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M P Birla Institute of Management Page 1 of 68

A PROJECT REPORT ON RISK CONTAINMENT MEASURE IN INDIAN STOCK INDEX FUTURES MARKET

SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS OF MBA PROGRAM OF BANGALORE UNIVERSITY BY P.K.DEEPAK GUPTA 03XQCM6026

MP BIRLA INSTITUTE OF MANAGEMENT ASSOC IATE BHARATIYA VIDYA BHAVAN # 43 RACE COURSE ROAD

BANGALORE 2003 2005 M P Birla Institute of Management Page 2 of 68

DECLERATION

I here by declare that, this Project Report entitled “ Risk Containment Measure In Indian Stock Index Futures Market ” has been undertaken and completed by me under the valuable guidance of Prof. Santhanam in partial fulfillment of degree of Master of Business Administration (MBA) program.

Place: Bangalore Date: P.K. DEEPAK GUPTA Reg No. 03XQCM6026

M P Birla Institute of Management Page 3 of 68

PRINCIPAL’S CERTIFICATE

This is to certify that Mr. Deepak Gupta P.K has undertaken Project Work on “ Risk Containment Measure In Indian Stock Index Futures Mark et ” under the able guidance of Prof. Santhanam,

Place: Bangalore Date: Dr. Nagesh Mallavalli (Principal)

M P Birla Institute of Management Page 4 of 68

GUIDE’S CERTIFICATE

This is to certify that the Project Work report titled “ Risk Containment Measure In Indian Stock Index Futures Market ” has prepared by Mr. Deepak Gupta P.K bearing registration number 03XQCM6026 , under my guidance.

Place: Bangalore Date: Prof. Santhanam

M P Birla Institute of Management Page 5 of 68

ACKNOWLEDGEMENT

I would li ke to express my sincere gratitude to my project guide Prof. Santhanam, who guided me through the entire project.

Also I would like to thank Bangalore Stock Exchange, my friends and also my college who have helped me in completing this project and also f or having given me this

opportunity.

DEEPAK GUPTA P.K

M P Birla Institute of Management Page 6 of 68

EXECUTIVE SUMMARY

The project starts off with the History of Derivatives in India, which includes Ev ents that made the launch of Derivatives in India .

Then the project goes on to the Performance of Commondity Exchanges in India. The initial move is the analysis of Risk Containment and related issues taking into considerations LC Gupta and Varma Commi

ttee reports. The project also states some risk management strategies implemented to manage risk in futures market.

M P Birla Institute of Management Page 7 of 68 DERIVATIVES IN INDIA

In the Indian context, the securities contracts (regulation) Act 1956, (SCRA) deri vative includes ¾ A security derived from a debt instrument, share and loan whether secured or unsecured. Risk instrument or contract for differences or any other form of security. ¾ A contract which derives its value from the price or index of prices, of un derlying securities.

The Bombay Stock Exchange and National Stock Exchange launched trading in Index Futures in June 2000. This marked the beginning of exchange traded financial derivatives in India. We had a strong Dollar – Rupee Forward markets with c ontracts being traded for 1 to 6 months. The daily trading volume here was approximately US $ 500 million. Motivation to use derivatives The real motivation to use derivatives is that they are useful in reallocating risk either across time or across ind ividuals with different risk bearing preferences. M P Birla Institute of Management Page 8 of 68 Types of Derivatives Derivatives are basically classified into two based upon the mechanism th at is used to trade on them. They are Over the Counter derivatives and Exchange traded derivatives. The OTC derivatives are between two private parties and are designed to suit the requirements of the parties concerned. The Exchange traded ones are standar dized ones where the exchange sets the standards for trading by providing the contract specifications and the clearing corporation provides the trade guarantee and the settlement activities ¢¡ ¤£ ¢¥ §¦ ©¨ µ¥

§ "! " µ¥ §¦ EVENTS THAT MADE THE LAUNCH OF DERIVATIVES IN INDIA ¾ November 1996, SEBI set up a committee under the chairmanship of Dr. L C Gupta, the well known economist and former SEBI Board Member. ¾ The Committee submitted its report on the March 17 1998. It advocated the introduction of derivatives in Indian market in a phased manner, starting with the ‘ Index Futures’. ¾ SEBI accepted the report on May 11, 1998 and June 16, 1998, it issued a circula tion allowing exchanges to submit their proposals for introduction of derivative trading. ¾ Government issued notification delineating the areas of responsibility between RBI and Market Regulator SEBI. ¾ On June 2000, derivative trading started in NSE and BSE. M P Birla Institute of Management Page 9 of 68

What is the role of commodity futures market and why do we need them? One answer that is heard in the financial sector is `we need commodity futures markets so that we will have volumes, brokerage fees, and something to trade''. I think that is missing the point. We have to look at futures market in a bigger perspective -what is the role for commodity futures in India's economy? In India agriculture has traditionally been a area with heavy government intervention. Government intervenes by trying to ma intain buffer stocks, they try to fix prices, they have import export restrictions and a host of other interventions. Many economists think that we could have major benefits from liberalization of the agricultural sector. In this case, the question arises about who will maintain the buffer stock, how will we smoothen the price fluctuations, how will farmers not be vulnerable that tomorrow the price will crash when the crop comes out, how will farmers get signals that in the future there will be a great need for wheat or rice. In all these aspects the futures market has a very big role to play. If you think there will be a shortage of wheat tomorrow, the futures prices will go up today, and it will carry signals back to the farmer making sowing decisions tod ay. In this fashion, a system of futures markets will improve cropping patterns. Next, if I am growing wheat and am worried that by the time the harvest comes out prices will go down, then I can sell my wheat on the futures market. I can sell my wheat at a price which is fixed today, which eliminates my risk from price fluctuations. These days, agriculture requires investments -farmers spend money on fertilizers, high yielding varieties, etc. They are worried when making these investments that by the tim e

the crop comes out prices might have dropped, resulting in losses. Thus a farmer would like to lock in his future price and not be exposed to fluctuations in prices. M P Birla Institute of Management Page 10 of 68 The third is the role about storage. Today we have the Food Corporation of India which i s doing a huge job of storage, and it is a system which -in my opinion -does not work. Futures market will produce their own kind of smoothing between the present and the future. If the future price is high and the present price is low, an arbitrager w ill buy today and sell in the future. The converse is also true, thus if the future price is low the arbitrageur will buy in the futures market. These activities produce their own "optimal" buffer stocks, smooth prices. They also work very effectively when there is trade in agricultural commodities; arbitrageurs on the futures market will use imports and exports to smooth Indian prices using foreign spot markets. In totality, commodity futures markets are a part and parcel of a program for agricultural libe ralization. Many agriculture economists understand the need of liberalization in the sector. Futures markets are an instrument for achieving that liberalization. What about futures in bullion? Futures in gold will be useful, since millions of people in India use gold as a financial asset and are exposed to fluctuations in the price of gold. In addition, it's very easy to start a gold futures market. Gold is a natural commodity where we should be dealing with warehouse receipts -banks have already started giving gold depositories receipts, which clearing corporations would be comfortable relying upon. A market like NSE could start trading in Gold futures with just a few weeks of preparation.

Obviously the consent of regulators will be required to getting such trading off the ground. Remarkably enough, it may not be necessary that we should have a gold fut ures market in India. There are several well functioning gold futures market outside India. Maybe we should just use them M P Birla Institute of Management Page 11 of 68 PERFORMANCE OF COMMONDITY EXCHANGES Year 2002 03 witnessed a surge in volumes in the commodity futures markets in India. The 20 plus commodity exchanges clocked a volume of about Rs. 100,000 crore in volumes against the volume of 34,500 crore in 2001 02 – remarkable performance for an industry that is being revived! This performance is more remarkable because the commodity exchanges as o f now are more regional and are for few commodities namely soybean complex, castor seed, few other edible oilseed complex, pepper, jute and gur. Interestingly, commodities in which future contracts are successful are commodities those are not protected th rough government policies; and trade constituents of these commodities are not complaining too. This should act as an eye opener to the policy makers to leave pricing and price risk management to the market forces rather than to administered mechanisms alo ne. Any economy grows when the constituents willingly accept the risk for better returns; if risks are not compensated with adequate or more returns, economic activity will come into a standstill. With the value of India’s commodity economy being around R

s. 300,000 crore a year potential for much greater volumes are evident with the expansion of list of commodities and nationwide availability. Opening up of the world trade barriers would mean more price risk to be managed. All these factors augur well for the future of futures. WAY AHEAD FOR COMMONDITY EXCHANGE

Commodity exchanges in India are expected to contribute significantly in strengthening Indian economy to face the challenges of globalization. Indian markets are poised to witness further developments in the areas of electronic warehouse receipts (equivalent of dematerialized shares), which would facilitate seamless nationwide spot M P Birla Institute of Management Page 12 of 68 market for commodities. Amendments to Essential Commodities Act and implementation of Value A dded tax would enable movement of across states and more unified tax regime, which would facilitate easier trading in commodities. Options contracts in commodities are being considered and this would again boost the commodity risk management markets in the country. We may see increased interest from the international players in the Indian commodity markets once national exchanges become operational. Commodity derivatives as an industry are poised to take off which may provide the numerous investors in this country with another opportunity to invest and diversify their portfolio. Finally, we may see greater convergence of markets – equity, commodities, forex and debt

– which could enhance the business opportunities for those have specialized in the above mar kets. Such integration would create specialized treasuries and fund houses that would offer a gamut of services to provide comprehensive risk management solutions to India’s corporate and trade community. In short, we are poised to witness the resurgence of India’s commodity trading which has more than 100 years of great history. FACTORS DRIVING THE GROWTH OF FINANCIAL DERIVATIVES IN INDIA ¾ Increased volatility in asset prices in financial markets. ¾ Increased integration of national financial markets with international markets. ¾ Marked improvement in communication facilities and sharp decline in the costs. ¾ Development of more sophisticated risk management tools, providing ecomomic agents a wider choice of risk management strategies. ¾ Innovation in derivative s market, which optimally combine the risks and return over a large number of financial assets, leading to higher return, reduced risk as well as transaction costs as compared to individual financial assets M P Birla Institute of Management Page

