Risk Management of Derivatives 1 | Page Bombay Stock Exchange Limited. Risk Management of Derivatives in BSE A Summer Project Report Submitted to Utkal University in the Partial Fulfillment of Degree of Master of Finance & Control. (2009 – 11) Submitted by Submitted by Submitted by Submitted by Dillip Dillip Dillip Dillip Khuntia huntia huntia huntia Roll No. Roll No. Roll No. Roll No. – 1370V091011 1370V091011 1370V091011 1370V091011 Under the Guidance of Under the Guidance of Under the Guidance of Under the Guidance of Dr. Kshitibhusan Das Dr. Kshitibhusan Das Dr. Kshitibhusan Das Dr. Kshitibhusan Das Mr. Mr. Mr. Mr. C. Vasudevan C. Vasudevan C. Vasudevan C. Vasudevan Reader, Reader, Reader, Reader, General General General General Manager, Manager, Manager, Manager, P.G. Department of Commerce P.G. Department of Commerce P.G. Department of Commerce P.G. Department of Commerce BSE Training Institute SE Training Institute SE Training Institute SE Training Institute, Utkal University Utkal University Utkal University Utkal University. Bombay Stock Exchange Bombay Stock Exchange Bombay Stock Exchange Bombay Stock Exchange Limited Limited Limited Limited. MASTER OF FINANCE & CONTROL P.G. DEPARTMENT OF COMMERCE, P.G. DEPARTMENT OF COMMERCE, P.G. DEPARTMENT OF COMMERCE, P.G. DEPARTMENT OF COMMERCE, UTKAL UNIVERSITY UTKAL UNIVERSITY UTKAL UNIVERSITY UTKAL UNIVERSITY, BHUBANESWAR BHUBANESWAR BHUBANESWAR BHUBANESWAR.
This my Summer project that i have done in Bombay Stock Exchange and it contains the role of exchange in risk mitigation of derivative trading.
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Risk Management of Derivatives
1 | P a g e B o m b a y S t o c k E x c h a n g e L i m i t e d .
Risk Management of Derivatives
in BSE
A Summer Project Report Submitted to Utkal University in the
Partial Fulfillment of Degree of Master of Finance & Control.
(2009 – 11)
Submitted bySubmitted bySubmitted bySubmitted by
Dillip Dillip Dillip Dillip KKKKhuntiahuntiahuntiahuntia Roll No. Roll No. Roll No. Roll No. –––– 1370V0910111370V0910111370V0910111370V091011
Under the Guidance ofUnder the Guidance ofUnder the Guidance ofUnder the Guidance of
Dr. Kshitibhusan DasDr. Kshitibhusan DasDr. Kshitibhusan DasDr. Kshitibhusan Das Mr.Mr.Mr.Mr. C. VasudevanC. VasudevanC. VasudevanC. Vasudevan
Reader,Reader,Reader,Reader, General General General General Manager,Manager,Manager,Manager,
P.G. Department of CommerceP.G. Department of CommerceP.G. Department of CommerceP.G. Department of Commerce BBBBSE Training InstituteSE Training InstituteSE Training InstituteSE Training Institute,,,,
2 | P a g e B o m b a y S t o c k E x c h a n g e L i m i t e d .
DECLARATION
I do hereby declare that the project entitled “Risk “Risk “Risk “Risk
Management of DerivativesManagement of DerivativesManagement of DerivativesManagement of Derivatives in BSEin BSEin BSEin BSE”””” is submitted to Utkal
University for the partial fulfillment of degree of Master of Master of Master of Master of
Finance and ControlFinance and ControlFinance and ControlFinance and Control, Utkal University. The project is an
authentic piece of work done by me under the guidance of
Dr. KshDr. KshDr. KshDr. Kshiiiitibhushan Dastibhushan Dastibhushan Dastibhushan Das, Reader, P.G. Department of
Commerce, Utkal University and it has neither been
submitted for award of any other degree to any other
University, Academy, Institution nor published in any
magazine or anywhere else in part or full to best of my
knowledge.
PLACE: BHUBANESWAR
DATE: (DILLIP KHUNTIA)
Risk Management of Derivatives
3 | P a g e B o m b a y S t o c k E x c h a n g e L i m i t e d .
ACKNOWLEDGEMENT
The satisfaction that accompanies the successful completion of any task would
be incomplete without mentioning people who made it possible, whose encouragement
and consistent guidance crowned my efforts with success.
