Mr. C. Vasudevan
General Manager, Institute, BSE Training Institute,
Limited. Bombay Stock Exchange Limited.
DECLARATION
I do hereby declare that the project entitled Risk BSE Management of Derivatives in BSE is submitted to Utkal University for the partial fulfillment of degree of Master of Control, Finance and Control Utkal University. The project is an authentic piece of work done by me under the guidance of Dr. Kshi Kshitibhushan Das, Das Reader, P.G. Department of
Commerce, Utkal University and it has neither been submitted for award of any other degree to any other University, Academy, Institution nor published in any magazine or anywhere else in part or full to best of my knowledge.
PLACE: BHUBANESWAR DATE: 2 | Page (DILLIP KHUNTIA) Bombay Stock Exchange Limited.
ACKNOWLEDGEMENT
The satisfaction that accompanies the successful completion of any task would be incomplete without mentioning people who made it possible, whose encouragement and consistent guidance crowned my efforts with success. At the outset, I would like to extend my sincere gratitude and reverence to the esteemed organization, Bombay Stock Exchange Limited and its management for providing me with the opportunity to pursue my summer project. I would like to thank Mr. C. Vasudevan, General Manager, Bombay Stock Exchange Limited and Mr. Pulakesh Dutta, Deputy Manager, BTI, Bombay Stock Exchange Limited, for allowing me to work on this project that not only interesting but has also added to my knowledge. I am also thankful to Product and Strategy department and Mr. Yogesh Sundaram, Consultant and Analyst, Bombay Stock Exchange Limited, for enlightening me with nuances of the risk management procedure followed by the Bombay Stock Exchange Limited and acknowledge the support and help of employees of Product and Strategy Department for their assistance in completion of this project. I would like to express my heartfelt indebtedness and deep sense of gratitude to my faculty guide Dr. Kshitibhushan Das for sharing his knowledge and giving me Kshi guidance and generous co-operation. I am also thankful to my other faculty members and my friends for their continuous support and encouragement. Last but not the least to MR. Madhusudan Sahu without whose help it was difficult to take on an internship at BSE
PLACE: BHUBANESWAR DATE: (DILLIP KHUNTIA)
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Certificate
This to certify that the project entitled Risk
Management of Derivatives in BSE is a record of bonafide research work carried out by Dillip Khuntia under my supervision and guidance. It embodies result of his original contribution. The project has reached the standard of fulfilling the requirements of the regulation relating to the degree of Master of Finance and Control. No part of this project has been submitted to any other institution for the award of any other degree.
PLACE: BHUBANESWAR DATE: (Dr. Kshitibhushan Das) P.G. Dept. of Commerce Utkal University. 4 | Page Bombay Stock Exchange Limited.
EXECUTIVE SUMMERY
In this project Risk Management of Derivatives in BSE, the major objective was to find out the effectiveness and efficiency of the risk management process of BSE for derivatives segment. For achieving this objective a survey was conducted, wherein some of the brokers are interviewed and the details of the risk management process of derivatives in BSE was analyzed. SEBI guidelines and circulars are also followed for this purpose. During the survey it was found that the risk management process of BSE is efficient and can be compared with any of the major stock exchange of the world. The SPAN margining system that BSE follows for margin calculation is an effective system of risk management and most of the exchanges of the world follow this method for margin calculation. The software PC SPAN, used by BSE for SPAN margin calculation is reliable and user friendly software. In case of risk management, BSE lags behind NSE in one area i.e. monitoring. NSE has an integrated system (PRISM) for monitoring the risk, whereas BSE does not have such facility Thus the recommendation in accordance with this project would be that BSE should take aggressive steps for expansion of its derivatives segment. This coupled with a few with the risk management process such as providing real time information about the parameters; especially the risk array and the trading information in tabular form rather than graphical form, use of better monitoring system for risk management would help BSE to improve its market position in derivatives.