13 of 68 POPULARITY OF STOCK INDEX FUTURES There are ma ny reasons for the wide international acceptance of stock index futures and for the strong preference for this instrument in India too compared to other forms of equity derivatives. This is because of the following advantages of stock index futures : 1. I nstitutional and other large equity holders need portfolio hedging facility. Hence, index based derivatives are more suited to them and more cost effective than derivatives based on individual stocks. Even pension funds in U.S.A. are known to use stock ind ex futures for risk hedging purposes. 1. Stock index is difficult to be manipulated as compared to individual stock prices, more so in India, and the possibility of cornering is reduced. This is partly because an individual stock has a limited supply whic h can be cornered. Of course, manipulation of stock index can be attempted by influencing the cash prices of its component securities. While the possibility of such manipulation is not ruled out, it is reduced by designing the index appropriately. There i s need for minimizing it further by undertaking cash market reforms, as suggested by the Committee later in this chapter. 2. Stock index futures enjoy distinctly greater popularity, and are, therefore, likely to be more liquid than all other types of equi ty derivatives, as shown both by responses to the Committee’s questionnaire and by international experience. 3. Stock index, being an average, is much less volatile than individual stock prices. This implies much lower capital adequacy and margin requirem ents in the case of index futures than in the case of derivatives on individual stocks. The lower margins will induce more players to join the market. 4. In the case of individual stocks, the positions which remain outstanding on the

expiration date will have to be settled by physical delivery. This is an accepted principle everywhere. The futures and the cash market prices have to converge on the expiration date. Since Index futures do not represent a physically deliverable asset, they are cash settled a ll over the world on the premise that the index value is derived from the cash M P Birla Institute of Management Page 14 of 68 market. This, of course, implies that the cash market is functioning in a reasonably sound manner and the index values based on it can be safely accepted as the settlement price . 5. Regulatory complexity is likely to be less in the case of stock index futures than for other kinds of equity derivatives, such as stock index options, or individual stock options. The Index is Pervasive Index derivatives are a powerful tool for risk management for anyone who has portfolios composed of positions in equity. Using index futures and index options, investors and portfolio managers can hedge themselves against the risk of a downturn in the market when they should so desire. For example, f or many investors, the volatility associated with the budget might not be a ride that they wish to bear. Today, in the absence of index derivatives, the investor has only one alternative: to sell off equity, and move into cash or debentures, prior to the b udget. Roughly a month after the budget, after the budget related volatility has subsided, these transactions could be reversed, and the person would be back to the original equity exposure. This is expensive in terms of the transactions costs faced in se lling off a significant amount of equity. For retail investors, the total cost of this two stage process could be around 5%, a high price to pay for the privilege of avoiding budget -

related volatility. Using index futures, the same objective would be acco mplished at around one -tenth the cost, or less. Using index options, a very interesting kind of ``portfolio insurance'' could be obtained, whereby an investor gets paid only if the market index drops. These are unique and new forms of risk management in the country. They are particularly appealing because the market index is highly correlated with every equity portfolio in the country. By the time a portfolio contains more than 15 stocks, it is very likely that the correlation between this portfolio and a market index like the NSE 50 M P Birla Institute of Management Page 15 of 68 would exceed 80%. This property holds, regardless of the identity of the securities which make up the portfolio: whether a person holds index stocks or not, the index is highly correlated with every portfolio in the country. This fact is quite apparent when we look back at the experience of 1995 and 1996 -every single equity investor in the country experienced poor returns in that period, regardless of the kind of portfolio owned. This widespread correlation of the risk expo sure of investors with the index makes index derivatives very special in their risk management. One example will help clarify matters. Suppose a person is long ITC. Unfortunately, by being long ITC on the cash market, he is simultaneously long ITC and

lon g index (ITC and the index have a 65% correlation). I.e., if the index should drop, he will suffer, even though he may have no interest in the index when forming his position. In this situation, this person can match his ITC exposure with an opposing posit ion using index futures (i.e. he would be simultaneously long ITC and short index futures) which effectively strips out his index exposure. Now, he is truly long ITC: whether the index goes up or down, he is unaffected, he is only taking a view on ITC. Thi s is far closer to his real interests and objectives, and is much less risky than present market practice (i.e., a pure long ITC position). FUTURES TRADING PROCESS Any person who wants to trade in futures has to contact a Futures Commission Merchant (FCM) or a broker. FCM is necessarily a member of the clearing house, An account has to be ope ned at his firm. You will be assigned to one of the accounts executive, who will look after the transactions. Whenever we place an order with the accounts executive, he will note down the order specifications and immediately transmit to one of the floor brokers at the exchange. The floor broker will execute the order and M P Birla Institute of Management Page 16 of 68 reports the transaction to the clearing house. Once he received the conformation form the clearing house, he calls back the accounts executive giving him all the details about the trade . The accounts executive intern passes on these details to his client. Other responsibilities of the FCM are maintaining all records and reporting the trading activity of all his clients to the clearing house and sending the clients monthly statement abou t their position and account balances. If the account is opened with a broker who is not a member of the clearinghouse, he should necessarily route the order through a member.

FUTURES TRADING STRATEGIES Arbitrage with Nifty futures Arbitrage is the opportunity of taking advantage of the price difference between two markets. An arbitrageur will buy at the cheaper market and sell at the c ostlier market. It is possible to arbitraged between NIFTY in the futures market and the cash market. If the futures price is any of the prices given below other than the equilibrium price then the strategy to be followed is M P Birla Institute of Management Page 17 of 68 Note: The arbitrage opportunity arising when the futures price is underpriced to the cash price is not feasible if the arbitrageur does not hold the scrip or borrowing of sec urities is not possible in the market. This is because the delivery in the spot market comes before the delivery in the futures market. Hedging with NIFTY futures . Case 1 Short Hedge Let us assume that an investor is holding a portfolio of following scrips as given below on 1 st May, 2001. # %$ '& )( §0 '1 32 4

65 §7 98 @ BA DC FE FG §H IC QP BR ¤C 'SUT WVXG §Y a` bVcG ed Ff hg i G §P C pf rq f s ¢tvu Fu w "x 6x Fy €x Fx 6x "ﾁ‚x 6x ƒ …„U† '‡ ‰ˆ '„h ﾐ '‘

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ﾁ €‚ F‚ 6‚ "}‚‚ 6‚ ƒ W„ Q… ‡† 'ˆ3‰ ¤† 'ˆcŠ p‹ Œ„ Qﾍ ﾏŽ 3„ 'ﾐ €… ‡ﾍ „ 'ˆc‘U„ ’ §“ €” 6” F” F“ €” 6” F” •‚” F” Trading Strategy to be followed The investor feels that the market will go down in the next two months and wants to protect him from any adverse movement. To achieve this the investor has to go short on 2 months NIFTY futures i.e he has to sell June Nifty. This strategy is called Short H edge . Formula to calculate the number of futures for hedging purposes is

Beta adjusted Value of Portfolio / Nifty Index level Beta of the above portfolio M P Birla Institute of Management Page 18 of 68 =(1.55*400,000)+(2.06*200,000)+(1.95*175,000)+(1.9*125, 000)/1,000,000 =1.61075 (round to 1.61) Applying the formula to calculate the number of futures contracts Assume NIFTY futures to be 1150 on 1 st May 2001 = (1,000,000.00 * 1.61) / 1150 = 1400 Units Since one Nifty contract is 200 units, the investor has to sell 7 Nifty contracts.

Short He dge

Stock Market Futures Market 1 st May

Holds Rs 1,000,000.00 in stock portfolio Sell 7 NIFTY futures contract at 1150. 25 th June Stock portfolio fall by 6% to Rs 940,000.00 NIFTY futures falls by 4.5% to 1098.25 Profit / Loss Loss: Rs 60,000.00 Pr ofit: 72,450.00

Net Profit: + Rs 15,450.00

Case 2 Long Hedge Let us assume that an investor feels that the market is at the beginning of a bull run. He is expecting to get Rs 1,500,000.00 in two months time. Waiting two months to invest could M P Birla Institute of Management Page 19 of 68 mean th

at he might miss the bull run altogether. An alternative to missing the market move is to use the NIFTY futures market. The investor could simply buy an amount of NIFTY futures contract that would be equivalent to Rs 1,500,000.00. This Strategy is called l ong hedge. Let us assume that on 1 st May 2001 the Nifty futures stand at 1150. He expects to get Rs. 1,500,000.00 by June end. He has to buy 2months June Nifty in May. The number of contracts he should buy is

1,500,000.00/(1150*200) = 6.52 (round to 7) contracts

Stock Market Futures Market 1 st May The investor expects Rs 1,500,000.00 in two months Buys 7 Nifty contracts at 1150 25 June 1,500,000.00 becomes available for investment The markets have risen and the June NIFTY futures stand at 1195

The investor will invest Rs 1,500,000.00 in the market but will not get the same amount of shares as on 1 st May 2001 Futures Profit: Rs 63,000.00

M P Birla Institute of Management Page 20 of 68 INTRODUCTION TO INDIAN STOCK INDEX FUTURES MARKET Index Futur es were introduced in June 2000. A future contract is an agreement between two parties to buy or well an asset at a certain time at a certain price. In this market the contract is standardized.

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The features of Future Contracts are as follows: 1. Highly liquid 2. Traded in stock exchanges 3. No presence of counter party 4. Margins paid by both buyer and seller 5. Standa rdized 6. Mode of delivery is cash settlement 7. They enable investors/funds to hedge their long/short positions in the market, thus reducing the risk associated with such stock holdings. 8. Also, they serve as another investment opportunity for investors looking to bet on the markets in general. M P Birla Institute of Management Page 21 of 68 9.

