment, safety & integrity and provide facilities

for redressal of investor grievances

Market Regulation & Investor Protection

We have seen that pursuant to the recommendations of JR Verma Committee SEBI formulated and

approved guidelines to the stock exchanges (NSE/BSE) and permitted trading in Derivatives. We will now

discuss the regulatory measures as envisaged by SEBI.

1. Futures/ Options contracts in both index as well as stocks can be bought and sold through the

trading members of National Stock Exchange, or the BSE Mumbai Stock Exchange. Some of the

trading members also provide the internet facility to trade in the futures and options market.
 2. The investor is required to open an account with one of the trading members and complete the

related formalities which include signing of member-constituent agreement, constituent

registration form and risk disclosure document.

3. The trading member will allot the investor an unique client identification number.

4. To begin trading, the investor must deposit cash and/or other collaterals with his trading

member as may be stipulated by him. SEBI has issued detailed guidelines for the benefit of the

investor trading in the derivatives exchanges. These may be viewed and studied.

5. Margins are computed and collected on-line, real time on a portfolio basis at the client level.

Members are required to collect the margin upfront from the client & report the same to the

Exchange.

6. All the Futures and Options contracts are settled in cash at the expiry or exercise of the

respective contracts as the case may, be. Members are not required to hold any stock of the

underlying for dealing in the Futures / Options market.

Important Eligibility/Regulatory Conditions Specified by SEBI

 Derivative trading to take place through an on-line screen based Trading System.

 The Derivatives Exchange/Segment shall have on-line surveillance capability to monitor

positions, prices, and volumes on a real time basis so as to deter market manipulation.

 The Derivatives Exchange/ Segment should have arrangements for dissemination of information

about trades, quantities and quotes on a real time basis through atleast two information vending

networks, which are easily accessible to investors across the country.

 The Derivatives Exchange/Segment should have arbitration and investor grievances redressal

mechanism operative from all the four areas / regions of the country.
 The Derivatives Exchange/Segment should have satisfactory system of monitoring investor

complaints and preventing irregularities in trading.

 The Derivative Segment of the Exchange would have a separate Investor Protection Fund.

 The Clearing Corporation/House shall perform full novation, i.e., the Clearing Corporation/House

shall interpose itself between both legs of every trade, becoming the legal counterparty to both

or alternatively should provide an unconditional guarantee for settlement of all trades.

 The Clearing Corporation/House shall have the capacity to monitor the overall position of

Members across both derivatives market and the underlying securities market for those

Members who are participating in both.

 The level of initial margin on Index Futures Contracts shall be related to the risk of loss on the

position. The concept of value-at-risk shall be used in calculating required level of initial margins.

The initial margins should be large enough to cover the one-day loss that can be encountered on

the position on 99% of the days.

 The Clearing Corporation/House shall establish facilities for electronic funds transfer (EFT) for

swift movement of margin payments.

 In the event of a Member defaulting in meeting its liabilities, the Clearing Corporation/House

shall transfer client positions and assets to another solvent Member or close-out all open

positions.

 The Clearing Corporation/House should have capabilities to segregate initial margins deposited

by Clearing Members for trades on their own account and on account of his client. The Clearing

Corporation/House shall hold the clients' margin money in trust for the client purposes only and

should not allow its diversion for any other purpose.

 The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades

executed on Derivative Exchange / Segment.

Measures Specified by SEBI to Enhance Protection of the Rights of Investors in the Derivative Market

SEBI has also specified measures to ensure protection of the rights of investors. These measures are as

follows:

 Investor's money has to be kept separate at all levels and is permitted to be used only against

the liability of the Investor and is not available to the trading member or clearing member or

even any other investor.

 The Trading Member is required to provide every investor with a risk disclosure document which

will disclose the risks associated with the derivatives trading so that investors can take a

conscious decision to trade in derivatives.

 Investor would get the contract note duly time stamped for receipt of the order and execution of

the order. The order will be executed with the identity of the client and without client ID order

will not be accepted by the system. The investor could also demand the trade confirmation slip

with his ID in support of the contract note. This will protect him from the risk of price favour, if

any, extended by the Member.

 In the derivative markets all money paid by the Investor towards margins on all open positions is

kept in trust with the Clearing House /Clearing Corporation and in the event of default of the

Trading or Clearing Member the amounts paid by the client towards margins are segregated and

not utilised towards the default of the member. However, in the event of a default of a member,

losses suffered by the Investor, if any, on settled / closed out position are compensated from the

Investor Protection Fund, as per the rules, bye-laws and regulations of the derivative segment of

the exchanges.

 Presently, SEBI has permitted Derivative Trading on the Derivative Segment of BSE and the F&O

Segment of NSE. Derivative products have been introduced in a phased manner starting with

Index Futures Contracts in June 2000, Index Options and Stock Options introduced in June 2001

and July 2001 followed by Stock Futures in November 2001.

Types of Derivative Contracts Permitted by SEBI

Derivative products have been introduced in a phased manner starting with Index Futures Contracts in

June 2000. Index Options and Stock Options were introduced in June 2001 and July 2001 followed by

Stock Futures in November 2001.

Minimum Contract Size

The Standing Committee on Finance, a Parliamentary Committee, at the time of recommending

amendment to Securities Contract (Regulation) Act, 1956 had recommended that the minimum contract

size of derivative contracts traded in the Indian Markets should be pegged not below Rs. 2 Lakhs. Based

on this recommendation SEBI has specified that the value of a derivative contract should not be less than

Rs. 2 Lakh at the time of introducing the contract in the market.

The Lot Size of a Contract

Lot size refers to number of underlying securities in one contract. Additionally, for stock specific

derivative contracts SEBI has specified that the lot size of the underlying individual security should be in

multiples of 100 and fractions, if any, should be rounded of to the next higher multiple of 100. This

requirement of SEBI coupled with the requirement of minimum contract size forms the basis of arriving

at the lot size of a contract

For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the minimum contract size is Rs.2 lacs,

then the lot size for that particular scrips stands to be 200000/1000 = 200 shares i.e. one contract in XYZ

Ltd. covers 200 shares.

SEBI Amendment to Stipulations on Lot Size

While the Legislative body stipulated the minimum contract size in terms of value (Rs.2 Lacs), the system

of standardising securities trade in Lots, had a multiplying effect, on the minimum value of a contract,

when the prices of the premium Scrips started appreciating over time. BSE Sensix Index which was less

than 3000 at that time swelled to nearly 6000 presently. As the value of individual scrips increased,
smaller number of such scrips would be sufficient to cover the minimum contract value of Rs.2.00 Lacs

prescribed by the Standing Committee of the Parliament. But stipulating a fixed number of shares as the

lot in many cases swelled the value of the contract to Rs.5 Lacs and even more in many cases. This

brought derivatives trading beyond he scope of the small investor.

Considering the fact SEBI revised its stipulations regarding Lot size, but retaining the minimum contract

value at Rs.2 Lacs and issued a press release on 07.01.2004 stating:

It has been noticed that in several derivative contracts the value has exceeded Rs. 2 lakh. In such cases it

has been decided to reduce the value of the contract to close to but not less than Rs. 2 lakh by using an

appropriate lot size / multiplier which could be half or 50%. The exchanges could determine any other lot

size / multipliers to keep the contract size of derivatives close to Rs. 2 lakh, but in any case not less than

Rs. 2 lakh. The exchanges would be able to reduce the contract size of a derivative contract by submitting

a detailed proposal to SEBI and after giving at least two weeks prior notice to the market.

What is Margin Money?

The aim of margin money is to minimize the risk of default by either counter-party. The payment of

margin ensures that the risk is limited to the previous day's price movement on each outstanding

position. However, even this exposure is offset by the initial margin holdings. Margin money is like a

security deposit or insurance against a possible future loss of value.

There are different types of margin viz. Initial Margin, Variation margin (or Mark-to-Market Margin ) and

Additional margin.-

 Initial Margin - Based on 99% VaR and worst case loss over a specified horizon, which depends

on the time in which Mark to Market margin is collected. The basic aim of Initial margin is to

cover the largest potential loss in one day. Both buyer and seller have to deposit margins. The

initial margin is deposited before the opening of the position in the Futures transaction. This

margin is calculated by SPAN (Standard Portfolio Analysis of Risk) by considering the worst case

scenario.
  Mark to Market Margin (MTM)- collected in cash for all futures contracts and adjusted against

the available liquid networth for option positions. In the case of Futures Contracts MTM may be

considered as Mark to Market Settlement. All daily losses must be met by depositing of further

collateral - known as variation margin, which is required by the close of business, the following

day. Any profits on the contract are credited to the client's variation margin account.

The Concept of Maintenance Margin

Some exchanges work on the system of maintenance margin, which is set at a level slightly less than

initial margin. The margin is required to be replenished to the level of initial margin, only if the margin

level drops below the maintenance margin limit. For e.g.. If Initial Margin is fixed at 100 and

Maintenance margin is at 80, then the broker is permitted to trade till such time that the balance in this

initial margin account is 80 or more. If it drops below 80, say it drops to 70, then a margin of 30 (and not

10) is to be paid to replenish the levels of initial margin. This concept is not being followed in India.

The Concept of Additional Margin

In case of sudden higher than expected volatility, additional margin may be called for by the exchange.

This is generally imposed when the exchange fears that the markets have become too volatile and may

result in some crisis, like payments crisis, etc. This is a preemptive move by exchange to prevent

breakdown.

The Concept of Cross Margining

This is a method of calculating margin after taking into account combined positions in futures, options,

cash market etc. Hence, the total margin requirement reduces due to cross-hedges.

What are Long/ Short Positions

In simple terms, long and short positions indicate whether you have a net over-bought position (long) or

over-sold position (short).

What do you mean by Closing out contracts?

A long position in futures can be closed out by selling futures, while a short position in futures can be

closed out by buying futures on the exchange. Once position is closed out, only the net difference needs

to be settled in cash, without any delivery of underlying. Most contracts are not held to expiry but closed

out before that. If held until expiry, some are settled for cash and others for physical delivery.

Dr. L.C Gupta Committee had recommended that the level of initial margin required on a position should

be related to the risk of loss on the position. The concept of value-at-risk should be used in calculating

required level of initial margins. The initial margins should be large enough to cover the one day loss that

can be encountered on the position on 99% of the days. The recommendations of the Dr. L.C Gupta

Committee have been a guiding principle for SEBI in prescribing the margin computation & collection

methodology to the Exchanges. With the introduction of various derivative products in the Indian

securities markets, the margin computation methodology, especially for initial margin, has been

modified to address the specific risk characteristics of the product. The margining methodology specified

is consistent with the margining system used in developed financial & commodity derivative markets

worldwide. The exchanges were given the freedom to either develop their own margin computation

system or adapt the systems available internationally to the requirements of SEBI.

A portfolio based margining approach which takes an integrated view of the risk involved in the portfolio

of each individual client comprising of his positions in all Derivative Contracts i.e. Index Futures, Index

Option, Stock Options and Single Stock Futures, has been prescribed. The initial margin requirements are

required to be based on the worst case loss of a portfolio of an individual client to cover 99% VaR over a

specified time horizon.

The Initial Margin is Higher of

(Worst Scenario Loss + Calendar Spread Charges)

Or

Short Option Minimum Charge

The worst scenario loss are required to be computed for a portfolio of a client and is calculated by

valuing the portfolio under 16 scenarios of probable changes in the value and the volatility of the Index/

Individual Stocks. The options and futures positions in a client's portfolio are required to be valued by

predicting the price and the volatility of the underlying over a specified horizon so that 99% of times the

price and volatility so predicted does not exceed the maximum and minimum price or volatility scenario.

In this manner initial margin of 99% VaR is achieved. The specified horizon is dependent on the time of

collection of mark to market margin by the exchange.

The probable change in the price of the underlying over the specified horizon i.e. 'price scan range', in

the case of Index futures and Index option contracts are based on three standard deviation (3s ) where 's

' is the volatility estimate of the Index. The volatility estimate 's ', is computed as per the Exponentially

Weighted Moving Average methodology. This methodology has been prescribed by SEBI. In case of

option and futures on individual stocks the price scan range is based on three and a half standard

deviation (3.5s ) where 's ' is the daily volatility estimate of individual stock.

For Index Futures and Stock futures it is specified that a minimum margin of 5% and 7.5% would be

charged. This means if for stock futures the 3.5s value falls below 7.5% then a minimum of 7.5% should

be charged. This could be achieved by adjusting the price scan range.

The probable change in the volatility of the underlying i.e. 'volatility scan range' is fixed at 4% for Index

options and is fixed at 10% for options on Individual stocks. The volatility scan range is applicable only for

option products.

Calendar spreads are offsetting positions in two contracts in the same underlying across different expiry.

In a portfolio based margining approach all calendar-spread positions automatically get a margin offset.

However, risk arising due to difference in cost of carry or the 'basis risk' needs to be addressed. It is

therefore specified that a calendar spread charge would be added to the worst scenario loss for arriving

at the initial margin. For computing calendar spread charge, the system first identifies spread positions

and then the spread charge which is 0.5% per month on the far leg of the spread with a minimum of 1%
and maximum of 3%. Further, in the last three days of the expiry of the near leg of spread, both the legs

of the calendar spread would be treated as separate individual positions.

In a portfolio of futures and options, the non-linear nature of options make short option positions most

risky. Especially, short deep out of the money options, which are highly susceptible to, changes in prices

of the underlying. Therefore a short option minimum charge has been specified. The short option

minimum charge is 5% and 7.5 % of the notional value of all short Index option and stock option

contracts respectively. The short option minimum charge is the initial margin if the sum of the worst

-scenario loss and calendar spread charge is lower than the short option minimum charge.

To calculate volatility estimates the exchange are required to uses the methodology specified in the Prof

J.R Varma Committee Report on Risk Containment Measures for Index Futures. Further, to calculated the

option value the exchanges can use standard option pricing models - Black-Scholes, Binomial, Merton,

Adesi-Whaley.

The initial margin is required to be computed on a real time basis and has two components:-

 The first is creation of risk arrays taking prices at discreet times taking latest prices and volatility

estimates at the discreet times, which have been specified.

 The second is the application of the risk arrays on the actual portfolio positions to compute the

portfolio values and the initial margin on a real time basis.

The initial margin so computed is deducted form the available Liquid Networth on a real time basis.

Mark to Market Margin

Options - The value of the option are calculated as the theoretical value of the option times the number

of option contracts (positive for long options and negetive for short options). This Net Option Value is

added to the Liquid Networth of the Clearing member. Thus MTM gains and losses on options are

adjusted against the available liquid networth. The net option value is computed using the closing price

of the option and are applied the next day.

Futures - The system computes the closing price of each series, which is used for computing mark to

market settlement for cumulative net position. This margin is collected on T+1 in cash. Therefore, the

exchange charges a higher initial margin by multiplying the price scan range of 3s & 3.5s with square root

of 2, so that the initial margin is adequate to cover 99% VaR over a two days horizon.

MARGIN COLLECTION

Initial Margin - is adjusted from the available Liquid Networth of the Clearing Member on an online real

time basis.

Marked to Market Margins

Futures contracts: The open positions (gross against clients and net of proprietary / self trading) in the

futures contracts for each member is marked to market to the daily settlement price of the Futures

contracts at the end of each trading day. The daily settlement price at the end of each day is the

weighted average price of the last half an hour of the futures contract. The profits / losses arising from

the difference between the trading price and the settlement price are collected / given to all the clearing

members.

Option Contracts: The marked to market for Option contracts is computed and collected as part of the

SPAN Margin in the form of Net Option Value. The SPAN Margin is collected on an online real time basis

based on the data feeds given to the system at discrete time intervals.

Client Margins

Clearing Members and Trading Members are required to collect initial margins from all their clients. The

collection of margins at client level in the derivative markets is essential as derivatives are leveraged

products and non-collection of margins at the client level would provided zero cost leverage. In the

derivative markets all money paid by the client towards margins is kept in trust with the Clearing House/

Clearing corporation and in the event of default of the Trading or Clearing Member the amounts paid by

the client towards margins are segregated and not utilised towards the default of the member.
Therefore, Clearing members are required to report on a daily basis details in respect of such margin

amounts due and collected from their Trading members / clients clearing and settling through them.

Trading members are also required to report on a daily basis details of the amount due and collected

from their clients. The reporting of the collection of the margins by the clients is done electronically

through the system at the end of each trading day. The reporting of collection of client level margins

plays a crucial role not only in ensuring that members collect margin from clients but it also provides the

clearing corporation with a record of the quantum of funds it has to keep in trust for the clients.

The position limits in Derivative Products

The position limits specified are as under-

Client / Customer level position limits:<

For index based products there is a disclosure requirement for clients whose position exceeds 15% of the

open interest of the market in index products.

For stock specific products the gross open position across all derivative contracts on a particular

underlying of a customer/client should not exceed the higher of -

 1% of the free float market capitalisation (in terms of number of shares). Or

 5% of the open interest in the derivative contracts on a particular underlying stock (in terms of

number of contracts).

This position limits are applicable on the combine position in all derivative contracts on an underlying

stock at an exchange. The exchanges are required to achieve client level position monitoring in stages.

