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M P Birla Institute of Management

I here by declare that, this Project Report entitled “Risk Containment Measure In Indian Stock Index Futures Market” has been undertaken and completed by me under the valuable guidance of Prof. Santhanam in partial fulfillment of degree of Master of Business Administration (MBA) program.

Place: Bangalore Date:


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M P Birla Institute of Management

This is to certify that Mr. Deepak Gupta P.K has undertaken Project Work on “Risk Containment Measure In Indian Stock Index Futures Market” under the able guidance of Prof. Santhanam,

Place: Bangalore Date:

Dr. Nagesh Mallavalli (Principal)

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M P Birla Institute of Management


This is to certify that the Project Work report titled “Risk Containment Measure In Indian Stock Index Futures Market” has prepared by Mr. Deepak Gupta P.K bearing registration number 03XQCM6026, under my guidance.

Place: Bangalore Date:

Prof. Santhanam

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M P Birla Institute of Management

I would like to express my sincere gratitude to my project guide Prof. Santhanam, who guided me through the entire project. Also I would like to thank Bangalore Stock Exchange, my friends and also my college who have helped me in completing this project and also for having given me this opportunity.


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M P Birla Institute of Management

The project starts off with the History of Derivatives in India, which includes Events that made the launch of Derivatives in India.

Then the project goes on to the Performance of Commondity Exchanges in India. The initial move is the analysis of Risk Containment and related issues taking into considerations LC Gupta and Varma Committee reports. The project also states some risk management strategies implemented to manage risk in futures market.

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M P Birla Institute of Management

In the Indian context, the securities contracts (regulation) Act 1956, (SCRA) derivative includes ¾ security derived from a debt instrument, share and loan whether secured or A unsecured. Risk instrument or contract for differences or any other form of ¾ contract which derives its value from the price or index of prices, of underlying A securities. The Bombay Stock Exchange and National Stock Exchange launched trading in Index Futures in June 2000. This marked the beginning of exchange traded financial derivatives in India. We had a strong Dollar – Rupee Forward markets with contracts being traded for 1 to 6 months. The daily trading volume here was approximately US $ 500 million. security.

Motivation to use derivatives
The real motivation to use derivatives is that they are useful in reallocating risk either across time or across individuals with different risk bearing preferences.

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M P Birla Institute of Management

Types of Derivatives
Derivatives are basically classified into two based upon the mechanism that is used to trade on them. They are Over the Counter derivatives and Exchange traded derivatives. The OTC derivatives are between two private parties and are designed to suit the requirements of the parties concerned. The Exchange traded ones are standardized ones where the exchange sets the standards for trading by providing the contract specifications and the clearing corporation provides the trade guarantee and the settlement activities

EVENTS THAT MADE THE LAUNCH OF DERIVATIVES IN INDIA ¾ November 1996, SEBI set up a committee under the chairmanship of Dr. L C ¾ The Committee submitted its report on the March 17 1998. It advocated the introduction of derivatives in Indian market in a phased manner, starting with the ¾ SEBI accepted the report on May 11, 1998 and June 16, 1998, it issued a circulation allowing exchanges to submit their proposals for introduction of ¾ Government issued notification delineating the areas of responsibility between On ¾ June 2000, derivative trading started in NSE and BSE. RBI and Market Regulator SEBI. derivative trading. ‘ Index Futures’. Gupta, the well known economist and former SEBI Board Member.

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M P Birla Institute of Management

What is the role of commodity futures market and why do we need them?
One answer that is heard in the financial sector is `we need commodity futures markets so that we will have volumes, brokerage fees, and something to trade''. I think that is missing the point. We have to look at futures market in a bigger perspective -what is the role for commodity futures in India's economy? In India agriculture has traditionally been a area with heavy government intervention. Government intervenes by trying to maintain buffer stocks, they try to fix prices, they have import-export restrictions and a host of other interventions. Many economists think that we could have major benefits from liberalization of the agricultural sector. In this case, the question arises about who will maintain the buffer stock, how will we smoothen the price fluctuations, how will farmers not be vulnerable that tomorrow the price will crash when the crop comes out, how will farmers get signals that in the future there will be a great need for wheat or rice. In all these aspects the futures market has a very big role to play. If you think there will be a shortage of wheat tomorrow, the futures prices will go up today, and it will carry signals back to the farmer making sowing decisions today. In this fashion, a system of futures markets will improve cropping patterns. Next, if I am growing wheat and am worried that by the time the harvest comes out prices will go down, then I can sell my wheat on the futures market. I can sell my wheat at a price which is fixed today, which eliminates my risk from price fluctuations. These days, agriculture requires investments -- farmers spend money on fertilizers, high yielding varieties, etc. They are worried when making these investments that by the time the crop comes out prices might have dropped, resulting in losses. Thus a farmer would like to lock in his future price and not be exposed to fluctuations in prices.

