Derivative Market in India

Table of Content

The derivatives markets are the financial markets for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets. The market can be divided into two, that for exchange traded derivatives and that for over-the-counter derivatives. The legal nature of these products is very different as well as the way they are traded, though many market participants are active in both What Are derivatives:-

In most cases derivatives are contracts to buy or sell the underlying asset at a future time, with the price, quantity and other specifications defined today. The contract may bind both parties, or just one party with the other party reserving the option to exercise or not. The underlying asset either has to be traded or some kind of cash settlement has to transpire. Derivatives are traded either in organized exchanges or over the counter. Examples of derivatives include forwards, futures, options, caps, floors, swaps, collars, and many others.

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What are the advantages of trading in derivatives? Derivative contracts are effective tool for hedging and thereby reducing the potential of future risk. They also allow investors to take a leveraged position in the market and hereby increase the possibilities of earning higher returns. What are the disadvantages of trading in derivatives? Because of their ability to provide leveraging, derivative disasters are pretty common in international markets.

Just as there is huge potential of earning higher returns, it also exposes individuals and corporations alike to lose money in case the market moves against the positions held by them. What is risk management of derivatives in India? Stock exchanges follow robust risk management measures for derivative trading. These include, initial base minimum capital requirements, margins and daily mark to market margin system and initial Value at risk (VAR) based margin system. Apart from that there are various position limits, broker wise limits and scrip wise limits also to avoid build up of huge positions.

Who monitors derivative trading in securities market? Derivative trading in India is very well monitored by the stock exchanges (NSE has a pre dominant position as far as derivative trading is concerned compared to BSE) Besides SEBI also monitors the derivative through appropriate policy measures. Why SENSEX Futures There are many reasons why SENSEX® futures makes sense: SENSEX as compared with other indices shows less volatility and at the same time gives returns equivalent to the returns given by the other indices. SENSEX is widely used to describe the mood in the Indian stock market.

Because of its long history and wide acceptance, no other index matches the BSE SENSEX® in reflecting market movements and sentiments and it makes an attractive underlying for index-based products like Index Funds, Futures & Options and Exchange Traded Funds. SENSEX is truly investible as it is the only broad based index in India that is “free float market capitalization weighted”, which reflects the market trends more rationally and takes into consideration only those shares that are available for trading in the market.

It may be noted that in addition to the SENSEX, five sectoral indices belonging to the 90/FF series are also available for trading in the Futures and Options Segment of BSE Limited. The term ’90 /FF’ means that the indices cover 90% of the market capitalisation of the sector to which the index belongs and is thus well representative of that sector. Also, FF stands for free float – i. e. the indices are based on the globally followed standard of free float market capitalisiation methodology.

Based on these circulars and notices and as per a SEBI surveillance measures the following criteria will be adopted by the Exchange for selecting stocks and indices on which Futures & Options contracts would be introduced: Futures & Options Contracts on Stocks The eligibility criteria for inclusion of scrips in F&O segment shall be as under: The stocks would be chosen from amongst the top 500 stocks in terms of average daily market capitalization and average daily traded value in the previous six-month period on a rolling basis.

For a stock to be eligible, the median quarter-sigma order size over the last six months should not be less than Rs. 5 lakh (Rs 0. 5 million). For this purpose, a stock’s quarter sigma order size shall mean the order size (in value terms) required to cause a change in the stock price equal to one-quarter of a standard deviation The Market Wide Position Limit in the stock shall not be less than Rs 100 crore (Rs 1000 million).

The Market Wide Position Limit is valued taking into consideration 20% of number of shares held by Non-Promoters (i. . free-float holdings) in the relevant underlying stock and the closing prices of the stock in the underlying cash market on the date of expiry of contract in the month. Market Wide Position Limit is calculated at the end of every month. The criteria for exclusion of scrips in F segment shall be as under: For an existing F stock, the continuing eligibility criteria is that market wide position limit in the stock shall not be less than Rs. 0 crores and the stock’s median quarter-sigma order size over the last six months shall be not less than Rs. 2 lakhs.

The stock shall be excluded if the above criteria are not fulfilled for consecutively three months. The methodology used for calculating quarter sigma order size is as follows: Quarter sigma order size is calculated by taking four snapshots in a day from the order book of the stock in the past six months. The sigma (standard deviation) or volatility estimate is calculated in the manner specified by Prof. J. R. Varma Committee on Risk Containment Measures for Index Futures. This daily closing volatility estimate value is applied to the day’s order book snapshots to compute the order size. The quarter sigma percentage is applied to the average of the best bid and offer price in the order book snapshot to compute the order size to move price of the stock by quarter sigma. The median order size to cause quarter sigma price movement is determined separately for the buy side and the sell side.

