Page 192 - DCOM510_FINANCIAL_DERIVATIVES

Unit 12: Risk Management of Financial Derivatives

monitoring and margining system. The actual margining and position monitoring is done Notes
online, on an intra-day basis using PRISM (Parallel Risk Management System) which is the real
time position monitoring and risk management system.

Notes The risk of each trading and clearing member is monitored on a real-time basis and
alerts/disablement messages are generated if the member crosses the set limits.

12.3.1 SPAN Approach of Computing Initial Margins
The objective of SPAN is to identify overall risk in a portfolio of futures and options contracts
for each member. The system treats futures and options contracts uniformly, while at the same
time recognising the unique exposures associated with options portfolios like extremely deep
out-of-the-money short positions, inter-month risk and inter-commodity risk. Because SPAN is
used to determine performance bond requirements (margin requirements), its overriding
objective is to determine the largest loss that a portfolio might reasonably be expected to suffer
from one day to the next day. In standard pricing models, three factors most directly affect the
value of an option at a given point in time:
1. Underlying market price
2. Volatility (variability) of underlying instrument

3. Time to expiration
As these factors change, so the value of futures and options maintained within a portfolio. SPAN
constructs sixteen scenarios of probable changes in underlying prices and volatilities in order to
identify the largest loss a portfolio might suffer from one day to the next. It then sets the margin
requirement at a level sufficient to cover this one-day loss. The computation of worst scenario
loss has two components. The first is the valuation of each contract under sixteen scenarios. The
second is the application of these scenario contract values to the actual positions in a portfolio to
compute the portfolio values and the worst scenario loss.

Did u know? The scenario contract values are updated at least 5 times in the day, which
may be carried out by taking prices at the start of trading, at 11:00 a.m., at 12:30 p.m., at
2:00 p.m., and at the end of the trading session.

12.3.2 Mechanics of SPAN
The results of complex calculations (e.g. the pricing of options) in SPAN are called risk arrays.
Risk arrays, and other necessary data inputs for margin calculation are then provided to members
on a daily basis in a file called the SPAN Risk Parameter file.
Members can apply the data contained in the risk parameter files, to their specific portfolios of
futures and options contracts, to determine their SPAN margin requirements. SPAN has the
ability to estimate risk for combined futures and options portfolios, and re-value the same
under various scenarios of changing market conditions.
Risk Arrays: The SPAN risk array represents how a specific derivative instrument (for example,
an option on NIFTY index at a specific strike price) will gain or lose value, from the current point
in time to a specific point in time in the near future, for a specific set of market conditions which
may occur over this time duration. The results of the calculation for each risk scenario i.e. the
amount by which the futures and options contracts will gain or lose value over the look-ahead
time under that risk scenario is called the risk array value for that scenario. The set of risk array

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