As the futures trading would be on the market index, it will be difficult for a few operators to manipulate the price of the index futures market. 10. Stock index futures are expected to require lower capital adequacy and margin requirements and lower brokerage costs. 11. Futures will give a sense of direction to the markets/investors. 12. Contracts are cash settled and hence no paperwork of transferring the stock either physically or through the deposit ory mode. Investors can use futures to hedge their portfolio risk. Say, an investor feels that a particular stock is undervalued. When he buys it, there are two kinds of risks. Either his understanding can be wrong, and the company is really not worth more than its market price, or the entire market moves against him and generates losses even though his underlying idea was correct. The second outcome happens most of the time. So now with Index futures, he will buy the stock and simultaneously short the futu re. Consider another investor who had the opposite view. So he shorted the stocks and bought the futures. If this investor is a portfolio manager, say with the view that the IT and the Pharma sector will do well, he invests in these sectors and shorts the futures. On the other hand, if he feels otherwise, he can short the portfolio of IT and Pharma scrips and buy futures. Background

The Securities and Exchange Board of India (SEBI) appointed a committee under the chairmanship of Dr. L. C. Gupta in November 1996 to "develop appropriate regulatory framework for derivatives trading in India". In March 1998, the L. C. Gupta Committee (LCGC) submitted its report recommending the introduction of derivatives markets in a phased manner beginning with the introduction of index futures. The SEBI M P Birla Institute of Management Page 22 of 68

Board while approving the introduction of index futures trading mandated the setting up of a group to recommend measures for risk containment in the derivative market in India. Accordingly, SEBI constituted a group consisting of the following in June, 1998:

1. Prof. J.R. Varma, Chairman 2. Dr. R.H. Patil, The National Stock Exchang e 3. Mr. Ravi Narain, The National Stock Exchange 4. Mr. Janak Raj, The Reserve Bank of India 5. Mr. Himanshu Kaji, The Stock Exchange, Mumbai 6. Mr. Ajit Surana, The Stock Exchange, Mumbai 7. Mr. Brian Brown, Indosuez W.I. Carr Securities 8. Mr. K.R. Bharat, Credit Suisse First Boston 9. Mr. Sarosh Irani, Jardine Fleming 10. Mr. O.P. Gahrotra, Member Secretary, SEBI Badla v/s Futures Badla is a system in which payment is postponed. A Badla transaction is identical to a spot trans action in shares, financed by lending against the securities of those shares. In other words, Badla is akin to lending and borrowing of shares and funds and is not a variant of futures. SIMILARITIES ¾

Both Badla and Futures help the investor in leveragin g his or her position. Hence, they attract speculative elements into the market. ¾ By allowing for speculation, Badla and Futures improve the liquidity of the cash markets. M P Birla Institute of Management Page 23 of 68 DIFFERENCES ¾ Unlike Badla, Future trading is carried out distinctly from each marke ts. Hence, the spot and Futures price are different from each other and do not get mixed up. ¾ Another distinguishing feature which can be identified from above is that, while initiating a contract, the futures price is clear and known in advance in Futures . In Badla, the price ultimately paid inclusively of Badla charges is indeterminate and known only when the transaction is concluded. ¾ In Futures market, the clearing corporation becomes counter party to each trade. Hence credit risk does not arise. How ever, Badla give rise to credit risk as there exists no clearing corporation to take up or assume one leg of every transaction. In India due to recurring market scandals and large defaults related to Badla, Securities and Exchange Board of India (SEBI) tr ied for years to eliminate it. Finally it

was in July 2001 that SEBI successfully banned Badla with the introduction of rolling settlement cycle and derivatives. RISK CONTAINMENT AND RELATED ISSUES IN INDEX FUTURES MARKET

1. VOLATILITY Volatility is typically calculated by using variance or annualized standard deviation of the price or return. A measure of th e relative volatility of a stock to the market is its beta. A highly volatile market means that prices have huge swings in very short periods of time. M P Birla Institute of Management Page 24 of 68 Several issues arise in the estimation of volatility are: a. Volatility in Indian market is quite high as compared to developed markets. b. The volatility in Indian market is not constant and is varying over time. 2. CALANDER SPREADS In developed markets, calendar spreads are essentially a play on interest rates with negligible stock market exposure. As such margins for calendar spreads are very low. However, in India, the calendar basis risk could be high because of the absence of efficient index arbitrage and the lack of channels for the flow of funds from the organised money market into the index futu

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v5 ae s' 94 TW µ' 9 w) S4 TC 32 Q§ F' 9I P$ £( bC QW XC !4 8§ Y5 `) x' 9 sW b4 c 3) yW @ µe £' ¨5 Y§ 2 Q§ ¨$ PI gf h§ 94 ci pI u5

€I u v5 xI ' 9 sW be 35 ¨ﾁ 3. MARGIN COLLECTION AND ENFORCEMENT Margin is: ‚ 3ƒ„ Q… s† c† ‡… ©ˆ ﾐ‰ ©‘ A’ t… £“ 9‰ ¨” –• ˜— 9™ ©• edf g ©h ai ©j –k ¥l Rm Dg £n bo

Yp ©q !h xi th xi ©o ¨g Un crk Tri ©h ©s!t up Qr¡h #m 3n bq !o k Tr¡o ai 0r¡h `n ‡i ¨v bi Un wn bi ©j 0k Xl Fq Dh xuy Dz 9{ s|u} ©~ v £} w€ #ﾁ £‚ b~

%|ƒ} Qxƒ„ … %†!‡ uˆ ©‰ tŠ £‹ pŒ Uﾍ UŽ 9ﾏ 6Œ ©ﾐ ‘‰ ©’ sﾍ £“ﾏ •” F– Œ £Ž 9ﾏ ˜— c“u˜ 3ﾍ 9ﾏ ¥‰ ©™ A˜ h” –Š –– Yﾍ ©š ﾏ cŒ s‹ #‰ U— ›Š !š œŠ Rﾝ 9‰ £—

b– a‰ UŽ 9ﾏ XŠ !ž Q‰ FŒ ©ﾐ ‘ﾏ Tˆ ©‰ p– Yﾍ £— w— b‰ UŽ ¨ﾏ Ÿ p £¡ c¢ h£ ¨¤ ¦¥ D £§P¨ !£ t© !ª ¤ ˜« ©£ t¬ a£ ! ¨¨ U¡ c®¤ T®£ ©¬ #« 9£ U§¡¯ A®u°

p Ÿ # £¡ b± %®ƒ° # ! a a© U¨ U° 9¤ 7²M P Birla Institute of Management Page 25 of 68 ³ %´sµ T¶ p· F¸ U¹ Q¶ ©¹ £º b· £»U¼ D½ !¾ Y¿u¶ 9¹ ©¾ a¾ €À aÁ £¶ 9 ¥¹ ¨Ã !Â Ä sÂ

˜Å !¹ pÆ q¿Ç gÇ V¹ Uº •¹ U¶ ©À a¹ ¼ 9¹ ¨Â XÈ ﾐ¹ !¹ Q¶ t· É Qº bÁ !Æ %½ ©À  ˜Ê ¾ `Ë cÁ £º ¾ a¹ £º ÍÌ s¿¡À ¹ QÊ¡¾ yÎ ¾ a¹ U»ƒ»u¿P¶ ©¸ AÉ 3º c¿¡À

a¹ · £¶ ©Æ – ˜Å 9¹ tÀ aÁ D¾ S ÏÁ ©Ç 6É Qº bÁ !Æ %½ ©À  T¿¡Á s¶ s´ Buying with borrowed money can be extremely risky because both gains and losses are amplified. That is, while the potential for greater profit exists, this comes at a hefty price -the potential for greater losses. Margin also subjects the investor to a number of unique risks such as interest payments for use of the borrowed money. Ð ©Ñ 9Ò ÔÓ aÕ £Ö !× #Ø %Ù &Ó xÚ

6Û uÜ uÝ DÑ DÞ Fß sÑ 9Ù dà Ü bÞ Qá XÞ !Ò 8Ó Yâ `ã xÑ 9ä sá bÒ cÖ 3ã aá bâ åÛ Pä wÖ –× vÖ !Ò ¥æ QÛ uä 0Ö 3ã aã xÑ DÞ !ä %á dÚ 6Ý 3Ñ DÞ –ß

QÖ sç hÓ Fá ‡Ñ × 0Ö !Û Pä %á VÖ Û uä 0Ö vã aÓ 9Ò Tá VÖ !Û uä 0Ö !× Ñ 3Þ !ä %á ›Ñ ©Ü × vÖ DÒ ¥æ UÛ Pä Rà 3Ó aØ Ó ¨ä sà !Û uä Uæ Ñ 9ä

0ß sÑ £è éá bß sÓ `× vÖ 3Ò cê !Ó !á ëç xÖ DÙ &Þ QÓ tÑ ©Ü ‘á bß sÓ ã aÑ 9ä %á VÒ cÖ Qã xá Vâ Hã Sß QÖ !ä Qæ £Ó !ì Apart from the correct calculation of margin, the actual collection of margin is also of equal importance. Since initial margins can be deposited in the form of bank g uarantee and securities, the risk containment issues in regard to these need to be tackled. 4. CLEARING CORPORATION It is an organization associated with an exchange to handle the confirmation,

settlement and delivery of transactions, fulfilling the main o bligation of ensuring transactions are made in a prompt and efficient manner. Also referred to as "clearing firms" or 'clearing houses." In order to make certain that transactions run smoothly, clearing corporations become the buyer to every seller and th e seller to every buyer, or, in other words, take the off setting position with a client in every transaction. The clearing corporation provides novation and becomes the counter party for each trade. In the circumstances, the credibility of the clearing c orporation assumes importance and issues of governance and transparency need to be addressed. 5. POSITION LIMIT It is a predetermined position level set by regulatory bodies for a specific contract or option. Position limits are created for the purpose o f maintaining stable and fair M P Birla Institute of Management Page 26 of 68 markets. Contracts held by one individual investor with different brokers may be

combined in order to gauge accurately the level of contr ol held by one party. It may be necessary to prescribe position limits for the market as a whole and for the individual clearing member / trading member / client.