At the outset, I would like to extend my sincere gratitude and reverence to the
esteemed organization, Bombay Stock Exchange Limited and its management for
providing me with the opportunity to pursue my summer project.
I would like to thank Mr. C. Vasudevan, General Manager, Bombay Stock
Exchange Limited and Mr. Pulakesh Dutta, Deputy Manager, BTI, Bombay Stock
Exchange Limited, for allowing me to work on this project that not only interesting but
has also added to my knowledge.
I am also thankful to Product and Strategy department and Mr. Yogesh
Sundaram, Consultant and Analyst, Bombay Stock Exchange Limited, for enlightening
me with nuances of the risk management procedure followed by the Bombay Stock
Exchange Limited and acknowledge the support and help of employees of Product and
Strategy Department for their assistance in completion of this project.
I would like to express my heartfelt indebtedness and deep sense of gratitude to
my faculty guide Dr. KshDr. KshDr. KshDr. Kshiiiitibhushan Das tibhushan Das tibhushan Das tibhushan Das for sharing his knowledge and giving me
guidance and generous co-operation. I am also thankful to my other faculty members
and my friends for their continuous support and encouragement.
Last but not the least to MR. Madhusudan Sahu without whose help it was
difficult to take on an internship at BSE
PLACE: BHUBANESWAR
DATE: (DILLIP KHUNTIA)
Risk Management of Derivatives
4 | P a g e B o m b a y S t o c k E x c h a n g e L i m i t e d .
Dr. Kshitibhushan Das
Reader, P.G. Department of Commerce
Utkal University
CertificateCertificateCertificateCertificate
This to certify that the project entitled “Risk
Management of Derivatives in BSE” is a record of bonafide
research work carried out by Dillip Khuntia under my
supervision and guidance. It embodies result of his original
contribution. The project has reached the standard of
fulfilling the requirements of the regulation relating to the
degree of Master of Finance and Control. No part of this
project has been submitted to any other institution for the
award of any other degree.
I wish him all success in his future endeavours.
PLACE: BHUBANESWAR
DATE: (Dr. Kshitibhushan Das)
P.G. Dept. of Commerce
Utkal University.
Risk Management of Derivatives
5 | P a g e B o m b a y S t o c k E x c h a n g e L i m i t e d .
EXECUTIVE SUMMERY
In this project “Risk Management of Derivatives in BSE”, the major objective
was to find out the effectiveness and efficiency of the risk management process of BSE
for derivatives segment.
For achieving this objective a survey was conducted, wherein some of the
brokers are interviewed and the details of the risk management process of derivatives in
BSE was analyzed. SEBI guidelines and circulars are also followed for this purpose.
During the survey it was found that the risk management process of BSE is
efficient and can be compared with any of the major stock exchange of the world. The
SPAN margining system that BSE follows for margin calculation is an effective system
of risk management and most of the exchanges of the world follow this method for
margin calculation. The software PC SPAN®, used by BSE for SPAN margin calculation
is reliable and user friendly software. In case of risk management, BSE lags behind NSE
in one area i.e. monitoring. NSE has an integrated system (PRISM) for monitoring the
risk, whereas BSE does not have such facility
Thus the recommendation in accordance with this project would be that BSE
should take aggressive steps for expansion of its derivatives segment. This coupled with
a few with the risk management process such as providing real time information about
the parameters; especially the risk array and the trading information in tabular form
rather than graphical form, use of better monitoring system for risk management would
help BSE to improve its market position in derivatives.
Risk Management of Derivatives
6 | P a g e B o m b a y S t o c k E x c h a n g e L i m i t e d .
CONTENTS Declaration…………………………………………………………………………………………………………………………………. i
Acknowledgement………………………………………………………………………………………………………………………. ii
Certificates………………………………………………………………………………………………………………………………… iii
Executive Summery…………………………………………………………………………………………………………………… iv
a) “a security derived from a debt instrument, share, loan whether secured or
unsecured, risk instrument or a contract for difference or any other form of
securities;
b) “a contract which derives its value from the prices, or index of prices, of
underlying securities”.
The underlying asset may be a stock, bond, a foreign currency, commodity or
even another derivative security. Derivative securities can be used by individuals,
corporations, and financial institutions to hedge an exposure to risk.
Risk Management of Derivatives
21 | P a g e B o m b a y S t o c k E x c h a n g e L i m i t e d .