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M P Birla Institute of Management The third is the role about storage. Today we have the Food Corporation of India which is doing a huge job of storage, and it is a system which -- in my opinion -- does not work. Futures market will produce their own kind of smoothing between the present and the future. If the future price is high and the present price is low, an arbitrager will buy today and sell in the future. The converse is also true, thus if the future price is low the arbitrageur will buy in the futures market. These activities produce their own "optimal" buffer stocks, smooth prices. They also work very effectively when there is trade in agricultural commodities; arbitrageurs on the futures market will use imports and exports to smooth Indian prices using foreign spot markets. In totality, commodity futures markets are a part and parcel of a program for agricultural liberalization. Many agriculture economists understand the need of liberalization in the sector. Futures markets are an instrument for achieving that liberalization.

What about futures in bullion?
Futures in gold will be useful, since millions of people in India use gold as a financial asset and are exposed to fluctuations in the price of gold. In addition, it's very easy to start a gold futures market. Gold is a natural commodity where we should be dealing with warehouse receipts -- banks have already started giving gold depositories receipts, which clearing corporations would be comfortable relying upon. A market like NSE could start trading in Gold futures with just a few weeks of preparation. Obviously the consent of regulators will be required to getting such trading off the ground. Remarkably enough, it may not be necessary that we should have a gold futures market in India. There are several well functioning gold futures market outside India. Maybe we should just use them

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M P Birla Institute of Management

Year 2002-03 witnessed a surge in volumes in the commodity futures markets in India. The 20 plus commodity exchanges clocked a volume of about Rs. 100,000 crore in volumes against the volume of 34,500 crore in 2001-02 –remarkable performance for an industry that is being revived! This performance is more remarkable because the commodity exchanges as of now are more regional and are for few commodities namely soybean complex, castor seed, few other edible oilseed complex, pepper, jute and gur. Interestingly, commodities in which future contracts are successful are commodities those are not protected through government policies; and trade constituents of these commodities are not complaining too. This should act as an eye-opener to the policy makers to leave pricing and price risk management to the market forces rather than to administered mechanisms alone. Any economy grows when the constituents willingly accept the risk for better returns; if risks are not compensated with adequate or more returns, economic activity will come into a standstill. With the value of India’s commodity economy being around Rs. 300,000 crore a year potential for much greater volumes are evident with the expansion of list of commodities and nationwide availability. Opening up of the world trade barriers would mean more price risk to be managed. All these factors augur well for the future of futures.

Commodity exchanges in India are expected to contribute significantly in strengthening Indian economy to face the challenges of globalization. Indian markets are poised to witness further developments in the areas of electronic warehouse receipts (equivalent of dematerialized shares), which would facilitate seamless nationwide spot Page 11 of 68

M P Birla Institute of Management market for commodities. Amendments to Essential Commodities Act and implementation of Value-Added-tax would enable movement of across states and more unified tax regime, which would facilitate easier trading in commodities. Options contracts in commodities are being considered and this would again boost the commodity risk management markets in the country. We may see increased interest from the international players in the Indian commodity markets once national exchanges become operational. Commodity derivatives as an industry are poised to take-off which may provide the numerous investors in this country with another opportunity to invest and diversify their portfolio. Finally, we may see greater convergence of markets – equity, commodities, forex and debt – which could enhance the business opportunities for those have specialized in the above markets. Such integration would create specialized treasuries and fund houses that would offer a gamut of services to provide comprehensive risk management solutions to India’s corporate and trade community. In short, we are poised to witness the resurgence of India’s commodity trading which has more than 100 years of great history.

¾ Increased volatility in asset prices in financial markets.

¾ Increased integration of national financial markets with international markets.

¾ Marked improvement in communication facilities and sharp decline in the costs. agents a wider choice of risk management strategies.

¾ Development of more sophisticated risk management tools, providing ecomomic ¾ Innovation in derivatives market, which optimally combine the risks and return over a large number of financial assets, leading to higher return, reduced risk as well as transaction costs as compared to individual financial assets

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M P Birla Institute of Management

There are many reasons for the wide international acceptance of stock index futures and for the strong preference for this instrument in India too compared to other forms of equity derivatives. This is because of the following advantages of stock index futures : 1. Institutional and other large equity holders need portfolio hedging facility. Hence, index-based derivatives are more suited to them and more cost-effective than derivatives based on individual stocks. Even pension funds in U.S.A. are known to use stock index futures for risk hedging purposes. 1. Stock index is difficult to be manipulated as compared to individual stock prices, more so in India, and the possibility of cornering is reduced. This is partly because an individual stock has a limited supply which can be cornered. Of course, manipulation of stock index can be attempted by influencing the cash prices of its component securities. While the possibility of such manipulation is not ruled out, it is reduced by designing the index appropriately. There is need for minimizing it further by undertaking cash market reforms, as suggested by the Committee later in this chapter. 2. Stock index futures enjoy distinctly greater popularity, and are, therefore, likely to be more liquid than all other types of equity derivatives, as shown both by responses to the Committee’s questionnaire and by international experience. 3. Stock index, being an average, is much less volatile than individual stock prices. This implies much lower capital adequacy and margin requirements in the case of index futures than in the case of derivatives on individual stocks. The lower margins will induce more players to join the market. 4. In the case of individual stocks, the positions which remain outstanding on the expiration date will have to be settled by physical delivery. This is an accepted principle everywhere. The futures and the cash market prices have to converge on the expiration date. Since Index futures do not represent a physically deliverable asset, they are cash settled all over the world on the premise that the index value is derived from the cash

