Personal Website of R.Kannan
Learning Circle -
Trading in Derivatives - Risk Containment Measures in the
Indian Derivative Market - Recommendations
of Dr.J.R.Verma Committee

Home Table of Contents Feedback



Project Map

Back to Module first page & view Table of Contents

Risk Containment Measures in the Indian Derivative Market
Recommendations of Dr.J.R.Verma Committee

The Securities and Exchange Board of India (SEBI) appointed a committee under the chairmanship of Dr. L. C. Gupta in November 1996 to "develop appropriate regulatory framework for derivatives trading in India". In March 1998, the L. C. Gupta Committee (LCGC) submitted its report recommending the introduction of derivatives markets in a phased manner beginning with the introduction of index futures. The SEBI Board while approving the introduction of index futures trading mandated the setting up of a group to recommend measures for risk containment in the derivative market in India. Accordingly, SEBI constituted a group in June, 1998: with Prof. J.R. Varma, as Chairman

The group submitted its report in the same year. The group began by enumerating the risk containment issues that assume importance in the Indian context while setting up an index futures market. The recommendations of the Group as covered by its report are as under:

Estimation of Volatility (Clause 2.1)

Several issues arise in the estimation of volatility:

  1. Volatility in Indian market is quite high as compared to developed markets.

  2. The volatility in Indian market is not constant and is varying over time.

  3. The statistics on the volatility of the index futures markets do not exist (as these markets are yet to be introduced) and therefore, in the initial period, reliance has to be made on the volatility in the underlying securities market. The LCGC has prescribed that no cross margining would be permitted and separate margins would be charged on the position in the futures market and the underlying securities market. In the absence of cross margining, index arbitrage would be costly and therefore possibly inefficient.

Calendar Spreads (Clause 2.2)

In developed markets, calendar spreads are essentially a play on interest rates with negligible stock market exposure. As such margins for calendar spreads are very low. However, in India, the calendar basis risk could be high because of the absence of efficient index arbitrage and the lack of channels for the flow of funds from the organised money market into the index future market.

Trader Net Worth (Clause 2.3)

Even an accurate 99% "value at risk" model would give rise to end of day mark to market losses exceeding the margin approximately once every six months. Trader networth provides an additional level of safety to the market and works as a deterrent to the incidence of defaults. A member with high networth would try harder to avoid defaults as his own networth would be at stake. The definition of networth needs to be made precise having regard to prevailing accounting practices and laws.

Margin Collection and Enforcement (Clause 2.4)

Apart from the correct calculation of margin, the actual collection of margin is also of equal importance. Since initial margins can be deposited in the form of bank guarantee and securities, the risk containment issues in regard to these need to be tackled.

Clearing Corporation (Clause 2.5)

The clearing corporation provides novation and becomes the counter party for each trade. In the circumstances, the credibility of the clearing corporation assumes importance and issues of governance and transparency need to be addressed.

Position Limit (Clause 2.6)

It may be necessary to prescribe position limits for the market as a whole and for the individual clearing member / trading member / client.

Margining System (Clause 3)

Mandating a Margin Methodology not Specific Margins (Clause 3.1.1)

The LCGC recommended that margins in the derivatives markets would be based on a 99% Value at Risk (VAR) approach. The group discussed ways of operationalizing this recommendation keeping in mind the issues relating to estimation of volatility discussed in 2.1 above. It is decided that SEBI should authorise the use of a particular VAR estimation methodology but should not mandate a specific minimum margin level. The specific recommendations of the group are as follows:

Initial Methodology (Clause 3.1.2)

The group has evaluated and approved a particular risk estimation methodology that is described in 3.2 below and discussed in further detail in Appendix 1. The derivatives exchange and clearing corporation should be authorised to start index futures trading using this methodology for fixing margins.

Continuous Refining (Clause 3.1.3)

The derivatives exchange and clearing corporation should be encouraged to refine this methodology continuously on the basis of further experience. Any proposal for changes in the methodology should be filed with SEBI and released to the public for comments along with detailed comparative backtesting results of the proposed methodology and the current methodology. The proposal shall specify the date from which the new methodology will become effective and this effective date shall not be less than three months after the date of filing with SEBI. At any time up to two weeks before the effective date, SEBI may instruct the derivatives exchange and clearing corporation not to implement the change, or the derivatives exchange and clearing corporation may on its own decide not to implement the change.

Initial Margin Fixation Methodology (Clause 3.2)

The group took on record the estimation and backtesting results provided by Prof. Varma (see Appendix 1) from his ongoing research work on value at risk calculations in Indian financial markets. The group, being satisfied with these backtesting results, recommends the following margin fixation methodology as the initial methodology for the purposes of 3.1.1 above.

