Risk Mgt Changes.docx

Risk Management Designing effective risk management policies leads to enhancement of investor protection and market development. The SEBI has laid down risk management policies to mitigate market, operational and systemic risks. On the instructions of the SEBI, the stock exchanges have developed a comprehensive risk management system to promote a safe and efficient market. The main concepts of a Risk Management System are listed below: • There should be a clear balance available in the client’s ledger account in the broker’s books. • The clients are required to provide margins upfront before putting in trade requests with the brokers. • The aggregate exposure of the client’s obligations should commensurate with the capital And net worth of the broker. • Ideally, the client must square-up all the extra positions that have been created on an intraday basis before 3.00 p.m. • The clients must settle the debits, if any, arising out of MTM settlements. • In futures and options segment, the positions are allowed based on the margin available to satisfy initial margin requirements of the Exchange.

Trading Rules And Regulations The trading rules relate to the margin system, intra-day trading limit and exposure limit. Brokers are levied various types of margins such as daily margins, mark-to-market margins, adhoc margins and volatility margins to check price volatility. Stock exchanges impose different types of margins on brokers for individual stocks, depending on the exposures taken by these brokers in these stocks, both on a proprietary basis and on behalf of clients, vis-à-vis the overall market exposure in the scrips . Several of these margins are paid upfront by brokers. If the markets become volatile, the exchanges impose different types of margins such as value-at-risk (VaR) to minimise the risk of default by either counter-party. The system of collecting margins is devised in such a manner that higher exposures attract higher margins. Besides the normal margin, scrips with

unusually high trading volumes attract special margins or a special ad hoc margin to keep defaults at bay. The SEBI has shifted the margining system from net basis to gross basis (sale and purchase) with effect from September 3, 2001, and introduced a 99% VaR-based margin for all scrips in the compulsory rolling system with effect from July 2, 2001. VaR measures the worst-expected potential loss from an unlikely adverse event in a normal, everyday market environment. Prior to VaR, trade positions were reported at book value only and no considerations were made for market changes. This margin is kept in a manner that covers price movements for more than 99% of the time. Usually, three sigma (standard deviation) is used for the measurement. The intra-day trading limits, that is, limit to volume is specifi ed and no broker’s trading volume can exceed this limit. The upper limit for the gross exposure of a broker is fi xed at 20 times his capital to ensure market safety. Besides these, there are capital adequacy norms for members, indemnity insurance and online-position monitoring by exchanges. To ensure fair trading practices, the SEBI has formulated Insider Trading Regulations prohibiting insider trading by making it a criminal offence. To enhance transparency of the takeover process and to protect the interests of the minority shareholders, there are now separate regulations relating to acquisitions and takeovers.

Margin Requirements The Exchange levies daily margin, Mark-to-Market (MTM) margin, Extreme loss margin in the equities segment and initial margin and MTM margin in case of futures and options segment. Initial Margin is calculated on a portfolio basis and not on individual scrip basis. Initial margin requirements are based on 99% value at risk over a one-day time horizon Exposure Margin is based on a single percentage on the value of the scrip determined at the beginning of every month for the following month by the exchange. This is charged over and above the initial margin and is popularly referred as second line of defense.

Extreme Loss Margin The Extreme Loss Margin for any security is higher of 5%, or 1.5 times the standard deviation of daily logarithmic returns of the security price in the last six months The Extreme Loss Margin is collected/ adjusted against the total liquid assets of the member on a real time basis. The Extreme Loss Margin is collected on the gross open position of the stock broker. The gross open position for this purpose means the gross of all net positions across all the clients of a member including its proprietary position.

Circuit Breakdown Factors like market speculations force stock prices or indices to enter in a circuit. Such a condition is beyond the control of regulatory authorities. Hence they use the circuit breaker to curb such market situations. Circuit breaker, simply put, is a set of rules formed and issued by SEBI in order to bring back normalcy in the stock markets in the event an index or stock enters a circuit. SEBI has different circuit breakers for indices and for stocks. Circuit breakers are applied only on equity and equity derivative markets. Whenever the major stock indices like BSE Sensex and Nifty cross the threshold level, SEBI rules require that the trading at the stock exchange be stopped for a certain period of time beginning from half an hour to even an entire day. The time frame for which trading is stopped depends upon the time and amount of movement in the indices. The idea is to allow the market to cool down and resume trading at normal levels. The thresholds are implemented stage wise.

Movement

in Time

Close period

Indices 10 per cent

15 per cent

Before 1.00 pm

1 hour

1.00 pm to 2.30 pm

½ hour

After 2.30 pm

Does not close

Before 1.00 pm

2 hour

1.00 pm to 2.30 pm

1 hour

After 2.30 pm

Close for the rest of the day

20 per cent

Any time

Close for the rest of the day

Circuit Breaker for a stock A price band specifies the span or price range for a stock to move without any interference from regulatory authorities. Only when the stock prices move beyond the range, it is considered as entering into a circuit and circuit breakers are applied. Daily price bands of 2 per cent, 5 per cent and 10 per cent are applicable to different equity stocks. Price bands of 20 per cent are applicable to all remaining scrip like preference shares or debentures. For example, for a stock with a price band of 5 per cent that closes at Rs100 on the previous day, the price band will be between Rs 105 and Rs 95. Stock prices can either move up or down and hence circuit breakers are required for movements in both directions. An upward movement over the threshold will cause a stock to enter an upper circuit. Similarly a downward movement in stock price beyond the threshold will cause a stock to enter a lower circuit. The objective of circuit breakers is to control the stock markets at times when they move beyond reasonable limits. When a stock enters an upper circuit, it puts an investor who has already invested in the stock at an advantage. On the contrary a stock movement into a lower circuit places the investor at a disadvantage because it is now difficult to sell off these shares as they have lost a lot of money.