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M P Birla Institute of Management market. This, of course, implies that the cash market is functioning in a reasonably sound manner and the index values based on it can be safely accepted as the settlement price. 5. Regulatory complexity is likely to be less in the case of stock index futures than for other kinds of equity derivatives, such as stock index options, or individual stock options.

The Index is Pervasive
Index derivatives are a powerful tool for risk management for anyone who has portfolios composed of positions in equity. Using index futures and index options, investors and portfolio managers can hedge themselves against the risk of a downturn in the market when they should so desire. For example, for many investors, the volatility associated with the budget might not be a ride that they wish to bear. Today, in the absence of index derivatives, the investor has only one alternative: to sell off equity, and move into cash or debentures, prior to the budget. Roughly a month after the budget, after the budget-related volatility has subsided, these transactions could be reversed, and the person would be back to the original equity exposure. This is expensive in terms of the transactions costs faced in selling off a significant amount of equity. For retail investors, the total cost of this two-stage process could be around 5%, a high price to pay for the privilege of avoiding budget-related volatility. Using index futures, the same objective would be accomplished at around one-tenth the cost, or less. Using index options, a very interesting kind of ``portfolio insurance'' could be obtained, whereby an investor gets paid only if the market index drops. These are unique and new forms of risk management in the country. They are particularly appealing because the market index is highly correlated with every equity portfolio in the country. By the time a portfolio contains more than 15 stocks, it is very likely that the correlation between this portfolio and a market index like the NSE-50 Page 14 of 68

M P Birla Institute of Management would exceed 80%. This property holds, regardless of the identity of the securities which make up the portfolio: whether a person holds index stocks or not, the index is highly correlated with every portfolio in the country. This fact is quite apparent when we look back at the experience of 1995 and 1996 -- every single equity investor in the country experienced poor returns in that period, regardless of the kind of portfolio owned. This widespread correlation of the risk exposure of investors with the index makes index derivatives very special in their risk management. One example will help clarify matters. Suppose a person is long ITC. Unfortunately, by being long ITC on the cash market, he is simultaneously long ITC and long index (ITC and the index have a 65% correlation). I.e., if the index should drop, he will suffer, even though he may have no interest in the index when forming his position. In this situation, this person can match his ITC exposure with an opposing position using index futures (i.e. he would be simultaneously long ITC and short index futures) which effectively strips out his index exposure. Now, he is truly long ITC: whether the index goes up or down, he is unaffected, he is only taking a view on ITC. This is far closer to his real interests and objectives, and is much less risky than present market practice (i.e., a pure long ITC position).

Any person who wants to trade in futures has to contact a Futures Commission Merchant (FCM) or a broker. FCM is necessarily a member of the clearing house, An account has to be opened at his firm. You will be assigned to one of the accounts executive, who will look after the transactions. Whenever we place an order with the accounts executive, he will note down the order specifications and immediately transmit to one of the floor brokers at the exchange. The floor broker will execute the order and

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M P Birla Institute of Management reports the transaction to the clearing house. Once he received the conformation form the clearing house, he calls back the accounts executive giving him all the details about the trade. The accounts executive intern passes on these details to his client. Other responsibilities of the FCM are maintaining all records and reporting the trading activity of all his clients to the clearing house and sending the clients monthly statement about their position and account balances. If the account is opened with a broker who is not a member of the clearinghouse, he should necessarily route the order through a member.

Arbitrage with Nifty futures Arbitrage is the opportunity of taking advantage of the price difference between two markets. An arbitrageur will buy at the cheaper market and sell at the costlier market. It is possible to arbitraged between NIFTY in the futures market and the cash market. If the futures price is any of the prices given below other than the equilibrium price then the strategy to be followed is

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M P Birla Institute of Management Note: The arbitrage opportunity arising when the futures price is underpriced to the cash price is not feasible if the arbitrageur does not hold the scrip or borrowing of securities is not possible in the market. This is because the delivery in the spot market comes before the delivery in the futures market. Hedging with NIFTY futures. Case 1 Short Hedge Let us assume that an investor is holding a portfolio of following scrips as given below on 1st May, 2001.