The exponential moving average method would be used to obtain the volatility estimate every day.

Daily Changes in Margins (Clause 3.3)

The group recommends that the volatility estimated at the end of the day's trading would be used in calculating margin calls at the end of the same day. This implies that during the course of trading, market participants would not know the exact margin that would apply to their position. It was agreed therefore that the volatility estimation and margin fixation methodology would be clearly made known to all market participants so that they can compute what the margin would be for any given closing level of the index. It was also agreed that the trading software would itself provide this information on a real time basis on the trading workstation screen.

Margining for Calendar Spreads (Clause 3.4)

The group took note of the international practice of levying very low margins on calendar spreads. A calendar spread is a position at one maturity which is hedged by an offsetting position at a different maturity: for example, a short position in the six month contract coupled with a long position in the nine month contract. The justification for low margins is that a calendar spread is not exposed to the market risk in the underlying at all. If the underlying rises, one leg of the spread loses money while the other gains money resulting in a hedged position. Standard futures pricing models state that the futures price is equal to the cash price plus a net cost of carry (interest cost reduced by dividend yield on the underlying). This means that the only risk in a calendar spread is the risk that the cost of carry might change; this is essentially an interest rate risk in a money market position. In fact, a calendar spread can be viewed as a synthetic money market position. The above example of a short position in the six month contract matched by a long position in the nine month contract can be regarded as a six month future on a three month T-bill. In developed financial markets, the cost of carry is driven by a money market interest rate and the risk in calendar spreads is very low.

In India, however, unless banks and institutions enter the calendar spread in a big way, it is possible that the cost of carry would be driven by an unorganised money market rate as in the case of the badla market. These interest rates could be highly volatile.

Given the evidence that the cost of carry is not an efficient money market rate, prudence demands that the margin on calendar spreads be far higher than international practice. Moreover, the margin system should operate smoothly when a calendar spread is turned into a naked short or long position on the index either by the expiry of one of the legs or by the closing out of the position in one of the legs. The group therefore recommends that:

  1. The margin on calendar spreads be levied at a flat rate of 0.5% per month of spread on the far month contract of the spread subject to a minimum margin of 1% and a maximum margin of 3% on the far side of the spread for spreads with legs upto 1 year apart. A spread with the two legs three months apart would thus attract a margin of 1.5% on the far month contract.

  2. The margining of calendar spreads be reviewed at the end of six months of index futures trading.

  3. A calendar spread should be treated as a naked position in the far month contract as the near month contract approaches expiry. This change should be affected in gradual steps over the last few days of trading of the near month contract. Specifically, during the last five days of trading of the near month contract, the following percentages of a calendar spread shall be treated as a naked position in the far month contract: 100% on day of expiry, 80% one day before expiry, 60% two days before expiry, 40% three days before expiry, 20% four days before expiry. The balance of the spread shall continue to be treated as a spread. This phasing in will apply both to margining and to the computation of exposure limits.

  4. If the closing out of one leg of a calendar spread causes the members' liquid net worth to fall below the minimum levels specified in 4.2 below, his terminal shall be disabled and the clearing corporation shall take steps to liquidate sufficient positions to restore the members' liquid net worth to the levels mandated in 4.2.

  5. The derivatives exchange should explore the possibility that the trading system could incorporate the ability to place a single order to buy or sell spreads without placing two separate orders for the two legs.

  6. For the purposes of the exposure limit in 4.2 (b), a calendar spread shall be regarded as an open position of one third of the mark to market value of the far month contract. As the near month contract approaches expiry, the spread shall be treated as a naked position in the far month contract in the same manner as in 3.4 (c).

Margin Collection and Enforcement(Clause 3.5)

Apart from the correct calculation of margin, the actual collection of margin is also of equal importance. The group recommends that the clearing corporation should lay down operational guidelines on collection of margin and standard guidelines for back office accounting at the clearing member and trading member level to facilitate the detection of non-compliance at each level.

Transparency and Disclosure (Clause 3.6)

The group recommends that the clearing corporation / clearing house shall be required to disclose the details of incidences of failures in collection of margin and / or the settlement dues at least on a quarterly basis. Failure for this purpose means a shortfall for three consecutive trading days of 50% or more of the liquid net worth of the member.


- - - : ( Continued ) : - - -
Previous                 Top                 Next

[..Page Updated on 20.03.2004..]
[chkd-appvd-ef]