6. LEGAL ISSUES Certain legal opinions seem to be suggesting that mere declaration of cas h settled futures as securities under SC(R)A would not put them on a sound legal footing unless the provisions of the Contract Act were either amended or explicitly overridden. Some court judgements in foreign countries were said to be extremely worrying i n this regard. 7. TRADER NET WORTH Trader networth provides an additional level of safety to the market and works as a deterrent to the incidence of defaults. A member with high networth would try harder to avoid defaults as his own networth would be at stake. The definition of networth needs to be made precise having regard to prevailing accounting practices and laws. Even an accurate 99% “value at risk” model would give rise to end of day mark to market losses exceeding the margin approximately once e very six months. MARGINING SYSTEM

The LCGC recommended that margins in the derivatives markets would be based on a 99% Value at Risk (VAR) approach. The group discussed ways of operationalizing M P Birla Institute of Management Page 27

of 68 this recommend ation keeping in mind the issues relating to estimation of volatility. It is decided that SEBI should authorise the use of a particular VAR estimation methodology but should not mandate a specific minimum margin level. The specific recommendations of the group are as follows: 1. INITIAL METHODOLOGY The percentage of the purchase price of securities (that can be purchased on margin) which the investor must pay for with their own cash or marginable securities. Also called the initial margin requirement. According to Regulation T of the Federal Reserve Board, the initial margin is currently 50%. This level is only a minimum and some brokerages require you to deposit more than 50%. For futures contracts, initial margin requirements are set by the exchange . 2. PERIODIC REPORTING The committee recommended that the derivatives exchange and clearing corporation should be required to submit periodic reports (quarterly or half yearly) to SEBI regarding the functioning of the risk estimation methodology highli ghting the specific instances where price moves have been beyond the estimated 99% VAR limits. 3 CONTINOUS REFINING

It also recommended that the derivatives exchange and clearing corporation should be encouraged to refine this methodology continuously o n the basis of further experience. Any proposal for changes in the methodology should be filed with SEBI and released to the public for comments along with detailed comparative back testing results of the proposed methodology and the current methodology. T he proposal shall specify M P Birla Institute of Management Page 28 of 68 the date from which the new methodology will become effective and this effective date shall not be less than three months after the date of filing with SEBI. At any time up to two weeks before the effective date, SEBI may instruct the derivatives exchange and clearing corporation not to implement the change, or the derivatives exchange and clearing corporation may on its own decide not to implement the change. The group recommends that the clearing corporation / clearing house sha ll be required to disclose the details of incidences of failures in collection of margin and / or the settlement dues at least on a quarterly basis. Failure for this purpose means a shortfall for three consecutive trading days of 50% or more of the liquid net worth of the member. RISK CONTAINMENT MEASURES

The parameters for risk containment model shall include the following: 1. Initial Margin or Worst Scenario Loss The Initial Margin requirement shall be based on the worst scenario loss of a portfolio of an individual client to cover 99% VaR over one day horizon across various scenarios of price changes, based on the volatility estimates, and volatility changes. The estimate at the end of day t (SDt) shall be estimated using the previous

vol atility estimate i.e., as at the end of t 1 day (SDt), and the return (rt) observed in the futures market during day t. The formula shall be 6'W

A§ 6'W 1)+(1 -

UW

A§ Where: DSDUDPHWHUZKLFKGHWHUPLQHVKRZUDSLGO\YRODWLOLW\HVWLPD WHVFKDQJHV7KH YDOXHRI LVIL[HGDW SD = Standard deviation of daily returns in the interest rate futures contract. M P Birla Institute of Management Page 29 of 68 In case of long term futures , the price scan range shall be 3.5SD and in no case the initial margin shall be less than 2 % of the notional value of the Futures Contract. For notional T Bill futures, the price scan range shall be 3.5SD and in no case the initial margin shall be less than 0.2% of the notional value of the futures contract. 2. Calendar Spread Charge The Calendar Spread margin is charged in addition to the Worst Scenario Loss of the portfolio. For interest rate futures contract a calendar spread margin shall be at a fla t rate of 0.125% per month of spread on the far month contract subject to minimum margin of 0.25% and a maximum margin of 0.75% on the far side of the spread with legs up to 1 year apart. 3. Exposure Limits

The notional value of gross open positions at any point in time in Futures contracts on a the Notional 10 year bond shall not exceed 100 times the available liquid net worth of a member. For futures contracts on the National T Bill, the notional value of gross open position at any point in the contract s hall not exceed 1000 times the available liquid net worth of a member. 4. Real Time Computation Initially, the zero coupon yield curve shall be computed at the end of the day. However, the Exchange/yield curve provider shall endeavour to compute the zero c oupon yield curve on a real time basis or at least several times during the course of the day. 5. Margin Collection and Enforcement M P Birla Institute of Management Page 30 of 68 The mark to market settlement margin for Interest Rate Futures Contracts shall be collected before the start of the next day’ s trading, in cash. If mark to market margins is not collected before start of the next day’s trading, the clearing corporation/house shall collect correspondingly higher initial margin to cover the potential for losses over the time elapsed in the collec tion of margins. The initial margin shall be calculated measures for index futures.

6. Position Limits In the case of Interest Rate Futures Contracts, position limits shall be specified at the client level and for near month contracts. The client level p osition limits shall be Rs. 100 crore or 15% of open interest whichever is higher. RISK MANAGEMENT

Clearing House h as developed a comprehensive risk containment mechanism for the F & O segment. The salient features of risk containment mechanism on the F& O segment are: ¾ 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. ¾ Clearing Houses charges an upfront initial margin for all the open operations of a Clearing member. It specifies the initial margin requirements for each futur es/options contract on a daily basis. It also follows value at risk based M P Birla Institute of Management Page 31 of 68 margining through SPAN. The Clearing Member in turn collects the initial margin form the Trading Members and their respective clients. ¾

The open position of the members are marked t o market based on contract settlement price for each contract. The difference is settled in cash on a T+1 basis. ¾ Clearing houses on line position monitoring system monitors a CM’s open positions on a real time basis. Limits are set for each CM based on his capital deposits. The online position monitoring system generates alters whenever a CM reaches a position limit set up by NSCCL. NSCCL monitors the CMs while TMs are monitored for contract wise position limit violation. ¾ CMs are provided a trading tem inal for the purpose of monitoring the open positions of all the TMs clearing and settling through him. A CM may set exposure limits for a TM clearing and settling through him. NSCCL assists the CM to monitor the intra day exposure limits set up by a CM a nd whenever a TM exceeds the limits, it stops that particular TM from further trading. ¾ A member is alerted of his position to enable him to adjust his exposure or bring in additional capital. Position violations result in withdrawal of trading facility fo r all TMs if a CM in case of a violation by the CM. ¾ A separate settlement gurantee fund for this segment has been created out of the capital of members. The fund has a balance of Rs. 648 crores at the end of March 2002. The most critical component of ris k containment mechanism for F & O segment is the margining system and online position monitoring. The actual position monitoring and margining system is carried out online through Parallel Risk Management System (PRISM) . Prism uses SPAM ( Standard Portf olio Analysis of Risk) system for the purpose of computation of online margins, based on the parameters defined by RBI.

POSITION LIMITS FOR FIIS The position limits specified for FIIs and their sub account is as under: M P Birla Institute of Management Page 32 of 68 ¾ At the level of the FII In the ca se of index related derivative products, the position limit is 15% of open interest in all futures and options contract on a particular underlying index, or Rs. 100 crore, whichever is higher. In case of underlying security, the position limit is 7.5 % of open interest, in all futures and options contracts on a particular underlying security, or Rs. 50 crore, whichever is higher. ¾ At the level of the sub account: The CM/TM is required to disclose to the NSCCL details of any person or persons acting in conce rt who together own 15% or more of the open

interest of all futures and options contracts on a particular underlying index on the exchange. In case of futures and option contracts on securities the gross open position across all futures and options contra cts on a particular underlying security of a sub account of an FII, should not exceed the higher or 1% of the free float market capitalization (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). These position limits are applicable on the combined position in all futures and options contracts on an underlying security on the exchange. If people trade on foreign derivatives exchanges, won't that hurt the interests of India's exchanges? M P Birla Institute of Management Page 33 of 68 From the viewpoint of India's securities industry, it would be great to trade gold futures -it would yield revenues and it wo uld raise sophistication. If that can be achieved, it would be great, but it looks like it will take a while for the regulatory apparatus to permit gold futures in India. From the view point of the Indian economy -and the economy is much more than the se curities industry -the important point is not the colour of the skin. It does not matter whether an Indian or a foreigner is running the exchange. The important point is to have access to these products. There are many situations where we would be better off by

merely giving permissions to Indian to go abroad and trade in these markets. Why do we take it for granted that we have to wait for India's markets to develop. Witness the two year delay in getting an index futures market started -these delays fo rce India's households and companies to continue to live with risk. India's economy will benefit from having access to derivatives, whether they are come about through India's regulators and exchanges or not. If the Singapore government is friendly to deri vatives markets in a way that India's government is not, India's citizens should go ahead and reduce their risk by using futures markets in Singapore. Hence we should not approach commodity derivatives looking only at the Indian securities industry. The in terest of Indian consumers, households and producers is more important, as these are the people who are exposed to risk and price fluctuations. To the extent that foreign derivatives markets can reduce the risk for Indians, this is good. The RBI has recent ly released the R. V. Gupta committee report on these issues. It is an excellent piece of work, which paves the way for Indians to benefit from using foreign commodity futures markets. I think that this report is going to be a milestone in the history of I ndia's financial sector. M P Birla Institute of Management Page 34 of 68 SEBI REGULATIONS OF 1992 (BROKER AND SUB BROKERS)