Trading Strategy to be followed The investor feels that the market will go down in the next two months and wants to protect him from any adverse movement. To achieve this the investor has to go short on 2 months NIFTY futures i.e he has to sell June Nifty. This strategy is called Short Hedge. Formula to calculate the number of futures for hedging purposes is Beta adjusted Value of Portfolio / Nifty Index level Beta of the above portfolio

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M P Birla Institute of Management =(1.55*400,000)+(2.06*200,000)+(1.95*175,000)+(1.9*125, 000)/1,000,000 =1.61075 (round to 1.61) Applying the formula to calculate the number of futures contracts Assume NIFTY futures to be 1150 on 1st May 2001 = (1,000,000.00 * 1.61) / 1150 = 1400 Units Since one Nifty contract is 200 units, the investor has to sell 7 Nifty contracts.

Short Hedge Stock Market 1st May Holds Rs 1,000,000.00 in stock portfolio 25th June Stock portfolio fall by 6% to Rs 940,000.00 Profit / Loss Loss: -Rs 60,000.00 Net Profit: + Rs 15,450.00 Case 2 Long Hedge Let us assume that an investor feels that the market is at the beginning of a bull run. He is expecting to get Rs 1,500,000.00 in two months time. Waiting two months to invest could Page 18 of 68 Futures Market Sell 7 NIFTY futures contract at 1150. NIFTY futures falls by 4.5% to 1098.25 Profit: 72,450.00

M P Birla Institute of Management mean that he might miss the bull run altogether. An alternative to missing the market move is to use the NIFTY futures market. The investor could simply buy an amount of NIFTY futures contract that would be equivalent to Rs 1,500,000.00. This Strategy is called long hedge. Let us assume that on 1st May 2001 the Nifty futures stand at 1150. He expects to get Rs. 1,500,000.00 by June end. He has to buy 2months June Nifty in May. The number of contracts he should buy is 1,500,000.00/(1150*200) = 6.52 (round to 7) contracts Stock Market 1st May The investor expects Rs 1,500,000.00 in two months 25 June 1,500,000.00 becomes available for investment The markets have risen and the June NIFTY futures stand at 1195 The investor will invest Rs 1,500,000.00 in the market but will not get the same amount of shares as on 1st May 2001 Futures Profit: Rs 63,000.00 Futures Market Buys 7 Nifty contracts at 1150

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Page 20 of 68 The features of Future Contracts are as follows: market the contract is standardized. between two parties to buy or well an asset at a certain time at a certain price. In this


8. Also, they serve as another investment opportunity for investors looking to bet on 7. They enable investors/funds to hedge their long/short positions in the market, thus 6. Mode of delivery is cash settlement 5. Standardized 4. Margins paid by both buyer and seller 3. No presence of counter party 2. Traded in stock exchanges 1. Highly liquid reducing the risk associated with such stock holdings. Index Futures were introduced in June 2000. A future contract is an agreement M P Birla Institute of Management

the markets in general.

M P Birla Institute of Management 9. As the futures trading would be on the market index, it will be difficult for a few operators to manipulate the price of the index futures market. 10. Stock index futures are expected to require lower capital adequacy and margin requirements and lower brokerage costs. 11. Futures will give a sense of direction to the markets/investors. 12. Contracts are cash settled and hence no paperwork of transferring the stock either physically or through the depository mode. Investors can use futures to hedge their portfolio risk. Say, an investor feels that a particular stock is undervalued. When he buys it, there are two kinds of risks. Either his understanding can be wrong, and the company is really not worth more than its market price, or the entire market moves against him and generates losses even though his underlying idea was correct. The second outcome happens most of the time. So now with Index futures, he will buy the stock and simultaneously short the future. Consider another investor who had the opposite view. So he shorted the stocks and bought the futures. If this investor is a portfolio manager, say with the view that the IT and the Pharma sector will do well, he invests in these sectors and shorts the futures. On the other hand, if he feels otherwise, he can short the portfolio of IT and Pharma scrips and buy futures.

The Securities and Exchange Board of India (SEBI) appointed a committee under the chairmanship of Dr. L. C. Gupta in November 1996 to "develop appropriate regulatory framework for derivatives trading in India". In March 1998, the L. C. Gupta Committee (LCGC) submitted its report recommending the introduction of derivatives markets in a phased manner beginning with the introduction of index futures. The SEBI Page 21 of 68

M P Birla Institute of Management Board while approving the introduction of index futures trading mandated the setting up of a group to recommend measures for risk containment in the derivative market in India. Accordingly, SEBI constituted a group consisting of the following in June, 1998:

1. Prof. J.R. Varma, Chairman 2. Dr. R.H. Patil, The National Stock Exchange 3. Mr. Ravi Narain, The National Stock Exchange 4. Mr. Janak Raj, The Reserve Bank of India 5. Mr. Himanshu Kaji, The Stock Exchange, Mumbai 6. Mr. Ajit Surana, The Stock Exchange, Mumbai 7. Mr. Brian Brown, Indosuez W.I. Carr Securities 8. Mr. K.R. Bharat, Credit Suisse First Boston 9. Mr. Sarosh Irani, Jardine Fleming 10. Mr. O.P. Gahrotra, Member Secretary, SEBI

Badla v/s Futures
Badla is a system in which payment is postponed. A Badla transaction is identical to a spot transaction in shares, financed by lending against the securities of those shares. In other words, Badla is akin to lending and borrowing of shares and funds and is not a variant of futures. SIMILARITIES ¾ Both Badla and Futures help the investor in leveraging his or her position. Hence, ¾ allowing for speculation, Badla and Futures improve the liquidity of the cash By markets. they attract speculative elements into the market.