Trading Member Level Position Limits:

1. For Index products the Trading Member position limits are Rs. 100 cr or 15% of the open interest

whichever is higher.

2. For stock specific products the trading member position limit are at 7.5% of the open interest or

Rs 50 crore whichever is higher for derivative contract in a particular underlying at an exchange.

It is also specified that once a member reaches the position limit in a particular underlying then the

member shall be permitted to take only offsetting positions (which result in lowering the open position

of the member) in derivative contracts on that underlying. In the event that the position limit is

breached due to the reduction in the overall open interest in the market, the member shall be permitted

to take only offsetting positions (which result in lowering the open position of the member) in derivative

contract in that underlying and no fresh positions shall be permitted. The position limit at trading

member level are required to be be computed on a gross basis across all clients of the Trading member.

Market wide limits:

There are no market wide limits for index products. However for stock specific products the market wide

limit of open positions (in terms of the number of underlying stock) on an option and futures contract on

a particular underlying stock would be lower of -

 30 times the average number of shares traded daily, during the previous calendar month, in the

cash segment of the Exchange, or

 10% of the number of shares held by non-promoters i.e. 10% of the free float, in terms of

number of shares of a company.

It is further specified that when the total open interest in a contract reaches 80% of the market wide

limit in that contract, the exchanges would double the price scan range and volatility scan range

specified. The exchanges are required to continuously review the impact of this measure and take

further proactive risk containment measures as may be appropriate, including, further increases in the

scan ranges and levying additional margins.

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Derivative Market in India

History of Derivative Markets History of financial markets is replete with crises. such as the break down

of the fixed exchange rate system in 1971 and the Black Monday of October 1987 in US Markets. the
steep fall in the Nikkei in 1989. the bond debacle of 1994 in US. All these events occur because of vcry

high degree of volatility of financial markets and thcir unpredictability. With increased global integration

of markets, such disasters have become more frequent. Since such volatility and associated disasters

cannot be wished away, innovative financial instruments emerged to protect against these hazards.

These included Futures and Options, which are the most dominant forms of financial derivatives. They

are called derivatives because their prices depend on the values of other more basic underlying financial

instruments. For example, the price of a stock option depends on the value of the underlying stock; a

commodity futures price depends on the value of the underlying commodity and so on. These

derivatives provide a mechanism, which market participants use to hedge their positions against adverse

movement of variables over which they have no control. Financial derivatives came into the spotlight

along with the growing instability in current markets during the post-1970 period. when the US

announced its decision to give up gold-dollar parity, the basic king pin of the Bretton Woods System of

fixed exchange rates. In less than three decades of their emergence, derivatives markets have become an

integral part of modern financial system. According to MLGreenspan Ex-Federal Governor of USA "By far

the most significant event in finance during the past decade has been the extraordinary development

and expansion of financial derivatives .... "

The Indian financial markets took a giant leap ahead with the introduction of derivatives trading on the

stock exchanges. The derivatives trading in India commenced with the introduction of index futures in

June 2000. The advent of stock futures and options in 200 I resulted in a dramatic increase in the

volumes of clerivatives. In less than five years, the volumes in the Futures and Options segment rose

more than that of the cash market. Since then, the volumes in the F&O segment have witnessed huge

growth. Currently. the volumes in F&O are consistently around four to five times more than the 61 cash

market volumes. This in itself reflects the huge popularity of these instruments among the retail and

institutional investors alike. Going ahead, the derivative markets arc expected to see a further rise with

the increase in knowledge levels among the investors about these products. They also act as a very

useful hedging tool for institutional investors who would like to protect their holdings against any

negative surprises. With the government liberalizing norms for Mutual Funds participation in the

derivatives segment, the participation is expected to rise further in the future. The Mutual Fund industry
is also launching derivative funds where the primary focus would be to generate returns through

investment in derivatives. Moreover with the Indian stock markets generating astronomical returns in

the last few years, the future prospects of derivatives looks extremely bright.

Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect

in May 2000. SEBI permitted the derivative segments of two stock exchanges, viz NSE and BSE, and their

clearing house/corporation to commence trading and settlement in approved derivative contracts. To

begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty Index and BSE-30

(Sensex) Index. This was followed by approval [or trading in options based on these two indices and

options on individual securities. The trading in index options commenced in June 2001 and those in

options on individual securities commenced in July 2001. Futures contracts on individual stock were

launched in November 200 I. The sequence of events leading to the introduction of trading of derivatives

is presented in Table-3.I.Simalrely details of participation of various players in Futures & Options markets

are given in Table-3.2. 62

Types of Derivative Markets in India Derivative markets can broadly be classified as commodity

derivative market and financial derivatives markets. As the name suggest. commodity

derivatives markets trade contracts for which the underlying asset is a Commodity. It can be an

agricultural commodity like wheat. soybeans. rapeseed. cotton. etc or precious metals like gold.

silver. etc. Financial derivatives markets trade contracts that have a financial asset or variable as

the underlying. The more popular financial derivatives are those, which have equity, interest

rates and exchange rates as the underlying. The most commonly used derivatives contracts are

forwards, futures and options. Details of various Derivative markets are given below.

Equity Derivatives There are various types of Equity Derivatives instruments in India details of

these instruments are given below.

Forwards: A forward contract is a customized contract between two entities, where settlement

takes place on a specific date in the future at today's pre-agreed price.

Futures: A futures contract is an agreement between two pm1ies to buy or sell an asset at a

certain time in the future at a certain price. Futures contracts are special types of forward

contracts in the sense that the former are standardized exchange traded contracts

Options: Options are of two types - calls and puts. Calls give the buyer the right but not the

obligation to buy a given quantity of the underlying asset. at a given price on or before a given

future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the

underlying asset at a given price on or before a given date. Warrants: Options generally have

lives of up to one year, the majority of options traded on options exchanges having a maximum

maturity of 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 arc options

having a maturity of up to three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is

usually a moving average or a basket of assets. Equity index options are a form of basket

options.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the future

according to a prearranged formula. They can be regarded as portfolios of forward contracts.

The two commonly used swaps are:

o Interest rate swaps: These entail swapping only the interest related cash tlows between the

parties in the same currency.

o Currency swaps: These entail swapping both principal and interest between the parties, with

the cash flows in one direction being in a different currency than those in the opposite

direction.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry

of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts,

the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an

option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive

tloating.

Commodity Derivatives

Futures contracts in pepper. turmeric, gur (jaggery). hessian (jute fabric), jute sacking, castor

seed, potato. coffee, cotton, and soybean and its derivatives are traded in 18 commodity

exchanges located in various parts of the country. Futures trading in other edible oils. oilseeds

and oil cakes have been permitted. Trading in futures in the new commodities. especially in

edible oils. is expected to cOlllmence in the near future. The sugar industry is exploring the

merits of trading sugar futures contracts.

The policy initiatives and the modernization programme include extensive training, structuring a

reliable clearinghouse, establishment of a system of warehouse receipts, and the thrust towards

the establishment of a national commmodity exchange. The Government of India has

constituted a committee to explore and evaluate issues pertinent to the establishment and

funding of the proposed national commodity exchange for the nationwide trading of

commodity futures contracts. and the other institutions and institutional processes such as

warehousing and clearinghouses. With commodity futures. delivery is best affected using

warehouse receipts (which are like dematerialized securities). Warehousing functions have

enabled viable exchanges to augment their strengths in contract design and trading. The
viability of the national commodity exchange is predicated on the reliability of the warehousing

functions. The programme for establishing a system of warehouse receipts is in progress. The

Coffee Futures Exchange India (COFEI) has operated a system of warehouse receipts since J 998.

Foreign Exchange Derivatives

During the period J 975-1992, the exchange rate of the rupee was officially set by the Reserve

Bank of India (RBI) in terms of a (weighted) basket of currencies of India's major trading

partners and there were significant restrictions on not only capital but current account

transactions as well. Since the early nineties. India is on the path of a gradual progress towards

capital account convertibility. The emphasis has been shifting away from debt creating to non-

debt creating inflows. with focus on more stable long tern inflows in the form of foreign direct

investment and portfolio investment. The exchange rate regime has evolved from a single-

cunency fixed exchange rate system to fixing the value of the rupee against a basket of

currencies and further to a market-determined floating exchange rate regime.

The Indian foreign exchange derivatives market owes its ongll1 to the impol1ant step that the

RBI took in 1978 to allow banks to undertake intra-day trading in foreign exchange; as a

consequence, the stipulation of maintaining square or near square position was to be complied

with only at the close of each business day. This was followed by use of products like cross-

currency options, interest rate and currency swaps, caps/collars and forward rate agreements in

the international foreign exchange market; development of a rupee-foreign currency swap

market; and introduction of additional hedging instruments such as foreign currency-rupee

options.

Exchange Traded Derivatives (ETD) & Over The Counter (OTC) Derivatives markets
Derivatives have probably been around for as long as people have been trading with one

another. Forward contracting dates back at least to the 12th century, and may well have been

around before then. These contracts were typically OTC kind of contracts. Over the counter

(OTC) derivatives are privately negotiated contracts. Merchants entered into contracts with one

another for future delivery of specified amount of commodities at specified price. A primary

motivation for pre arranging a buyer or seller for a stock of commodities in early forward

contracts was to lessen the possibility that large swing would inhibit marketing the commodity

after a harvest. Later many of these contracts were standardized in terms of quantity and

delivery dates and began to trade on an exchange.

The OTC derivatives markets have witnessed rather sharp growth over the last few years, which

have accompanied the modernization of commercial and investment banking and globalization

of financial activities. The recent developments in information technology have contributed to a

great extent to these developments. While both exchange-traded and OTC derivative contracts

offer many benefits, the former have rigid structures compared to the latter.

The OTC derivatives markets have the following features compared to exchange-traded

derivatives:

• The management of counter-party (credit) risk is decentralized and located within individual

institutions,

• There are no formal centralized limits on individual positions, leverage, or margining,

• There are no formal rules for risk and burden-sharing,

• There are no formal rules or mechanisms for ensuring market stability and integrity, and for

safeguarding the collective interests of market participants, and

• The OTC contracts are generally not regulated by a regulatory authority and the exchange’s

self-regulatory organization, although they are affected indirectly by national legal systems,

banking supervision and market surveillance.

Development of Derivative Markets in India

Derivatives markets have been in existence in India in some form or other for a long time. In the

area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and,

by the early 1900s India had one of the world's largest futures industry. In 1952 the government

banned cash settlement and options trading and derivatives trading shifted to informal forwards

markets. In recent years, government policy has changed, allowing for an increased role for

market-based pricing and less suspicion of derivatives trading. The ban on futures trading of

many commodities was lifted starting in the early 2000s, and national electronic commodity

exchanges were created.

In the equity markets, a system of trading called "BadIa" ("Badla" allowed investors to trade

single stocks on margin and to carry forward positions to the next settlement cycle. Earlier, it

was possible to carry forward a position indefinitely but later the maximum carry forward

period was 90 days. Unlike a futures or options, however, in a "Badla" trade there is no fixed

expiration date. and contract terms and margin requirements arc not standardized) involving

some elements of forwards trading had been in existence for decades. However, the system led

to a number of undesirable practices and it was prohibited off and on till the Securities and

Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the stock

market between 1993 and 1996 paved the way for the development of exchange-traded equity

derivatives markets in India. In 1993, the government created the NSE in collaboration with

state-owned financial institutions. NSE improved the efficiency and transparency of the stock

markets by offering a fully automated screen-based trading system and real-time price

dissemination. In 1995, a prohibition on trading options was lifted. In 1996, the NSE sent a
proposal to SEBI for listing exchange-traded derivatives. The report of the L. C. Gupta

Committee, set up by SEBI, recommended a phased introduction of derivative products, and bi-

Ievel regulation (i.e., self-regulation by exchanges with SEBI providing a supervisory and

advisory role). Another report, by the J. R. Vanna Committee in 1998, worked out various

operational details such as the margining systems. In 1999, the Securities Contracts (Regulation)

Act of 1956, or SeeR) A, was amended so that derivatives could be declared "securities." This

allowed the regulatory framework for trading securities to be extended to derivatives. The Act

considers derivatives to be legal and valid, but only if they are traded on exchanges.

Finally, a 3D-year ban on forward trading was also lifted in 1999. The economic liberalization of

the early nineties facilitated the introduction of derivatives based on interest rates and foreign

exchange. A system of market-determined exchange rates was adopted by India in March 1993.

In August 1994, the rupee was made fully convertible on current account. These reforms

allowed increased integration between domestic and international markets, and created a need

to manage currency risk. The casing of various restrictions on the free movement of interest

rates resulted in the need to manage interest rate risk.

Derivatives: Developments in India

• Developments Prior to 1998-99

In the last few years there have been substantial improvements in the functioning of the

securities market. Requirements of adequate capitalization, margining and establishment of

clearing corporations have reduced market and 69 credit risks. Systemic improvements have

been effected through introduction of screen based trading system and electronic transfer and

maintenance of ownership records of securities. However there are inadequate advanced risk

management tools. In order to provide such tools and to deepen and strengthen cash market, a

need was felt for trading of derivatives like futures and options. But it was not possible in view
of prohibitions in the SCRA. Its preamble stated that the Act is to prevent undesirable

transactions in securities by regulating business of dealing therein, by prohibiting options and

by providing for certain other matters connected therewith. Section 20 of the Act explicitly

prohibited all options in securities. The Act empowered Central Government to prohibit by

notification any type of transaction in any security. In exercise of this power, Government by its

notification in 1969 prohibited all forward trading in securities. As the need for derivatives was

felt, it was thought that if these prohibitions were withdrawn, trading in derivatives could

commence. The Securities Laws (Amendment) Ordinance, 1995, promulgated on 25'h January

1995, lifted the ban by replacing section 20 of the SCRA and amending its preamble. The market

for derivatives, however, did not take off, as there was no regulatory framework to govern

trading of derivatives. SEBI set up a 24 member Committee under the Chairmanship of Dr. L. C.

Gupta on 18th November 1996 to develop appropriate regulatory framework for derivatives

trading in India. The Committee submitted its report on March \7, 1998. Market went ahead

with preparation. It was soon realized that there was no law under which the regulations could

be framed for derivatives. It was felt that if derivatives could be treated as "securities" under

the SCRA, trading in derivatives would be possible within the framework of that Act. According

to section 2 (h) of the SCRA, 'Securities' includes shares, scrips. stocks, bonds, debentures,

debenture stock, or other marketable securities of a like nature in or of any incorporated

company or other body corporate, government securities, such other instruments as may be

declared by the Central Government to be securities, and rights and interests in securities. SEBI

felt that the definition of "Securities" under SC(R)A could be expanded by declaring derivative

contracts based on 70 ( index of prices of securities and other derivative contracts as securities.

It was thought that Government could declare derivatives to be securities under its delegated

powers. Government. however did not declare derivatives as "securities". probably because its

power was circumscribed by the words slIch other. Only those instruments, which resemble the

ones listed in the Act, could he declared.

• Developments During 1998-99

A. L. C. Gupta Committee (LCGC) Report The major recommendations of LCGC were accepted by

SEBI on Illh May 1998. Major Recommendations of L. C. Gupta Committee (LCGC)

I. The Committee strongly favors the introduction of financial derivatives to facilitate hedging in

a most cost-efficient way against market risk

2. There is a need for equity derivatives, interest rate derivative and currency derivatives.

3. There should phased introduction of derivatives product. To start with, index futures will be

introduced, which will be followed by options on index and later options on stocks.

4. Regulatory framework for derivatives trading envisaged two-level regulation i.e. exchange-

level and SEBl level. with considerable emphasis on self-regulatory competence of derivative

exchanges under the overall supervision and guidance of SEBI.

5. The derivative trading should take place on a separate segment of the existing stock

exchanges with an independent governing council where the number of trading members will

be limited to 40% of the total number. The Chairn1an of the governing council will not be

permitted to trade on any of the stock exchanges.

6. TI1e settlement of derivatives will be through an independent clearing corporationlclearing

house. which will become counter party for all trades or alternatively guarantee the settlement

of all trades. The clearing corporation will have adequate risk containment measures and will

collect margins through EFT.

7. The derivative exchange will have on-line trading and surveillance systems. It will disseminate

trade and price information on real time basis through two information vending networks. It

should inspect 100% of members every year.

8. There will be complete segregation of client money at the level of trading & clearing member

and even at the level of clearing corporation.

9. The trading and clearing member will have stringent eligibility conditions. At least two

persons should have passed the certification programme approved by SEBI.

10. The clearing members should deposit m1Jllmum Rs. 50 lakh with the clearing corporation

and should have a net worth of Rs. 3 crore

. 11. Removal of the regulatory prohibition on the use of derivatives by mutual funds while

making the trustees responsible to restrict the use of derivatives by mutual funds only to

hedging and p0l1folio balancing and not for speculation.

12. The operations of the cash market, on which the derivatives market will be based, needed

improvement in many respects.

13. Creation of Derivatives Cell, a Derivatives Advisory Committee, and Economic Research Wing

by SEBI.