In this section we shall have a look at the regulations that apply to brokers under the SEBI Regulations. BROKERS: A broker is an intermediary who arranges to buy and sell securities on behalf of clients. According to section 2 (c) of the SEBI rules, a stock broker means a memb er of a recognized stock exchange. No stock broker is allowed to buy or sell or deal in securities, unless he or she holds a certificate of registration granted by SEBI. A stock broker applies for registration to SEBI through a stock exchange or stock ex changes of which he or she is admitted as a member. SEBI may grant a certificate to a stock broker subject to the condition that: ¾ He holds the membership of any stock exchange. ¾ He shall abide by the rules. Regulations and bye laws of the stock exchange o r stock exchanges of which he is a member. ¾ In case of any change in the status and constitution, he shall obtain prior permission of SEBI to continue to buy, sell or deal in securities in any stock exchange ¾ He shall pay the amount of fee for registration i n the prescribed manner ¾ He shall take adequate steps for redressal of grievances of the investor with in one month of the date of the receipt of the complaint and keep SEBI informed about

the member, nature and other particulars of the complaints. M P Birla Institute of Management Page 35 of 68 REGULAT ION FOR DERIVATIVES TRADING SEBI setup a 24 member committee under the chairmanship of Dr. L.C. Gupta to develop the appropriate regulatory framework for derivatives trading in India. The committee submitted its report in March 1998. On may 11, 1998 SEB I accepted the recommendations of the committee and approved the phased introduction of derivatives trading in India beginning with stock index futures. SEBI also approved the “Suggestive by laws” recommended by the committee for regulation and control of trading and settlement of derivatives contracts. The provisions for SC( R ) A and regulatory framework developed their undergovern 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 the Act. ¾ Any Exchange fulfilling the eligibility criteria as prescribed in the LC Gupta committee report may apply to SEBI for grant of recognition under Section 4 of the SC( R)A, 1956 to star t trading derivatives. The derivatives exchange/segment should have a separate governing council and representation of trading/clearing member shall be limited to maximum of 40% of the total members of the governing council. The exchange shall regulate t he sales practices of its members and will obtain prior approval of SEBI before start of trading in any derivative

contract. ¾ The exchange shall have minimum 50 members. ¾ The members of an existing segment of the exchange will not automatically become the me mbers of derivative segment. The embers of the derivative segment need to fill the eligibility conditions as laid down by the LC Gupta committee. M P Birla Institute of Management Page 36 of 68 ¾ The clearing and settlement of derivatives trades shall be through a SEBI approval clearing corporation/house . Clearing corporation/house complying with the eligibility as laid down by the committee have to apply to SEBI grant of approval. ¾ Derivative brokers/dealers and clearing members are required to seek registration from SEBI. This is in addition to their r egistration as broker of existing stock exchange. The minimum net worth for clearing member of the derivatives clearing corporation/house shall be Rs. 300 lakhs. The net worth of the member shall be computed as follows: 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 ¾ The minimum contract value shall n ot be less than Rs. 2 lakhs. Exchanges should also submit details of the futures contract they propose to introduce. ¾

The initial margin requirement, exposure limits linked to capital adequacy and margin demands related to the risk of loss on the position shall be prescribe by SEBI/Exchange from time to time. ¾ The LC 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 se gment are also M P Birla Institute of Management Page 37 of 68 required to make their clients aware of the risks involved in derivatives trading by issuing to the client Risk Disclosure Document and obtain a copy of the same duly signed by the client. ¾ The trading member are required to have qualified ap proval user and sales person who have passed a certification program approved by SEBI. REGULATION FOR RISK MANAGEMENT The following risk management measures have been prescribed by SEBI: 1. Liquid Networth Requirement: The clearing member’s minimum li quid net worth must be at least Rs. 50 lakh at any point of time. 2. Initial Margin Computation:

A portfolio based margining approach has been adopted which takes an integrated view of the risk involved in the portfolio of each individual client compri sing of his position in all derivative contracts. The initial margin requirement are based on worst scenario loss of a portfolio of an individual client to cover 99% VAR over one day time horizon. Provided, however, in the case of futures, where it may n ot be possible to collect the mark to market settlement value, before the commencement of trading on the next day, the initial margin may be computed over a two day time horizon, applying the appropriate statistical formula. The methodology for computatio n of Value at Risk is as per recommendation of SEBI from time to time. Initial margin requirements for a member are as follows: M P Birla Institute of Management Page 38 of 68 a. For client positions – It shall be netted at the level of individual client and grossed across all clients, at the Trading/C learing Member Level, without any setoffs between clients. b. For proprietary position – It shall be betted at Trading/Clearing Member Level without any setoffs between client and proprietary positions. For the purpose of SPAN margin, various parameters shal l be specified hereunder or such other parameters as may be specified by the relevant authority form time to time:

• Calendar Spread Charge: Calendar Spread Charge covers the calendar (inter month etc.,) basis risk that may exist for portfolios containing f utures and options with different expirations. In the case of Futures and Options contracts on Index and Individual securities, the margin on calendar spread shall be calculated on the basis of delta of the portfolio consisting of futures and options cont racts in each month. A calendar spread position shall be treated as non spread (naked) positions in the far month contract, 3 trading days prior to expirations of the near month contract. • Premium Margin: Premium Margin shall mean and include premium amoun t due to be paid to clearing corporation towards premium settlement, at client level. Premium Margin for a day shall be levied till the completion of pay in towards the premium settlement. • Position Limit: Position limit have been specified by SEBI at tra ding member, client, market and FII level respectively; Trading Member Position Limit: There is a position limit in derivative contracts on an index of 15% of the open interest of all derivative contracts on the same underlying or Rs. 100 crore, whicheve r is higher, in all the futures and options contracts on the same underlying. The trading member positions limits is linked to the market wide position limit is less than or equal to Rs. 250 crore, the trading member limit in such securities shall be 20% of the market wide position limit. For securities, in which M P Birla Institute of Management Page 39 of

68 the market wide position limit is greater than Rs. 250 crore, the trading member position limit in such stocks shall be Rs. 50 crore. The position of all FII/Sub accounts shall be monitored at t he end of the day for limits of 7.5% of the open interest of all derivative contracts on the same underlying or Rs. 50 crore, whichever is higher, in all the futures and option contracts on the same underlying security as per existing applicable position l imits. For futures contracts open interest shall be equivalent to the open positions in that futures contract multiplied by its last available closing price. Market Wide Position Limits: The market wide limit of open position on all futures on a partic ular stocks shall be lower of 30 times the average number of shares traded daily, during the previous calendar month, in the relevant underlying security in the underlying segment of the relevant exchange, or, 10% of the number of shares held by non promot ers in the relevant underlying security i.e., 10% of the free float, in terms of number of shares of a company. RISK MANAGEMENT DEVELOPED BY 16&&/

NSCCL has developed a comprehensive risk containment mechanism for the F&O segment. The sailent features of risk containment mechanism on the F&O segment are: ¾ The financial soundness of the members is the key to risk management. Therefore, the requirement for membership in terms of capital adequacy (net

worth, security deposits) are quite stringent. ¾ NSCCL c harges an upfront initial margin for all the open positions of a CM. It specifies the initial margin requirement for each futures contract on a daily basis. It also follows value at risk (VAR) based margining through SPAN. The CM is turn collects the in itial margin from the TMs and their respective clients. M P Birla Institute of Management Page 4 0 of 68 ¾ The open positions of the members are marked to market based on contact settlement price for each contract. The difference is settled in cash on a T+1 basis. ¾ NSCCL’s online position monitoring system monitors a CM’s open position on a real time basis. Limits are set for each CM based on his capital deposits. The online position monitoring system generates alerts whenever a CM reaches a position limit set up by NSCCL. NSCCL, monitors the CM’s for MT M value violation, while TMs are monitored for contract wise position limit violation. ¾ 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 exposure limits for a TM clearing and settling through him. NSCCL assists the CM to monitor the intra day exposure limits set up by a CM and whenever a TM exceed the limits, it stops that particular TM from further trading. ¾

A member is alerted of his position to enable him t o adjust his exposure or bring in additional capital. Position violations result in withdrawal or trading facility for all TMs of a CM in case of a violation by the CM. ¾ A separate settlement gurantee fund for this segment has been created out of the capit al of members. The fund has a balance of Rs. 13002 million at the end of march 2003/ The most critical component of risk management mechanism for F&O segment is the margining system and online position monitoring. The actual position monitoring and marg ining is carried out online through Parallel Risk Management System (PRISM). PRISM uses SPAN ® (Standard Portfolio Analysis of Risk) system for the purpose of computation of online margins, based on the parameters defined by SEBI. ELIGIBILITY OF STOCKS F OR FUTURES The stocks which are eligible for futures trading should meet the following criteria: M P Birla Institute of Management Page 41 of 68 ¾ The stock should be amongst the top 200 scrips, on the basis of average market capitalization during the last six months and the average free float market capitalization should not be less than Rs. 750 crore. The free float market capitalization means the non promoter holding in the stock. ¾

The stock should be amongst the top 200 scrips on the basis of average daily volume (in value terms), during the last six months. Further, the average daily volume should not be less than Rs. 5 crore in the underlying cash market. ¾ The stock should be traded on atleast 90% of the trading days in the last six months, with the exception of cases in which a stock is unable to trade due to corporate actions like de mergers etc., ¾ The non promoter holding in the company should be at least 30%. ¾ The ratio of the daily volatility of the stock vis à vis the daily volatility of the index (either BSE 30 sensex or S&P CNX Nifty) should not be more than 4, at any time during the previous six months. For this purpose the volatility would be computed as per the exponentially weighted moving average formula. ¾ The stock on which options contracts are permitted to be traded on one derivative exchange/segment would also be permitted to trade on other derivative exchange/segments. VALUE AT RISK MODELS IN THE INDIAN STOCK MARKET 1. The Exponentially Weighted Moving Average Method

The successful use of value at risk models is critically dependent upon estimates of the volatility of underlying p rices. The principal difficulty is that the volatility is not constant over time if it were, it could be estimated with very high accuracy by using a M P Birla Institute of Management Page 42 of 68 sufficiently long sample of data. Thus models of time varying volatility become very important. Practiti oners have often dealt with time varying parameters by confining attention to the recent past and ignoring observations from the distant past. Econometricians have on the other hand developed sophisticated models of time varying volatility like the GARCH ( Generalised Auto Regressive Conditional Heteroscedasticity) model. Straddling the two are the exponentially weighted moving average (EWMA) methods popularised by J. P. Morgan’s Risk Metrics system. EWMA methods can be regarded as a variant of the practiti oner’s idea of using only the recent past because the practitioners’ idea is essentially that of a simple moving average where the recent past gets a weight of one and data before that gets a weight of zero. The variation in EWMA is that the observations a re given different weights with the most recent data getting the highest weight and the weights declining rapidly as one goes back. Effectively, therefore, EWMA is also based on the recent past, in fact, it is even more responsive than the simple moving av erage to sudden changes in volatility. EWMA can also be regarded as a special case of GARCH in which the “persistence parameter” is set to unity. This means that unlike GARCH, EWMA does not have a notion of long run volatility at all and is therefore more robust under regime shifts. EWMA is computationally very simple to implement (even simpler than a simple

moving average). The volatility at the end of day t, WLVHVWLPDWHGXVLQJWKHSUHYLRXV volatility estimate SDt 1 (as at the end of day t 1), and the return rt observed in the index during day t:

