Risk Management Of Derivatives In Bse (new).docx

CHAPTER - I INTRODUCTION

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1.1 INTRODUCTION

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

1.2 RATIONALE In this world of uncertainty risk management has an immense importance for corporate. Financial derivatives which are introduced with a prime objective of hedging risk, when used for speculative purposes resulted with increased risk. Thus, risk management of financial derivatives is a major area of concern. In case of an exchange, as exchange plays the role of counterparty for both buyer and seller, it is more exposed to counterparty risk and all other risk associated with the financial derivatives. This leads to the essence of risk management of derivatives in exchanges. The various tools used by the exchanges for risk management includes margins, position limits, and various rules and regulations laid down by the regulatory authority for derivative trading. 2

All these process of risk management is done by wholly computerized process and with specific software. The inclusion of latest technology has made the risk management process more reliable. The risk management of derivatives not only secures Stock Exchanges, but also creates confidence in the minds of the investors. This enhances more investments in the derivatives market, which leads to business prosperity. Thus the most of the exchanges have their risk management procedure for risk management of derivatives.

1.3 OBJECTIVE On the above outset, the following are the laid down as the objective of this study, I. II.

To study the risk associated with derivative market and derivative trading. To study the risk management tools used in Bombay Stock Exchange Limited for mitigating these risks.

III.

To study the margining system for derivatives.

V.

To do comparative analysis of the risk management process of BSE with that of NSE

VI.

To give suggestion and recommendations for improvement in risk management process of derivatives in BSE.

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

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CHAPTER – II REVIEW OF LITERATURE

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2.1 REVIEW OF LITERATURE

Scharfstein and Stein (1993) constructed the models of financial risk management. These models predicted that firms attempted to reduce the risks arising from large costs of potential bankruptcy, or had funding needs for future investment projects in the face of strongly asymmetric information. In many instances, such risk reduction can be achieved by the use of derivative instruments.

Campbell and Kracaw (1987), Bessembinder (1991), Nance, Smith and Smithson (1993), Dolde (1995), Mian (1996), as well as Getzy, Minton and Schrand (1997) and Haushalter (2000) found empirical evidence that firms with highly leveraged capital structures are more inclined to hedging by using derivatives. The probability of a firm to encounter financial distress is directly related to the size of the firm’s fixed claims relative to the value of its assets. Hence, hedging will be more valuable the more indebted the firm, because financial distress can lead to bankruptcy and restructuring or liquidation - situations in which the firm faces direct costs of financial distress.

Nance, Smith and Smithson (1993), Dolde (1995), Mian (1996), Getzy, Minton and Schrand (1997) and Hushalter (2000) argue that larger firms are more likely to hedge and use derivatives. One of the key factors in the corporate risk management rationale pertains to the costs of engaging in risk-management activities. The hedging costs include the direct transaction costs and the agency costs of ensuring that managers transact appropriately. The assumption underlying this rationale is that there are substantial economies of scale or economically significant costs related to derivatives use.

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Lin, Pantzalis and Park (2007) provided an additional insight into firms’ risk management practices risk management activities. In particular, their evidence establishes the use of derivatives as an important corporate policy with real implications in terms of valuation. It is well documented that larger and more sophisticated firms are more likely to use derivatives. They provide the additional evidence that information asymmetry has a more negative impact on firm value for firms that do not use derivatives. Their findings are consistent with the notion that large numbers of diversified firms rationally choose to use derivatives to lower information asymmetry and to thereby reduce the negative valuation effects of diversification. Their evidence compliments the earlier findings of both the risk management literature and the diversification discount literature.

Anand and Kaushik (2007) analyse the derivatives usage in India, focusing on foreign exchange risk management. The questionnaire was mailed to 640 companies, which were common across two most widely used Indian stock market indices having foreign exchange exposure. In their study 55 responses were received leading to a response rate of 8.59%. Answers show that 70.4% of the respondents firms explained that they used foreign exchange risk management plan or policy or programme because risk managers had acquired the awareness that these activities not only mitigate the risks but also allow the reduction of the volatility in profits and in the cost of the capital, therefore increasing the value of the firms. Also, the firms with high debt ratio were more likely to use foreign currency derivatives. The authors, finally, classified the finalities to which the risks managers tended in their activity: the major objective of using derivatives is hedging the risk for arbitrage purpose and price discovery; the speculation as objective of using foreign currency derivative is the least preferred option.

Lien and Zhang (2008) revealed financial derivatives markets have helped to support capital inflows into emerging market economies. On the other hand, using financial derivatives has had negative effects, leading to exacerbated volatility and accelerated capital outflow. There is a consensus that the derivatives are seldom the cause of the crisis, but they could amplify the negative effects of the crisis and accelerate contagion. The underlying reasons for the negative effects are associated with the leverage nature of derivatives transactions, non-transparent reporting of transaction risks, and unsophisticated or insufficient risk management controls in financial institutions, as well as weak prudential supervision.

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Nguyen and Faff (2010) investigated the relationship between the use of financial derivatives and firm risk using a sample of Australian firms. Their results suggest that this relationship is nonlinear in nature. They found that the use of financial derivatives is associated with a risk reduction for moderate derivative users. Derivative usage among extensive derivative users, on the other hand, appears to lead to an increase in firm risk. They also found that compared to firms that do not make use of derivatives, there is no evidence that extensive derivative users are exposed to a risk level in excess of that of nonderivative users. Their results are, therefore, indicative of a hedging motive behind the use of financial derivatives.

Bartram, Brown and Conrad (2011) used a large sample of nonfinancial firms from 47 countries and examined the effect of derivative use on firm risk and value. They control for endogeneity by matching users and nonusers on the basis of their propensity to use derivatives. They also use a new technique to estimate the effect of omitted variable bias on inferences. They find strong evidence that the use of financial derivatives reduces both total risk and systematic risk. The effect of derivative use on firm value is positive but more sensitive to endogeneity and omitted variable concerns. However, using derivatives is associated with significantly higher value, abnormal returns, and larger profits during the economic downturn in 2001–2002, suggesting that firms are hedging downside risk.