14. Declaration of derivatives as securities under section 2(h)(iia) of the SCRA and suitable

amendment in the notification issued by the Central Government in June 1969 under section 16

of the SCRA

B. Securities Contracts (Regulation) Amendment Bill, 1998 As the derivatives could not be

declared to be "securities", government explored the possibility of amending the SCRA to

explicitly define securities to include derivatives. The Securities Contracts (Regulation)

Amendment Bill, 1998 was introduced in the Indian Parliament on 41h July 1998 proposing to

expand the definition of "securities" to include derivatives within its ambit so that trading in

derivatives could be introduced and regulated under the SCRA. The Bill was referred to the

Standing Committee on Finance (SCF) on 10'h July 1998 for examination and report thereon.
The Committee submitted its report on 171h March 1999. The committee was of the opinion

that the introduction of derivatives. if implemented with proper safeguards and risk

containment measures will certainly gives a fillip to the sagging market. result in enhanced

investment activity and instill greater confidence among the investors/participants. The

committee after having examined the Bill and being convinced of the needs and objectives of

the Bill approved the same for enactment by Parliament with certain modifications.

• Developments in 1999-2000 The Securities Laws (Amelldment) Act, 1999 The Securities Laws

(Amendment) Bill, 1999 was introduced in Indian Parlament on 281h October 1999. This Bill

incorporated the amendments proposed in the Securities Contracts Regulation (Amendment)

Bill, 1998 as well as the modifications suggested by the SCF. It became the Securities Laws

(Amendment) Act 1999 on receiving the assent of the President on 161h December 1999. The

Act would, however, come into force on such date as the Central Government may, by

notification in the official gazette, appoint. 3.4 Present scenario of Derivatives Markets in India

In India, the derivative market is still in a nascent stage. Derivatives in India were gIVen a new

lease of life last year. On January 25, 1995, the Securities Contract (Regulation) Act, 1956 (SCRA)

was amended with an intention to make options legal. Prior to this date all options in securities

were considered illegal. Securities covered by this legislation include shares, scripts, stocks,

bonds, debentures and other marketable securities. In fact. this amendment also renders

obsolete a notification issued by the Government of India, dated June 27 1969, which imposed

restrictions on the sale or purchase of securities sans delivery. Thus under SCRA, 'option in

securities' is no longer illegal. This term includes a contract for the purchase or sale of a right to

buy or sell securities in future and includes a put, a call or a put and call in securities. Besides

the provisions of SCRA, marketable securities based derivatives fall within the purview of the

regulations framed by the Securities and Exchange Board of India (SEBI) and the rules and

regulations of the regional stock exchanges. The first steps towards index-based futures trading
in India have been taken. Recently, on September 141h, 1997, the committee headed by L.c.

Gupta which was appointed by SEBI to look into the possibility of futures trading in India, has

submitted Part of its report and recommended the introduction of index-based futures trading,

as a first step towards introduction of equity derivative products. It will be submitting Part II of

its report a month later. In Part II the committee will deal basically with devising a regulatory

framework for derivatives. In the report already submitted, the committee has tried to remove

the misconception prevailing about derivative trading and has recommended its introduction in

a phased manner. While the committee has concentrated mainly on derivatives in equities it has

also touched upon interest rate futures and forward exchange futures. Currently, the committee

has not recommended the use of any particular index for index-based futures trading. This

leaves the field wide open, Nifty Midcap, Crisil 500, BSE Sensitive Index and National Index arc

the base indices that could be adopted by any stock exchange. Later, in PaIt II of its report the

committee will deal with the rules and regulations for derivative trading. In addition, it is also

likely to set criteria such as the minimum base requirement and other eligibility norms for those

stock exchanges which would be interested in introducing derivative trading. The depositories

system is in place III India and the L.C. Gupta committee is optimistic that this mechanism will

provide a cheaper option for derivative trading. The logic is that, dematerialized shares will

provide the much-needed arbitrage, between the current and the futures market. Taking

delivery, holding and finally ornoading of the stocks will have a much lower cost and will be

more efficient in the dematerialized segment of trading. Timing is of the essence in derivative

trading and hcnec the depository mode is more apt for derivatives. Under the depository

mechanism, an investor can invest in the entire index by buying up to one share in each of the

index stocks and thereby drastically rcduce his investment cost. If shares are not dematerialized,

it may even necessitate purchase of the market lot of each index stock. The report has also

emphasized that mutual funds will benefit greatly from derivatives trading. While SEBI is likely

to playa predominant role in the futures market, trading in currency derivatives in India, is
regulated under the Foreign Exchange Regulation Act, 1973 (FERA) and specific guidelines of the

Reserve Bank of India (RBI). Credit policy announcement in April this year, by India's central

bank i.e. RBI, has boosted activities relating to currency swaps. Commercial banks are allowed

to run swap books by offering currency swaps to corporate entities having foreign currency

exposures. Further, banks can now book forward contracts for importers and exporters on the

basis of a declaration instead of documented transactions. However, such swaps have to be

within the commercial bank's open positions or gap limits. Leeway on foreign currency

borrowings has also been given to these authorized dealers (commercial banks) regarding

foreign currency borrowings. Banks can borrow up to $ 10 million (Rs35 crore) from their

overseas branches without any restrictions on the end use of such funds in India. A further

impetus to derivative trading has come from an unexpected quat1er. A committee chaired by a

former director of the RBI (S.S.Tarapore) submitted its report on Capital Account Convertibility

(CAC) to the apex bank on June 3, 1997. This report advocates a phased implemcntation of

capital account convertibility over a three-year period: Phase I (1997-98), Phase II (1998-99) and

Phase III (1999-2000). This report emphasizes that CAC will usher in a variety of derivative and

risk management products. It mentions that currently, companies are allowed to usc derivatives

for hedging their currency or interest rate through authorized dealers in India and arc not

allowed to access the overseas markets directly. The Committee has recommended that in

Phase II corporate entities may be allowed to access overseas markets directly for derivatives

without having to route such transactions through authorized dealers in India. The L.c. Gupta

committee has taken into cognisance this rep0l1 Oil CAC, while touching upon interest rate

futures and foreign exchange futures. However, this committee has emphasized the need for a

strong cash market. It states that: The futures products delive their value from the cash market.

if the cash market is not functioning properly, then the cash asset will not be properly valued.

Trading in derivatives is yet to catch on in India and no specific tax provisions exist. Courts have

also not yet dealt with issues pertaining to tax liabilities mising out of currency derivatives.
However, India has had a mature dollar - rupee forward market with contracts being traded for

one, two or evcn six months maturity. The daily trading volume on this forward market is

around Rs 500 million.

The use of derivatives varies by type of institution. Financial institutions, such as banks, have

assets and liabilities of different maturities and in different currencies, and are exposed to

different risks of default from their borrowers. Thus, they are likely to use derivatives on interest

rates and cun'cncies, and derivatives to manage credit risk. Nonfinancial institutions are

regulated differently from financial institutions, and this affects their incentives to use

derivatives. Indian insurance regulators, for example, are yet to issue guidelines relating to the

use of derivatives by insurance companies. In India, financial institutions have not been heavy

users of exchange-traded derivatives so far, with their contribution to total value of NSE trades

being less than 8% in October 200S. However, market insiders feel that this may be changing, as

indicated by the growing share of index derivatives (which are used more by institutions than by

retail investors). In contrast to the exchange-traded markets, domestic financial institutions and

mutual funds have shown great interest in OTC fixed income instruments. Transactions between

banks dominate the market for interest rate derivatives, while state-owned banks remain a

small presence (Chitale, 2003). Corporations are active in the currency forwards and swaps

markets, buying these instruments from banks.

Reasons for the institutions to participate to a greater extent in derivatives markets

Some institutions such as banks and mutual funds are only allowed to use derivatives to hedge

their existing positions in the spot market. or to rebalance their existing portfolios. Since banks

have little exposure to equity markets due to banking regulations, they have little incentive to
trade equity derivatives. Foreign investors must register as foreign institutional investors (FIll to

trade exchange-traded derivatives, and be subject to position limits as specified by SEB!.

Alternatively. they can incorporate locally as a broker-dealer. FlIs have a small but increasing

presence in the equity derivatives markets. They have no incentive to trade interest rate

derivatives since they have little investments in the domestic bond markets (Chitale, 2003). It is

possible that unregistered foreign investors and hedge funds trade indirectly. using a local

proprietary trader as a front (Lee, 2004). Retail investors (including small brokerages trading for

themselves) are the major participants in equity derivatives. accounting for about 60'70 of

turnover in October 2005, according to NSE. The success of single stock futures in India is

unique, as this instrument has generally failed in most other countries. One reason for this

success may be retail investors' prior familiarity with "Badla" trades. which shared some

features of derivatives trading. Another reason may be the small size of the futures contracts.

compared to similar contracts in other countries. Retail investors also dominate the markets for

commodity derivatives, due in part to their long-standing expertise in trading in the "Hawala”"

or forwards markets.

For the retail traders, derivatives offer an undoubted advantage of leveraging 4-6 times their

investable amount. The minimum amount one would require to trade in futures could be as

minimal as Rs.20000. Options on the other hand can allow you to take positions even with a

meager principal amount, catering even to the most marginal traders. Larger investors can make

use of this 'leverage' for the purpose of investing. People holding substantial shares in any

derivative stocks can dilute the same in the cash market and pick up the same asset Via its

underlying derivative contract, as this would scale down their investment substantially and free

up cash. Hedging is the most sail able feature of any derivative instrument and also the primary

purpose for their creation.

Institutions funds often use these instruments to hedge their cash market positions or make use

of writing options to earn some money in range bound markets. As funds can only limit

themselves to hedging and cannot take speculative positions, arbitrage opportunities offer

scope to make safe money. This free money would add in to their regular capital appreciation

and dividend incomes.

Use of Derivatives by India's Institutional Investors

The Institutional Investors in India could be meaningfully classified into:

• Banks

• All India Financial Institutions (FIs) • Mutual Funds (MFs)

• Foreign Institutional Investors (FIls)

• Life & General Insurers

Issues and impediments in the use of following types of derivatives by these institutional

investors in India:

• Equity Derivatives • Fixed Income Derivatives

• Foreign Currency Derivatives

• Commodity Derivatives

The intensity of derivatives usage by any institutional investor is a function of its ability and

willingness to use derivatives for one or more of the following purposes:

a. Risk Containment: Using derivatives for hedging and risk containment purposes;

b. Risk Trading / Market Making: Running derivatives trading book for profits and arbitrage;

and/or
c. Covered Intermediation: On balance sheet derivatives intermediation for client transactions,

without retaining any net risk on the balance sheet (except credit risk).

Role of above FI in Equity Derivatives are as follows.

Banks

Types of Banks Based on the differences III governance structure, business practices and

organizational ethos, it is meaningful to classify the Indian banking sector into the following:

i.Public Sector Banks (PSBs);

ii. Private Sector Banks (Old Generation);

iii. Private Sector Banks (New Generation); and 80 iv. Foreign Banks (with banking and

authorized dealer license).

Equity Derivatives in Banks

Given the highly leveraged nature of banking business. and the attendant regulatory

concerns of their investment in equities. banks in India can. at best. be termed as

marginal investors in equities. Use of equity derivatives by banks ought to be inherently

limited to risk containment (hedging) and arbitrage trading between the cash market

and options and futures market. J]owever. for the following reasons, banks with direct

or indirect equity market exposure are yet to usc exchange traded equity derivatives (viz

.. index futures. index options, security specific futures or security specific options)

currently available on the National Stock Exchange (NSE) or Bombay Stock Exchange

(BSE):

RBI guidelines on investment by banks in capital market instruments do not authorize

banks to use equity derivatives for any purpose. RBI guidelines also do not authorize

banks to undertake securities lending and/or borrowing of equities. This disables also
banks possessing arbitrage trading skills and institutionalized risk management

processes for running an arbitrage trading book to capture risk free pricing mismatch

spreads between the equity cash and options and futures market an activity banks

currently any way undertake in the fixed income and FX cash and forward markets;

Direct and indirect equity exposure of banks is negligible and does not warrant serious

management attention and resources for hedging purposes;

III. The internal resources and processes in most bank treasuries are inadequate to

manage the risk of equity market exposures, and monitor use of equity derivatives

(even if used only for risk containment purposes);

Inadequate technological and business process readiness of their treasuries to run an

equity arbitrage-trading book. and manage related risks.

All India Financial Institutions (FJ)

With the merger of ICICI into ICICI Bank, the universe of all India Fls comprises IDB!.

IFCI, IIBI, SIDBI, EXIM. NABARD and IDFC. In the context of use of financial derivatives.

the universe of FIs could perhaps be extended to include a few other financially

significant players such as HDFC and NHB.

Equity Derivatives in FIs

Equity risk exposure of most FIs is rather insignificant, and often limited to equity

devolved on them under underwriting commitments they made in the era up to the

mid-I 990s. Use of equity derivatives by FIs could be for risk containment (hedging)

purposes, and for arbitrage trading purposes between the cash market and options

and futures market. For reasons identical to those outlined earlier vis-a-vis banks, FIs

too are not users of equity derivatives. However. there is no RBI guideline disabling FIs
from running an equities arbitrage trading book to capture risk free pricing mismatch

spreads between the equity cash and options and futures market. Yet. it appears that

most FIs do not run an equities arbitrage-trading book. Possible reasons could include

inadequate readiness in terms of possessing arbitrage-trading skills and

institutionalized risk management processes for running an arbitrage-trading book.

Mutual Funds

Mutual Funds came in limelight in 1960 with the rise of UTI (Unit Trust of India) later

on after globalization many domestic as well as MNC have entered in to India. There

are number of popular names like Fidelity. Reliance, HDI'C, IISBC, ICICI. Franklin

Templeton etc. As on today MF size in Indian market is about US$ 50 bn and its size

increasing day by day. Basically MF caters to those risks averse investors who afraid to

invest directly in stock market. Hence through MF different retail as well HNI can invest

in stock market.

Equity Derivatives in Mutual Funds

Mutual Funds ought to be natural players in the equity derivatives market. SEB!

(Mutual Funds) Regulations also authorize use of exchange traded equity derivatives

by mutual funds for hedging and portfolio rebalancing purposes. And. being tax

exempt. there are also no tax issues relating to use of equity derivatives by them.

However. most mutual funds (whether managed by Indian or foreign owned asset

management companies) arc not yet active in use of equity derivatives available on the

NSE or BSE. The following impediments seem to hinder use of exchange trade equity

derivatives by mutual funds:

1. SEBI (Mutual Funds) Regulations restrict use of exchange traded equity derivatives

to 'hedging and portfolio rebalancing purposes'. The popular view in the mutual fund

industry is that this regulation is very open to interpretation; and the trustees of

mutual funds do not wish to be caught on the wrong foot! The mutual fund industry

therefore wants SEBI to clarify the scope of this regulatory provision;

2. Inadequate technological and business process readiness of several players in the

mutual fund industry to use equity derivatives and manage related risks;

3. The regulatory prohibition on use of equity derivatives for Portfolio optimization

return enhancement strategies, and arbitrage strategies constricts their ability to use

equity derivatives; and

4. Relatively insignificant investor interest in equity funds ever since exchange traded

options and futures were launched in June 2000 (on NSE, later on BSE).

Foreign Institutional Investors (FII)

Foreign Institutional Investors (FIl) Indian capital markets has permitted FJI to invest in

various listed as well as unlisted companies in year 1995 and from that year onwards

there investment has increased in leap and frog manner. Today Indian Capital markets

both cash and derivatives markets are largely depend on Fll money because they

provide liquidity and stability to Indian markets.

Equity Derivatives in FIls

Till January 2002, applicable SEBI & RBI Guidelines permitted FIls to trade only in index

futures contracts on NSE & BSE. It is only since 4 February 2002 that RBI has permitted

(as a sequel to SEBI permission in December 200 I) FIls to trade in all exchange traded

derivatives contracts within the position limits for trading of Fils and their sub
accounts. These open position limits have been spelt out in SEBI circular dated 12

February 2002.J With the enabling regulatory framework available to FIls from

February 2002, their activity in the exchange traded equity derivatives market in India

should increase noticeably in the emerging future. Evidently. several FIls are still in the

process of completing the process of their internal approvals for use of exchange

traded equity derivatives on the NSE or BSE. Perhaps, the two years of successful track

record of the NSE in managing the systemic risk associated with its futures and options

(F&O) segment would also pave way for greater FII activity in the equity derivatives

market in India in the emerging future.

Life & General Insurers

Life & General Insurance companies Insurance companies both life and general

insurers are also very active in Indian capital market after getting permission from IRDA

(Insurance Regulatory Development Authority a parent body for insurance companies)

these companies have started investing portion of insurance premium money (mainly

ULIP money) in capital markets. Some popular names like LIC, HDFC, ICICI. and

Reliance etc.