6'W

A§ è 6'W 1)^2 + (1 -

UW

A§ ZKHUH ﾏ ﾏ LVDSDUDPHWHUZKLFKGHWHUPLQHVKRZUDSLGO\YRODWLOLW\HVWLP DWHVFKDQJH

M P Birla Institute of Management Page 43 of 68 2. Empirical Tests on the Indian Stock Market 3. Whatever intuitive or theoretical meri ts a value at risk model may have, the ultimate test of its usability is how well it holds up against actual data. For example, tentative results3 indicate that foreign exchange markets in India are best modelled by processes that allow jumps and that EWMA methods do not perform well in that market at all. Empirical tests of the EWMA model in the Indian stock market are therefore of great importance. The EWMA model was therefore tested using historical data on the Indian stock market indices the NSE 50 In dex (Nifty) and the BSE 30 Index (Sensex). 2.1 Sample Period

The data period used is from July 1, 1990 to June 30, 1998. The long sample period reflects the view that risk management studies must attempt (wherever possible) to cover at least two full busi ness cycles (which would typically cover more than two interest rate cycles and two stock market cycles). It has been strongly argued on the other hand that studies must exclude the securities scam of 1992 and must preferably confine itself to the period a fter the introduction of screen based trading (post 1995). The view taken in this study is that the post 1995 period is essentially half a business cycle though it includes complete interest rate and stock market cycles. The post 1995 period is also an a berration in many ways as during this period there was a high positive autocorrelation in the index which violates weak form efficiency of the market. (High positive autocorrelation is suggestive of an administered market; for example, we see it in a manag ed exchange rate market). The autocorrelation in the stock market was actually low till about mid 1992 and peaked in 1995 96 when volatility reached very low levels. In mid 1998, the autocorrelation dropped as volatility rose sharply. In short there is dis tinct cause for worry that markets were artificially smoothed during the 1995 97 periods. Similarly, this study takes the view that the scam is a period of episodic volatility (event risk) which could quite easily recur. If we disregard issues of morality and legality, M P Birla Institute of Management Page 44 of 68 the scam was essentially a problem of monetary policy or credit policy. Since both the bull and bear sides of the market financed themselves through the scam in roughly equal measure, the scam was roughly neutral in terms of direct buy or se ll pressure on the market. What caused a strong impact on stock prices was the vastly enhanced liquidity in

the stock market. The scam was (in its impact on the stock market) essentially equivalent to monetary easing or credit expansion on a large scale. T he exposure of the scam was similarly equivalent to dramatic monetary (or credit) tightening. Any sudden and sharp change in the stance of monetary policy can be expected to have an impact on the stock market very similar to the scam and its exposure. A pr udent risk management system must be prepared to deal with events of this kind. 2.2 Logarithmic Return The usual definition of return as the percentage change in price has a very serious problem in that it is not symmetric. For example, if the index rises from 1000 to 2000, the percentage return would be 100%, but if it falls back from 2000 to 1000, the percentage return is not 100% but only 50%. As a result, the percentage return on the negative side cannot be below 100%, while on the positive side, t here is no limit on the return. The statistical implication of this is that returns are skewed in the positive direction and the use of the normal distribution becomes inappropriate. For statistical purposes, therefore, it is convenient to define the retu rn in logarithmic terms as rt = ln(It/It 1) where It is the index at time t. The logarithmic return can also be rewritten as rt = ln(1+Rt) where Rt is the percentage return showing that it is essentially a logarithmic transformation of the usual return. In the reverse direction, the percentage return can be recovered from the logarithmic return by the formula, Rt = exp(rt) 1. Thus after the entire analysis is done in terms of logarithmic return, the results can be restated in terms of percentage returns. It is worth pointing out that the percentage return and the logarithmic return are very close to each other when the return is small in magnitude. However, when there is a large return (positive or negative) the logarithmic return can be substantially differ

ent from the percentage return. For example, in the earlier illustration of the index rising from 1000 to 2000 and then dropping back to 1000, M P Birla Institute of Management Page 45 of 68 the logarithmic returns would be +69.3% and 69.3% respectively as compared to the percentage returns of +100% an d 50% respectively. 2.3 Maximum Likelihood Estimation 7KH(:0$PHWKRGUHTXLUHVWKHVSHFLILFDWLRQRIWKHYDOXHRI ﾏ 2QHFDQHVWLPDWH itself statistically by the method of maximum likelihood. This process yielded an estimate for ﾏ ﾏ RI§IRUWKH1L fty and 0.929 for the Sensex. These values are not statistically VLJQLILFDQWO\GLIIHUHQWIURPWKHYDOXHRIIRU ﾏ ﾏ XVHGLQ-30RUJDQ¶V5LVN0HWULFV ﾏ V\VWHPIRUGDLO\KRUL]RQV 7KHOLNHOLKRRGUDWLRWHVWJLYHVFKL squares with 1 df of 1.89 for the S ensex and 4.46 for the Nifty which are not significant at the 1% level even though we have a sample size of over 1750). The analysis was therefore carried out using

D ﾏ ﾏ RIWRSHUPLWHDVLHUFRPSDUDELOLW\DQGIDFLOLWDWHIXUWKHUH[WH QVLRQVWRWKHPRGHO . 2.4 Conditional Normality It is well known that stock market returns are not normally distributed even if one uses logarithmic returns to induce symmetry. However, the time varying volatility itself is one major cause for non normality. It is to be expe cted therefore that the “conditional distribution” of the return given the volatility estimate is approximately normal. In other words, the returnon each day divided by the estimated standard deviation for that day should be roughly normally distributed. T he results do indicate significant reduction in non normality. The unconditional distribution has an excess kurtosis6 of 5.42 for Nifty and 4.77 for Sensex while the “conditional distribution” has an excess kurtosis of only 1.75 for Nifty and 1.13 for Sens ex. Thus over two thirds of the excess kurtosis is eliminated by the time varying volatility estimation process. Nevertheless, the kurtosis (which is a measures the fat tails) is still too large for use of the normal distribution values without modificati on. For example, the normal distribution would imply applying a value of 2.58 SD ﾏ IRUDWZRVLGHG³YDOXHDWULVN´OLPLW of 1%. However, the presence of fat tails even in the conditional stock market returns implies that it is necessary to use a higher valu e to get the same degree of protection. A M P Birla Institute of Management Page 46 of 68

common rule of thumb for distributions with a moderate degree of kurtosis is to use a value of 3 SD ﾏ IRUDµWDLODQGWKLVYDOXHLVXVHGLQWKHUHVWRIWKLVVWXG\ 2.5 Margins Since the volatility estimates are f or the logarithmic return, the +or ﾏ  è OLPLWVIRU a 99% VAR would specify the maximum/minimum limits on the logarithmic returns not the percentage returns. To convert these into percentage margins, the logarithmic returns would have to be converted into percentage price changes by reversing the logarithmic transformation. Therefore the percentage margin on short positions would be equal to 100(exp(3SDt) 1) and the percentage margin on long positions would be equal to 100(1 exp( 3SDt)). This implies slight ly larger margins on short positions than on long positions, but the difference is not significant except during periods of high volatility where the difference merely reflects the fact that the downside is limited (prices can at most fall to zero) while t he upside is unlimited. 2.6 Back Testing Results Backtesting this model for the period over a 8 year period showed that the 1% VAR limit was crossed 22 times in the case of Nifty and 23 times in the case of Sensex as against the expected number of 18 viol ations. The hypothesis that the true probability of a violation is 1% cannot be rejected at even the 5% level of statistical significance though we have a sample size of over 1750. The actual number of violations is therefore well within the allowable limi ts of sampling error. In the terminology of the Bank for International Settlements (“Supervisory framework for the use of ‘backtesting’ in

conjunction with the internal models approach tomarker risk capital requirements”, Basle Committee on Banking Supervi sion, January 1996),these numbers are well within the “Green Zone” where the “test results are consistent with an accurate model, and the probability of accepting an inaccurate model is low”. The market movements, margins and margin shortfalls are shown g raphically in Figures 1 and 2. The summary statistics about the actual margins on the sell side are M P Birla Institute of Management Page 47 of 68 tabulated below while year by year details of the sell side and buy side margins are given in Tables 1 and 2. REGULATORY FRAMEWORK FOR DERIVATIVES REGULATORY OBJECTIVE (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 f or 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 contr olled 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 client’s money: Moneys and securities deposited by clients with the tradi

ng members should not only be kept in a separate clients account but should also not by attachable for meeting the broker’s own debts. It should be ensured that trading by dealers on account is totally segregated from that for clients. (iii) Competent and hone st 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 M P Birla Institute of Management Page 48 of 68 to prescribe qualification for derivatives brokers/dealers and th e 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 minimizing the possibility of defaults. This requires farming 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 regulation 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. Of course the ultimate objective of regulation of financial markets has to be promote more efficiency functioning of markets on the “real” side of the economy, i.e., economic ef ficiency. MAJOR ISSUES CONCERNING REGULATORY FRAMEWORK The committee’s attention has been drawn to several important issues connecting with derivatives trading. The committee has considered such issues, some of which have a direct bearing on the design of the regulatory framework. They are listed below: ¾ Should derivatives exchange be organized as independent and separate form an existing stock exchange? ¾ What exactly should be the division of regulatory responsibility, including both framing and enforci ng the regulations, between SEBI and the derivatives exchange? M P Birla Institute of Management Page 49 of 68 ¾ How should ensure that the derivatives exchange will effectively fulfill its regulatory responsibility. ¾ What criteria should SEBI adopt for granting permission for derivatives trading to an exc

hange? ¾ What condition should the clearing mechanism for derivatives trading satisfy in view of high leverage involved? ¾ What new regulations or changes in existing regulations will have to be introduced by SEBI for derivative trading? ARGUMENTS FOR SETTING UP SEPARATE FUTURES EXCHANGE

(a) The trading rules and entry requirements for futures trading would have to be different from those for cash trading. (b) The possibility of collusion among traders for market manipulation seems to be greater if cash and futures trading are conducted in the same exchange. (c) A separate exchange will start with a clean slate and would not have to restrict the entry to the existing members only but the entry will be thrown open to all potential eligible players. Implicit Cost of Carry in Inter Index Arbitrage It is well known that since the BSE and NSE operate different settlement cycles it is possible to do a form of carry forward (or badla) trad ing by continuously shifting

positions from one exchange to the other to avoid delivery. A person who has bought on M P Birla Institute of Management Page 50 of 68 BSE can square his position on that exchange on or before Friday and simultaneously buy on NSE. Since he has squared up on BSE, he does not have to take delivery there. On or before Tuesday, he can square up on NSE and buy on BSE avoiding delivery at NSE. He can keep repeating this cycle as long as he likes. Since this is very similar to carry forward trading (or rolling a futures contract), i t is clear that this person would implicitly pay a carry forward charge (contango or backwardation) in the form of a price difference between the two exchanges. To model this, this study assumes that a trade in the BSE could be regarded as a futures contr act for Friday expiry while a trade on the NSE could be regarded as a futures contract for Tuesday expiry. The cost of carry model of futures prices tells us that the futures price equals the cash price plus the cost of carry till the expiry date. Two futu res contract with different expiry dates will be priced to yield a price difference equal to the cost of carry for the difference between the two expiry dates.