Flavio Angelini and Stefano Herzel (2010) explicitly compute closed formulas for the minimal variance hedging strategy in discrete time of a European option and for the variance of the corresponding hedging error under the hypothesis that the underlying asset is a martingale following a geometric Brownian motion. The formulas are easy to implement, hence the optimal hedge ratio can be employed as a valid substitute of the standard Black–Scholes delta, and the knowledge of the variance of the total error can be a useful tool for measuring and managing the hedging risk.

Jitka Hilliard and Wei Li (2013) developed a new volatility measure: the volatility implied by price changes in option contracts and their underlying, referred to this as price-change implied volatility. In this study, the authors compared moneyness and maturity effects of price-change and implied volatilities, and their performance in delta hedging. They found that delta hedges based on a price-change implied volatility surface outperform hedges based on the traditional implied volatility surface when applied to S&P 500 future options.

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CHAPTER – III COMPANY PROFILE

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3.1 COMPANY PROFILE Bombay Stock Exchange Limited is the oldest stock exchange of Asia and one of the oldest in World with a rich heritage. As the first stock exchange in India, the Bombay Stock Exchange Limited is considered to have played a very important role in the development of county’s capital market. The BSE is the largest stock exchange of 24 exchanges in India, with over 6000 listed companies. It is also the fifth largest exchange in the world with a market capitalization of $466 billion.

The Bombay Stock Exchange Limited uses BSE SENSEX, an index of 30 large, developed BSE stocks. This index gives a measure of overall performance of BSE and is tracked worldwide.

In addition to individual stocks the Bombay Stock Exchange Limited also a market for derivatives, which was first introduced in India. Listed derivatives on the exchange include stock futures and options, Index futures and options and weekly options. The Bombay Stock exchange is also actively involved with the development of retail debt market.

The Exchange has a nationwide reach with its presence in 417 cities and towns of India. The systems and processes of the exchange are designed to safeguard market integrity and enhance transparency in the operations. The Exchange provides an efficient and transparent market for trading in equity, debt and derivative instruments. The BSE provides online trading with the BSE’s Online Trading System (BOLT), which is a proprietary system of the exchange and is BS 7799-2-2002 certified. The Surveillance and Clearing Settlement function of the Exchange are ISO 9001:2000 certified. VISION “Emerge as the premier Indian stock exchange by establishing global benchmark”

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

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3.3 PROMINENT POSITION The journey of BSE is as eventful and interesting as the history of securities markets of India. India’s biggest bourse, in terms of listed companies and market capitalization, BSE has played a pioneering role in Indian securities market. Much before the actual legislations were enacted, BSE had formulated comprehensive set of rules and regulations for Indian capital markets. It also laid down best practices adopted by Indian capital market after India gained its independence. Perhaps, there would not be any leading corporate in India, which has not sourced BSE’s services in resource mobilization. 3.4 A PIONEER BSE as brand is synonymous with the capital markets in India. The BSE SENSEX is the benchmark equity index that reflects the robustness of the economy and finance. At par with international standards, BSE has been a pioneer in several areas. It has a several firsts to its credit,  First in India to introduce Equity Derivatives  First in India to launch a Free Float Index  First in India to launch US$ version of BSE SENSEX.  First in India to launch Exchange Enable Internet Trading Platform  First in India to obtain ISO certification for Surveillance, Clearing and Settle.  First to have exclusive facility for financial training.  ‘BSE On-Line Trading System’ (BOLT) has awarded with the global recognized Information Security Management System Standard BS7799-2-2002.  Moved from Open Outcry to Electronic Trading within just 50 days.

An equal important accomplishment of BSE is the launch of a nationwide investor awareness campaign – Safe Investing in the Stock Market – under which nationwide awareness campaigns and dissemination of information through print and electronic medium was undertaken. BSE also actively promoted the securities market awareness campaign of the Securities and Exchange Board of India (SEBI).

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3.5 AWARDS

Bombay Stock Exchange Limited has many awards to its name for its excellence in several fields, these are  The World Council of Corporate Governance has awarded the Golden Peacock Global CSR Award for BSE’s initiatives in Corporate Social Responsibility (CSR).  The Annual Reports and Accounts of BSE for the year ended March 31, 2006 and March 31, 2007 have been awarded the ICAI Awards for excellence in financial reporting.  The Human Resource Management at BSE has won the Asia – Pacific HRM Award for its efforts in employer branding through talent management at work, health management at work and excellence in HR through technology.

3.6 BSE SWOT ANALYSIS

STRENGHS:  BSE has inherent advantages: its history, larger scrip base and a stronger brand.  The SENSEX (BSE’s 30-share sensitive index) is one of the most recognized indexes and tracked worldwide.  Apart from lager base of listed companies, BSE also has a historical perspective.  Its online trending system (BOLT) has awarded with the global recognized Information Security Management System Standard BS7799-2-2002.  It got the ISO certification for its surveillance and clearing and settlement.

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WEAKNESS:  The BSE SENSEX, which delivers inferior hedging effectiveness and higher impact cost.  At present BSE has fewer than 12% share across the cash and derivative market of equity markets.  At present, BSE is almost non-existence in derivatives space.  BSE also lacks in terms of providing better services to its customers and is not proactive. OPPORTUNITIES:  Corporatization will improve internal management systems and investor relations, and benefit companies that are listed on BSE.  Derivatives market is growing at exponential rate and BSE with its large infrastructure and long presence in the capital market has the capability to expand its market share in this segment.  If large a private sector bank picks up a strategic stake in BSE, it could give the exchange access to a large distribution network and promote new products like derivatives. The strategic investor could also be a market maker (providing buy and sell quotes at any given time).  30 to 40 percent of the income of exchange like NASDAQ and NYSE is from vending data. For BSE, it’s measly 4 percent. The potential for growth then, is immense. THREATS:  Aggressive competitor like NSE poses major threat to BSE’s future.  NSE’s top 100 stocks alone account for nearly 80 percent of its cash segment’s turnover, indicating that NSE is clearly the preferred destination for trading in the top stocks. 14

CHAPTER – IV INTRODUCTION TO DERIVATIVES

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4.1 DERIVATIVES

Risk is a characteristic feature of all commodity and capital markets. Over time, variations in the prices of agricultural and non-agricultural commodities occur as a result of interaction of demand and supply forces. The last two decades have witnessed a many-fold increase in the volume of international trade and business due to the ever growing wave of globalization and liberalization sweeping across the world. As a result, financial markets have experienced rapid variations in interest and exchange rates, stock market prices thus exposing the corporate world to a state of growing financial risk.