Equity Derivatives in Life & General Insurers

The Insurance Act as well as the IRDA (Investment) Regulations 2000 are silent about

use of equity (or other) derivatives by life or general insurance com panics. It is the

view of the Insurance Regulatory and Development Authority (IRDA) that life and

general insurers are not permitted to use equity (or other financial) derivatives until

IRDA frames guidelines regulations relating to their use. And. IRDA is yet to frame

these guidelines/regulations, though it is seized of the urgent need to frame them. Life
 or general insurers would have to wait for these guidelines regulations to fall in place

before they can use equity (or other financial) derivatives. Assuming this happens

sooner than later, most new life and general insurers have been established only in the

past two years or so, and they currently have little or no equity investments at all.

Given the nascent stage at which they are, it will take at least a few years before they

become active investors in the equity market.

Till then, use of equity derivatives would be of relevance primarily to the incumbent

public sector insurance majors, namely, Life Insurance Corporation of India (L1C),

General Insurance Corporation of India (GIC), New India Assurance Company Limited

(NIA), United India Insurance Company Limited, National Insurance Company Limited.

and Oriental Insurance Company Limited. And, these incumbents would have to

overcome the following key impediments before they actively use equity (or other

financial) derivatives:

I. Inadequate technological and business process readiness of their investment

management function to run a derivatives trading book, and manage related

risks;

II. Inadequate readiness of human resources/talent in their investment

management function to run a derivatives trading book, and manage related

risks; and

III. Inadequate willingness of insurer managements to 'risk' being held

accountable for bonafide losses in the derivatives trading book (assuming

regulations permitting use of equity derivatives for purposes other than

hedging), and be exposed to subsequent onerous investigative reviews.

TRADING, CLEARING AND SETTLEMENT

4.1 TRADING

4.1.1 Trading Rules

The Derivatives Trading at BSE takes place through a fully automated screen-based trading

platform called DTSS (Derivatives Trading and Settlement System).The DTSS is designed

to allow trading on a real-time basis. In addition to generating trades by matching opposite

orders, the DTSS also generates various reports for the member participants.

4.1.2 Order Matching Rules

Order Matching takes place after order acceptance wherein the system searches for an

opposite matching order. If a match is found, a trade is generated. The order against which

the trade has been generated is removed from the system. In case the order is not exhausted

further matching orders are searched for and trades generated till the order gets exhausted

or no more match-able orders are found. If the order is not entirely exhausted, the system

retains the order in the pending order book. Matching of the orders is in the priority of price

and timestamp. A unique trade-id is generated for each trade and the entire information of

the trade is sent to the relevant Members.

4.1.3 Order Conditions

The derivatives market is order driven i.e. the traders can place only orders in the system.

Following are the order types allowed for the derivative products. These order types have

characteristics similar to the ones in the cash market.

• Limit Order: An order for buying or selling at a limit price or better, if possible.

Any unexecuted portion of the order remains as a pending order till it is matched or

its duration expires.

• Market Order: An order for buying or selling at the best price prevailing in the

market at the time of submission of the order.

There are two types of Market Orders:

1. Partial Fill Rest Kill (PF): execute the available quantity and kill any
unexecuted portion.

2. Partial Fill Rest Convert (PC): execute the available quantity and convert

any unexecuted portion into a limit order at the traded price.

• Stop Loss: An order that becomes a limit order only when the market trades at a

specified price.

All orders have the following attributes:

• Order Type (Limit / Market PF/Market PC/ Stop Loss)

• Asset Code, Product Type, Maturity, Call/Put and Strike Price

• Buy/Sell Indicator

• Order Quantity

• Price

• Client Type (Proprietary / Institutional / Normal)

• Client Code

• Order Retention Type (GFD / GTD / GTC)

o Good For Day (GFD) - The lifetime of the order is that trading session

o Good Till Date (GTD) - The life of the order is till the number of days as

specified by the Order Retention Period.

o Good Till Cancelled (GTC) - The order if not traded will remain in the

system till it is cancelled or the series expires, whichever is earlier.

• Order Retention Period (in calendar days): This field is enabled only if the value of

the previous attribute is GTD. It specifies the number of days the order is to be

retained.

• Protection Points Protection Points: This is a field relevant in Market Orders and

Stop Loss orders. The value enterable will be in absolute underlying points and

specifies the band from the touchline price or the trigger price within which the

market order or the stop loss order respectively can be traded.

• Risk Reducing Orders (Y/N): When a Member's collateral falls below 50 lakhs, he

will be allowed to put only risk reducing orders and will not be allowed to take any

fresh positions. It is not essentially a type of order but a mode into which the

Member is put into when he violates his collateral limit. A Member who has entered

the risk-reducing mode will be allowed to put only one risk reducing order at a

time.

4.1.4 Order Conditions

The derivatives market is order driven i.e. the traders can place only orders in the system.

Following are the order types allowed for the derivative products. These order types have

characteristics similar to the ones in the cash market.

• Limit Order: An order for buying or selling at a limit price or better, if possible.

Any unexecuted portion of the order remains as a pending order till it is matched or

its duration expires.

• Market Order: An order for buying or selling at the best price prevailing in the

market at the time of submission of the order.

There are two types of Market Orders:

1. Partial Fill Rest Kill (PF): execute the available quantity and kill any

unexecuted portion.

2. Partial Fill Rest Convert (PC): execute the available quantity and convert

any unexecuted portion into a limit order at the traded price.

• Stop Loss: An order that becomes a limit order only when the market trades at a

specified price.

All orders have the following attributes:

• Order Type (Limit / Market PF/Market PC/ Stop Loss)

• Asset Code, Product Type, Maturity, Call/Put and Strike Price

• Buy/Sell Indicator
• Order Quantity

• Price

• Client Type (Proprietary / Institutional / Normal)

• Client Code

• Order Retention Type (GFD / GTD / GTC)

35

o Good For Day (GFD) - The lifetime of the order is that trading session

o Good Till Date (GTD) - The life of the order is till the number of days as

specified by the Order Retention Period.

o Good Till Cancelled (GTC) - The order if not traded will remain in the

system till it is cancelled or the series expires, whichever is earlier.

• Order Retention Period (in calendar days): This field is enabled only if the value of

the previous attribute is GTD. It specifies the number of days the order is to be

retained.

• Protection Points Protection Points: This is a field relevant in Market Orders and

Stop Loss orders. The value enterable will be in absolute underlying points and

specifies the band from the touchline price or the trigger price within which the

market order or the stop loss order respectively can be traded.

• Risk Reducing Orders (Y/N): When a Member's collateral falls below 50 lakhs, he

will be allowed to put only risk reducing orders and will not be allowed to take any

fresh positions. It is not essentially a type of order but a mode into which the

Member is put into when he violates his collateral limit. A Member who has entered

the risk-reducing mode will be allowed to put only one risk reducing order at a

time.

CLEARING AND SETTLEMENT

BOI Shareholding Ltd. a joint company between BSE and Bank of India handles the
operations of funds and securities for the Exchange.

CLEARING ENTITIES

Clearing and settlement activities in the F&O segment are undertaken by BOISL with the

help of the following entities:

Clearing members

In the F&O segment, some members, called self clearing members, clear and settle their

trades executed by them only either on their own account or on account of their clients.

Some others called trading member-cum-clearing member, clear and settle their own trades

as well as trades of their trading members (TMs). Besides, there is a special category of

members, called professional clearing members (PCM) who clear and settle trades

executed by TMs. The members clearing their own trades and trades of the TMs, and the

PCMs are required to bring in additional security deposits in respect of every TM whose

trades they undertake to clear and settle.

Clearing banks

Funds settlement takes place through clearing banks. For the purpose of settlement all

clearing members are required to open a separate bank account with BOISL designated

clearing bank for F&O segment. The Clearing and Settlement process comprises of the

following three main activities:

1) Clearing

2) Settlement

3) Risk Management

36

CLEARING MECHANISM

The clearing mechanism essentially involves working out open positions and obligations of

clearing (self-clearing/trading-cum-clearing/professional clearing) members. This position

is considered for exposure and daily margin purposes. The open positions of CMs are
arrived at by aggregating the open positions of all the TMs and all custodial participants

clearing through him, in contracts in which they have traded. A TM's open position is

arrived at as the summation of 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 identify the orders, whether proprietary (if they are their own trades) or client

(if entered on behalf of clients) through 'Pro/Cli' indicator provided in the order entry

screen. Proprietary positions are calculated on net basis (buy - sell) for each contract.

Clients' positions are arrived at by summing together net (buy - sell) positions of each

individual client. A TM's open position is the sum of proprietary open position, client open

long position and client open short position.

SETTLEMENT MECHANISM

All futures and options contracts are cash settled, i.e. through exchange of cash. The

underlying for index futures/options of the SENSEX cannot be delivered. These contracts,

therefore, have to be settled in cash. Futures and options on individual securities can be

delivered as in the spot market. However, it has been currently mandated that stock options

and futures would also be cash settled. The settlement amount for a CM is netted across all

their TMs/clients, with respect to their obligations on MTM, premium and exercise

settlement.

Settlement of futures contracts

Futures contracts have two types of settlements, the MTM settlement which happens on a

continuous basis at the end of each day, and the final settlement which happens on the last

trading day of the futures contract.

MTM settlement:

All futures contracts for each member are mark-to-market (MTM) to the daily settlement

price of the relevant futures contract at the end of each day. The profits/losses are

computed as the difference between:

• The trade price and the day's settlement price for contracts executed during the day

but not squared up.

• The previous day's settlement price and the current day's settlement price for

brought forward contracts.

• The buy price and the sell price for contracts executed during the day and squared

up.

The CMs who have a loss are required to pay the mark-to-market (MTM) loss amount in

cash which is in turn passed on to the CMs who have made a MTM profit. This is known as

daily mark-to-market settlement. CMs are responsible to collect and settle the daily MTM

profits/losses incurred by the TMs and their clients clearing and settling through them.

Similarly, TMs are responsible to collect/pay profits/losses from/to their clients by the next

day. The pay-in and pay-out of the mark-to-market settlement are effected on the day

following the trade day. In case a futures contract is not traded on a day, or not traded

during the last half hour, a 'theoretical settlement price' is computed as per specified

formula.

After completion of daily settlement computation, all the open positions are reset to the

daily settlement price. Such positions become the open positions for the next day.

Final settlement for futures

On the expiry day of the futures contracts, after the close of trading hours, BOISL marks all

positions of a CM to the final settlement price and the resulting profit/loss is settled in cash.

Final settlement loss/profit amount is debited/ credited to the relevant CM's clearing bank

account on the day following expiry day of the contract.

Settlement prices for futures

Daily settlement price on a trading day is the closing price of the respective futures

contracts on such day. The closing price for a futures contract is currently calculated as the

last half an hour weighted average price of the contract in the F&O Segment of BSE. Final
settlement price is the closing price of the relevant underlying index/security in the capital

market segment of BSE, on the last trading day of the contract. The closing price of the

underlying Index/security is currently its last half an hour weighted average value in the

capital market segment of BSE.

Settlement of options contracts

Options contracts have three types of settlements, daily premium settlement, exercise

settlement, interim exercise settlement in the case of option contracts on securities and final

settlement.

Daily premium settlement

Buyer of an option is obligated to pay the premium towards the options purchased by him.

Similarly, the seller of an option is entitled to receive the premium for the option sold by

him. The premium payable amount and the premium receivable amount are netted to

compute the net premium payable or receivable amount for each client for each option

contract.

Exercise settlement

Although most option buyers and sellers close out their options positions by an offsetting

closing transaction, an understanding of exercise can help an option buyer determine

whether exercise might be more advantageous than an offsetting sale of the option. There is

always a possibility of the option seller being assigned an exercise. Once an exercise of an

option has been assigned to an option seller, the option seller is bound to fulfil his

obligation (meaning, pay the cash settlement amount in the case of a cash-settled option)

even though he may not yet have been notified of the assignment.

38

Interim exercise settlement

Interim exercise settlement takes place only for 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 effected for such options at the close of the trading

hours, on the day of exercise. Valid exercised option contracts are assigned to short

positions 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 of the option from the

CM who has been assigned the option contract.

Final exercise settlement

Final exercise settlement is effected for all open long in-the-money strike price options

existing at the close of trading hours, on the expiration day of an option contract. All such

long positions are exercised and automatically assigned to short positions in option

contracts with the same series, on a random basis. The investor who has long in-the-money

options on the expiry date will receive the exercise settlement value per unit of the option

from the investor who has been assigned the option contract.

Exercise process

The period during which an option is exercisable depends on the style of the option. On

BSE, index options are European style, i.e. options are only subject to automatic exercise

on the expiration day, if they are in-the-money. As compared to this, options on securities

are American style. In such cases, the exercise is automatic on the expiration day, and

voluntary prior to the expiration day of the option contract, provided they are in-the-money.

Automatic exercise means that all in-the-money options would be exercised by BOISL on

the expiration day of the contract. The buyer of such options need not give an exercise

notice in such cases. Voluntary exercise means that the buyer of an in-the-money option

can direct his TM/CM to give exercise instructions to BOISL. In order to ensure that an

option is exercised on a particular day, the buyer must direct his TM to exercise before the

cut-off time for accepting exercise instructions for that day. Usually, the exercise orders

will be accepted by the system till the close of trading hours. Different TMs may have
different cut -off times for accepting exercise instructions from customers, which may vary

for different options. An option, which expires unexercised becomes worthless. Some TMs

may accept standing instructions to exercise, or have procedures for the exercise of every

option, which is in the money at expiration. Once an exercise instruction is given by a CM

to BOISL, it cannot ordinarily be revoked. Exercise notices given by a buyer at anytime on

a day are processed by BOISL after the close of trading hours on that day. All exercise

notices received by NSCCL from the NEAT F&O system are processed to determine their

validity. Some basic validation checks are carried out to check the open buy position of the

exercising client/TM and if option contract is in-the-money. Once exercised contracts are

found valid, they are assigned.

Assignment process

The exercise notices are assigned in standardized market lots to short positions in the

option contract with the same series (i.e. same underlying, expiry date and strike price) at

the client level. Assignment to the short positions is done on a random basis. BOISL

determines short positions, which are eligible to be assigned and then allocates the

exercised positions to any one or more short positions. Assignments are made at the end of

the trading day on which exercise instruction is received by BOISL and notified to the

members on the same day. It is possible that an option seller may not receive notification

from its TM that an exercise has been assigned to him until the next day following the date

of the assignment to the CM by BOISL.

Exercise settlement computation

In case of index option contracts, all open long positions at in-the-money strike prices are

automatically exercised on the expiration day and assigned to short positions in option

contracts with the same series on a random basis. For options on securities, where exercise

settlement may be interim or final, interim exercise for an open long in-the-money option

position can be effected on any day till the expiry of the contract. Final exercise is
automatically effected by BOISL for all open long in-the-money positions in the expiring

month option contract, on the expiry day of the option contract. The exercise settlement

price is the closing price of the underlying (index or security) on the exercise day (for

interim exercise) or the expiry day of the relevant option contract (final exercise). The

exercise settlement value is the difference between the strike price and the final settlement

price of the relevant option contract. For call options, the exercise settlement value

receivable by a buyer is the difference between the final settlement price and the strike

price for each unit of the underlying conveyed by the option contract, while for put options

it is difference between the strike price and the final settlement price for each unit of the

underlying conveyed by the option contract. Settlement of exercises of options on securities

is currently by payment in cash and not by delivery of securities. It takes place for in-themoney

option contracts. The exercise settlement value for each unit of the exercised

contract is computed as follows:

Call options = Closing price of the security on the day of exercise — Strike price

Put options = Strike price — Closing price of the security on the day of exercise

For final exercise the closing price of the underlying security is taken on the expiration day.

The exercise settlement value is debited / credited to the relevant CMs clearing bank

account on T + 1 day (T = exercise date).

Special facility for settlement of institutional deals

BOISL provides a special facility to Institutions/Foreign Institutional Investors

(FIIs)/Mutual Funds etc. to execute trades through any TM, which may be cleared and

settled by their own CM. Such entities are called custodial participants (CPs). To avail of

this facility, a CP is required to register with BOISL through his CM. A unique CP code is

allotted to the CP by BOISL. All trades executed by a CP through any TM are required to

have the CP code in the relevant field on the trading system at the time of order entry. Such

trades executed on behalf of a CP are confirmed by their own CM (and not the CM of the
TM through whom the order is entered), within the time specified by BSE on the trade day

though the on-line confirmation facility. Till such time the trade is confirmed by CM of

concerned CP, the same is considered as a trade of the TM and the responsibility of

settlement of such trade vests with CM of the TM. Once confirmed by CM of concerned

CP, such CM is responsible for clearing and settlement of deals of such custodial clients.

FIIs have been permitted to trade in all the exchange traded derivative contracts subject to

compliance of the position limits prescribed for them and their subaccounts, and

compliance with the prescribed procedure for settlement and reporting. A FII/a sub-account

of the FII, as the case may be, intending to trade in the F&O segment of the exchange, is

required to obtain a unique Custodial Participant (CP) code allotted from the BOISL.

FII/sub-accounts of FIIs which have been allotted a unique CP code by BOISL are only

permitted to trade on the F&O segment. The FD/sub-account of FII ensures that all orders

placed by them on the Exchange carry the relevant CP code allotted by BOISL.

