Risk Containment - VaR Framework

The ACD regards this (existing) risk containment framework as adequate except for changing the second line of defence to the higher of 5% or 1.5 standard deviations as already mentioned in 3.3 above. The underlying rationale for the multiplier 1.5 is that under the assumption of power law tails, the expected price change conditional on the change being greater than x is h/(h-1)x where h is the tail index. Since the first line of margins is equal to x, the second line must cover the excess over x or [h/(h-1)-1]x. If we assume h to be in the range of 3.25 to 3.75 and x is 3.5 standard deviations, then the second line is about 1.5 standard deviations. We put a floor of 5% on this to deal with situations where the estimated volatility is very low because of a long period of very low actual volatility.

The LCGC was of the view that cross margining should be introduced only after the derivative markets have become fully established and the systems capability for adopting sophisticated systems has emerged. Derivative markets are now well established and the systems capability for implementing complex margining systems now exists. Cross-margining is now the logical next step.

The ACD recommends the following method of implementing cross margining without commingling the cash and derivative segments:

• Cross margining should be implemented at the client level. The margin should be computed on the integrated position of a client across cash and derivative market.

• To achieve efficiency in client level cross margining, it would be desirable that a client has the same clearing member across both the cash and derivative segment

In the event if a client chooses to settle trades through more than one clearing member, the client would decide by way of an agreement which clearing member would collect margin from the client and in event of a default what would be the obligation of other clearing members.

In a sense, this problem arises because of the use of an EWMA model instead of a full fledged GARCH model.

• In the event of default the clearing corporations would liquidate the positions in their respective markets and under an agreement transfer the surplus, if any to the clearing corporation where there is a deficit.

• This method of cross margining avoids commingling the two segments of the exchange. However, it does involve each clearing corporation taking a credit exposure on the other. This must be limited by internal prudential guidelines and embodied in the agreement between the two clearing bodies.

• To achieve cross margining certain legal changes would have to be made in the cash / derivative markets. These are-

• Legal provisions as regard default, TGF/SGF would have to be modified.

• Agreement between clearing corporation, client/clearing member/ trading member to be framed and bye-laws suitably amended.

• Common client identification is necessary to implement cross margining at the client level. The quickest way to do this would be to make a global unique client identification (say PAN number) a pre-requisite for those clients who wish to avail of cross margining. Those who do not have this global unique client identification will still be able to trade but they will not get the benefit of cross margining. From a risk management point of view, there are technical issues to be resolved for cross margining between an index derivative position and an offsetting cash market position in a basket of stocks that tracks the index.

The positions in the underlying that are eligible for cross margining against positions in single stock derivatives are:

• The underlying in dematerialized form transferred to or pledged with the clearing corporation

• Short or long positions in any cash market segment that has a cross margining agreement with the derivative market segment under consideration.

A position in the underlying offset by an equal opposite position in the stock future would be margined like a calendar spread. For the purpose of calculating the spread margin, the maturity difference between the underlying and the near month contract will be taken as one month and the maturity difference between the underlying and a far month contract will be taken as one month plus the maturity difference between the near month contract and the far month contract. Calendar spread treatment will also be accorded to stock option positions whose deltas are offset by opposite positions in the underlying in the same manner in which the calendar spread treatment is applied to option positions of one maturity delta-hedged with futures of a different maturity. Just as for calendar spreads between two futures contracts, calendar spreads between the underlying and the derivative will also cease three days before expiry of the relevant derivative contract. This has to be done because of the basis risk that arises on settlement.

The only possible exception would be where the derivative is a futures contract that is physically settled and the underlying position consists of a position in the cash market segment whose settlement obligations can be netted against the settlement obligations arising on expiry of the future.

Strictly speaking there is a settlement related basis risk whenever an American option is delta hedged with futures or with positions in the underlying. This is because the American option can be exercised at any time. This basis risk is ignored under the assumption that it can be managed by (a) requiring a one day notice before exercise, (b) imposing daily exercise and assignment limits, and (c) withdrawing the spread treatment when the option position has been given notice of assignment for exercise.

Cross margining would be allowed between positions in index futures and a basket of positions in the constituent stocks provided the client designates the basket of positions as an index basket. The permissible positions in the constituent stocks would be

• Actual holdings in the stock in unencumbered dematerialized form that are transferred or pledged with the clearing corporation

• Short or long positions in the stock in any cash market segment that has a cross margining agreement with the derivative market segment under consideration.

• Short or long positions in the stock futures.

• An exchange traded fund (ETF) that tracks the index could also be regarded as a basket of constituent stocks after applying an appropriate haircut to cover redemption costs and tracking error

Cross margining between the basket and the index future will be permitted only if the following eligibility condition is satisfied:

• The total deviation portfolio must have a value not exceeding 5% of the value of the basket. In other words, the basket must approximate the index quite closely

• The Committee recommends that the limit of 5% be reviewed after six months of experience of cross margining.

The margin offset between index futures and the replica portfolio will be identical to that between single stock futures and the underlying. In other words, the position will be treated as a calendar spread and margined as such

• The total deviation portfolio can be margined as a portfolio of positions on individual constituents of the portfolio. This would require that the volatility and other margin parameters must be computed for even those index constituents that do not have options or stock futures trading on them.

• A simpler solution is to margin the total deviation portfolio as if it were a position in a single hypothetical stock whose volatility is twice that of the index and which is assumed to be sufficiently liquid (impact cost less than 1%) not to require a 3 scaling for illiquidity. The smallness of the total deviation portfolio is a critical factor in using this approximation.

No cross margining will be permitted between positions in index options and a basket of positions in options on constituent stocks in the index. The reasons for this stand are:

• It is unlikely that any arbitrageur will delta hedge index options with a basket of constituent stock options. It is much easier to delta hedge index options with index futures and stock options with stock futures. Therefore, though it is not too difficult to give a cross margin benefit for the offsetting deltas of the two positions, there are little practical benefits from doing so

• An arbitrageur might indeed to want vega hedge index options with a basket of constituent stock options under the belief that the index implied volatility must be a weighted average of constituent implied volatilities. Price discovery might indeed be aided by giving a cross margining benefit for such a vega hedge, but the methodology for doing so would be too complex to implement.

No cross margining will be permitted between two indices even if they are highly correlated.

No cross margining will be permitted between two stocks even if they are highly correlated.