3.2 DERIVATIVE PRODUCTS
Derivative contracts have several variants. The most common variants are
forwards, futures, options and swaps. Various derivatives contracts are described
below,
3.2.1 FORWARDS
A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at today’s pre-agreed price. A
forward contract is an agreement between two parties to buy or sell an asset at a
specific point of time in future and the price which is paid /received by the parties is
decided at the time of entering the contract.
3.2.2 FUTURE
A future contract is an agreement between two parties to buy or sell an asset at
a certain time in the future at a certain price. Future contracts are standardized forward
contracts. Future contracts are traded in exchanges and exchange sets the standardized
terms in term of quantity, quality, price quotation, date and delivery date (in case of
commodities).
3.2.3 OPTIONS
An option contract, as the name suggests, is in some sense an optional contract.
An option is the right, but not the obligation, to buy or sell something at a stated date
at a stated price. Options are of two types;
• CALL OPTIONS: A call option gives the buyer of the option the right, but not
the obligation to buy a given quantity of the underlying asset, at a given price
and on or before a given date.
• PUT OPTION: Put options give the buyer the right, but the obligation to sell a
given quantity of underlying asset at a given price on before a given date.
Risk Management of Derivatives
22 | P a g e B o m b a y S t o c k E x c h a n g e L i m i t e d .
Options can also be European options and American options. This
classification is based on the exercise of the options. European options can be
exercised at the maturity date of the option. On the other hand, American options can
be exercised at any time up to and including the maturity date.
3.2.4 WARRANTS
Options generally have lives of up-to one year. Long dated options are called as
warrants and generally traded over-the-counter.
3.2.5 LEAPS
Long-Term-Equity-Anticipated Securities are options having a maturity of
more than three years or in other words options having a maturity of more than three
years are termed as LEAPS.
3.2.6 BASKETS
Basket options are options on portfolio of underlying assets. Equity index
options are a form of basket options
3.2.7 SWAPS
A swap means a barter or exchange. Thus, a swap is an agreement between two
parties to exchange stream of cash flows over a period of time in future. The two
commonly used swaps are,
i) INTEREST RATE SWAPS: Swaps which entail swapping only the interest related
cash flows between the parties in the same currency.
ii) CURRENCY SWAPS: These entail swapping both principal and interest between
two parities, with cash flows in one direction being in different currency than those in
the opposite direction.
3.3 PARTICIPANTS IN DERIVATIVE MARKET
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23 | P a g e B o m b a y S t o c k E x c h a n g e L i m i t e d .
The reason for which derivatives are so attractive is that they have attracted
different types of investors and have a great deal of liquidity. When an investor wants
to take one side of a contract, there is usually no problem in finding someone that is
prepared to take the other side. Three broad kinds of participants can be found in
derivatives market, namely, hedgers, speculators and arbitrageurs.
1. Hedgers: They use derivatives markets to reduce or eliminate the risk associated
with price of an asset. Majority of the participants in derivatives market belongs to
this category.
2. Speculators: They transact futures and options contracts to get extra leverage in
betting on future movements in the price of an asset. They can increase both the
potential gains and potential losses by usage of derivatives in a speculative venture.
3. Arbitrageurs: Their behaviour is guided by the desire to take advantage of a
discrepancy between prices of more or less the same assets or competing assets in
different markets. If, for example, they see the futures price of an asset getting out of
line with the cash price, they will take offsetting positions in the two markets to lock
in a profit.
3.4 CLASSIFICATION OF DERIVATIVES
Broadly derivatives can be classified into two categories, commodity
derivatives and financial derivatives. In case of commodity derivatives, the underlying
asset can be commodities like wheat, gold, silver etc; whereas in case of financial
derivatives the underlying assets are stocks, currencies, bonds and other interest
bearing securities etc. A figure below shows the classification of derivatives,
Figure – 3.1
Classification of Derivatives
Risk Management of Derivatives
24 | P a g e B o m b a y S t o c k E x c h a n g e L i m i t e d .
Basing on the type of market, derivative market is of two types, exchange-
traded derivatives market and over-the-counter derivative market. In the exchange-
traded derivatives, the derivatives which are standardized in nature are traded. The
trading of the derivatives is well regulated by the exchanges. The over-the-counter
market is an important derivative market and has larger volume of trade than the
exchange-traded market. It is a telephone- and computer- linked network of dealers.
Traders are done over the phone and are usually between two financial institutions or
between a financial institution and one of its clients. Telephone conversations in the
OTC market are usually taped. If there is a dispute about what was agreed, the tapes
are replayed to resolve the issue. A key advantage of over-the-counter market is that
all the products are customized. Market participants are free to negotiate any mutually
alternative deal. A disadvantage is that there is usually credit risk in an over-the-
counter trade. The over-the-counter market is not regulated by any regulatory body
and hence posses a huge counterparty risk.