Increased financial risk causes losses to an otherwise profitable organization. This underlines the importance of risk management to hedge against uncertainty. Derivatives provide an effective solution to the problem of risk caused by uncertainty and volatility in underlying asset. Derivatives are risk management tools that help an organization to effectively transfer risk. Derivatives are instruments which have no independent value. Their value depends upon the underlying asset. The underlying asset may be financial or non-financial. The term “derivative” can be defined as a financial contract whose value is derived from the value of an underlying asset. Section 2(ac) of Securities Contract (Regulation) Act, (SCRA), 1956 defines derivatives as, a) “a security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or a contract for difference or any other form of securities; b) “a contract which derives its value from the prices, or index of prices, of underlying securities”.

The underlying asset may be a stock, bond, a foreign currency, commodity or even another derivative security. Derivative securities can be used by individuals, corporations, and financial institutions to hedge an exposure to risk.

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4.2 DERIVATIVE PRODUCTS

Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. Various derivatives contracts are described below, 4.2.1 FORWARDS A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price. A forward contract is an agreement between two parties to buy or sell an asset at a specific point of time in future and the price which is paid /received by the parties is decided at the time of entering the contract.

4.2.2 FUTURE A future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Future contracts are standardized forward contracts. Future contracts are traded in exchanges and exchange sets the standardized terms in term of quantity, quality, price quotation, date and delivery date (in case of commodities). 4.2.3 OPTIONS An option contract, as the name suggests, is in some sense an optional contract. An option is the right, but not the obligation, to buy or sell something at a stated date at a stated price. Options are of two types;  CALL OPTION: A call option gives the buyer of the option the right, but not the obligation to buy a given quantity of the underlying asset, at a given price and on or before a given date.   PUT OPTION: Put options give the buyer the right, but the obligation to sell a given quantity of underlying asset at a given price on before a given date.

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Options can also be European options and American options. This classification is based on the exercise of the options. European options can be exercised at the maturity date of the option. On the other hand, American options can be exercised at any time up to and including the maturity date. 4.2.4 WARRANTS Options generally have lives of up-to one year. Long dated options are called as warrants and generally traded over-the-counter. 4.2.5 LEAPS Long-Term-Equity-Anticipated Securities are options having a maturity of more than three years or in other words options having a maturity of more than three years are termed as LEAPS.

4.2.6 BASKETS Basket options are options on portfolio of underlying assets. Equity index options are a form of basket options 4.2.7 SWAPS A swap means a barter or exchange. Thus, a swap is an agreement between two parties to exchange stream of cash flows over a period of time in future. The two commonly used swaps are,  INTEREST RATE SWAPS: Swaps which entail swapping only the interest related cash flows between the parties in the same currency.  CURRENCY SWAPS: These entail swapping both principal and interest between two parities, with cash flows in one direction being in different currency than those in the opposite direction.

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4.3 PARTICIPANTS IN DERIVATIVE MARKET

The reason for which derivatives are so attractive is that they have attracted different types of investors and have a great deal of liquidity. When an investor wants to take one side of a contract, there is usually no problem in finding someone that is prepared to take the other side. Three broad kinds of participants can be found in derivatives market, namely, hedgers, speculators and arbitrageurs.

 Hedgers: They use derivatives markets to reduce or eliminate the risk associated with price of an asset. Majority of the participants in derivatives market belongs to this category.

 Speculators: They transact futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture.

 Arbitrageurs: Their behaviour is guided by the desire to take advantage of a discrepancy between prices of more or less the same assets or competing assets in different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

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4.4 CLASSIFICATION OF DERIVATIVES

Broadly derivatives can be classified into two categories, commodity derivatives and financial derivatives. In case of commodity derivatives, the underlying asset can be commodities like wheat, gold, silver etc.; whereas in case of financial derivatives the underlying assets are stocks, currencies, bonds and other interest bearing securities etc. A figure below shows the classification of derivatives,

Figure – 4.1 Classification of Derivatives

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Basing on the type of market, derivative market is of two types, exchange-traded derivatives market and over-the-counter derivative market. In the exchange-traded derivatives, the derivatives which are standardized in nature are traded. The trading of the derivatives is well regulated by the exchanges. The over-the-counter market is an important derivative market and has larger volume of trade than the exchange-traded market. It is a telephone- and computer- linked network of dealers. Traders are done over the phone and are usually between two financial institutions or between a financial institution and one of its clients. Telephone conversations in the OTC market are usually taped. If there is a dispute about what was agreed, the tapes are replayed to resolve the issue. A key advantage of over-the-counter market is that all the products are customized. Market participants are free to negotiate any mutually alternative deal. A disadvantage is that there is usually credit risk in an over-the-counter trade. The overthe-counter market is not regulated by any regulatory body and hence possess a huge counterparty risk.

4.5 ECONOMIC SIGNIFICANCE OF DERIVATIVES

Some of the significance of financial derivatives can be enumerated as follows; 1. The most important function of derivatives is risk management. Financial derivatives provide a powerful tool for limiting risks that individuals and organizations face in ordinary conduct of their business.

2. The prices of derivatives converge with the prices of underlying at the expiration of derivative contract. Thus, derivatives help in discovering the future as well as current prices.

3. As derivatives are closely linked with the underlying cash market, with the introduction of derivatives, the underlying cash markets witness higher trading volumes. This is because; more people participate in stock market due to the risk transferring nature of derivatives. 21

4. Speculative trade shift to a more controlled environment of derivative market. In the absence of an organized derivatives market, speculators trade in the cash markets. Margining, monitoring and surveillance of various participants become extremely difficult in these kinds of mixed markets. 5. Derivatives trading acts as a catalyst for new entrepreneurial activities.