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M P Birla Institute of Management DIFFERENCES ¾ Unlike Badla, Future trading is carried out distinctly from each markets. Hence, ¾ Another distinguishing feature which can be identified from above is that, while the spot and Futures price are different from each other and do not get mixed up. initiating a contract, the futures price is clear and known in advance in Futures. In Badla, the price ultimately paid inclusively of Badla charges is indeterminate and ¾ Futures market, the clearing corporation becomes counter party to each trade. In Hence credit risk does not arise. However, Badla give rise to credit risk as there exists no clearing corporation to take up or assume one leg of every transaction. In India due to recurring market scandals and large defaults related to Badla, Securities and Exchange Board of India (SEBI) tried for years to eliminate it. Finally it was in July 2001 that SEBI successfully banned Badla with the introduction of rolling settlement cycle and derivatives. known only when the transaction is concluded.


1. VOLATILITY Volatility is typically calculated by using variance or annualized standard deviation of the price or return. A measure of the relative volatility of a stock to the market is its beta. A highly volatile market means that prices have huge swings in very short periods of time. Page 23 of 68

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Page 24 of 68 Margin is: 3. MARGIN COLLECTION AND ENFORCEMENT money market into the index futures market. efficient index arbitrage and the lack of channels for the flow of funds from the organised However, in India, the calendar basis risk could be high because of the absence of negligible stock market exposure. As such margins for calendar spreads are very low. 2. CALANDER SPREADS b. The volatility in Indian market is not constant and is varying over time. a. Volatility in Indian market is quite high as compared to developed markets. Several issues arise in the estimation of volatility are: M P Birla Institute of Management In developed markets, calendar spreads are essentially a play on interest rates with

M P Birla Institute of Management
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Buying with borrowed money can be extremely risky because both gains and losses are amplified. That is, while the potential for greater profit exists, this comes at a hefty price -- the potential for greater losses. Margin also subjects the investor to a number of unique risks such as interest payments for use of the borrowed money.
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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. 4. CLEARING CORPORATION It is an organization associated with an exchange to handle the confirmation, settlement and delivery of transactions, fulfilling the main obligation of ensuring transactions are made in a prompt and efficient manner. Also referred to as "clearing firms" or 'clearing houses." order to make certain that transactions run smoothly, In clearing corporations become the buyer to every seller and the seller to every buyer, or, in other words, take the off-setting position with a client in every transaction. 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. 5. POSITION LIMIT It is a predetermined position level set by regulatory bodies for a specific contract or option. Position limits are created for the purpose of maintaining stable and fair

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Ó ß á Ü Ñ sb‘©tQ&Dxë!!c3v`sbé£s09Uu!s¨a3RPU¥Dv©›%!3!0u!VT9av0uÛ Ó Þ Ù Ö ç á Ó ê Ò Ö × Ó ß á è Ñ ß ä Ñ æ ä Û à ä Ó Ø Ó à ä Û æ Ò Ö × Ü Ñ á ä Þ Ñ × Ö ä Û Ö á Ò Ó ã Ö ä

Apart from the correct calculation of margin, the actual collection of margin is

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M P Birla Institute of Management markets. Contracts held by one individual investor with different brokers may be combined in order to gauge accurately the level of control held by one party. It may be necessary to prescribe position limits for the market as a whole and for the individual clearing member / trading member / client. 6. LEGAL ISSUES Certain legal opinions seem to be suggesting that mere declaration of cash settled futures as securities under SC(R)A would not put them on a sound legal footing unless the provisions of the Contract Act were either amended or explicitly overridden. Some court judgements in foreign countries were said to be extremely worrying in this regard. 7. TRADER NET WORTH Trader networth provides an additional level of safety to the market and works as a deterrent to the incidence of defaults. A member with high networth would try harder to avoid defaults as his own networth would be at stake. The definition of networth needs to be made precise having regard to prevailing accounting practices and laws. Even an accurate 99% “value at risk” model would give rise to end of day mark to market losses exceeding the margin approximately once every six months.

