Page 210 - DCOM510_FINANCIAL_DERIVATIVES

Unit 13: Regulatory Framework

Continuous refining (Clause 3.1.3): The derivatives exchange and clearing corporation Notes
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 back testing 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.

13.3.8 Initial Margin Fixation Methodology (Clause 3.2)

The group took on record the estimation and back testing results provided by Prof. Varma from
his ongoing research work on value at risk calculations in Indian financial markets. The group,
being satisfied with these back testing results, recommends the following margin fixation
methodology as the initial methodology for the purposes of Clause 3.1.1.
The exponential moving average method would be used to obtain the volatility estimate every
day.
13.3.9 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.

13.3.10 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.

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.

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