In a nut shell, derivatives markets encourage investment in long run. Transfer of risk enables market participants to expand their volume of activity. 4.6 HISTORY OF DERIVATIVES

The history of derivatives is quite colourful and surprisingly a lot longer than most people think. The origin of derivatives can be traced in Bible. In Genesis Chapter 29, believed to be about the years 1700 B.C., Jacob purchased an option costing him seven years labour that granted him the right to marry Laban’s daughter Rachel. Around 580 B.C., Thales the Milesian purchased option on Olive presses and made a fortunate off of a bumper crop in Olives. So, derivatives were before the time of Christ.

The first exchange for trading derivatives appeared to be Royal Exchange in London, which permitted forward contracting on tulip bulbs at around 1637. The first “futures” contracts are generally traced to the Yodaya rice market in Osaka, Japan around 1650. These were evidently standardized contracts, which made them much like today’s futures, although it is not known whether the contracts are marked to market daily, and/or had credit guarantee.

Probably the next major event, and the most significant as far as the history of derivatives markets, was the creation of Chicago Board of Trade in 1848. Due to its prime location, Chicago was developing as a major centre for the storage, sale, and distribution of Midwestern grain. Due to seasonality of grain, however Chicago’s storage facilities were unable to accommodate the enormous increase in supply that

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occurred following the harvest. Similarly, its facilities were underutilized in spring. Chicago’s spot prices rose and fall drastically. To resolve this problem a group of grain traders created “to-arrive” contracts which permitted the farmers to lock in the price and deliver the grains in future. These to-arrive contracts are called as forward contracts. The forward contracts proved as a useful device for hedging the price risk. However, “credit risk” remained as serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT), in 1848. The primary intention of CBOT was to provide a centralize location for buyers and sellers to negotiate forward contracts. In 1865, CBOT went one step further and listed the first “exchange traded” derivatives in US, which are termed as “Futures Contracts”. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, got approval for futures trading. Its name was changed to Chicago Mercantile Exchange (CME). In 1925, the first clearing house for derivatives trading was established. Since then, derivatives are traded in many exchanges, although their trading was banned by Government of different countries from time to time. But, the modern derivative market has originated in 1970’s. This is due to the unprecedented volatility in the international financial environment, starting with the breakdown of Brettonwoods systems on 15 August 1971 and ending with the well-known Saturday night massacre of Federal Reserve on 6th October 1979. The breakdown of Bretton woods system resulted in inflation, volatility in the market place and currency turmoil. This state of affairs heralded the emergence of financial derivatives. The next major fillip for development of derivatives was provided in October 1979, when the US Federal Reserve started its policy of interest rate deregulation and anti-inflationary monetary policy. This resulted in increased interest rates. This marked the emergence of interest rate derivatives to hedge interest rate risk. The history of financial derivatives is concurrent with the history of various risks in the financial world. The fascination with risk and its components started during the early 1970’s has grown substantially since then, resulting in the expansion of financial derivatives market.

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4.7 INTERNATIONAL DERIVATIVE MARKET

The financial derivatives which were meant to address the needs of farmers and merchants have now a major share in the financial market place. Started with the establishment of Chicago Board of Trade (CBOT), derivatives are now traded in almost all major stock exchanges of the world. Boosted with the breakdown of Brettonwoods system, the derivatives got the recognition of risk management instruments and are used by all investors starting from individual investor to institutional investor. Thus, the global derivative market is now a wide spread market with a potential of further growth. In last two decades derivatives has shown a tremendous growth and also continuing to grow in future. Major stock exchanges of derivatives trading are Chicago Mercantile Exchange (CME), Eurex, Hongkong Futures Exchange, The London International Financial Futures and Options Exchange (LIFFE), Singapore Exchange, Sydney Futures Exchange etc. Apart from these stock exchanges other stock exchanges of various countries has shown a huge growth in derivatives trading. 4.8 INDIAN DERIVATIVE MARKET

Derivatives markets in India have been in existence in one form or the other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading way back in 1875. In 1952, the Government of India banned cash settlement and options trading. Derivatives trading shifted to informal forwards markets. In recent years, government policy has shifted in favour of an increased role of market-based pricing and less suspicious derivatives trading. The first step towards introduction of financial derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995. It provided for withdrawal of prohibition on options in securities. The last decade, beginning the year 2000, saw lifting of ban on futures trading in many commodities. Around the same period, national electronic commodity exchanges were also set up.

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Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001 on the recommendation of L. C Gupta committee. Securities and Exchange Board of India (SEBI) permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. Initially, SEBI approved trading in index futures contracts based on various stock market indices such as, S&P CNX, Nifty and SENSEX. Subsequently, index-based trading was permitted in options as well as individual securities.

The trading in BSE SENSEX options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX. In June 2003, NSE introduced Interest Rate Futures which were subsequently banned due to pricing issue. Since the scope of this project is limited to equity derivatives only, so the further discussion will be confined to equity derivatives only. Equity derivatives market in India has registered an "explosive growth" and is expected to continue the same in the years to come. Introduced in 2000, financial derivatives market in India has shown a remarkable growth both in terms of volumes and numbers of traded contracts. NSE alone accounts for 99 percent of the derivatives trading in Indian markets. The introduction of derivatives has been well received by stock market players. Trading in derivatives gained popularity soon after its introduction. In due course, the turnover of the NSE derivatives market exceeded the turnover of the NSE cash market. For example, in 2008, the value of the NSE derivatives markets was Rs. 130, 90,477.75 Cr. whereas the value of the NSE cash markets was only Rs. 3,551,038 Crore. If I compare the trading figures of NSE and BSE, performance of BSE is not encouraging both in terms of volumes and numbers of contracts traded in all product categories. 25

Figure 3.2 Business Growth of Derivatives in India from 2000- 2011(May)

Indian Derivatives Market 20000000 18000000 16000000 14000000 12000000 10000000 8000000 6000000 4000000 2000000 0 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11

Indian Derivatives Market

NSE’S DERIVATIVE SEGMENT

The National Stock Exchange accounts almost 99% of the Indian derivatives market in terms of turnover, volume etc. Its equity derivatives market is most boosted one and in turnover it is a major stock exchange. All products in equity derivative segment i.e. Index Futures and Options and Stock Futures and Options have marked a tremendous growth over the last decade. The graph below shows the average yearly turnover in each equity derivative products and average daily turnover of derivative segment of NSE.