The LCGC recommended that margins in the derivatives markets would be based on a 99% Value at Risk (VAR) approach. The group discussed ways of operationalizing

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M P Birla Institute of Management this recommendation keeping in mind the issues relating to estimation of volatility. It is decided that SEBI should authorise the use of a particular VAR estimation methodology but should not mandate a specific minimum margin level. The specific recommendations of the group are as follows: 1. INITIAL METHODOLOGY The percentage of the purchase price of securities (that can be purchased on margin) which the investor must pay for with their own cash or marginable securities. Also called the initial margin requirement. According to Regulation T of the Federal Reserve Board, the initial margin is currently 50%. This level is only a minimum and some brokerages require you to deposit more than 50%. For futures contracts, initial margin requirements are set by the exchange. 2. PERIODIC REPORTING The committee recommended that the derivatives exchange and clearing corporation should be required to submit periodic reports (quarterly or half-yearly) to SEBI regarding the functioning of the risk estimation methodology highlighting the specific instances where price moves have been beyond the estimated 99% VAR limits. 3 CONTINOUS REFINING It also recommended that 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 comments along with detailed comparative back testing results of the proposed methodology and the current methodology. The proposal shall specify

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M P Birla Institute of Management 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. The group recommends that the clearing corporation / clearing house shall be required to disclose the details of incidences of failures in collection of margin and / or the settlement dues at least on a quarterly basis. Failure for this purpose means a shortfall for three consecutive trading days of 50% or more of the liquid net worth of the member.

The parameters for risk containment model shall include the following: 1. Initial Margin or Worst Scenario Loss The Initial Margin requirement shall be based on the worst scenario loss of a portfolio of an individual client to cover 99% VaR over one day horizon across various scenarios of price changes, based on the volatility estimates, and volatility changes. The estimate at the end of day t (SDt) shall be estimated using the previous volatility estimate i.e., as at the end of t-1 day (SDt), and the return (rt) observed in the futures market during day t. The formula shall be 6'WA  6'W-1)+(1-UWA Where:  D SDUDPHWHUZKLFK GHWHUPLQHVKRZ UDSLGO\ YRODWLOLW\ HVWLPDWHVFKDQJHV7KH  YDOXH RI LVIL[HG DW SD = Standard deviation of daily returns in the interest rate futures contract.

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M P Birla Institute of Management In case of long term futures, the price scan range shall be 3.5SD and in no case the initial margin shall be less than 2 % of the notional value of the Futures Contract. For notional T-Bill futures, the price scan range shall be 3.5SD and in no case the initial margin shall be less than 0.2% of the notional value of the futures contract. 2. Calendar Spread Charge The Calendar Spread margin is charged in addition to the Worst Scenario Loss of the portfolio. For interest rate futures contract a calendar spread margin shall be at a flat rate of 0.125% per month of spread on the far month contract subject to minimum margin of 0.25% and a maximum margin of 0.75% on the far side of the spread with legs up to 1 year apart. 3. Exposure Limits The notional value of gross open positions at any point in time in Futures contracts on a the Notional 10 year bond shall not exceed 100 times the available liquid net worth of a member. For futures contracts on the National T-Bill, the notional value of gross open position at any point in the contract shall not exceed 1000 times the available liquid net worth of a member. 4. Real Time Computation Initially, the zero coupon yield curve shall be computed at the end of the day. However, the Exchange/yield curve provider shall endeavour to compute the zero coupon yield curve on a real time basis or at least several times during the course of the day. 5. Margin Collection and Enforcement

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M P Birla Institute of Management The mark to market settlement margin for Interest Rate Futures Contracts shall be collected before the start of the next day’ s trading, in cash. If mark to market margins is not collected before start of the next day’s trading, the clearing corporation/house shall collect correspondingly higher initial margin to cover the potential for losses over the time elapsed in the collection of margins. The initial margin shall be calculated measures for index futures. 6. Position Limits In the case of Interest Rate Futures Contracts, position limits shall be specified at the client level and for near month contracts. The client level position limits shall be Rs. 100 crore or 15% of open interest whichever is higher.


Clearing House has developed a comprehensive risk containment mechanism for the F & O segment. The salient features of risk containment mechanism on the F& O segment are: ¾ The financial soundness of the members is the key to risk management. Therefore, the requirements for membership in terms of capital adequacy (net ¾ Clearing Houses charges an upfront initial margin for all the open operations of a Clearing member. It specifies the initial margin requirements for each futures/options contract on a daily basis. It also follows value at risk based worth, security deposits) are quite stringent.

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M P Birla Institute of Management margining through SPAN. The Clearing Member in turn collects the initial ¾ The open position of the members are marked to market based on contract settlement price for each contract. The difference is settled in cash on a T+1 ¾ Clearing houses on line position monitoring system monitors a CM’s open positions on a real time basis. Limits are set for each CM based on his capital deposits. The online position monitoring system generates alters whenever a CM reaches a position limit set up by NSCCL. NSCCL monitors the CMs while TMs ¾ CMs are provided a trading teminal for the purpose of monitoring the open positions of all the TMs clearing and settling through him. A CM may set exposure limits for a TM clearing and settling through him. NSCCL assists the CM to monitor the intra day exposure limits set up by a CM and whenever a TM ¾ member is alerted of his position to enable him to adjust his exposure or bring A in additional capital. Position violations result in withdrawal of trading facility ¾ separate settlement gurantee fund for this segment has been created out of the A capital of members. The fund has a balance of Rs. 648 crores at the end of March 2002. The most critical component of risk containment mechanism for F & O segment is the margining system and online position monitoring. The actual position monitoring and margining system is carried out online through Parallel Risk Management System (PRISM) . Prism uses SPAM ( Standard Portfolio Analysis of Risk) system for the purpose of computation of online margins, based on the parameters defined by RBI. for all TMs if a CM in case of a violation by the CM. exceeds the limits, it stops that particular TM from further trading. are monitored for contract wise position limit violation. basis. margin form the Trading Members and their respective clients.