The table below summarises the impact of the differing settlement cycles. (Throughout this stu dy, day means trading day and yesterday means last trading day). Days of week Yesterday Days to expiry Today Days to expiry Change in

differential BSE NSE DIFF. BSE NSE DIFF Days to expiry Monday 0 2 2 4 1 3 5 Tuesday 4 1 3 3 0

3 0 Wednesday 3 0 3 2 4 2 5 Thursday 2 4 2 1 3 2 0 Friday 1 3

2 0 2 2 0

The last column of this table is crucial. It tells us that the relation between BSE and NSE undergoes a change on Monday and Wednesday. M P Birla Institute of Management Page 51 of 68 • From Friday close to Monday close the BSE contract chan ges from an expiry 2 days ahead of NSE to an expiry 3 days after NSE a net positive change of 5 trading days or one week. From being priced two days’ carry below NSE, the BSE contract will now be priced three days’ carry above the NSE price causing a net change of 5 trading days’ or one week’s cost of carry in the difference between the two prices. Therefore Monday's return on BSE should exceed that in NSE by one week’s cost of carry • Similarly from Tuesday close to Wednesday close the BSE contract changes from an expiry 3 days after NSE to an expiry 2 days ahead of NSE

a net negative change of 5 trading days or one week. This is the reverse of the above situation and therefore Wedn esday's return on BSE should be lower than that in NSE by one week’s cost of carry. To estimate the cost of carry, the Nifty index was used. The Nifty Index based on Last Traded Prices (LTP) at the NSE was obtained from the NSE and the returns on this ind ex were computed. The returns on the Nifty Index was computed separately using BSE prices for the period from January 1, 1998 to June 30, 1998. It turns out that on average on Mondays, the return in BSE exceeds that in NSE by 0.61% while on Wednesdays, it is the other way around the return in NSE exceeds that in BSE by 0.71%. This implies that one week’s cost of carry is approximately 0.6 0.7% or that the annual cost of carry is about 30 35% on a simple interest basis or 35 45% on a compound interest bas is. These rates are far above any money market rate and indicates very strong barriers to the flow of money into financing stock market transactions. A closer look at Table 1 suggests a way of measuring the volatility of the cost of carry as well: • Both on Monday close and on Tuesday close the BSE contract is for expiry 3 days after NSE. The difference in the returns between the two exchanges is therefore only due to the

change in the cost of carry during Tuesday. Standard deviation of the differen tial return is M P Birla Institute of Management Page 52 of 68 therefore the standard deviation of daily change in 3 days' cost of carry. • Similarly the standard deviation of the differential return on Thursday and Fridays is equal to the standard deviation of daily change in 2 days' cost of carry of carry. The critical assumption in the above is that the differences in prices between the BSE and NSE is due only to the difference in the two expiry dates and that various other differences in market microstructure in the two exchanges do not have any imp act. In reality perhaps a lot of the fluctuation in the price differences is attributable to these microstructure differences. MARKET OUTCOME In India derivatives are traded only on two exchanges. The details of trades on these exchanged during 2002 03 are presented in the table below. The total exchange traded derivatives witnessed a volume of Rs. 4423333 million during the current year as against Rs. 1038480 million during the preceding year. While NSE accounted for about 99.4% of total turnover, BSE accounted for less than 1%. It is believed that India is the second largest market in the world for stock futures. TRADE DETAILS OF DERIVATIVES MARKET

NSE

BSE TOTAL Month/year No. of Contracts Traded Turnover ( Rs. mn.) No. of Contracts Traded T urnover ( Rs. mn) No. of Contracts Traded Turnover (Rs. mn) OCT 02 1378088 34413 618 140 1378706 334553

NOV 02 1554551 398360 546 132 1555097 398492 DEC 02 1966839 556201 611 160 1967450 556361 JAN 03 2061155 591400 36470 6471 2097625 597871 M P Birla Institute of Management Page 53

of 68 FEB 03 1 863217 493948 39513 6848 1902730 500796 MAR 03 1950004 493317 43648 7182 1993652 500499 TOTAL 02 03 16768909 4398548 138037 24785 16906946

4423333 The product wise distribution of turnover in F&O segment for the year 2002 03 is presented in the chart b elow

Product wise distribution of turnover of F&O segment of NSE 2002-03 Stock options 23% Stock futures 65% Index options 2% Index futures 10% M P Birla Institute of Management Page 54 of 68 CITYWISE DISTRIBUTION OF TURNOVER OF F&O SEGMENT OF NSE 2002 03

Sl No. Location Share in Turnover

(%)

2001 02 03

2002

1 Mumbai 49.08 41.20 2 Delhi/Ghaziabad 24.28 20.31 3 Calcutta/Howrah 12.6 15.6 4 Cochin/Ernakulam/Parur/Kalamserry/Alwaye 2.44 .63 5 Ahamedabad

2.25 2.1 6 Chennai 2.01 2.24 7 Hydrabad/Secundrabad/Kukatpally 1.54 .97 8 Others 5.2 9.38 TOTAL 100 100

TAXABILITY OF INCOME ARISING FROM DERIVATIVE CONTRACTS The Income Tax Act does not have any specific provision regarding taxability of income from derivatives. Only provisions, which have an indirect bearing on derivative transaction, are section 73(1) and 43(5). Section 73(1) provides that any loss, computed in respect of a speculative business carried on by the assessee, shall not be set off expect

against pr ofits and gains, if any, of any speculative business. Section (43) of the Act defines a speculative transaction as a transaction in which contract for purchase or sale of any commodity, including stocks and shares, is periodically or ultimately settled o therwise than by actual delivery or transfer of the commodity or scrips. It excludes the following types of transactions from the ambit of speculative transaction: 1. A contract in respect of stocks and shares entered into by a dealer or investor therein to guard against loss in his holding of stocks and shares through price fluctuations; 2. A contract entered into by a member of a forward market or a stock exchange in the course of any transaction in the nature of jobbing or arbitrage to guard against loss, wh ich arise in ordinary course of business as such member. A transaction is thus considered speculative if M P Birla Institute of Management Page 55 of 68 i. It is in commodities, shares, stock or scrips, ii. It is settled otherwise than by actual delivery iii. It is not for arbitrage, and iv. The participant has no underlying position In the absence of a specific provision, it is apprehended that the derivative contracts, particularly the index futures/options which are essentially cash settled, may be

constructed as speculative transactions. Therefore, the losses, if any will not be eligible for set off against other incomes of the assessee and will be carried forward and set off against speculative income only up to a maximum of eight years. In fact, however, is that derivative contracts a re not for purchase/sale of any commodity, stock, share or scrips. Derivatives are a special class of securities under the Securities Contracts (Regulation) Act, 1956 and do not any way resemble any other type of securities like shares, stock or scrips. Derivative contracts are cash settled, as these can not be settled otherwise. Derivative contracts are entered into by the hedgers, speculators and arbitrageurs. A derivatives contract has any of these two parties and hence some of the derivative contra cts, (not all), have an element of speculation. All types of participants need to be provided level playing field so that the market is competitive and efficient. As regards taxability, the law should not treat income of the hedgers, speculators and arbi trageurs differently. Income of all the participants from derivatives need to be treated uniformly. This is all the more necessary as it is well neigh impossible to ascertain if a participant is trading for speculation, hedging or arbitrage. A transacti on is thus considered speculative, if a participant enters into a hedging transaction in scrips outside his holdings. It is possible that an investor does not have all the 30 or 50 stocks represented by the index. As a result an investor’s losses or prof its out of derivatives transactions, even though they are of hedging nature in real sense, it is apprehended, may be treated as speculative. This is contrary to capital asset pricing model, which states that portfolios in any economy move in sympathy with the index although the portfolios do not necessarily contain any security in the index. The index derivatives are, therefore, used even for hedging the portfolio risk of non index stocks. M P Birla Institute of Management Page 56 of 68 An investor who does not have the index stocks can also se the in dex derivatives to hedge against the market risk as all the portfolios have a correlation with the overall movement of the market (i.e, index).