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Figure – 3.3 Equity Derivative Market of India

Figure – 3.4 Average Daily Turnover of India’s Derivatives Market

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CHAPTER – V RISK AND RISK MANAGEMENT

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5.1 RISK

Over the past two decades and so, the markets have seen debacle after another, each of which has brought its lessons – from some of which the markets have learned and from many of which markets still need to learn. The Great Depression of 1930’s has brought remainder to all financial markets or the economies as a whole. The 1987 crash taught markets the dangers of automated trading models and the second and thirdorder effects of credit crisis. In 1990, Wall Street learned the horrors of holding huge illiquid investments. In 1994’s spectacular bond market collapse, financial executives saw for the first time how correlated global markets had become as the fallout from Federal Reserve Board rate hikes swept from the US through Europe, before devastating Mexico and other emerging markets.

The Russian meltdown in August 1998 was widespread and mounting. Banks and brokerage firms took turns announcing trading losses from emerging markets, high yield, equities, or dealings with hedge funds. Most recently, the Global Financial Meltdown, which was started with the US sub-prime mortgage crisis, has captured almost all economies of the world. Many banks become bankrupt, people loss their job, increased budgetary deficits are the result of this crisis. Thus, it can be said that, the financial market is full of risk and uncertainties.

Finance has never been so competitive, so far-flung, and so quantitative. Information flow has never been so fast. But with the passage of time, financial markets are becoming more sophisticated in pricing, isolating, repackaging, and transferring risks. Tools such as derivatives and securitization contribute to this process, but they pose their own risks. The failure of accounting and regulation to keep abreast of developments includes yet more risks, with occasionally spectacular consequences.

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Practical applications – including risk limits, trader performance-based compensation, portfolio optimization, and capital calculations – all depend on the measurement of risk. In the absence of a definition of risk, it is unclear what, exactly, such measurements reflect.

Charles Tschampion, the MD of the $50 bn GM Pension fund, once said – “Investment management is not an art, not science, it is engineering. We are in the business of managing and engineering financial investment risk”; the challenge “is to first not take more risk than we need to generate the returns that is offered”. It is a profound statement that well captures the philosophical and mathematical connotation of ‘Risk’.

The terms risk and uncertainty are often used interchangeably though there is a clear distinction between them. Certainty is a state of being completely confident, having no doubts of whatever being expected. Uncertainty is just opposite of that. Risk is situation where there are a number of specific, probable outcomes, but it is not certain as to which one of them will actually happen. In that context risk is not an abstract concept. It is a variable, which can be calibrated, measured and compared. So to define risk, risk entails two essential components; exposure and uncertainty. Thus, risk is the exposure to uncertainty.

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5.2 RISK MANAGEMENT PROCESS

Market integration, liberalization, globalization and technical advancement has resulted with an increased competition in the market and the corporate are hence exposed to risk. Thus a proper and unbiased assessment of risk is a prerequisite for a sound management process. Moreover, with the advancement of communication system and technology, the markets over the world are getting interconnected. Thus making an effective risk management system is the need of the hour.

Risk management is the process in which risk is minimized with the application of certain tools. The risk management process essentially comprises of certain steps, such as, identification, assessment, prioritization, followed by coordinated and economical application of resources to minimize, monitor and control it. These steps are described below:

5.2.1 IDENTIFICATION The risk management process starts with the identification of the factors which are exposed to risk. It is always of primary concerns to identify the factors which are more vulnerable and weak points in the system.

5.2.2 ASSESSMENT After identifying the risk exposure points, it then to be assessed, i.e. to what extent it is susceptible to that particular risk that has to be measured. Assessment of risk helps in knowing the extent of vulnerability of a particular factor which is risk exposed.

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5.2.3 PRIORITIZATION The next step of risk management process is the prioritization of factors which are more vulnerable. The assessment of risk results in identifying the factors which are more risk exposed and then these factors are prioritized from risk management point of view.

5.2.4 APPLICATION OF RESOURCES TO MINIMIZE RISK After identifying the most vulnerable factor, the management team applies economic resources to minimizing the risk. This is the most important stage of risk management as any wrong step can result a more susceptible situation.

5.2.5 MONITOR The final step of risk management is monitoring the risk management process. Simply applying the resources to minimize the risk is not the last step of risk management, as it is needed to analyze the success of the risk management process. For this reason, the entire process is monitored and if anything goes wrong, it is rectified.

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5.3 RISK ASSOCIATED WITH DERIVATIVES TRADING

The continuing discussion of risks and its management in derivative markets illustrates that there is little agreement on what the risks are and how to control it. One source of confusion is the sheer profusion of names describing the risks arising from derivatives. Besides the “price risk” of losses on derivatives from change in underlying asset values, there is “default risk”, “settlement risk”, and “operational risk”. Last, but certainly not the least, is the spectre of “systemic risk” that has captured so much congressional and regulatory attention. All these risks associated with derivatives market are described below:

5.3.1 PRICE RISK

Price arises for the simple reason that the price of the underlying and price of the derivatives are correlated. If the prices of the underlying increases, the impact is seen in corresponding prices of derivatives products i.e. their prices also increase. For an investor who is short in a futures contract or long in a put option or short in a call option, there are potential losses. Thus, he or she may default in the obligation of the derivative contract. This is price risk associated with the derivatives. Default due to Price risk is mitigated by imposing some risk management tools in exchange-traded derivatives, but in case of over-the-counter market, since it is largely unregulated, default is more due to price risk.

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5.3.2 DEFAULT RISK

This may the most popular and hazardous risk associated with the derivatives. As derivatives are contracts or agreements, they need the obligations to be performed. If any party default from the contract, then the contract is meaningless. The risk that arises from the default of any party in derivatives is called as default risk. This is common risk that is found in over-the-counter derivative market, but in exchange-traded market, this type of risk is minimized by regulating the transactions. Default risk is the risk that losses will be incurred due to default by the counterparty. As noted above, part of the confusion in the current debate about derivatives stems from the profusion of names associated with the default risk. Terms such as “credit risk” and “counterparty risk” are essentially synonyms for default risk. “Legal risk” refers to the enforceability of the contract. Terms such as “Settlement risk” and “Herstatt risk” refer to defaults that occur at a specific point in the life of the contract: date of settlement. These terms do not represent independent risks; they just describe different occasions or causes of default.