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CONTENTS
Declaration. i Acknowledgement. ii Certificates iii Executive Summery iv CHAPTER 1: INTRODUCTION 1.1 Introduction 2 1.2 Rationale 2 1.3 Objective 3 1.4 Research Methodology.. 3 1.5 Limitation.. 4 1.6 Chapterisation.. 4 CHAPTER 2: COMPANY PROFILE 2.1 Company Profile . 7 2.2 History . 8 2.3 Prominent Position . 8 2.4 A Pioneer 9 2.5 Awards . 9 2.6 BSE SWOT . 10 CHAPTER 3: INTRODUCTION TO DERIVATIVES 3.1 Derivatives .. 13 3.2 Derivatives products .. 14 3.3 Participants of Derivatives Market . 16 3.4 Classification of Derivatives . 16 3.5 Economic Significance of Derivatives 18 3.6 History of Derivatives . 18 3.7 International Derivative Market . 20 3.8 Indian Derivative Market . 20 3.9 NSEs Derivative Segment . 22 CHAPTER 4: RISK AND RISK MANAGEMENT 4.1 Risk ... 25 4.2 Risk Management Process . 26 6 | Page Bombay Stock Exchange Limited.
Risk Management of Derivatives 4.3 Risk Associated with Derivatives . 27 4.4 Risk Management of Derivatives .. 30 CHAPTER 5: ANALYSIS AND INTEPRETATION 5.1 The SPAN Margining System 33 5.2 Working of SPAN Margining System .. 36 5.3 Margin 36 5.4 Mark-to-Market of Margin . 37 5.5 Exposure Limits . 37 5.6 Position Limits 38 5.7 Final Settlement 39 CHAPTER 6: SUMMERY AND CONCLUSION 6.1 Major Findings . 41 6.2 Suggestions . 42 6.3 Conclusion 43 6.4 Bibliography . 45
LIST OF FIGURES
3.1 Classification of Derivatives . 17 3.2 Business Growth of Derivative in India ... 22 3.3 Equity Derivative Market of India . 23 3.4 Average Daily Turnover of Indias Derivative Market . 23
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1.6 CHAPTERISATION
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The Bombay Stock Exchange Limited uses BSE SENSEX, an index of 30 large, developed BSE stocks. This index gives a measure of overall performance of BSE and is tracked worldwide.
In addition to individual stocks the Bombay Stock Exchange Limited also a market for derivatives, which was first introduced in India. Listed derivatives on the exchange include stock futures and options, Index futures and options and weekly options. The Bombay Stock exchange is also actively involved with the development of retail debt market.
The Exchange has a nationwide reach with its presence in 417 cities and towns of India. The systems and processes of the exchange are designed to safeguard market integrity and enhance transparency in the operations. The Exchange provides an efficient and transparent market for trading in equity, debt and derivative instruments. The BSE provides online trading with the BSEs Online trading System (BOLT), which is a proprietary system of the exchange and is BS 7799-2-2002 certified. The Surveillance and Clearing Settlement function of the Exchange are ISO 9001:2000 certified. VISION Emerge as the premier Indian stock exchange by establishing global benchmark
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STRENGHS: BSE has inherent advantages: its history, larger scrip base and a stronger brand. The SENSEX (BSEs 30-share sensitive index) is one of the most recognized indexes and tracked worldwide. Apart from lager base of listed companies, BSE also has a historical perspective. Its online trending system (BOLT) has awarded with the global recognized Information Security Management System Standard BS7799-2-2002. It got the ISO certification for its surveillance and clearing and settlement.
WEAKNESS The BSE SENSEX, which delivers inferior hedging effectiveness and higher impact cost. At present BSE has fewer than 12% share across the cash and derivative market of equity markets. At present, BSE is almost non-existence in derivatives space. BSE also lacks in terms of providing better services to its customers and is not proactive.
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THREATS Aggressive competitor like NSE poses major threat to BSEs future. NSEs top 100 stocks alone account for nearly 80 percent of its cash segments turnover, indicating that NSE is clearly the preferred destination for trading in the top stocks.
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CHAPTER THREE
INTRODUCTION TO DERIVATIVES
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3.2.6 BASKETS Basket options are options on portfolio of underlying assets. Equity index options are a form of basket options 3.2.7 SWAPS A swap means a barter or exchange. Thus, a swap is an agreement between two parties to exchange stream of cash flows over a period of time in future. The two commonly used swaps are, i) INTEREST RATE SWAPS: Swaps which entail swapping only the interest related cash flows between the parties in the same currency. ii) CURRENCY SWAPS: These entail swapping both principal and interest between two parities, with cash flows in one direction being in different currency than those in the opposite direction.