In view of i. practical difficulties in administration of tax for different purpose of the same transaction, ii. inher ent nature of a derivative contract requiring its settlement otherwise than by actual delivery, iii. need to provide level playing field to all the parties to derivatives contracts, and iv. need to promote derivatives markets, the exchange traded derivatives contra cts need to be exempted from the purview of speculative transactions. Thus must, however, be taxed as normal business income. EFFECT OF INTRODUCTION OF INDEX FUTURES ON STOCK MARKET VOLATILITY: THE INDIAN EVIDENCE The Indian capital market has witness ed a major transformation and structural change during the past one decade or so as a result of on going financial sector reforms initiated by the Government of India since 1991 in the wake of policies of liberalization and globalization. The major objecti ves of these reforms have been to improve market efficiency, enhancing transparency, checking unfair trade practices, and bringing the Indian capital market up to international standards. As a result of the reforms several

changes have also taken place in the operations of the secondary markets such as automated on line trading in exchanges enabling trading terminals of the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) to be available across the country and making geographical location of an exchange irrelevant; reduction in the settlement period, opening of the stock markets to foreign portfolio investors etc. In addition to these developments, India is perhaps one of the real emerging markets in South Asian region that has introduced deriva tive products on two of its principal existing exchanges M P Birla Institute of Management Page 57 of 68 viz., BSE and NSE in June 2000 to provide tools for risk management to investors. There had, however, been a considerable debate on the question of whether derivatives should be introduced in India o r not. The L.C. Gupta Committee on Derivatives, which examined the whole issue in details, had recommended in December 1997 the introduction of stock index futures in the first place (1). The preparation of regulatory framework for the operations of the in dex futures contracts took another two and a halfyear more as it required not only an amendment in the Securities Contracts (Regulation) Act, 1956 but also the specification of the regulations for such contracts. Finally, the Indian capital market saw the launching of index futures on June 9, 2000 on BSE and on June 12, 2000 on the NSE. A year later options on index were also introduced for trading on these exchanges. Later, stock options on individual stocks were launched in July 2001.

The latest product to enter in to the derivative segment on these exchanges is contracts on stock futures in November 2001. Thus, with the launch of stock futures, the basic range of equity derivative products in India seems to be complete. Despite the existence of a well d eveloped stock market for over a hundred years, trading on derivative contracts in India (index futures) started only in June 2000. It is but natural that the market players took time to understand the intricacies involved in the operations of these new in struments. This is clearly reflected in the growth of business in the index futures contracts during the period June 2000 to June 2002. The growth can at the best be said to be modest not only in terms of the number of contracts involved but also in terms of value of such contracts. As far as developed capital markets are concerned, a number of in depth studies have been carried out to examine various issues relating to financial derivatives. In recent years, some attempts have also been made to study vari ous aspects of index futures relating to emerging markets . Since the introduction of index futures in India is a recent phenomenon, there has hardly been any attempt to examine the impact of their introduction on the underlying stock market volatility . M P Birla Institute of Management Page 58 of 68 RECOMMENDATION BASED ON J.R VERMA COMMITTEE REPORT ON RISK CONTAINMENT MEASURE

1. INITIAL MARGIN FIXATION METHODOLOGY: The exponential moving average method would be used to obtain volatility estimate everyday. The estimate at the end of day t, is based using the previous volatility estimate and the returns observed in the futures market during day t. The margins for 99% Val ue at risk would be based on 3 sigma limits. There should be slightly large margin on short positions than on long positions, but the difference is significant only during period of high volatility where the difference merely reflects the fact that the do wnside is limited while the upside is unlimited. The derivative exchange may apply higher margins on both buy and sell side in such situation. For a transactional measure, for first six months of trading (until futures market stabilizes with reasonable le vel of trading) a parallel estimation of volatility would be done using the cash index prices instead of index futures prices and the higher of the two volatility measure would be used to get margins for the first 6 months initial margin should not be less than 5%. 2. DAILY CHANGES IN MARGIN:] The volatility estimated at the end of the day’s trading would be used in calculating margin calls at the end of the same day. This implies that during the course of trading, market participants would not know the exa ct margin that would apply to their positions. Trading software should provide volatility estimation and margin fixation on a realtime basis on trading work station screen. M P Birla Institute of Management Page 59 of 68

3. MARGINING FOR CALENDER SPREADS: International Markets levy very low margins on c alendar spreads. A calendar spread is a position at one maturity which hedged by an offsetting position at different maturity like a short position in six month contract coupled with a long position in the nine month contract. The justification for low m argins is that a calendar spread is not exposed to the market risk in underlying at all in India. However, unless banks and institutions enter the calendar spread in a bigway, it would be possible that the cost of carry would be driven by an unorganized m oney market rate as in the case of badla market. These interest rate could be highly volatile. 4. MARGIN COLLECTION AND ENFORCEMENT: A part from correct calculation, the actual collection of margin is also of equal importance. The group recommended that t he clearing corporation should lay down operational guidelines on collection of margins and standard guidelines for back office accounting at the clearing member and trading member level to facilitate the detection of non compliance at each level. OTHER R ECOMMENDATION From the purely regulatory angle, a separate exchange for futures trading seems to be a neater arrangement. However, considering the constraints in infrastructure facilities, the existing stock exchanges having cash trading may also be permit ted to trade derivatives provided they meet the minimum eligibility conditions as indicated below: 1. The trading should take place through an online screen based trading system which also has a disaster recovery site. The per half hour capacity of the

comp uters and the network should be atleast 4 to 5 times of the anticipated peak load in any half hour or of the actual peak load seen in any half hour M P Birla Institute of Management Page 60 of 68 during the preceding six months. This shall be reviewed from time to time on the basis of experience. 2. The c learing of the derivatives market should be done by an independent clearing corporation, which satisfies the conditions listed. 3. The exchange must have an online surveillance capacity which moniters positions, prices and volumes in realtime so as to deter m arket manipulation. Price and position limits should be used for improving market quality. 4. Information about trades, quantities and quotes should be disseminated by the exchange in real time over at least two information vending networks which are access ible to investors in the country. 5. The exchange should have atleast 50 members to start derivatives trading. 6. If derivatives trading is to take place at an existing cash market, it should be done in a separate segment with a separate membership i.e., all mem bers of the existing cash market would not automatically become members of the derivatives market. 7.

The derivatives market should have a separate governing council which shall not have representation of trading/clearing members of the derivatives Exchange b eyond whatever percentage SEBI may prescribe after reviewing the working of the present governance system of exchanges. 8. The Chairman of the Governing Council of the Derivative Division/Exchange shall be a member of the Governing Council, if the chairman is a Broker/dealer, then, he shall not carry on any broking or dealing business on any Exchange during his tenure as Chairman. 9. The exchange should have arbitration and investor grievances redressal mechanism operative from all the four areas/regions of the c ountry. 10. The exchange should have an adequate inspection capability. 11. No trading/clearing member should be allowed simultaneously to be on the governing council of both the derivatives market and the cash market. 12. If already existing, the exchange should have a satisfactory record of monitoring its members, handling investor complaints and preventing irregularities in trading. M P Birla Institute of Management Page 61 of 68 TECHNICAL ANALYSIS OF TITAN INDUSTRIES LTD

This study is for making the real Futures contracts taking Titan Industries as underlying. These contracts are mainly based on the information provided by technical analysis. Fundamental analysis is not included as these contracts for only one month and only technical analysis can be provided buying and selling points and the movement of this stock in one month. Where as fundamental analysis cannot predict the market The above Graph which indicates the price movement of Titan shows that it is in bullish trend. This bullish is also supported by the huge volume of shares traded. Volume gene rally moves along with prices, and is indicative of the intensity of a price reaction. Both the price and volume are on the rise. M P Birla Institute of Management Page 62 of 68 Thus above are the indicative signs for an investor to go bullish on Titan Industries Ltd., But whether to trade in Futures a nd Options of this underlying is yet to be seen on further evaluation through technical analysis. Simple Moving Average of Titan Industries Ltd All simple moving averages 13 days, 34days and 89days does not predict any reversal in the bullish trend. All the Moving Averages are below the price line and are moving in the same direction as the price line there fore showing no signs of trend reversal in near future and conforming bullishness of the stock in near future also. As far as these simple moving ave rages move in the same direction and are below the price line you can safely bet on the contracts. All this based on simple logic that as long as price at the end of a period is above the average that prevailed in the immediate past, prices are on an up tr end. The converse is true for conforming end or a bear market. M P Birla Institute of Management Page 63

of 68 Exponential Moving averages of Titan Industries Ltd Simple moving averages constructed over long time lags behind the trend so to minimize that more weightage is given to the present data a nd an Exponential moving average is constructed. This moving average is more sensitive to any price changes in the underling. Thus EMA provides a smooth base for analyzing price trends. The above graph studies the 34 days, 89days and 200days exponential moving averages. All averages do not show any trend reversal of bullish phase in prices of underlying in near future. All are moving along the price line and are below it, indicating no price fall in near future.

M P Birla Institute of Management Page 64 of 68 Moving Average Convergence and Diverge nce (MACD)

The darker line in the MACD and lighter one is the signal line in the above chart below the price chart. Taking ratio of 9day EMA to 20 day EMA draws the chart and signal line is 9day EMA. The chart gives the buying and selling signals. Sin ce the indicator crosses the reference line from below, we interpret that point as signal for buying the underlying. Signal line acts as the trigger, which alerts the trader to take an appropriate buy or sale decision. In the chart above signal line is a lso giving buy signal as it is above the indicator. M P Birla Institute of Management

Page 65 of 68 CHART6 M P Birla Institute of Management Page 66 of 68 Relative Strength Index is another Oscillator which measures the momentum of the stock. It moves between 0 and 100. This indicator measures the relative internal strength of the stock. 7 day and 13 day’s Relative Strength Index is taken into consideration. The indicator is well within the two boundaries. But in both the above RSI charts the indicators are moving above the reference line in a direction indicating an uptrend. Only when the in dicator crosses the overbought position or the oversold position line, it is a warning signal to the trader. Thus it shows that it is safe to enter into the F & O contracts at this point of time Rate of Change Index (ROC)

M P Birla Institute of Management Page 67 of 68 This is one of the simples t and widely used methods to measure momentum of the price change over a certain period of time. A rising index indicates a growth in momentum ( a bullish factor ) and falling

index a loss in momentum ( a bearish factor). The line drawn 112 here is a refe rence line. In the above price chart ROC is well above the reference line and still raising indicating further rise in momentum in near future and the rate at which the price is increasing is growing. Based on above technical analysis a person can enter i nto either futures contracts or into options. M P Birla Institute of Management Page 68 of 68

BIBLIOGRAPHY

NSE -Derivatives core module BSE -The study material MAGAZINES • Business world • Dalal Street magazine •

Futures and Options WEB SITES • Investopedia.com • Derivativesindia.com • Nseindia.com • Bseindia.com