The position limits specified for FIIs and their sub-account is as under: Page 31 of 68

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¾ the level of the FII At In the case of index related derivative products, the position limit is 15% of open interest in all futures and options contract on a particular underlying index, or Rs. 100 crore, whichever is higher. In case of underlying security, the position limit is 7.5 % of open interest, in all futures and options contracts on a particular underlying security, or Rs. 50 crore, whichever is higher. ¾ the level of the sub-account: At The CM/TM is required to disclose to the NSCCL details of any person or persons acting in concert who together own 15% or more of the open interest of all futures and options contracts on a particular underlying index on the exchange.

- In case of futures and option contracts on securities the gross open
position across all futures and options contracts on a particular underlying security of a sub account of an FII, should not exceed the higher or 1% of the free float market capitalization (in terms of number of shares) or 5% of the open interest in the derivative contracts on a particular underlying stock (in terms of number of contracts). These position limits are applicable on the combined position in all futures and options contracts on an underlying security on the exchange.

If people trade on foreign derivatives exchanges, won't that hurt the interests of India's exchanges?

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M P Birla Institute of Management From the viewpoint of India's securities industry, it would be great to trade gold futures -- it would yield revenues and it would raise sophistication. If that can be achieved, it would be great, but it looks like it will take a while for the regulatory apparatus to permit gold futures in India. From the view point of the Indian economy -- and the economy is much more than the securities industry -- the important point is not the colour of the skin. It does not matter whether an Indian or a foreigner is running the exchange. The important point is to have access to these products. There are many situations where we would be better off by merely giving permissions to Indian to go abroad and trade in these markets. Why do we take it for granted that we have to wait for India's markets to develop. Witness the two year delay in getting an index futures market started -- these delays force India's households and companies to continue to live with risk. India's economy will benefit from having access to derivatives, whether they are come about through India's regulators and exchanges or not. If the Singapore government is friendly to derivatives markets in a way that India's government is not, India's citizens should go ahead and reduce their risk by using futures markets in Singapore. Hence we should not approach commodity derivatives looking only at the Indian securities industry. The interest of Indian consumers, households and producers is more important, as these are the people who are exposed to risk and price fluctuations. To the extent that foreign derivatives markets can reduce the risk for Indians, this is good. The RBI has recently released the R. V. Gupta committee report on these issues. It is an excellent piece of work, which paves the way for Indians to benefit from using foreign commodity futures markets. I think that this report is going to be a milestone in the history of India's financial sector.

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M P Birla Institute of Management



In this section we shall have a look at the regulations that apply to brokers under the SEBI Regulations. BROKERS: A broker is an intermediary who arranges to buy and sell securities on behalf of clients. According to section 2 (c) of the SEBI rules, a stock broker means a member of a recognized stock exchange. No stock broker is allowed to buy or sell or deal in securities, unless he or she holds a certificate of registration granted by SEBI. A stock broker applies for registration to SEBI through a stock exchange or stock exchanges of which he or she is admitted as a member. SEBI may grant a certificate to a stock broker subject to the condition that: ¾ holds the membership of any stock exchange. He stock exchanges of which he is a member.

¾ shall abide by the rules. Regulations and bye-laws of the stock exchange or He ¾ case of any change in the status and constitution, he shall obtain prior In permission of SEBI to continue to buy, sell or deal in securities in any stock ¾ shall pay the amount of fee for registration in the prescribed manner He exchange

¾ shall take adequate steps for redressal of grievances of the investor with in one He month of the date of the receipt of the complaint and keep SEBI informed about the member, nature and other particulars of the complaints.

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SEBI setup a 24 member committee under the chairmanship of Dr. L.C. Gupta to develop the appropriate regulatory framework for derivatives trading in India. The committee submitted its report in March 1998. On may 11, 1998 SEBI accepted the recommendations of the committee and approved the phased introduction of derivatives trading in India beginning with stock index futures. SEBI also approved the “Suggestive by-laws” recommended by the committee for regulation and control of trading and settlement of derivatives contracts. The provisions for SC( R ) A and regulatory framework developed their undergovern trading in securities. The amendment of the SC( R )A to include derivatives within the ambit of ‘securities’ in the SC( R) A made trading in derivatives possible within the framework of the Act. ¾ Any Exchange fulfilling the eligibility criteria as prescribed in the LC Gupta committee report may apply to SEBI for grant of recognition under Section 4 of the SC( R)A, 1956 to start trading derivatives. The derivatives exchange/segment should have a separate governing council and representation of trading/clearing member shall be limited to maximum of 40% of the total members of the governing council. The exchange shall regulate the sales practices of its members and will obtain prior approval of SEBI before start of trading in any derivative ¾ The exchange shall have minimum 50 members. contract.