ADJUSTMENTS FOR CORPORATE ACTIONS

The basis for any adjustment for corporate actions is such that the value of the position of

the market participants, on the cum and ex-dates for the corporate action, continues to

remain the same as far as possible. This facilitates in retaining the relative status of

positions, namely in-the-money, at-the-money and out-of-money. This also addresses

issues related to exercise and assignments.

Corporate actions can be broadly classified under stock benefits and cash benefits. The

various stock benefits declared by the issuer of capital are bonus, rights, merger/demerger,

amalgamation, splits, consolidations, hive off, warrants and secured premium notes

(SPNs) among others. The cash benefit declared by the issuer of capital is cash dividend.

Any adjustment for corporate actions is carried out on the last day on which a security is

traded on a cum basis in the underlying equities market, after the close of trading hours.

Adjustments may entail modifications to positions and/or contract specifications as listed

below, such that the basic premise of adjustment laid down above is satisfied:

• Strike price

• Position

• Market lot/multiplier

The adjustments are carried out on any or all of the above, based on the nature of the

corporate action. The adjustments for corporate actions are carried out on all open,

exercised as well as assigned positions.

4.5 RISK MANAGEMENT

4.5.1 EQUITY DERIVATIVES

4.5.1.1 Stock Futures

A portfolio based margining model is adopted by the exchange which takes an integrated

view of the risk involved in the portfolio of each individual client comprising of his

positions in all the derivatives contract traded on Derivatives Segment. The parameters for

such a model is as follows:

I) Initial Margin or Worst Case Scenario Loss:

The Initial Margin requirement is based on the worst-case loss of portfolio at client level to

cover 99% VaR over one day horizon. The initial margin requirement is net at client level

and shall be on gross basis at the Trading/Clearing member level. The initial margin

requirement for the proprietary position of Trading / Clearing Member shall also be on net

basis.

a) Worst Scenario Loss

The worst-case loss of a portfolio is calculated by valuing the portfolio under several

scenarios of changes in the respective stock prices.

.b) Minimum Margin

The minimum initial margin equal to 7.5% of the notional value of the contract based on

the last available price of the futures contract is applied at all times. To achieve the same,
the price scan range is adjusted to ensure that the minimum margin collected doesn’t fall

below 7.5% at any time. The Minimum Initial Margin for Stock Futures Contract shall further be

scaled up by square root of three in respect of stocks which have a mean value of impact cost of

more than 1%. This would be in addition to the look ahead period.

c) Calendar Spread

The margin on calendar spread is calculated and benefit is given to the members for such

position. The calendar-spread margin is charged in addition to worst-scenario loss of the

portfolio. A calendar spread is treated as a naked position in the far month contract as the

near month contract approaches expiry. A calendar spread will be treated as naked

positions in the far month contract three trading days before the near month contract

expires. The margin on calendar spread is calculated on the basis of delta of the portfolio

consisting of futures and option contracts in each month. Thus, a portfolio consisting of a near

month contract with a delta of 100 and a far month contract with a delta of –100 will attract a

spread charge equal to the spread charge for a portfolio, which is long 100 near month

futures and short 100 far month futures. The spread charge is specified as 0.5% per month

for the difference between the two legs of the spread subject to minimum 1% and

maximum 3% as specified in the J. R. Varma committee report. While calculating the

spread charge, the last available closing price of the far month contract is used to determine

the spread charge.

II) Exposure Limits/Second Line of Defence:

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 networth of a member, i.e. 10% of the

notional value of gross open position in single stock futures or 1.5σ of the notional value of

gross open position in single stock futures, whichever is higher, would be collected /

adjusted from the liquid networth of a member on a real time basis.

STOCK OPTIONS
A portfolio based margining model is adopted which will take an integrated view of the

risk involved in the portfolio of each individual client comprising of his positions in all the

derivatives contract traded on Derivatives Segment. The parameters for such a model is as

follows:

I) Initial Margin or Worst Case Scenario Loss:

The Initial Margin requirement is based on the worst-case loss of portfolio at client level to

cover 99% VaR over one day horizon. The initial margin requirement is net at client level

and shall be on gross basis at the Trading/Clearing member level. The initial margin

requirement for the proprietary position of Trading / Clearing Member shall also be on net

basis. The initial margin (or the worst scenario loss) is adjusted against the available liquid

networth of the member. The members in turn will collect the initial margin from their

clients on an up front basis.

a) Worst Scenario Loss

The worst-case loss of a portfolio is calculated by valuing the portfolio under several

scenarios of changes in the underlying stock price and also the changes in the volatility of

the underlying stocks.

The price scan range is taken at three and a half standard deviations 3.5σ where σ is daily

volatility of respective stocks. However, the Derivatives Segment may specify a higher

price scan range than the said 3.5σ values for better risk management. The price scan range

shall be linked to liquidity, measured in terms of impact cost for an order size of Rs.5 lakh,

calculated on the basis of order book snapshots in the previous six months. Accordingly, if

the mean value of impact cost exceeds 1%, the price scanning range is scaled up by square

root of three. The value of σ is computed in line with the guidelines specified under J.R.

Varma Committee report. The volatility scan range is levied at 10%. The Black-Scholes

model is used for valuing options.

The computation of risk arrays for Stock option contract is done only at discrete time points
each day and the latest available risk arrays is applied to the portfolios on a real time basis.

The risk arrays is updated 5 times in a day taking the closing price of the previous day at

the start of trading and taking the last available traded prices at 11:00 a.m., 12:30 p.m., 2:00

p.m., and at the end of the trading session taking closing price of the day.

b) Short Option minimum margin

The short option minimum margin equal to 7.5% of the notional value of all short stock

options shall be charged if sum of the worst-scenario loss and the calendar spread margin is

lower than the short option minimum margin. The notional value of option positions is

calculated by applying the last closing price of the underlying stock.

The Short Option Minimum Charge for Stock Options Contract, shall be scaled up by

square root of three in respect of stocks which have a mean value of impact cost of more

than 1%.

c) Net Option Value (NOV)

The net option value shall be calculated as the current market value of the option times the

number of options (positive for long options and negative for short options) in the portfolio.

This NOV is added to the liquid networth of the Clearing Member i.e. the value of short

options will be deducted from the liquid networth and the value of long options will be

added thereto. Thus mark-to-market gains and losses on option positions will be adjusted

against the available liquid networth of the clearing member. Since the options are

premium style, there will be no mark-to-market profit or loss.

d) Cash Settlement of Premium

The premium is paid in by the buyers in cash and paid out to the sellers in cash on T+1 day.

e) Unpaid Premium

Until the buyer pays in the premium, the premium due shall be deducted from the available

liquid networth on a real time basis. However, the premium is deducted only for those

portfolios where open position is long for a particular series.

II) Exposure Limits/Second Line of Defence:

In case of stock options contracts, the notional value of gross short open positions at any

point in time would not exceed 20 times the available liquid networth of a member, i.e. 5%

of the notional value of gross short open position in single stock options or 1.5_ of the

notional value of gross short open position in single stock options, whichever is higher, will

be collected / adjusted from the liquid networth of a member on a real time basis over and

above the margin calculated by SPAN.

This is calculated as mentioned below:

Long Call / Put Options:

No Capital Adequacy required

Short Call / Put Options:

Last available closing price of underlying stock* No. of Market lots * x%.

Where "x%" is the higher of 5% or 1.5 σ.

For the purpose of computing 1.5σ , the σ of daily logarithmic returns of prices in the

underlying stock in the cash market in the last six months shall be computed. This value

shall be applicable for the next month and shall be re-calculated at the end of the month by

once again taking the price data on a rolling basis for the past six months.

However, the Exchange may specify higher exposure margin for better risk management.

III) Position Limits:

a) Market Level:

A market wide limit on the open position (in terms of the number of underlying stock) on

stock options and futures contract 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. The limit would be applicable on all open positions in all

futures and option contracts on a particular underlying stock.

The Market Wide limit is enforced in the following manner:

At the end of the day, the Exchange tests whether the market wide-open interest for any

scrip exceeds 95% of the market wide position limit for that scrip. If so, the Exchange takes

note of open position of all client/Trading Members as at the end of that day in that scrip

and from next day onwards the members / client are required to trade only to decrease their

positions through offsetting positions. Though the action is taken only at the end of the day,

the real time information about the market wide-open interest as a percentage of the market

wide position limits is disclosed to the market participants.

At the end of each day during which the ban on fresh positions is in force for any scrip, the

Exchange tests whether any member or client has increased his existing positions, or has

created a new position in that scrip. If so, the client shall be subject to a penalty equal to a

specified % of the increase in the position. The penalty is recovered along with the Mark to

Market on the next day.

The normal trading in the scrip is resumed after the open outstanding position comes down

to 80% or below of the market wide position limit.

b) Trading Member Level:

For stocks having applicable market-wide position limit (MWPL) of Rs. 500 crores or

more, the combined futures and options position limit shall be 20% of applicable MWPL or

Rs. 300 crores, whichever is lower and within which stock futures position cannot exceed

10% of applicable MWPL or Rs. 150 crores, whichever is lower.

For stocks having applicable market wide position limit (MWPL) less than Rs. 500 crores,

the combined futures and options position limit would be 20% of applicable MWPL and

futures position cannot exceed 20% of applicable MWPL or Rs. 50 crores whichever is

lower.

Once a member reaches the position limit in a particular underlying then the member is

permitted to take only offsetting positions (which results in lowering the open position of

the member) in derivative contracts on that underlying. The position limit at trading
member level will be computed on a gross basis across all clients of the trading member.

c) Client Level:

The Client's gross open position across all derivative contracts on a particular underlying

shall not exceed higher of-

1% of the free float market capitalization (in terms of number of shares)

OR

5% of the open interest in the underlying stock (in terms of number of shares).

The position is applicable on the combined positions in all derivatives contracts on an

underlying stock. The members are advised to disclose the position of the clients in case

the client crosses the aforesaid limits. The members are also advised to inform their clients

about the disclosure requirement to the Exchange on part of the client.

d) FII Level:

For stocks having applicable market-wide position limit (MWPL) of Rs. 500 crores or

more, the combined futures and options position limit shall be 20% of applicable MWPL or

Rs. 300 crores, whichever is lower and within which stock futures position cannot exceed

10% of applicable MWPL or Rs. 150 crores, whichever is lower.

For stocks having applicable market wide position limit (MWPL) less than Rs. 500 crores,

the combined futures and options position limit would be 20% of applicable MWPL and

futures position cannot exceed 20% of applicable MWPL or Rs. 50 crores whichever is

lower

e) Sub Account level

Each Sub-account of a FII would have the following position limits:

The gross open position across all derivative contracts on a particular underlying stock of a

sub-account of a FII should not exceed the higher of:

1% of the free float market capitalisation (in terms of number of shares).

or

5% of the open interest in the derivative contracts on a particular underlying stock (in

terms of number of contracts).

This position limits would be applicable on the combined position in all derivative

contracts on an underlying stock at an exchange.

f) NRI Level

For stock option and single stock futures contracts, the gross open position across all

derivative contracts on a particular underlying stock of a NRI shall not exceed the higher

of:

1% of the free float market capitalisation (in terms of number of shares).

or

5% of the open interest in the derivative contracts on a particular underlying stock (in

terms of number of contracts).

This position limits would be applicable on the combined position in all derivative

contracts on an underlying stock at an exchange.

g) Mutual Fund Level:

For stocks having applicable market-wide position limit (MWPL) of Rs. 500 crores or

more, the combined futures and options position limit shall be 20% of applicable MWPL or

Rs. 300 crores, whichever is lower and within which stock futures position cannot exceed

10% of applicable MWPL or Rs. 150 crores, whichever is lower.

For stocks having applicable market wide position limit (MWPL) less than Rs. 500 crores,

the combined futures and options position limit would be 20% of applicable MWPL and

futures position cannot exceed 20% of applicable MWPL or Rs. 50 crores whichever is

lower.

h) Limits of each scheme of Mutual Fund:

For Stock Futures and Option Contracts, the gross open position across all derivative
contracts on a particular underlying stock of a scheme of mutual fund shall not exceed the

higher of:

1% of the free float market capitalisation (in terms of number of shares)

Or

5% of the open interest in the derivative contracts on a particular underlying stock (in terms

of number of contracts)

This position limits is applicable on the combined position in all derivative contracts on an

underlying stock.

IV) Exercise Limits:

At present, there would not be any exercise limit for trading in Stock Option contracts.

However, the Derivatives Segment may specify such limit as it may deem fit from time to

time.

V) Assignment of Options:

On Exercise of an Option by an option holder, it will be assigned to the option writer on

random basis at client level. The system will use the same algorithm as in case of

Assignment of Stock Option Contracts.

VI) Settlement of Options:

On Exercise/ Assignment of options, the settlement will take place on T+1 basis. The

Settlement shall take place on the closing price of the underlying in the Cash Segment.

4.6 INDEX DERIVATIVES

4.6.1 INDEX FUTURES

A portfolio based margining model is adopted which will take an integrated view of the

risk involved in the portfolio of each individual client comprising of his positions in all the

derivatives contract traded on Derivatives Segment. The parameters for such a model is as

follows:

I) Initial Margin or Worst Case Scenario Loss:

The Initial Margin requirement is based on the worst-case loss of portfolio at client level to

cover 99% VaR over one day horizon. The initial margin requirement is net at client level

and shall be on gross basis at the Trading/Clearing member level. The initial margin

requirement for the proprietary position of Trading / Clearing Member shall also be on net

basis.

a) Worst Scenario Loss

The worst-case loss of a portfolio is calculated by valuing the portfolio under several

scenarios of changes in the respective Index prices.

12:30 p.m., 2:00 p.m., and at the end of the trading session taking closing price of the day.

b) Minimum Margin

The minimum initial margin equal to 5% of the notional value of the contract based on the

last available price of the futures contract is applied at all times. To achieve the same, the

price scan range is adjusted to ensure that the minimum margin collected doesn’t fall below

5% at any time. In addition the minimum margin shall also be scaled up by the look ahead

point.

c) Calendar Spread

The margin on calendar spread is calculated and benefit is given to the members for such

position. The calendar-spread margin is charged in addition to worst-scenario loss of the

portfolio. A calendar spread is treated as a naked position in the far month contract as the

near month contract approaches expiry. A calendar spread will be treated as naked

positions in the far month contract three trading days before the near month contract

expires.

The spread charge is specified as 0.5% per month for the difference between the

two legs of the spread subject to minimum 1% and maximum 3% as specified in the

J. R. Varma committee report. While calculating the spread charge, the last

available closing price of the far month contract is used to determine the spread
charge.

II) Exposure Limits/Second Line of Defence:

In case of Index futures & Index options contracts, the notional value of gross open

positions at any point in time would not exceed 33 1/3 times the available liquid networth

of a member. In case of Index futures contract, 3% of the notional value of gross open

position in Index future contract would be collected / adjusted from the liquid networth of a

member on a real time basis.

This is calculated as mentioned below:

Long /Short Index Futures:

Last available closing price of the future series * Quantity * 3%

However, the Exchange may specify higher exposure margin for better risk management.

In case of a calendar spread contracts, the calendar spread is regarded as an open position

of one third (1/3rd) of the far month contract. As the near month contract approaches

expiry, the spread shall be treated as a naked position in the far month contract three days

prior to the expiry of the near month contract.

III) Mark-to-Market Margin:

The clients’ positions are marked to market on a daily basis at the portfolio level. However,

for payment of mark-to-market margin to the Exchange, the same is netted out at the

member level.

a) Collection / Payment : The mark-to-market margin is paid in / out in cash on T+1 day.

b) Methodology for calculating Closing Price for mark-to-market: The daily closing price

of the Index futures contract for mark-to-market settlement is arrived at using the following

algorithm:

• Weighted average price of all the trades in last half an hour of the continuous

trading session.
• If there were no trades during the last half an hour, then the theoretical price is

taken as the official closing price.

The theoretical price is arrived at using following algorithm:

Theoretical price = Closing value of underlying Index + {closing value of underlying Index

* No. of days to expiry * risk free interest rate (at present 7%) / 365}

The Bank Rate + 1% would be taken as risk free interest rate percentage and dividend yield

is taken as zero for simplicity.

IV) Final Settlement:

On the expiry of an Index futures contract, the contract is settled in cash at the final

settlement price. However, the profit /loss is paid in /paid out in cash on T+1 basis. The

final settlement price of the expiring futures contract is taken as the closing price of the

underlying Index. The following algorithm is presently being used for calculating closing

value of the (individual scrips including the scrips constituting the Index) in the equity

segment of BSE:

• Weighted average price of all the trades in the last thirty minutes of the continuous

trading session.

• If there are no trades during the last thirty minutes, then the last traded price in the

continuous trading session would be taken as the official closing price.

V) Position Limits:

a) Trading Member Level:

The trading member position limits in equity index futures contracts shall be higher of:

• Rs.500 Crore

Or

• 15% of the total open interest in the market in equity index futures contracts.