The average of the median order size for the buy and the sell side is taken as the median quarter sigma order size. The quarter sigma order size in stock is calculated on the 15th of each month, on a rolling basis, considering the order book snapshots in the previous six months. Similarly, the average daily market capitalization and the average daily traded value is also be computed on the 15th of each month, on a rolling basis, to arrive at the list of top 500 stocks.

Eligibility criteria for stocks on account of corporate restructuring All of the following conditions should be met in the case of shares of a company undergoing restructuring through any means for eligibility to re-introduce derivative contracts on that company from the first day of listing of the post restructured company in the underlying market: The Futures and Options contracts on the stock of the original (pre-restructure) company were traded on any exchange prior to its restructuring.

The pre restructured company had a market capitalization of at least Rs. 1000 crore (Rs 10 billion) prior to restructuring. The post restructure company would be treated like a new stock and if it is, in the opinion of the exchange, likely to be at least one third of the size of the pre structuring company in terms of revenues or assets or analyst valuations, and In the opinion of BSE, the scheme of restructuring does not suggest that the post restructured company would have any characteristic that would render the company ineligible for derivatives trading.

If the post restructured company comes out with an Initial Public Offering , the same prescribed criteria as currently applicable for introduction of derivatives on a company coming out with an IPO will be applied for introduction of derivatives on stocks of the post restructured company from its first day of listing. If a stock does not conform to the above eligibility criteria for a consecutive period of 3 months, no fresh month contracts shall be issued on the same.The exit criteria shall be more flexible as compared to entry criteria in order to prevent frequent entry and exit of stocks in the derivatives segment. If a stock fails to meet the aforesaid eligibility criteria for 3 months consecutively, then no fresh month contract shall be issued on that stock.

However, the existing unexpired contracts may be permitted to trade till expiry and new strikes may also be introduced in the existing contract months. BSE may compulsorily close out all derivative contract positions in a particular underlying when that underlying has ceased to satisfy the eligibility criteria or BSE is of the view that the continuance of derivative contracts on such underlying is detrimental to the interest of the market keeping in view the market integrity and safety.

The decision of such forced closure of derivative contracts shall be taken in consultation with other exchanges where such derivative contracts and are also traded shall be applied uniformly across all exchanges. Re-Introduction of Stocks Discontinued from Futures & Options Trading: A stock, which is dropped from derivatives trading shall not be considered for re-inclusion for a period of one year after this period stock may become eligible once again. In such instances, the stock is required to fulfill the eligibility criteria for 3 consecutive months to be re-introduced for derivatives trading.

Derivative contracts on such stocks may be re-introduced by BSE itself. However, introduction of futures and option contracts on a stock for the first time would continue to be subject to SEBI approval. Trading Rules The Derivatives Trading at BSE takes place through a fully automated screen-based trading platform called DTSS (Derivatives Trading and Settlement System). The DTSS is designed to allow trading on a real-time basis. In addition to generating trades by matching opposite orders, the DTSS also generates various reports for the member participants.

Order Matching Rules Order Matching takes place after order acceptance wherein the system searches for an opposite matching order. If a match is found, a trade is generated. The order against which the trade has been generated is removed from the system. In case the order is not exhausted further matching orders are searched for and trades generated till the order gets exhausted or no more match-able orders are found. If the order is not entirely exhausted, the system retains the order in the pending order book. Matching of the orders is in the priority of price and timestamp.

A unique trade-id is generated for each trade and the entire information of the trade is sent to the relevant Members. Order Conditions The derivatives market is order driven i. e. the traders can place only orders in the system. Following are the order types allowed for the derivative products. These order types have characteristics similar to the ones in the cash market.

The value enterable will be in absolute underlying points and specifies the band from the touchline price or the trigger price within which the market order or the stop loss order respectively can be traded. Risk Reducing Orders (Y/N): When a Member’s collateral falls below 50 lacs, he will be allowed to put only risk reducing orders and will not be allowed to take any fresh positions. It is not essentially a type of order but a mode into which the Member is put into when he violates his collateral limit. A Member who has entered the risk-reducing mode will be allowed to put only one risk reducing order at a time. TOP Risk Management BSE has a comprehensive risk management system for Futures & Options. The most vital component in risk management is online position monitoring and margining system.

Actual margining and position monitoring is done on-line, on an intra-day basis. BSE uses the SPAN® (Standard Portfolio Analysis of Risk) a registered trademark of the Chicago Mercantile Exchange, used herein under License for the purpose of margining, which is risk-based, portfolio-approach. Index Futures A portfolio based margining model is adopted which will take an integrated view of the risk involved in the portfolio of each individual client comprising of his positions in all the derivatives contract traded on Derivatives Segment.