3.5 ECONOMIC SIGNIFICANCE OF DERIVATIVES
Some of the significance of financial derivatives can be enumerated as follows;
Risk Management of Derivatives
25 | P a g e B o m b a y S t o c k E x c h a n g e L i m i t e d .
1) The most important function of derivatives is risk management. Financial
derivatives provide a powerful tool for limiting risks that individuals and
organizations face in ordinary conduct of their business.
2) The prices of derivatives converge with the prices of underlying at the
expiration of derivative contract. Thus, derivatives help in discovering the
future as well as current prices.
3) As derivatives are closely linked with the underlying cash market, with the
introduction of derivatives, the underlying cash markets witness higher trading
volumes. This is because; more people participate in stock market due to the
risk transferring nature of derivatives.
4) Speculative trade shift to a more controlled environment of derivative market.
In the absence of an organized derivatives market, speculators trade in the cash
markets. Margining, monitoring and surveillance of various participants
become extremely difficult in these kinds of mixed markets.
5) Derivatives trading acts as a catalyst for new entrepreneurial activities.
In a nut shell, derivatives markets encourage investment in long run. Transfer of risk
enables market participants to expand their volume of activity.
3.6 HISTORY OF DERIVATIVES
The history of derivatives is quite colorful and surprisingly a lot longer than
most people think. The origin of derivatives can be traced in Bible. In Genesis Chapter
29, believed to be about the years 1700 B.C., Jacob purchased an option costing him
seven years labour that granted him the right to marry Laban’s daughter Rachel.
Around 580 B.C., Thales the Milesian purchased option on Olive presses and made a
fortunate off of a bumper crop in Olives. So, derivatives were before the time of
Christ.
The first exchange for trading derivatives appeared to be Royal Exchange in
London, which permitted forward contracting on tulip bulbs at around 1637. The first
“futures” contracts are generally traced to the Yodaya rice market in Osaka, Japan
around 1650. These were evidently standardized contracts, which made them much
Risk Management of Derivatives
26 | P a g e B o m b a y S t o c k E x c h a n g e L i m i t e d .
like today’s futures, although it is not known whether the contracts are marked to
market daily, and/or had credit guarantee.
Probably the next major event, and the most significant as far as the history of
derivatives markets, was the creation of Chicago Board of Trade in 1848. Due to its
prime location, Chicago was developing as a major centre for the storage, sale, and
distribution of Midwestern grain. Due to seasonality of grain, however Chicago’s
storage facilities were unable to accommodate the enormous increase in supply that
occurred following the harvest. Similarly, its facilities were underutilized in spring.
Chicago’s spot prices rose and fall drastically. To resolve this problem a group of
grain traders created “to-arrive” contracts which permitted the farmers to lock in the
price and deliver the grains in future. These to-arrive contracts are called as forward
contracts. The forward contracts proved as a useful device for hedging the price risk.
However, “credit risk” remained as 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 CBOT was to provide a centralize location for buyers and
sellers to negotiate forward contracts. In 1865, CBOT went one step further and listed
the first “exchange traded” derivatives in US, which are termed as “Futures
Contracts”. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, got approval
for futures trading. Its name was changed to Chicago Mercantile Exchange (CME). In
1925, the first clearing house for derivatives trading was established.
Since then, derivatives are traded in many exchanges, although their trading
was banned by Government of different countries from time to time. But, the modern
derivative market has originated in 1970’s. This is due to the unprecedented volatility
in the international financial environment, starting with the breakdown of Bretton-
woods systems on 15 August 1971 and ending with the well-known Saturday night
massacre of Federal Reserve on 6th October 1979. The breakdown of Brettonwoods
system resulted in inflation, volatility in the market place and currency turmoil. This
state of affairs heralded the emergence of financial derivatives.
Risk Management of Derivatives
27 | P a g e B o m b a y S t o c k E x c h a n g e L i m i t e d .
The next major fillip for development of derivatives was provided in October
1979, when the US Federal Reserve started its policy of interest rate deregulation and
anti-inflationary monetary policy. This resulted in increased interest rates. This
marked the emergence of interest rate derivatives to hedge interest rate risk.
The history of financial derivatives is concurrent with the history of various
risks in the financial world. The fascination with risk and its components started
during the early 1970’s has grown substantially since then, resulting in the expansion
of financial derivatives market.