This limit would be applicable on open positions in all futures contracts on a particular
underlying index as prescribed by SEBI.

b) Client Level:

Any person or persons acting in concert who hold 15% or more of the open interest in all

derivatives contracts on the Index shall be required to report the fact to the Exchange and

failure to do so shall attract a penalty as laid down by the exchange / clearing corporation /

SEBI.

c) FII position limits in Index Futures Contracts.

FII position limits in equity index futures contracts shall be higher of:

• Rs.500 Crore

Or

• 15% of the total open interest in the market in equity index futures contracts.

This limit would be applicable on open positions in all futures contracts on a particular

underlying index as prescribed by SEBI.

In addition to the above, FIIs can take exposure in equity index derivatives subject to the

following limits

• Short positions in Index Derivatives (Short Futures, Short Calls and Long puts) not

exceeding (in notional value) the FIIs holding of stocks. The stocks shall be valued

at the closing price in the cash market as on the previous trading day.

• Long positions in Index Derivatives (long futures, long alls and short puts) not

exceeding (in notional value) the FIIs holding of cash, government securities, TBills

and similar instruments. The government securities and T-Bills are to be

valued at book value. Money Market Mutual Funds and Gilt Funds shall be valued

at Net Asset Value (NAV).

d) Sub-account Level

Each Sub-account of a FII would have the following position limits: A disclosure

requirement for any person or persons acting in concert who together own 15% or more of
the open interest of all derivative contracts on a particular underlying index.

e) NRI Level

The position limits for NRIs shall be the same as the client level position limits specified

above. Therefore, the NRI position limits shall be – For Index based contracts, a disclosure

requirement for any person or persons acting in concert who together own 15% or more of

the open interest of all derivative contracts on a particular underlying index.

f) Mutual Fund Level:

Mutual Fund position limits in equity index futures contracts shall be higher of:

• Rs.500 Crore

Or

• 15% of the total open interest in the market in equity index futures contracts.

This limit would be applicable on open positions in all futures contracts on a particular

underlying index as prescribed by SEBI.

In addition to the above, Mutual Funds can take exposure in equity index derivatives

subject to the following limits:

• Short positions in Index Derivatives (Short Futures, Short Calls and Long puts) not

exceeding (in notional value) the Mutual Fund holding of stocks. The stocks shall

be valued at the closing price in the cash market as on the previous trading day.

• Long positions in Index Derivatives (long futures, long alls and short puts) not

exceeding (in notional value) the Mutual Fund holding of cash, government

securities, T-Bills and similar instruments. The government securities and T Bills

are to be valued at book value. Money Market Mutual Funds and Gilt Funds shall

be valued at Net Asset Value (NAV).

g) Limits of each scheme of Mutual Fund:

For Index based Contracts, Mutual Funds are required to disclose the total open interest
held by its scheme or all schemes put together in a particular underlying index, if such open

interest equals to or exceeds 15% of the open interest of all derivative contracts on that

underlying index.

4.6.2 INDEX OPTIONS

A portfolio based margining model is adopted which will take an integrated view of the

risk involved in the portfolio of each individual client comprising of his positions in all the

derivatives contract traded on Derivatives Segment. The parameters for such a model is as

follows:

I) Initial Margin or Worst Case Scenario Loss:

The Initial Margin requirement is based on the worst-case loss of portfolio at client level to

cover 99% VaR over one day horizon. The initial margin requirement is net at client level

and shall be on gross basis at the Trading/Clearing member level. The initial margin

requirement for the proprietary position of Trading / Clearing Member shall also be on net

basis. The initial margin (or the worst scenario loss) is adjusted against the available liquid

networth of the member. The members in turn will collect the initial margin from their

clients on an up front basis.

a) Worst Scenario Loss

The worst-case loss of a portfolio is calculated by valuing the portfolio under several

scenarios of changes in the underlying Index value and also the changes in the volatility of

the underlying Index.

The price scan range is taken at three standard deviations (100*e(3σ-1)) where σ is daily

volatility of respective Index. However, the Derivatives Segment may specify a higher

price scan range than the said 3σ values for better risk management. The value of σ is

computed in line with the guidelines specified under J.R. Varma Committee report. The
volatility scan range is levied at 4%. The Black-Scholes model is used for valuing options.

The computation of risk arrays for Index option contract is done only at discrete time points

each day and the latest available risk arrays is applied to the portfolios on a real time basis.

The risk arrays is updated 5 times in a day taking the closing price of the previous day at

the start of trading and taking the last available traded prices at 11:00 a.m., 12:30 p.m., 2:00

p.m., and at the end of the trading session taking closing price of the day.

b) Short Option minimum margin

The short option minimum margin equal to 3% of the notional value of all short Index

options shall be charged if sum of the worst-scenario loss and the calendar spread margin is

lower than the short option minimum margin. The notional value of option positions is

calculated by applying the last closing price of the underlying Index.

c) Net Option Value (NOV)

The net option value shall be calculated as the current market value of the option times the

number of options (positive for long options and negative for short options) in the portfolio.

This NOV is added to the liquid networth of the Clearing Member i.e. the value of short

options will be deducted from the liquid networth and the value of long options will be

added thereto. Thus mark-to-market gains and losses on option positions will be adjusted

against the available liquid networth of the clearing member. Since the options are

premium style, there will be no mark-to-market profit or loss.

d) Cash Settlement of Premium

The premium is paid in by the buyers in cash and paid out to the sellers in cash on T+1 day.

e) Unpaid Premium

Until the buyer pays in the premium, the premium due shall be deducted from the available

liquid networth on a real time basis. However, the premium is deducted only for those

portfolios where open position is long for a particular series.

II) Exposure Limits/Second Line of Defence:

In case of Index Futures & Index options contracts, the notional value of gross short open

positions at any point in time would not exceed 33 1/3 times the available liquid networth

of a member. The 3% of the notional value of gross short open position in Index options,

will be collected / adjusted from the liquid networth of a member on a real time basis over

and above the margin calculated by SPAN.

This is calculated as mentioned below:

Long Call / Put Options:

No Capital Adequacy required

Short Call / Put Options:

Last available closing price of underlying Index * Quantity * 3%.

However, the Exchange may specify higher exposure margin for better risk management.

III) Position Limits:

a) Trading Member Level:

The trading member position limits in equity index options contracts shall be higher of:

• Rs.500 Crore

Or

• 15% of the total open interest in the market in equity index options contracts.

This limit would be applicable on open positions in all Options contracts on a particular

underlying index as prescribed by SEBI.

b) Client Level:

Any person or persons acting in concert who hold 15% or more of the open interest in all

derivatives contracts on the Index shall be required to report the fact to the Exchange and

failure to do so shall attract a penalty as laid down by the exchange / clearing corporation /

SEBI.
c) FII position limits in Index options Contracts:

FII position limits in equity index options contracts shall be higher of:

• Rs.500 Crore

Or

• 15% of the total open interest in the market in equity index options contracts.

This limit would be applicable on open positions in all Options contracts on a particular

underlying index as prescribed by SEBI.

In addition to the above, FIIs can take exposure in equity index derivatives subject to the

following limits

• Short positions in Index Derivatives (Short Futures, Short Calls and Long puts) not

exceeding (in notional value) the FIIs holding of stocks. The stocks shall be valued

at the closing price in the cash market as on the previous trading day.

• Long positions in Index Derivatives (long futures, long alls and short puts) not

exceeding (in notional value) the FIIs holding of cash, government securities, TBills

and similar instruments. The government securities and T-Bills are to be

valued at book value. Money Market Mutual Funds and Gilt Funds shall be valued

at Net Asset Value (NAV).

d) Sub-account Level

Each Sub-account of a FII would have the following position limits: A disclosure

requirement for any person or persons acting in concert who together own 15% or more of

the open interest of all derivative contracts on a particular underlying index.

e) NRI Level

The position limits for NRIs shall be the same as the client level position limits specified

above. Therefore, the NRI position limits shall be –

For Index based contracts, a disclosure requirement for any person or persons acting in

concert who together own 15% or more of the open interest of all derivative contracts on a
particular underlying index.

f) Mutual Fund Level

Mutual Fund position limits in equity index options contracts shall be higher of

• Rs.500 Crore

Or

• 15% of the total open interest in the market in equity index options contracts.

This limit would be applicable on open positions in all options contracts on a particular

underlying index as prescribed by SEBI.

In addition to the above, Mutual Funds can take exposure in equity index derivatives

subject to the following limits

• Short positions in Index Derivatives (Short Futures, Short Calls and Long puts) not

exceeding (in notional value) the Mutual Fund holding of stocks. The stocks shall

be valued at the closing price in the cash market as on the previous trading day.

• Long positions in Index Derivatives (long futures, long alls and short puts) not

exceeding (in notional value) the Mutual Fund holding of cash, government

securities, T-Bills and similar instruments. The government securities and T-Bills

are to be valued at book value. Money Market Mutual Funds and Gilt Funds shall

be valued at Net Asset Value (NAV).

g) Limits of each scheme of Mutual Fund:

For Index based Contracts, Mutual Funds are required to disclose the total open interest

held by its scheme or all schemes put together in a particular underlying index, if such open

interest equals to or exceeds 15% of the open interest of all derivative contracts on that

underlying index.

IV) Exercise Limits:

At present, there would not be any exercise limit for trading in Index Option contracts.

However, the Derivatives Segment may specify such limit, as it may deem fit from time to
time.

V) Assignment of Options:

On Exercise of an Option by an option holder, it will be assigned to the option writer on

random basis at client level.

REGULATORY FRAMEWORK

The trading of derivatives is governed by the provisions contained in the SC(R) A, the

SEBI Act, the rules and regulations framed there under and the rules and bye–laws of stock

exchanges.

5.1 SECURITIES CONTRACTS (REGULATION) ACT, 1956

SC(R)A aims at preventing undesirable transactions in securities by regulating the business

of dealing therein and by providing for certain other matters connected therewith. This is

the principal Act, which governs the trading of securities in India. The term “securities” has

been defined in the SC(R)A. As per Section 2(h), the ‘Securities’ include:

1. Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable

securities of a like nature in or of any incorporated company or other body

corporate.

2. Derivatives

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

investors in such schemes.

4. Government securities

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

securities.

6. Rights or interests in securities.

“Derivative” is defined to include:

1. A security derived from a debt instrument, share, loan whether secured or

unsecured, risk instrument or contract for differences or any other form of security.

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

securities.

Section 18A provides that notwithstanding anything contained in any other law for the time

being in force, contracts in derivative shall be legal and valid if such contracts are:

• Traded on a recognized stock exchange

• Settled on the clearing house of the recognized stock exchange, in accordance with

the rules and bye–laws of such stock exchanges.

5.2 SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992

SEBI Act, 1992 provides for establishment of Securities and Exchange Board of

India(SEBI) with statutory powers for (a) protecting the interests of investors in securities

(b) promoting the development of the securities market and (c) regulating the securities

market. Its regulatory jurisdiction extends over corporates in the issuance of capital and

transfer of securities, in addition to all intermediaries and persons associated with securities

market. SEBI has been obligated to perform the aforesaid functions by such measures as it

thinks fit. In particular, it has powers for:

• regulating the business in stock exchanges and any other securities markets.

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

• promoting and regulating self-regulatory organizations.

• prohibiting fraudulent and unfair trade practices.

• calling for information from, undertaking inspection, conducting inquiries and

audits of the stock exchanges, mutual funds and other persons associated with the

securities market and intermediaries and self–regulatory organizations in the

securities market.

• performing such functions and exercising according to Securities Contracts

(Regulation) Act, 1956, as may be delegated to it by the Central Government.

5.3 REGULATION FOR DERIVATIVES TRADING

SEBI set up a 24- member committee under the Chairmanship of Dr. L. C. Gupta to

develop the appropriate regulatory framework for derivatives trading in India. On May 11,

1998 SEBI accepted the recommendations of the committee and approved the phased

introduction of derivatives trading in India beginning with stock index futures. The

provisions in the SC(R)A and the regulatory framework developed there under govern

trading in securities. The amendment of the SC(R)A to include derivatives within the ambit

of ‘securities’ in the SC(R)A made trading in derivatives possible within the framework of

that Act.

1. Any Exchange fulfilling the eligibility criteria as prescribed in the L. C. Gupta

committee report can apply to SEBI for grant of recognition under Section 4 of the

SC(R)A, 1956 to start trading derivatives. The derivatives exchange/segment should

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

shall be limited to maximum of 40% of the total members of the governing council.

The exchange would have to regulate the sales practices of its members and would

have to obtain prior approval of SEBI before start of trading in any derivative

contract.

2. The Exchange should have minimum 50 members.

3. The members of an existing segment of the exchange would not automatically

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

segment would need to fulfil the eligibility conditions as laid down by the L. C.

Gupta committee.

4. The clearing and settlement of derivatives trades would be through a SEBI

approved clearing corporation/house. Clearing corporations/houses complying with

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

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

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

exchanges. The minimum networth for clearing members of the derivatives clearing

corporation/house shall be Rs.300 Lakh. The networth of the member shall be

computed as follows:

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

(a) Fixed assets

(b) Pledged securities

(c) Member’s card

(d) Non-allowable securities(unlisted securities)

(e) Bad deliveries

(f) Doubtful debts and advances

(g) Prepaid expenses

(h) Intangible assets

(i) 30% marketable securities

7. The minimum contract value shall not be less than Rs.2 Lakh. Exchanges have to

submit details of the futures contract they propose to introduce.

8. The initial margin requirement, exposure limits linked to capital adequacy and

margin demands related to the risk of loss on the position will be prescribed by

SEBI/Exchange from time to time.

9. The L. C. Gupta committee report requires strict enforcement of “Know your

customer” rule and requires that every client shall be registered with the derivatives

broker. The members of the derivatives segment are also required to make their

clients aware of the risks involved in derivatives trading by issuing to the client the

Risk Disclosure Document and obtain a copy of the same duly signed by the client.
10. The trading members are required to have qualified approved user and sales person

who have passed a certification programme approved by SEBI.

5.4 ACCOUNTING

5.4.1 Accounting for futures

The Institute of Chartered Accountants of India (ICAI) has issued guidance notes on

accounting of index futures contracts from the view point of parties who enter into such

futures contracts as buyers or sellers. For other parties involved in the trading process, like

brokers, trading members, clearing members and clearing corporations, a trade in equity

index futures is similar to

problems. Hence in this section we shall largely focus on the accounting treatment of

equity index futures in the books of the client. But before we do so, a quick re-look at some

of the terms used.

• Clearing corporation/house: Clearing corporation/house means the clearing

corporation/house approved by SEBI for clearing and settlement of trades on the

derivatives exchange/segment. All the clearing and settlement for trades that happen

on the BSE’s market is done through BOISL.

• Clearing member: Clearing member means a member of the clearing corporation

and includes all categories of clearing members as may be admitted as such by the

clearing corporation to the derivatives segment.

• Client: A client means a person, on whose instructions and, on whose account, the

trading member enters into any contract for the purchase or sale of any contract or

does any act in relation thereto.

• Contract month: Contract month means the month in which the exchange/clearing

corporation rules require a contract to be finally settled.

• Daily settlement price: Daily settlement price is the closing price of the equity index

futures contract for the day or such other price as may be decided by the clearing
house from time to time.

• Derivative exchange/segment: Derivative exchange means an exchange approved

by SEBI as a derivative exchange. Derivative segment means segment of an

existing exchange approved by SEBI as derivatives segment.

• Final settlement price: The final settlement price is the closing price of the equity

index futures contract on the last trading day of the contract or such other price as

may be specified by the clearing corporation, from time to time.

• Long position: Long position in an equity index futures contract means outstanding

purchase obligations in respect of the equity index futures contract at any point of

time .

• Open position: Open position means the total number of equity index futures

contracts that have not yet been offset and closed by an opposite position.

• Settlement date: Settlement date means the date on which the settlement of

outstanding obligations in an equity index futures contract are required to be settled

as provided in the Bye-Laws of the Derivatives exchange/segment.

• Short position: Short position in an equity index futures contract means outstanding

sell obligations in respect of an equity index futures contract at any point of time.

• Trading member: Trading member means a Member of the Derivatives

exchange/segment and registered with SEBI.

Accounting at the inception of a contract

Every client is required to pay to the trading member/clearing member, the initial margin

determined by the clearing corporation as per the byelaws/ regulations of the exchange for

entering into equity index futures contracts. Such initial margin paid/payable should be

debited to “Initial margin - Equity index futures account”. Additional margins, if any,

should also be accounted for in the same manner. It may be mentioned that at the time
when the contract is entered into for purchase/sale of equity index futures, no entry is

passed for recording the contract because no payment is made at that time except for the

initial margin. At the balance sheet date, the balance in the ‘Initial margin - Equity index

futures account’ should be shown separately under the head ‘current assets’. In those cases

where any amount has been paid in excess of the initial/additional margin, the excess

should be disclosed separately as a deposit under the head ‘current assets’. In cases where

instead of paying initial margin in cash, the client provides bank guarantees or lodges

securities with the member, a disclosure should be made in the notes to the financial

statements of the client.

Accounting at the time of daily settlement

This involves the accounting of payment/receipt of mark-to-market margin money.