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Basing on the type of market, derivative market is of two types, exchangetraded derivatives market and over-the-counter derivative market. In the exchangetraded derivatives, the derivatives which are standardized in nature are traded. The trading of the derivatives is well regulated by the exchanges. The over-the-counter market is an important derivative market and has larger volume of trade than the exchange-traded market. It is a telephone- and computer- linked network of dealers. Traders are done over the phone and are usually between two financial institutions or between a financial institution and one of its clients. Telephone conversations in the OTC market are usually taped. If there is a dispute about what was agreed, the tapes are replayed to resolve the issue. A key advantage of over-the-counter market is that all the products are customized. Market participants are free to negotiate any mutually alternative deal. A disadvantage is that there is usually credit risk in an over-thecounter trade. The over-the-counter market is not regulated by any regulatory body and hence posses a huge counterparty risk. 3.5 ECONOMIC SIGNIFICANCE OF DERIVATIVES Some of the significance of financial derivatives can be enumerated as follows;
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The first exchange for trading derivatives appeared to be Royal Exchange in London, which permitted forward contracting on tulip bulbs at around 1637. The first futures contracts are generally traced to the Yodaya rice market in Osaka, Japan around 1650. These were evidently standardized contracts, which made them much
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Probably the next major event, and the most significant as far as the history of derivatives markets, was the creation of Chicago Board of Trade in 1848. Due to its prime location, Chicago was developing as a major centre for the storage, sale, and distribution of Midwestern grain. Due to seasonality of grain, however Chicagos storage facilities were unable to accommodate the enormous increase in supply that occurred following the harvest. Similarly, its facilities were underutilized in spring. Chicagos spot prices rose and fall drastically. To resolve this problem a group of grain traders created to-arrive contracts which permitted the farmers to lock in the price and deliver the grains in future. These to-arrive contracts are called as forward contracts. The forward contracts proved as a useful device for hedging the price risk. However, credit risk remained as serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT), in 1848. The primary intention of CBOT was to provide a centralize location for buyers and sellers to negotiate forward contracts. In 1865, CBOT went one step further and listed the first exchange traded derivatives in US, which are termed as Futures Contracts. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, got approval for futures trading. Its name was changed to Chicago Mercantile Exchange (CME). In 1925, the first clearing house for derivatives trading was established.
Since then, derivatives are traded in many exchanges, although their trading was banned by Government of different countries from time to time. But, the modern derivative market has originated in 1970s. This is due to the unprecedented volatility in the international financial environment, starting with the breakdown of Brettonwoods systems on 15 August 1971 and ending with the well-known Saturday night massacre of Federal Reserve on 6th October 1979. The breakdown of Brettonwoods system resulted in inflation, volatility in the market place and currency turmoil. This state of affairs heralded the emergence of financial derivatives.
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Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001 on the recommendation of L. C Gupta committee. Securities and Exchange Board of India (SEBI) permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. Initially, SEBI approved trading in index futures contracts based on various stock market indices such as, S&P CNX, Nifty and SENSEX. Subsequently, index-based trading was permitted in options as well as individual securities.
The trading in BSE SENSEX options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX. In June 2003, NSE introduced Interest Rate Futures which were subsequently banned due to pricing issue. Since the scope of this project is limited to equity derivatives only, so the further discussion will be confined to equity derivatives only. Equity derivatives market in India has registered an "explosive growth" and is expected to continue the same in the years to come. Introduced in 2000, financial derivatives market in India has shown a remarkable growth both in terms of volumes and numbers of traded contracts. NSE alone accounts for 99 percent of the derivatives trading in Indian markets. The introduction of derivatives has been well received by
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NSES DERIVATIVE SEGMENT The National Stock Exchange accounts almost 99% of the Indian derivatives market in terms of turnover, volume etc. Its equity derivatives market is most boosted one and in turnover it is a major stock exchange. All products in equity derivative segment i.e. Index Futures and Options and Stock Futures and Options have marked a tremendous growth over the last decade. The graph below shows the average yearly turnover in each equity derivative products and average daily turnover of derivative segment of NSE. Figure 3.3 Equity Derivative Market of India
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CHAPTER FOUR
RISK AND RISK MANAGEMENT
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4.2.1 IDENTIFICATION
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CHAPTER FIVE
INTERPRETATION AND ANALYSIS
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CHAPTER SIX
SUMMERY AND CONCLUSION
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