Page 194 - DCOM510_FINANCIAL_DERIVATIVES

Unit 12: Risk Management of Financial Derivatives

Scanning Risk Charge: As shown in the table giving the sixteen standard risk scenarios, SPAN Notes
starts at the last underlying market settlement price and scans up and down three even intervals
of price changes (price scan range). At each price scan point, the program also scans up and down
a range of probable volatility from the underlying market’s current volatility (volatility scan
range). SPAN calculates the probable premium value at each price scan point for volatility up
and volatility down scenario. It then compares this probable premium value to the theoretical
premium value (based on last closing value of the underlying) to determine profit or loss.
Deep-out-of-the-money short options positions pose a special risk identification problem. As
they move towards expiration, they may not be significantly exposed to “normal” price moves
in the underlying. However, unusually large underlying price changes may cause these options
to move into-the-money, thus creating large losses to the holders of short option positions. In
order to account for this possibility, two of the standard risk scenarios in the risk array, Number
15 and 16, reflect an “extreme” underlying price movement, currently defined as double the
maximum price scan range for a given underlying. However, because price changes of these
magnitudes are rare, the system only covers 35% of the resulting losses.

After SPAN has scanned the 16 different scenarios of underlying market price and volatility
changes, it selects the largest loss from among these 16 observations.

Notes This “largest reasonable loss” is the scanning risk charge for the portfolio.
Calendar Spread Margin: A calendar spread is a position in an underlying with one maturity
which is hedged by an offsetting position in the same underlying with a different maturity.

Example: A short position in a July futures contract on Reliance and a long position in
the August futures contract on Reliance is a calendar spread. Calendar spreads attract lower
margins because they are not exposed to market risk of the underlying. If the underlying rises,
the July contract would make a loss while the August contract would make a profit.
As SPAN scans futures prices within a single underlying instrument, it assumes that price moves
correlate perfectly across contract months. Since price moves across contract months do not
generally exhibit perfect correlation, SPAN adds a calendar spread charge (also called the inter-
month spread charge) to the scanning risk charge associated with each futures and options
contract. To put it in a different way, the calendar spread charge covers the calendar basis risk
that may exist for portfolios containing futures and options with different expirations. For each
futures and options contract, SPAN identifies the delta associated each futures and option position,
for a contract month. It then forms spreads using these deltas across contract months.

Notes For each spread formed, SPAN assesses a specific charge per spread which constitutes
the calendar spread charge.
The margin for calendar spread is calculated on the basis of delta of the portfolio in each month.
Thus a portfolio consisting of a near month option with a delta of 100 and a far month option
with a delta of 100 would bear a spread charge equivalent to the calendar spread charge for a
portfolio which is long 100 near month futures contract and short 100 far month futures contract.
A calendar spread position on Exchange traded equity derivatives may be granted calendar
spread treatment till the expiry of the near month contract. Margin on calendar spreads is levied
at 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 month contract of the spread.

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