Default risk has two components: the expected exposure and the probability that default will occur. The expected exposure measures how much capital is likely to be at risk should the counterparty defaults. The probability of default is the measure of the possibility that the counterparty will default.

5.3.3 SYSTEMATIC RISK One of the prominent concerns of regulators is “systematic risk” arising from derivatives. Although this risk is rarely defined and almost never quantified, the systemic risk associated with the derivative contracts is often envisioned as a potential domino effect in which default in one derivative contract spreads to other contracts and markets, ultimately threatening the entire financial system. 34

For the purpose of this paper, systemic risk can be defined as widespread default in any set of financial contracts associated with default in derivatives. If derivative contracts are to cause widespread default in other markets, there first must be large defaults in derivative markets. In other words, significant derivative defaults are a necessary condition for systematic problems. It is argued that widespread corporate risk management with derivatives increases the correlation of default among financial contracts. What this argument fails to recognize, is that the adverse effects of stocks on individual firms should be smaller precisely because the same shocks are spread more widely. Moe important, to the extent firms use derivatives to hedge their existing exposures, much of impact of stocks is being transferred from corporations and investors less able to bear them to counterparties better able to absorb them. It is conceivable that financial markets could be hit by a large disturbance. The effect of such disturbances depends, in particular, on the duration of the disturbances and whether firms suffer common or independent shocks. If the disturbance were large but temporary many outstanding derivatives would be essentially unaffected because they specify only relative infrequent payment. Therefore, a tempore disturbance would primarily affect contracts with required settlements during this period. If the shock were permanent, it would affect the derivatives in a much hazardous way.

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5.4 RISK MANAGEMENT OF DERIVATIVES

Derivatives, which come to light as a hedging instrument against volatility of market and market related risk, created risk when there is a default. This gave rise to the essence of risk management of derivatives and derivatives trading. In case of OTC derivatives, as it is not regulated, it is riskier and there is no risk management at all. But in case of exchange traded derivatives, several risk management tools are applied to ensure the integrity of the market. The tools used for risk management of derivatives are described below:

5.4.1 MARGINS Margins are upfront payment by the participants of the derivatives market to the exchanges. This upfront payment is collected to ensure that none will default in future in obliging his obligation. If someone defaults, then the clearinghouse settles the contract from this margin account. Exchange’s clearinghouse collects the margin from the clearing member, the clearing member collects the margin from the trading member or the brokers and it is the responsibility of the trading members to collect the same from its clients.

5.4.2 MARK-TO-MARKET MARGIN In case of futures contracts, the margin is mark-to-market on daily basis i.e. the gain or loss of a day is settled to the margin account on a daily basis. If the long position gains, then the amount he gained will be transferred to his account in the end of the day. Similarly, if the investor losses, the amount that he lost is withdrawn from his account.

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5.4.3 EXPOSURE LIMITS

If an investor holds quite a large position than his capacity, then the probability that he will default is more. For this reason, the regulatory body of the derivative market put an exposure limit for the participants beyond which one cannot take position in the market. This will ensure the integrity in term that nobody will default.

5.4.4 POSISTION LIMITS Position limit is more applicable for the high net worth individuals, the FIIs and the mutual funds. This is because, these people have huge investible cash and they can direct the market as their wish. This will harm the market and other participants of the market. Thus a position limit is introduced for this type of risk by the regulators for the sound running of the market.

5.4.5 FINAL SETTLEMENT Final settlement is the last part of risk management in case of derivatives. The settlement is done by the clearing house of the exchange. On exercise the settlement is done on the closing price of the derivative product and final settlement takes place on T+1 basis. If the long position exercises his right, then the settlement is done by randomly assigning the obligation on a short position at the end of the day. Frankly speaking risk management of derivatives comprises of two things i.e. margining requirement and the regulatory requirement. Thus risk management of derivatives is nothing but, complying the rules and regulation laid down by the regulator and satisfying the margin requirement.

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CHAPTER – VI RESEARCH METHODOLOGY

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6.4 RESEARCH METHODOLOGY 6.4.1 SCOPE The scope of this project is confined to the study of risk management of derivatives in BSE, about the margining system. The software used for this purpose, details about the process and tools of risk management and various problems faced by them.

6.4.2 SOURCES OF DATA The data has been collected from both primary and secondary sources. The primary data are collected by interviewing brokers and some officials of BSE. Some data are collected from personnel of the various departments in BSE, like Product and Strategy Department, Bank of India Shareholding Limited. (Clearinghouse of BSE). The secondary data consists of books and journals provided by BSE, SEBI circulars and Guidelines. This also contains the data of derivative segment of NSE, which was collected from the website of NSE.

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

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CHAPTER – VII DATA ANALYSIS AND INTERPRETATION AND FINDINGS

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INTERPRETATION & ANALYSIS In the course of study of the risk management process used in BSE for derivative segment, the following things are observed. The risk management of derivatives in BSE has two parts; one is the margining system and the regulatory requirement. The details of these are explained below, For margining the BSE is following portfolio based margining system and the margin calculation is done by software known as PC SPAN. The portfolio based margining model adopted by the exchange takes an integrated view of the risk involved in the portfolio of each and every individual client comprising of his positions in all derivatives contract traded on derivative segment. The SPAN (Standard Portfolio Analysis of Risk System) is a portfolio based margining system developed by Chicago Mercantile Exchange and it is being used by almost all stock exchanges now. For setting the margin the exchange has a margin committee, which decides about various factors to be considered while calculating the margin requirements. 7.1 THE SPAN MARGINING SYSTEM The SPAN margins are estimates of changes in futures and futures-options contract prices that would occur under various next-day realizations of futures prices and implied volatility. The inputs into SPAN are; the futures price scan range, the implied volatility scan range, the minimum short option charge, the calendar spread charge, the inter-commodity spread charge. These are described below; 7.1.1 THE FUTURE’S PRICE SCAN RANGE: The price scan range input sets the maximum underlying price movement that the margin committee chooses to consider in setting margin collateral requirements. The future’s price scan range is the clearinghouse margin requirement on a naked future position and controlling input into the option pricing model simulation that ultimately determines the margin requirements. The future scan range is set by the margin committee after examining historical price movements and applying subjective judgments. 41