3.7 INTERNATIONAL DERIVATIVE MARKET
The financial derivatives which were meant to address the needs of farmers and
merchants have now a major share in the financial market place. Started with the
establishment of Chicago Board of Trade (CBOT), derivatives are now traded in
almost all major stock exchanges of the world. Boosted with the breakdown of
Brettonwoods system, the derivatives got the recognition of risk management
instruments and are used by all investors starting from individual investor to
institutional investor.
Thus, the global derivative market is now a wide spread market with a potential
of further growth. In last two decades derivatives has shown a tremendous growth and
also continuing to grow in future. Major stock exchanges of derivatives trading are
Chicago Mercantile Exchange (CME), Eurex, Hongkong Futures Exchange, The
London International Financial Futures and Options Exchange (LIFFE), Singapore
Exchange, Sydney Futures Exchange etc. Apart from these stock exchanges other
stock exchanges of various countries has shown a huge growth in derivatives trading.
3.8 INDIAN DERIVATIVE MARKET
Derivatives markets in India have been in existence in one form or the other for
a long time. In the area of commodities, the Bombay Cotton Trade Association started
futures trading way back in 1875. In 1952, the Government of India banned cash
settlement and options trading. Derivatives trading shifted to informal forwards
markets. In recent years, government policy has shifted in favour of an increased role
Risk Management of Derivatives
28 | P a g e B o m b a y S t o c k E x c h a n g e L i m i t e d .
of market-based pricing and less suspicious derivatives trading. The first step towards
introduction of financial derivatives trading in India was the promulgation of the
Securities Laws (Amendment) Ordinance, 1995. It provided for withdrawal of
prohibition on options in securities. The last decade, beginning the year 2000, saw
lifting of ban on futures trading in many commodities. Around the same period,
national electronic commodity exchanges were also set up.
Derivatives trading commenced in India in June 2000 after SEBI granted the
final approval to this effect in May 2001 on the recommendation of L. C Gupta
committee. Securities and Exchange Board of India (SEBI) permitted the derivative
segments of two stock exchanges, NSE and BSE, and their clearing house/corporation
to commence trading and settlement in approved derivatives contracts. Initially, SEBI
approved trading in index futures contracts based on various stock market indices such
as, S&P CNX, Nifty and SENSEX. Subsequently, index-based trading was permitted
in options as well as individual securities.
The trading in BSE SENSEX options commenced on June 4, 2001 and the
trading in options on individual securities commenced in July 2001. Futures contracts
on individual stocks were launched in November 2001. The derivatives trading on
NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in
index options commenced on June 4, 2001 and trading in options on individual
securities commenced on July 2, 2001. Single stock futures were launched on
November 9, 2001. The index futures and options contract on NSE are based on S&P
CNX. In June 2003, NSE introduced Interest Rate Futures which were subsequently
banned due to pricing issue. Since the scope of this project is limited to equity
derivatives only, so the further discussion will be confined to equity derivatives only.
Equity derivatives market in India has registered an "explosive growth" and is
expected to continue the same in the years to come. Introduced in 2000, financial
derivatives market in India has shown a remarkable growth both in terms of volumes
and numbers of traded contracts. NSE alone accounts for 99 percent of the derivatives
trading in Indian markets. The introduction of derivatives has been well received by
Risk Management of Derivatives
29 | P a g e B o m b a y S t o c k E x c h a n g e L i m i t e d .
stock market players. Trading in derivatives gained popularity soon after its
introduction. In due course, the turnover of the NSE derivatives market exceeded the
turnover of the NSE cash market. For example, in 2008, the value of the NSE
derivatives markets was Rs. 130, 90,477.75 Cr. whereas the value of the NSE cash
markets was only Rs. 3,551,038 Crore. If I compare the trading figures of NSE and
BSE, performance of BSE is not encouraging both in terms of volumes and numbers
of contracts traded in all product categories.
Figure 3.2
Business Growth of Derivatives in India from 2000- 2011(May)
NSE’S DERIVATIVE SEGMENT
The National Stock Exchange accounts almost 99% of the Indian derivatives market in terms of turnover, volume etc. Its equity derivatives market is most boosted one and in turnover it is a major stock exchange. All products in equity derivative segment i.e. Index Futures and Options and Stock Futures and Options have marked a tremendous growth over the last decade. The graph below shows the average yearly turnover in each equity derivative products and average daily turnover of derivative segment of NSE.