The parameters for such a model are as follows: I) Initial Margin or Worst Case Scenario Loss The Initial Margin requirement is based on the worst-case loss of portfolio at client level to cover 99% VaR over one day horizon. The initial margin requirement is net at the client level and is on gross basis at the Trading/Clearing Member level. The initial margin requirement for the proprietary position of Trading / Clearing Member is also be on net basis.

Loss The worst-case loss of a portfolio is calculated by valuing the portfolio under several scenarios of changes in the respective Index prices. The computation of risk arrays for various Index future contracts is done only at discrete time points each day and the latest available risk arrays is applied to the portfolios on a real time basis. The risk arrays is updated at 5 times in a day taking the closing price of the previous day at the start of trading and taking the last available traded prices at 11. 00 am, 12. 30 pm, 2. 00 pm, and at the end of the trading session taking closing price of the day.

The minimum initial margin equal to 5% of the notional value of the contract based on the last available price of the futures contract is applied at all times. To achieve the same, the price scan range is adjusted to ensure that the minimum margin collected doesn’t fall below 5% at any time.

In addition, the minimum margin shall also be scaled up by the look ahead point. c)Calendar Spread The margin on calendar spread is calculated and benefit is given to the Members for such position till expiry of near month contract. The calendar-spread margin is charged in addition to worst-scenario loss of the portfolio. The spread charge is specified as 0. 5% per month for the difference between the two legs of the spread subject to minimum 1% and maximum 3% as specified in the J. R. Varma Committee report. While calculating the spread charge, the last available closing price of the far month contract is used to determine the spread charge. II) Exposure Limits/Second Line of Defense

As the near month contract approaches expiry, the spread shall be treated as a naked position in the far month contract three days prior to the expiry of the near month contract. III) Mark-to-Market Margin The clients’ positions are marked-to-market on a daily basis at the portfolio level. However, for payment of mark-to-market margin to BSE, the same is netted out at the Member level. a) Collection / Payment : The mark-to-market margin is paid in / out in cash on T+1 day.

Closing Price for mark-to-market: The daily closing price of the Index futures contract for mark-to-market settlement is arrived at using the following algorithm: Weighted average price of all the trades in last half an hour of the continuous trading session. If there were no trades during the last half an hour, then the theoretical price is taken as the official closing price.

The theoretical price is arrived at using following algorithm: Theoretical price = Closing value of underlying Index + {closing value of underlying Index * No. of days to expiry * risk free interest rate (at present 7%) / 365} The Bank Rate + 1% would be taken as risk free interest rate percentage and dividend yield is taken as zero for simplicity.

On the expiry of an Index futures contract, the contract is settled in cash at the final settlement price. However, the profit /loss is paid in /paid out in cash on T+1 basis. The final settlement price of the expiring futures contract is taken as the closing price of the underlying Index. The following algorithm is presently being used for calculating closing value of the (individual scrips including the scrips constituting the Index) in the equity segment of BSE: The spread charge is specified as 0. 5% per month for the difference between the two legs of the spread subject to minimum 1% and maximum 3% as specified in the J. R. Varma Committee report.

In addition to the above, FIIs can take exposure in equity index derivatives subject to the following limits. Short positions in Index Derivatives (Short Futures, Short Calls and Long puts) not exceeding (in notional value) the FIIs holding of stocks. The stocks shall be valued at the closing price in the cash market as on the previous trading day. Long positions in Index Derivatives (long futures, long alls and short puts) not exceeding (in notional value) the FIIs holding of cash, government securities, T-Bills and similar instruments. The government securities and T-Bills are to be valued at book value. Money Market Mutual Funds and Gilt Funds shall be valued at Net Asset Value (NAV).

Sub-account Level Each sub-account of a FII would have the following position limits: A disclosure requirement for any person or persons acting in concert who together own 15% or more of the open interest of all derivative contracts on a particular underlying index. e) NRI Level The position limits for NRIs shall be the same as the client level position limits specified above. Therefore, the NRI position limits shall be – For Index based contracts, a disclosure requirement for any person or persons acting in concert who together own 15% or more of the open interest of all derivative contracts on a particular underlying index.

Mutual Fund position limits in equity index futures contracts shall be higher of Rs. 500 crore or 15% of the total open interest in the market in equity index futures contracts This limit would be applicable on open positions in all futures contracts on a particular underlying index as prescribed by SEBI. In addition to the above, Mutual Funds can take exposure in equity index derivatives subject to the following limits Short positions in Index Derivatives (Short Futures, Short Calls and Long puts) not exceeding (in notional value) the Mutual Fund holding of stocks. The stocks shall be valued at the closing price in the cash market as on the previous trading day.

Long positions in Index Derivatives (long futures, long alls and short puts) not exceeding (in notional value) the Mutual Fund holding of cash, government securities, T-Bills and similar instruments. The government securities and T-Bills are to be valued at book value. Money Market Mutual Funds and Gilt Funds shall be valued at Net Asset Value (NAV).

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