7.1.2 THE IMPLIED VOLATILITY SCAN RANGE: The implied volatility scan range is the largest movement in implied volatility that margin committee chooses. The margin committee sets input scan ranges after analyzing histograms of absolute value of day-to-day changes in the implied volatility of traded futures-option contracts. The underlying average implied volatility estimate that is analyzed is a simple average of eight contracts implied volatility on a given maturity: the first is in-the-money and first three out-of-the-money implied volatility estimates for both calls and puts. 7.1.3 THE MINIMUM SHORT OPTION CHARGE: The minimum short option charge or minimum margin on an option contract is set at 2.5% of the clearing member’s futures price scan range. 7.1.4THE CALENDAR SPREAD CHARGE: The calendar spread charge is put into the SPAN is a parameter that sets the amount of margin collateral, the clearinghouse collects against calendar spread basis risk in portfolios. The calendar spread basis is the difference between prices of contracts with different maturities. The basis between nearest quarterly and next quarterly futures contract is calculated. Histograms of the absolute value changes in basis series are constructed for different windows periods, and the histograms are considered by the margin committee while calculating margin. 7.1.5 THE INTER-COMMODITY SPREAD CHARGE: The inter-commodity spread charge is an input that sets the collateral requirement that must be posted to protect against correlation risk in inter-commodity spread positions. In SPAN, futures and futures options changes are estimate under alternative scenario that are determined by the values chosen for the price and implied volatility scan range inputs. In the simulation analysis, the value of each option contract is estimated for following day using Black Option Pricing Model.

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The next-day contract prices are determined under alternative scenarios in which underlying futures contract’s price and implied volatility move by predetermined function of their scan range. The futures price and implied volatility scan inputs are translated into 16 different scenarios that represent alternative combinations of futures price and implied volatility changes. For each scenario simulated, the contract’s value is reported as an element called “SPAN risk array”. This average implied volatility is then “shocked” by the implied volatility scan range in the SPAN simulations. The next day simulated contract prices are compared with the prior day’s theoretical settlement price and contract gains and losses are calculated as the difference in these prices. In extreme price move scenarios, the CME’s margin committee has decided to margin 35% of the simulated price move gain or loss is the value reported in these extreme price move SPAN array entries. The SPAN risk array is given below, 1. Underlying unchanged; volatility up 2. Underlying down; volatility down 3. Underlying up by 1/3 of price scan range; volatility up 4. Underlying down by 1/3 of price scan range; volatility down 5. Underlying down by 1/3 of price scan range; volatility up 6. Underlying up by 1/3 of price scan range; volatility down 7. Underlying up by 2/3 of price scan range; volatility up 8. Underlying down by 2/3 of price scan range; volatility down 9. Underlying down by 2/3 of price scan range; volatility up 10. Underlying up by 2/3 of price scan range; volatility down 11. Underlying up by 1 of the price scan range; volatility up 12. Underlying down by 1 of the price scan range; volatility down 13. Underlying down by 1 of price scan range; volatility up 14. Underlying up by 1 of price scan range; volatility down 15. Underlying up extreme move, double the price scanning range 16. Underlying down extreme move, double the price scanning range

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The clearinghouse of the exchange electronically distributes a SPAN risk array for every derivative product that it clears and settles. Clearing member firms receive these arrays and use them to calculate their margin requirements for their customers account. The maximum loss across the 16 scenarios becomes the “Preliminary” SPAN margin for that account. The final margin requirements may differ from this preliminary margin owing to additional margin requirements that resulted from margin requirement on calendar spreads and minimum margin requirement for written options contracts. Inter-commodity spread charges also enter into the final margin calculation. Each written option contract is subjected to minimum margin requirement. For a portfolio, this margin requirement is the product of the number of written options times the minimum short option charge. 7.3 MARGINS The BSE collects margin collateral in advance to minimize its risk exposure. The margin required for different equity derivatives are explained below;  The initial margin requirements on all derivative products are based on worstcase loss of portfolio at client level to cover 99% Vary over one-day horizon. The initial margin requirement is net at client level and shall be on gross at the trading and clearing member level.  For this purpose, the price scan range of index products and stock products is taken as 3σ and 3.5σ respectively. The price scan range of options and futures on individual securities is also linked to liquidity. This is measured in terms of impact cost for an order size of Rs. 5 lakh calculated on the basis of order book snapshots in the previous six months. If the impact cost exceeds by 1%, the price scan range is increased by square root of three.  For stock futures and short stock options contracts a minimum initial margin equal to 7.5% of the notional value of the contract based on the last available price of futures and option contract respectively is collected. For index futures a minimum margin equal to 5% of the notional value of the contract is collected. For index options a minimum of 3% is charged as the minimum margin.

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 The margin on calendar spread is calculated on the basis of delta of the portfolio consisting of futures and options contracts in each month. The spread charge is specified as 0.5% per month for the difference between the two legs of the spread subjected to minimum of 1% and maximum of 3%.

7.4 MARK-TO-MARKET OF MARGIN  For all stock futures and index futures contract, the client’s position is markedto-market on a daily basis at portfolio level. The mark-to-market margin is paid in/out in T+1 day in cash. For determining the mark-to-market margin, the closing price is taken into consideration.

7.5 EXPOSURE LIMITS The exposure limit for different equity derivatives products are given below;  In case of stock futures contracts, the notional value of gross open positions at any point in time should not exceed 20 times the available liquid net-worth of a member, i.e. 10% of the notional value of gross open position in single stock futures or 1.5σ of the notional value of gross open position in single stock futures, whichever is higher. However, BSE charges exposure margin for better risk management.  For stock options contracts, the notional value of gross short open position at any time would not exceed 20 times of the available liquid net-worth of the member, i.e. 5% of the notional value of gross short open position in single stock options or 1.5σ of notional value of gross short open position in single stock options whichever is higher.  In case of index products, the notional value of gross open positions at any time would not exceed 33 1/3 times of the available liquid net worth of the member. for index products, 3% of the notional value of gross open position would be collected from the liquid net worth of a member on a real time basis.