Payments made or received on account of daily settlement by the client would be

credited/debited to the bank account and the corresponding debit or credit for the same

should be made to an account titled as “Mark-to-market margin - Equity index futures

account”. Some times the client may deposit a lump sum amount with the broker/trading

member in respect of mark-to-market margin money instead of receiving/paying mark-tomarket

margin money on daily basis. The amount so paid is in the nature of a deposit and

should be debited to an appropriate account, say, “Deposit for mark-to-market margin

account”. The amount of “mark-to-market margin” received/paid from such account should

be credited/debited to “Mark-to-market margin - Equity index futures account” with a

corresponding debit/credit to “Deposit for mark-to-market margin account”. At the yearend,

any balance in the “Deposit for mark-to-market margin account” should be shown as a

deposit under the head “current assets”.

Accounting for open positions

Position left open on the balance sheet date must be accounted for. Debit/credit balance in

the “mark-to-market margin - Equity index futures account”, maintained on global basis,
represents the net amount paid/received on the basis of movement in the prices of index

futures till the balance sheet date. Keeping in view ‘prudence’ as a consideration for

preparation of financial statements, provision for anticipated loss, which may be equivalent

to the net payment made to the broker (represented by the debit balance in the “mark-to

market margin - Equity index futures account”) should be created by debiting the profit and

loss account. Net amount received (represented by credit balance in the “mark-to-market

margin - Equity index futures account”) being anticipated profit should be ignored and no

credit for the same should be taken in the profit and loss account. The debit balance in the

said “mark-to-market margin - Equity index futures account”, i.e., net payment made to the

broker, may be shown under the head “current assets, loans and advances” in the balance

sheet and the provision created there against should be shown as a deduction there from.

On the other hand, the credit balance in the said account, i.e., the net amount received from

the broker, should be shown as a current liability under the head “current liabilities and

provisions in the balance sheet”.

Accounting at the time of final settlement

This involves accounting at the time of final settlement or squaring-up of the This involves

accounting at the time of final settlement or squaring-up of the contract. At the expiry of a

series of equity index futures, the profit/loss, on final settlement of the contracts in the

series, should be calculated as the difference between final settlement price and contract

prices of all the contracts in the series. The profit/loss, so computed, should be recognized

in the profit and loss account by corresponding debit/credit to “mark-to-market margin -

Equity index futures account”. However, where a balance exists in the provision account

created for anticipated loss, any loss arising on such settlement should be first charged to

such provision account, to the extent of the balance available in the provision account, and

the balance of loss, if any, should be charged to the profit and loss account. Same
accounting treatment should be made when a contract is squared-up by entering into a

reverse contract. It appears that, at present, it is not feasible to identify the equity index

futures contracts. Accordingly, if more than one contract in respect of the series of equity

index futures contracts to which the squared-up contract pertains is outstanding at the time

of the squaring of the contract, the contract price of the contract so squared-up should be

determined using First In, First-Out (FIFO) method for calculating profit/loss on squaringup.

On the settlement of an equity index futures contract, the initial margin paid in respect

of the contract is released which should be credited to “Initial margin - Equity index futures

account”, and a corresponding debit should be given to the bank account or the deposit

account (where the amount is not received).

Accounting in case of a default

When a client defaults in making payment in respect of a daily settlement, the contract is

closed out. The amount not paid by the Client is adjusted against the initial margin. In the

books of the Client, the amount so adjusted should be debited to “mark-to-market - Equity

index futures account” with a corresponding credit to “Initial margin - Equity index futures

account”. The amount of initial margin on the contract, in excess of the amount adjusted

against the mark-to-market margin not paid, will be released. The accounting treatment in

this regard will be the same as explained above. In case, the amount to be paid on daily

settlement exceeds the initial margin the excess is a liability and should be shown as such

under the head ‘current liabilities and provisions’, if it continues to exist on the balance

sheet date. The amount of profit or loss on the contract so closed out should be calculated

and recognized in the profit and loss account in the manner dealt with above.

Disclosure requirements

The amount of bank guarantee and book value as also the market value of securities lodged

should be disclosed in respect of contracts having open positions at the year end, where

initial margin money has been paid by way of bank guarantee and/or lodging of securities.
Total number of contracts entered and gross number of units of equity index futures traded

(separately for buy/sell) should be disclosed in respect of each series of equity index

futures. The number of equity index futures contracts having open position, number of

units of equity index futures pertaining to those contracts and the daily settlement price as

of the balance sheet date should be disclosed separately for long and short positions, in

respect of each series of equity index futures.

5.4.2 Accounting for options

The Institute of Chartered Accountants of India issued guidance note on accounting for

index options and stock options from the view point of the parties who enter into such

contracts as buyers/holder or sellers/writers. Following are the guidelines for accounting

treatment in case of cash settled index options and stock options:

Accounting at the inception of a contract

The seller/writer of the option is required to pay initial margin for entering into the option

contract. Such initial margin paid would be debited to ‘Equity Index Option Margin

Account’ or to ‘Equity Stock Option Margin Account’, as the case may be. In the balance

sheet, such account should be shown separately under the head ‘Current Assets’. The

buyer/holder of the option is not required to pay any margin. He is required to pay the

premium. In his books, such premium would be debited to ‘Equity Index Option Premium

Account’ or ‘Equity Stock Option Premium Account’, as the case may be. In the books of

the seller/writer, such premium received should be credited to ‘Equity Index Option

Premium Account’ or ‘Equity Stock Option Premium Account’ as the case may be.

Accounting at the time of payment/receipt of margin

Payments made or received by the seller/writer for the margin should be credited/debited to

the bank account and the corresponding debit/credit for the same should also be made to

‘Equity Index Option Margin Account’ or to ‘Equity Stock Option Margin Account’, as the

case may be. Sometimes, the client deposit a lump sum amount with the trading/clearing
member in respect of the margin instead of paying/receiving margin on daily basis. In such

case, the amount of margin paid/received from/into such accounts should be

debited/credited to the ‘Deposit for Margin Account’. At the end of the year the balance in

this account would be shown as deposit under ‘Current Assets’.

Accounting for open positions as on balance sheet dates

The ‘Equity Index Option Premium Account’ and the ‘Equity Stock Option Premium

Account’ should be shown under the head ‘Current Assets’ or ‘Current Liabilities’, as the

case may be. In the books of the buyer/holder, a provision should be made for the In the

books of the buyer/holder, a provision should be made for the amount by which the

premium paid for the option exceeds the premium prevailing on the balance sheet date. The

provision so created should be credited to ‘Provision for Loss on Equity Index Option

Account’ to the ‘Provision for Loss on Equity Stock Options Account’, as the case may be.

The provision made as above should be shown as deduction from ‘Equity Index Option

Premium’ or ‘Equity Stock Option Premium’ which is shown under ‘Current Assets’. In

the books of the seller/writer, the provision should be made for the amount by which

premium prevailing on the balance sheet date exceeds the premium received for that

option. This provision should be credited to ‘Provision for

Loss on Equity Index Option Account’ or to the ‘Provision for Loss on Equity Stock

Option Account’, as the case may be, with a corresponding debit to profit and loss account.

‘Equity Index Options Premium Account’ or ‘Equity Stock Options Premium Account’

and ‘Provision for Loss on Equity Index Options Account’ or ’Provision for Loss on Equity

Stock Options Account’ should be shown under ‘Current Liabilities and Provisions’. In

case of any opening balance in the ‘Provision for Loss on Equity Stock Options Account’

or the ‘Provision for Loss on Equity Index Options Account’, the same should be adjusted

against the provision n required in the current year and the profit and loss account be

debited/credited with the balance provision required to be made/excess provision written

back.

Accounting at the time of final settlement

On exercise of the option, the buyer/holder will recognize premium as an expense and debit

the profit and loss account by crediting ‘Equity Index Option Premium Account’ or ‘Equity

Stock Option Premium Account’. Apart from the above, the buyer/holder will receive

favourable difference, if any, between the final settlement price as on the exercise/expiry

date and the strike price, which will be recognized as income. On exercise of the option, the

seller/writer will recognize premium as an income and credit the profit and loss account by

debiting ‘Equity Index Option Premium Account’ or ‘Equity Stock Option Premium

Account’. Apart from the above, the seller/writer will pay the adverse difference, if any,

between the final settlement price as on the exercise/expiry date and the strike price. Such

payment will be recognized as a loss. As soon as an option gets exercised, margin paid

towards such option would be released by the exchange, which should be credited to

‘Equity Index Option Margin Account’ or to ‘Equity Stock Option Margin Account’, as the

case may be, and the bank account will be debited.

Accounting at the time of squaring off an option contract

The difference between the premium paid and received on the squared off transactions

should be transferred to the profit and loss account. Following are the guidelines for

accounting treatment in case of delivery settled index options and stock options: The

accounting entries at the time of inception, payment/receipt of margin and open options at

the balance sheet date will be the same as those in case of cash settled options. At the time

of final settlement, if an option expires un-exercised then the accounting entries will be the

same as those in case of cash settled options. If the option is exercised then shares will be

transferred in consideration for cash at the strike price. For a call option the buyer/holder

will receive equity shares for which the call option was entered into. The buyer/holder
should debit the relevant equity shares account and credit cash/bank. For a put option, the

buyer/holder will deliver equity shares for which the put option was entered into. The

buyer/holder should credit the relevant equity shares account and debit cash/bank.

Similarly, for a call option the seller/writer will deliver equity shares for which the call

option was entered into. The seller/writer should credit the relevant equity shares account

and debit cash/bank. For a put option the seller/writer will receive equity shares for which

the put option was entered into. The seller/writer should debit the relevant equity shares

account and credit cash/bank. In addition to this entry, the premium paid/received will be

transferred to the profit and loss account, the accounting entries for which should be the

same as those in case of cash settled options.

5.5 TAXATION OF DERIVATIVE TRANSACTION IN SECURITIES

5.5.1 Taxation of Profit/Loss on derivative transaction in securities

Prior to Financial Year 2005–06, transaction in derivatives were considered as speculative

transactions for the purpose of determination of tax liability under the Income -tax Act.

This is in view of section 43(5) of the Income -tax Act which defined speculative

transaction as a transaction in which a contract for purchase or sale of any commodity,

including stocks and shares, is periodically or ultimately settled otherwise than by the

actual delivery or transfer of the commodity or scrips. However, such transactions entered

into by hedgers and stock exchange members in course of jobbing or arbitrage activity

were specifically excluded from the purview of definition of speculative transaction.

In view of the above provisions, most of the transactions entered into in derivatives by

investors and speculators were considered as speculative transactions. The tax provisions

provided for differential treatment with respect to set off and carry forward of loss on such

transactions. Loss on derivative transactions could be set off only against other speculative

income and the same could not be set off against any other income. This resulted in
payment of higher taxes by an assessee. Finance Act, 2005 has amended section 43(5) so as

to exclude transactions in derivatives carried out in a “recognized stock exchange” for this

purpose. This implies that income or loss on derivative transactions which are carried out in

a “recognized stock exchange” is not taxed as speculative income or loss. Thus, loss on

derivative transactions can be set off against any other income during the year. In case the

same cannot be set off, it can be carried forward to subsequent assessment year and set off

against any other income of the subsequent year. Such losses can be carried forward for a

period of 8 assessment years. It may also be noted that securities transaction tax paid on

such transactions is eligible as deduction under Income-tax Act, 1961.

SCOPE OF DERIVATIVES IN INDIA

In India, all attempts are being made to introduce derivative instruments in the capital market. The

National Stock Exchange has been planning to introduce index-based futures. A stiff net worth

criteria of Rs.7 to 10 corers cover is proposed for members who wish to enroll for such trading. But,

it has not yet received the necessary permission from the securities and Exchange Board of India.

In the forex market, there are brighter chances of introducing derivatives on a large scale. Infact, the

necessary groundwork for the introduction of derivatives in forex market was prepared by a high-

level expert committee appointed by the RBI. It was headed by Mr. O.P. Sodhani. Committee’s

report was already submitted to the Government in 1995. As it is, a few derivative products such as

interest rate swaps, coupon swaps, currency swaps and fixed rate agreements are available on a
limited scale. It is easier to introduce derivatives in forex market because most of these products are

OTC products (Over-the-counter) and they are highly flexible. These are always between two parties

and one among them is always a financial intermediary.

However, there should be proper legislations for the effective implementation of derivative contracts.

The utility of derivatives through Hedging can be derived, only when, there is transparency with

honest dealings. The players in the derivative market should have a sound financial base for dealing

in derivative transactions. What is more important for the success of derivatives is the prescription of

proper capital adequacy norms, training of financial intermediaries and the provision of well-

established indices. Brokers must also be trained in the intricacies of the derivative-transactions.

Now, derivatives have been introduced in the Indian Market in the form of index options and index

futures. Index options and index futures are basically derivate tools based on stock index. They are

really the risk management tools. Since derivates are permitted legally, one can use them to insulate

his equity portfolio against the vagaries of the market.

Every investor in the financial area is affected by index fluctuations. Hence, risk management using

index derivatives is of far more importance than risk management using individual security options.

Moreover, Portfolio risk is dominated by the market risk, regardless of the composition of the

portfolio. Hence, investors would be more interested in using index-based derivative products rather

than security based derivative products.

There are no derivatives based on interest rates in India today. However, Indian users of hedging

services are allowed to buy derivatives involving other currencies on foreign markets. India has a

strong dollar- rupee forward market with contracts being traded for one to six month expiration.

Daily trading volume on this forward market is around $500 million a day. Hence, derivatives

available in India in foreign exchange area are also highly beneficial to the users.

IMPACT OF DERIVATIVE MARKET ON FINANCIAL MARKETS:

Derivatives are becoming increasingly popular, so the obvious question is whether, and how, they

affect the stability of financial markets. Generally, derivatives improve the overall allocation of risks

within financial systems. They do so in two ways:

• Derivatives make risk management more efficient and flexible especially at banks.

• Derivatives allow a more efficient distribution of individual risks and a related reduction of

aggregate risk within an economy. Nevertheless, a number of risk factors must be taken into account:

• Poor market transparency makes it difficult at present to give an adequate assessment of risk

distribution. Initiatives to gain additional market information and set appropriate reporting rules

which reflect the interests of both the supervisory bodies and the market participants are therefore to

be welcomed.

• Risks attributable to poor contract wording (documentation risk) have already been largely

overcome thanks to the steadily ongoing development of standardized rules (ISDA).

• A high market concentration currently hinders the economically optimal allocation of risks,

although it does not directly endanger the stability of the financial markets. But the high degree of

concentration is expected to last only temporarily.

• There is no clear evidence so far that credit derivatives have systematically been wrongly priced.

However, this cannot be ruled out entirely at present –

Especially given the inexperience of some of the participants entering the market. Systematically

wrong pricing would result primarily in a misallocation of resources.

• The use of derivatives may change traditional incentive structures. This is mainly a theoretical

phenomenon. In practice, various mechanisms help to deal with the incentive problems which could

potentially increase risk. Risks associated with the use of credit derivatives will merit special

attention until

The market has matured. Banks and financial markets will then benefit additionally from their use

and become more stable.

While derivatives are being used more and more in operative financial and risk management, their

long-term implications for the credit and financial markets are only beginning to emerge. For the

overall economy, the growing use of derivatives affects the stability of financial markets.

ECONOMIC FUNCTION OF THE DERIVATIVE MARKET

In spite of the fear and criticism with which the derivative markets are commonly looked at, these
markets perform a number of economic functions.

1. Prices in an organized derivatives market reflect the perception of market participants about the
future and lead the prices of underlying to the perceived future level. The prices of derivatives
converge with the prices of the underlying at the expiration of the derivative contract. Thus
derivatives help in discovery of future as well as current prices.

2. The derivatives market helps to transfer risks from those who have them but may not like them to
those who have an appetite for them.

3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the
introduction of derivatives, the underlying market witnesses’ higher trade volumes because of
participation by more players who would not otherwise participate for lack of an arrangement to
transfer risk.

4. Speculative trades shift to a more controlled environment of derivatives market. In the absence of
an organized derivatives market, speculators trade in the underlying cash markets. Margining,
monitoring and surveillance of the activities of various participants become extremely difficult in
these kinds of mixed markets.

5. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for
new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-
educated people with an entrepreneurial attitude. They often energize others to create new
businesses, new products and new employment opportunities, the benefit of which are immense.

In a nut shell, derivatives markets help increase savings and investment in the long run. Transfer of
risk enables market participants to expand their volume of activity.
According to survey conducted in India regarding the sub brokers’ opinion on the impact of

derivatives market on financial market, the result obtained is given as under.

Derivative securities have penetrated the Indian stock market and it emerged that investors are using

these securities for different purposes, namely, risk management, profit enhancement, speculation

and arbitrage. High net worth individuals and proprietary traders account for a large proportion of

broker turnover. Interestingly, some retail participation was also witnessed despite the fact that these

securities are considered largely beyond the reach of retail investors (because of complexity and

relatively high initial investment). Based on the survey results, the authors identified some important

policy issues such as the need to bring in more institutional participation to make the derivative

market in India more efficient and to bring it in line with the best practices. Further, there is a need to

popularize option instruments because they may prove to be a useful medium for enhancing retail

participation in the derivative market.

