Page 22 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 2: Evolution of Derivatives in India

margining would be permitted and separate margins would be charged on the position in Notes
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 organized money market into the index future
market.

Trader Net Worth (Clause 2.3)

Even an accurate 99 percent "value at risk" model would give rise to end of day mark to market
losses exceeding the margin approximately once every six months. Trader net worth provides
an additional level of safety to the market and works as a deterrent to the incidence of defaults.
A member with high net worth would try harder to avoid defaults as his own net worth would
be at stake. The definition of net worth 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 3.1)

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 percent Value at Risk (VAR)
approach. It is decided that the SEBI should authorize the use of a particular VAR estimation
methodology but should not mandate a specific minimum margin level.
Initial methodology (Clause 3.1.2): The group has evaluated and approved a particular risk
estimation methodology that is described in Clause 3.2. The derivatives exchange and clearing
corporation should be authorized 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

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