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7.6 POSITION LIMITS  A market wide limit on the open position on stock options and futures contracts of a particular underlying stock is 20% of the number of shares held by nonpromoters i.e. 20% of the free float, in terms of number of shares of a company.  In case of stock futures and options, the stock having applicable market wide position limit (MWPL) of Rs. 500 crores or more, the combined futures and options position limits shall be 20% of market wide position limit or Rs. 300 crores, whichever is lower and within which shock futures position cannot exceed 10% of applicable market wide position limit or Rs. 150 crores, whichever is lower. This is the position limit for trading members, FII and mutual funds.  For stocks having applicable market wide position limit less than Rs. 500 crores, the combined futures and options position limit would be 20% of applicable market wide position limit or Rs. 50 crores whichever is lower. This is applicable for trading members, FII and mutual funds.  For futures and options contracts, the trading members, FII and mutual funds position limits shall be higher of; Rs. 500 crores or 15% of total open interest in the market in equity index futures contracts or equity index options contract respectively.  The gross open position of clients, sub-accounts, NRI level and for each scheme of mutual funds across all derivatives contracts on a particular underlying shall not exceed higher of; 1% of the free float market capitalization or 5% of the open interest in underlying stock.  Any person who holds 15% or more of the open interest in all derivatives contracts on the index shall be required to disclose the fact to the exchange and failure of which will attract a penalty. 46

7.7 FINAL SETTLEMENT

 On expiry of a stock futures or index futures contract, the contract is settled in cash at the final settlement price. The final settlement price is the closing price of the underlying stock or the index respectively. The profit or loss is paid in or out in T+1 day.

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

7.8 MAJOR FINDINGS On course of study of the risk management process of derivatives in BSE, the following observations are pointed out. Since the study is focused on equity derivatives only, the findings are concerned only about equity derivatives. 7.8.1 SPAN MARGINING SYSTEM The SPAN (Standard Portfolio Analysis of Risk) is a portfolio based margining approach for calculation of margin requirement of derivatives. This is an integrated system of margining that reduces margining requirement on derivatives than any other system of margining. The SPAN margining system in BSE is an efficient system of margin calculation. The procedure in which the SPAN is calculated in BSE can be compared to any major exchange of the world and covers almost 99% of risk exposure of the exchange. 47

7.8.2 PC SPAN®  The software used by BSE for margin calculation is PC SPAN®. This software is developed by the Chicago Mercantile Exchange.  This software provides adequate information to its user.  It is user friendly. It provides the margin on a real time basis. As soon as the data is input to the system, it takes 5 to 7 minutes to calculate the margin requirement.  This is efficient software for calculation of SPAN margin and used by almost all stock exchanges of the world.

7.8.3 RISK MANAGEMENT  The risk management process for derivatives used by BSE is efficient and effective system.  It covers about 99% Vary at any time.  This also helps in protecting the market and helps in increasing the market integration.  On comparing the risk management process of BSE with that of NSE, it is found that it is almost same. But NSE has an added advantage for the information related services that it provides.  BSE provides its data on a graphical format, whereas NSE provides the same on a tabular format, which is easy to understand.  The NSE uses PRISM (Parallel Risk Management System), which monitors the derivatives segment of NSE on a real time basis. But BSE do not have, this system.

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CHAPTER – VIII CONCLUSION

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8.1 CONCLUSION

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

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Coming to risk management of derivatives in BSE, BSE has an efficient and effective risk management system, which can be compared with any of the exchange of the world. The SPAN margining system followed by BSE for margin calculation is one of the most efficient systems of margining. Along with this the regulatory requirement of BSE makes the risk management system stronger and effective.

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

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CHAPTER – IX RECOMMENDATIONS

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9.1 RECOMMENDATIONS Based on the interaction with different broking firms, it is observed that BSE is comparable to NSE in technical terms. However, BSE lacks in providing better services and information to the investors, which leads to poor market position in derivatives.  During our interaction with the brokers we come to know that, the services provided by NSE are more reliable than that of BSE. So BSE should try to provide integrated services to its members to improve its derivatives segment.

 Regarding the risk management procedure, as there is no difference between NSE and BSE, it can be said that, BSE should continue with this process.  BSE should improve its monitoring system for better risk management of the exchange.  Another major cause for BSE’s lost market share is the failure in providing data. BSE can focus on this part in particular. It should also provide data in tabular format rather than graphical format, so that it can be easily understood by the investors.

 To improve its derivatives segment, BSE has to constantly innovate in terms of services, products and technology, otherwise it cannot compete with NSE.  BSE charges more margins for better risk management, which in terms harms its market position. Thus, a reasonable margin should be charged on the members for development of derivatives market and better risk management.

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CHAPTER – X BIBLIOGRAPHY

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10.1 BIBLIOGRAPHY

BOOKS AND JOURNALS

Hull, Basu., (2010), “Options, Futures and other Derivatives”. Pearson publications. New Delhi.

Jarrow, Turnbull., (2000), “Derivative Securities”. South-Western College Publication, USA.

Bhaskar, Mahapatra., (2003), “Derivatives Simplified: An Introduction to Risk Management”. Response Books, New Delhi.

Gosain, Varun., (1994), “Derivatives on Emerging Markets”. Derivatives & Synthetics, Pg. 477- 488.

Kothari, C.R., (1990), “Research Methodology: Methods and Techniques”, Wishwa Prakashan.

Holton, Glyn., (2004), “Defining Risk”. Financial Analyst Journal, Vol. 60, No. 6, CFA Institute.

Bernanke, Ben S., (1990), “Clearing and Settlement During the Crash”. Review of Financial Studies, Vol.3, No. 1, Pg. 167-179.

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WEBSITES www.moneycontrol.com www.nseindia.com www.bseindia.com www.investorworld.com www.yahoo.com/finance http://www.bis.org/publ/cpss06.pdf http://www.premiumdata.net/ http://www.emeraldinsight.com/journals.htm?articleid=1527485&show=pdf http://www.cboe.com/learncenter/glossary.aspx http://www.cme.com/SPAN/ http://www.sgx.com/ http://www.asx.com/ http://www.sebi.gov/ http://www.myiris.com http://www.bseindia.com/riskmanagement/about.asp http://www.en.wikipedia.org/wiki/Risk_Management

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