THE NEED OF DERIVATIVES MARKET:

The derivatives market performs a number of economic functions:

1. They help in transferring risks from risk adverse people to risk oriented people
2. They help in the discovery of future as well as current prices
3. They catalyze entrepreneurial activity
4. They increase the volume traded in markets because of participation of risk adverse people in
greater numbers
5. They increase savings and investment in the long run

SCENARIO OF DERIVATIVES MARKET IN INDIA

The emergence of the market for derivatives products, most notable forwards, futures, options and

swaps can be traced back to the willingness of risk-averse economic agents to guard themselves

against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial
markets can be subject to a very high degree of volatility. Through the use of derivative products, it

is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk

management, derivatives products generally do not influence the fluctuations in the underlying asset

prices. However, by locking-in asset prices, derivatives products minimize the impact of fluctuations

in asset prices on the profitability and cash flow situation of risk-averse investors.

Starting from a controlled economy, India has moved towards a world where prices fluctuate every

day. The introduction of risk management instruments in India gained momentum in the last few

years due to liberalization process and Reserve Bank of India’s (RBI) efforts in creating currency

forward market. Derivatives are an integral part of liberalization process to manage risk. NSE

gauging the market requirements initiated the process of setting up derivative markets in India. In

July 1999, derivatives trading commenced in India

Chronology of instruments
1991 Liberalization process initiated
14 December 1995NSE asked SEBI for permission to trade index futures.
18 November 1996SEBI setup L.C.Gupta Committee to draft a policy framework for index futures.
11 May 1998 L.C.Gupta Committee submitted report.
7 July 1999 RBI gave permission for OTC forward rate agreements (FRAs) and interest rate
swaps.
24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian index.
25 May 2000 SEBI gave permission to NSE and BSE to do index futures trading.
9 June 2000 Trading of BSE Sensex futures commenced at BSE.
12 June 2000 Trading of Nifty futures commenced at NSE.
25,September 2000
Nifty futures trading commenced at SGX.
2 June 2001 Individual Stock Options & Derivatives

THE TREND OF DERIVATIVE MARKET IN INDIA

Derivative products made a debut in the Indian market during 1998 and overall progress of

derivatives market in India has indeed been impressive.

The Indian equity derivatives market has registered an "explosive growth" and is expected to

continue its dream run in the years to come with the various pieces that are crucial for the market's

growth slowly falling in place.

Over the counter derivatives market in Interest Rate and Foreign Exchange has also witnessed

impressive growth with RBI allowing the local banks to run books in Indian Rupee Interest Rate and

FX derivatives. The complexity of market continues to increase as clients have become savvier,

demanding more fine tuned solution to meet their risk management objectives, rather than using the

vanilla products.

Besides Rupee derivatives offered by the local players, RBI has also allowed the client to use more

exotic products like barrier options. These products are offered by the local bank on back-to-back

basis, wherein they buy similar product from market maker from the offshore markets.

The complexity of derivatives market has increased, but the growth in deployment of risk

management systems required to manage such complex business has not grown at the same pace.

The reason being, the very high cost of such system and absence of any local player who could offer

the solution, which could compete with product offered by the international vendors.

DERIVATIVES MARKET GROWTH

The Derivatives Market Growth was about 30% in the first half of 2007 when it reached a size of $US 370

trillion. This growth was mainly due to the increase in the participation of the bankers, investors and

different companies. The derivative market instruments are used by them to hedge risks as well as to satisfy

their speculative needs.

The derivative market growth for different derivative market instruments may be discussed under the

following heads.

• Derivative Market Growth for the Exchange-traded-Derivatives

The Derivative Market Growth for equity reached $114.1 trillion. The open interest in the futures and

options market grew by 38 % while the interest rate futures grew by 42%. Hence the derivative market size

for the futures and the options market was $49 trillion.

• Derivative Market Growth for the Global Over-the-Counter Derivatives

The contracts traded through Over-the-Counter market witnessed a 24 % increase in its face value and the

over-the -counter derivative market size reached $70,000 billion. This shows that the face value of the

derivative contracts has multiplied 30 times the size of the US economy. Notable increases were recorded for

foreign exchange, interest rate, equity and commodity based derivative following an increase in the size of

the Over-the Counter derivative market.

The Derivative Market Growth does not necessitate an increase in the risk taken by the different investors.

Even then, the overshoot in the face value of the derivative contracts shows that these derivative

instruments played a pivotal role in the financial market of today.

• Derivative Market Growth for the Credit Derivatives

The credit derivatives grew from $4.5 trillion to $0.7 trillion in 2001. This derivative market growth is

attributed to the increase in the trading in the synthetic collateral Debt obligations and also to the electronic

trading systems that have come into existence.

The Bank of International Settlements measures the size and the growth of the derivative market. According

to BIS, the derivative market growth in the over the counter derivative market witnessed a slump in the

second half of 2006. Although the credit derivative market grew at a rapid pace, such growth was made

offset by a slump somewhere else. The notional amount of the Credit Default Swap witnessed a growth of

42%. Credit derivatives grew by 54%. The single name contracts grew by 36%. The interest derivatives grew

by 11%. The OTC foreign exchange derivatives slowed by 5%, the OTC equity derivatives slowed by 10%.

Commodity derivatives also experienced crawling growth pattern.

 Business Growth in Derivatives segment

Year Index Futures Stock Futures Index Options Stock Options

No. of contracts Turnover No. of Turnover No. of Notional TurnoverNo. of Notional

contracts contracts Turnover (Rs.
(Rs. cr.) contracts (Rs. cr.) (Rs. cr.)
cr.)

2009-10 86651879 1715349.01 59128122 2257189.61 132889753 2789950.24 4731748 187261.34

2008-09 210428103 3570111.40 221577980 3479642.12 212088444 3731501.84 13295970 229226.81

2007-08 156598579 3820667.27 203587952 7548563.23 55366038 1362110.88 9460631 359136.55

2006-07 81487424 2539574 104955401 3830967 25157438 791906 5283310 193795

2005-06 58537886 1513755 80905493 2791697 12935116 338469 5240776 180253

2004-05 21635449 772147 47043066 1484056 3293558 121943 5045112 168836

2003-04 17191668 554446 32368842 1305939 1732414 52816 5583071 217207

2002-03 2126763 43952 10676843 286533 442241 9246 3523062 10131

2001-02 1025588 21483 1957856 51515 175900 3765 1037529 25163

2000-01 90580 2365

YEAR BSE Turnover(Rs. Cr,)(F.Y. Jan- NSE Turnover(Rs. Cr.)(F.Y Apr-
Dec) Mar)

2009-10 (upto 31st Aug.) 587901 1922783

2008-2009 1586441.49 2,752,023

2007-2008 1160248.63 3,551,038

2006-2007 701709.67 1,945,285

2005-2006 547922.44 1,569,556

2004-2005 365613.61 1,140,071

2003-2004 409372.67 1,099,535

2002-2003 332909.01 617,989

2001-2002 475278.79 513,167

TURNOVER OF CASH MARKET AFTER DERIVATIVES INTRODUCED:

 TURNOVER OF CASH MARKET BEFORE DERIVATIVES INTRODUCED:

YEAR BSE Turnover(Rs. Cr,)(F.Y. Jan-Dec) NSE Turnover (Rs. Cr.)(F.Y. Apr-
Mar)

2000-2001 998655.28 1,339,510

1999-2000 527960.16 839,052

1998-1999 414,474

1997-1998 370,193

1996-1997 294,503

1995-1996 67,287

1994-1995 1,805

https://www.scribd.com/doc/20563466/Growth-and-Dev-Elopement-of-Derivatives-Market-in-India-
FINAL

Margins

NSCCL has developed a comprehensive risk containment mechanism for the Futures & Options

segment. The most critical component of a risk containment mechanism for NSCCL is the online

position monitoring and margining system. The actual margining and position monitoring is

done on-line, on an intra-day basis. NSCCL uses the SPAN®(Standard Portfolio Analysis of Risk)

system for the purpose of margining, which is a portfolio based system.

Initial Margin

a. Span Margin

NSCCL collects initial margin up-front for all the open positions of a CM based on the margins

computed by NSCCL-SPAN®. A CM is in turn required to collect the initial margin from the TMs

and his respective clients. Similarly, a TM should collect upfront margins from his clients.
Initial margin requirements are based on 99% value at risk over a one day time horizon.

However, in the case of futures contracts (on index or individual securities), where it may not be

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

the next day, the initial margin is computed over a two-day time horizon, applying the

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

as per the recommendations of SEBI from time to time.

Initial margin requirement for a member:

 For client positions - is netted at the level of individual client and grossed across all clients, at the

Trading/ Clearing Member level, without any setoffs between clients.

 For proprietary positions - is netted at Trading/ Clearing Member level without any setoffs

between client and proprietary positions.

For the purpose of SPAN Margin, various parameters are specified from time to time.

In case a trading member wishes to take additional trading positions his CM is required to

provide Additional Base Capital (ABC) to NSCCL. ABC can be provided by the members in the

form of Cash, Bank Guarantee, Fixed Deposit Receipts and approved securities.

b. Premium Margin

In addition to Span Margin, Premium Margin is charged to members. The premium margin is

the client wise premium amount payable by the buyer of the option and is levied till the

completion of pay-in towards the premium settlement.

c. Assignment Margin

Assignment Margin is levied on a CM in addition to SPAN margin and Premium Margin. It is

levied on assigned positions of CMs towards interim and final exercise settlement obligations

for option contracts on index and individual securities till the pay-in towards exercise
settlement is complete.

The Assignment Margin is the net exercise settlement value payable by a Clearing Member

towards interim and final exercise settlement and is deducted from the effective deposits of

the Clearing Member available towards margins.

Assignment margin is released to the CMs for exercise settlement pay-in.

Initial Margin requirement = Total SPAN Margin Requirement + Buy Premium + Assignment

Margin

Exposure Margin

The exposure margins for options and futures contracts on index are as follows:

i. For Index options and Index futures contracts:

3% of the notional value of a futures contract. In case of options it is charged only on short

positions and is 3% of the notional value of open positions.

ii. For option contracts and Futures Contract on individual Securities:

The higher of 5% or 1.5 standard deviation of the notional value of gross open position in

futures on individual securities and gross short open positions in options on individual

securities in a particular underlying. The standard deviation of daily logarithmic returns of

prices in the underlying stock in the cash market in the last six months is computed on a

rolling and monthly basis at the end of each month.

For this purpose notional value means :

 - For a futures contract – the contract value at last traded price/ closing price.

- For an options contract – the value of an equivalent number of shares as conveyed by the

options contract, in the underlying market, based on the last available closing price.

In case of calendar spread positions in futures contract, exposure margins are levied on one

third of the value of open position of the far month futures contract. The calendar spread

position is granted calendar spread treatment till the expiry of the near month contract. .

https://www.nseindia.com/content/nsccl/nsccl_fomargins.htm

Charges

Brokerage Charges

The maximum brokerage chargeable by a trading member in relation to trades in

the contracts admitted to dealing on the F&O segment of NSE is fixed at 2.5% of the

contract value in the case of index futures and stock futures. In the case of index options

and stock options it is 2.5% of notional value of the contract [(Strike Price + Premium) ×

Quantity)], exclusive of statutory levies.

Transaction Charges

The transaction charges payable to the exchange by the trading member for the trades executed

by him on the F&O segment were fixed at the rate of Rs.2 per lakh of turnover (0.002%) subject

to a minimum of Rs.1,00,000 per year.

Securities Transaction Tax

The trading members are also required to pay securities transaction tax (STT) on non-delivery

transactions at the rate of 0.017 (payable by the seller) for derivatives w. e. f June 1, 2008.

Contribution to Investor Protection Fund (F&O Segment)

The trading members contribute to Investor Protection Fund of F&O segment at the rate of

Re.1/- per Rs.100 crores of the traded value (each side) in case of Futures segment and Re.1/-

per Rs.100 crores of the premium amount (each side) in case of Options segment.

Clearing and Settlement

NSCCL undertakes clearing and settlement of all trades executed on the F&O Segment of the

Exchange. It also acts as legal counterparty to all trades on this segment and guarantees their

financial settlement. The Clearing and Settlement process comprises of three main activities,

viz., Clearing, Settlement and Risk Management.

Clearing Mechanism

The clearing mechanism essentially involves working out open positions and obligations of

clearing (self-clearing/trading-cum-clearing/professional clearing) members. This position is

considered for exposure and daily margin purposes. The open positions of clearing members

(CMs) are arrived at by aggregating the open positions of all the trading members (TMs) and all

custodial participants clearing through him, in contracts in which they have traded. A TM’s open

position is arrived at as the summation of 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 identify the orders. These orders can be proprietary (if they are their own

trades) or client (if entered on behalf of clients) through ‘Pro/Cli’ indicator provided in the order

entry screen. Proprietary positions are calculated on net basis (buy - sell) for each contract.
Clients’ positions are arrived at by summing together net (buy - sell) positions of each individual

client. A TM’s open position is the sum of proprietary open position, client open long position

and client open short position.

Settlement Mechanism

All futures and options contracts are cash settled i.e. through exchange of cash. The settlement

amount for a CM is netted across all their TMs/clients, with respect to their obligations on mark-

to-market (MTM), premium and exercise settlement. For the purpose of settlement, all CMs are

required to open a separate bank account with National Securities Clearing Corporations Ltd.

(NSCCL) designated clearing banks for F&O segment. Settlement of Futures Contracts on Index

or Individual Securities Futures contracts have two types of settlements, the MTM settlement

which happens on a T+1 day basis and the final settlement which happens on the next day of

the expiry day.

• MTM Settlement for Futures: The positions in futures contracts for each member are marked

to-market to the daily settlement price of the relevant futures contract at the end of each day.

The CMs who have suffered a loss are required to pay the mark-to-market (MTM) loss amount

in cash which in turn passed on to the CMs who have made a MTM profit. This is known as daily

mark-to-market settlement. CMs are responsible to collect and settle the daily MTM

profits/losses incurred by the TMs and their clients clearing and settling through them. Similarly,

TMs are responsible to collect/pay losses/ profits from/to their clients by the next day. The pay-

in and pay-out of the mark-to-market settlement are effected on the day following the trade day

(T+1). After completion of daily settlement computation, all the open positions are reset to the

daily settlement price. Such positions become the open positions for the next day.

• Final Settlement for Futures: On the expiry day of the futures contracts, after the

close of trading hours, NSCCL marks all positions of a CM to the final settlement price
and the resulting profit/loss is settled in cash. Final settlement loss/profit amount is

debited/credited to the relevant CM’s clearing bank account on the day following expiry

day of the contract.

• Settlement Prices for Futures: Daily settlement price on a trading day is the closing

price of the respective futures contracts on such day. The closing price for a futures

contract is currently calculated as the last half an hour weighted average price of the

contract in the F&O Segment of NSE. Final settlement price is the closing price of the

relevant underlying index/security in the Capital Market segment of NSE, on the last

trading day of the contract.

The closing price of the underlying Index/security is currently its last half an hour

weighted average value in the Capital Market Segment of NSE.

Risk Management System

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

salient features of risk containment measures on the F&O segment are:

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

requirements for membership in terms of capital adequacy (net worth, security deposits) are

quite stringent.

• NSCCL charges an upfront initial margin for all the open positions of a Clearing Member (CM).

It specifies the initial margin requirements for each futures/options contract on a daily basis. It

follows VaR-based margining computed through Standard Portfolio Analysis of Risk (SPAN)

system. The CM in turn collects the initial margin from the trading members (TMs) and their
respective clients.

• The open positions of the members are marked to market based on contract settlement price

for each contract at the end of the day. The difference is settled in cash on a T+1 basis.

• NSCCL’s on-line position monitoring system monitors a CM’s open position on a real-time

basis. Limits are set for each CM based on his effective deposits. The on-line position monitoring

system generates alert messages whenever a CM reaches 70 %, 80 %, 90 % and a disablement

message at 100 % of the limit. NSCCL monitors the CMs for Initial Margin violation, Exposure

margin violation, while TMs are monitored for Initial Margin violation and position limit

violation. CMs are provided a trading terminal for the purpose of monitoring the open positions

of all the TMs clearing and settling through him. A CM may set limits for a TM clearing and

settling through him. NSCCL assists the CM to monitor the intra-day limits set up by a CM and

whenever a TM exceeds the limits, it stops that particular TM from further trading. • A member

is alerted of his position to enable him to adjust his exposure or bring in additional capital.

Margin violations result in disablement of trading facility for all TMs of a CM in case of a

violation by the CM. • A separate Settlement Guarantee Fund for this segment has been created

out of deposits of members. The most critical component of risk containment mechanism for

F&O segment is the margining system and on-line position monitoring. The actual position

monitoring and margining is carried out on-line through Parallel Risk Management System

(PRISM) using SPAN(R)2 (Standard Portfolio Analysis of Risk) system for the purpose of

computation of on-line margins, based on the parameters defined by SEBI.