¾ The members of an existing segment of the exchange will not automatically become the members of derivative segment. The embers of the derivative segment need to fill the eligibility conditions as laid down by the LC Gupta committee.

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M P Birla Institute of Management ¾ The clearing and settlement of derivatives trades shall be through a SEBI approval clearing corporation/house. Clearing corporation/house complying with the ¾ Derivative brokers/dealers and clearing members are required to seek registration from SEBI. This is in addition to their registration as broker of existing stock exchange. The minimum net worth for clearing member of the derivatives clearing corporation/house shall be Rs. 300 lakhs. The net worth of the member shall be computed as follows: Capital + Free reserves Less: non-allowable assets viz., (a) Fixed assets (b) Pledged securities (c) Member’s card (d) Non-allowable securities (unlisted securities) (e) Bad deliveries (f) Doubtful debts and advances (g) Prepaid expenses (h) Intangible assets (i) 30% marketable securities ¾ The minimum contract value shall not be less than Rs. 2 lakhs. Exchanges should also submit details of the futures contract they propose to ¾ The initial margin requirement, exposure limits linked to capital adequacy and margin demands related to the risk of loss on the position shall be ¾ The LC Gupta committee report requires strict enforcement of “Know your customer” rule and requires that every client shall be registered with the derivatives broker. The members of the derivatives segment are also prescribe by SEBI/Exchange from time to time. introduce. eligibility as laid down by the committee have to apply to SEBI grant of approval.

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M P Birla Institute of Management required to make their clients aware of the risks involved in derivatives trading by issuing to the client Risk Disclosure Document and obtain a ¾ The trading member are required to have qualified approval user and sales person who have passed a certification program approved by SEBI. copy of the same duly signed by the client.

The following risk management measures have been prescribed by SEBI: 1. Liquid Networth Requirement: The clearing member’s minimum li quid net worth must be at least Rs. 50 lakh at any point of time. 2. Initial Margin Computation: A portfolio based margining approach has been adopted which takes an integrated view of the risk involved in the portfolio of each individual client comprising of his position in all derivative contracts. The initial margin requirement are based on worst scenario loss of a portfolio of an individual client to cover 99% VAR over one day time horizon. Provided, however, in the case of futures, where it may not be possible to collect the mark to market settlement value, before the commencement of trading on the next day, the initial margin may be computed over a two day time horizon, applying the appropriate statistical formula. The methodology for computation of Value at Risk is as per recommendation of SEBI from time to time. Initial margin requirements for a member are as follows:

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M P Birla Institute of Management a. For client positions – It shall be netted at the level of individual client and grossed across all clients, at the Trading/Clearing Member Level, without any setoffs between clients. b. For proprietary position – It shall be betted at Trading/Clearing Member Level without any setoffs between client and proprietary positions. For the purpose of SPAN margin, various parameters shall be specified hereunder or such other parameters as may be specified by the relevant authority form time to time: • Calendar Spread Charge: Calendar Spread Charge covers the calendar (inter-month etc.,) basis risk that may exist for portfolios containing futures and options with different expirations. In the case of Futures and Options contracts on Index and Individual securities, the margin on calendar spread shall be calculated on the basis of delta of the portfolio consisting of futures and options contracts in each month. A calendar spread position shall be treated as non spread (naked) positions in the far month contract, 3 trading days prior to expirations of the near month contract. • Premium Margin: Premium Margin shall mean and include premium amount due to be paid to clearing corporation towards premium settlement, at client level. Premium Margin for a day shall be levied till the completion of pay in towards the premium settlement. • Position Limit: Position limit have been specified by SEBI at trading member, client, market and FII level respectively; Trading Member Position Limit: There is a position limit in derivative contracts on an index of 15% of the open interest of all derivative contracts on the same underlying or Rs. 100 crore, whichever is higher, in all the futures and options contracts on the same underlying. The trading member positions limits is linked to the market wide position limit is less than or equal to Rs. 250 crore, the trading member limit in such securities shall be 20% of the market wide position limit. For securities, in which

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M P Birla Institute of Management the market wide position limit is greater than Rs. 250 crore, the trading member position limit in such stocks shall be Rs. 50 crore. The position of all FII/Sub accounts shall be monitored at the end of the day for limits of 7.5% of the open interest of all derivative contracts on the same underlying or Rs. 50 crore, whichever is higher, in all the futures and option contracts on the same underlying security as per existing applicable position limits. For futures contracts open interest shall be equivalent to the open positions in that futures contract multiplied by its last available closing price. Market Wide Position Limits: The market wide limit of open position on all futures on a particular stocks shall be lower of 30 times the average number of shares traded daily, during the previous calendar month, in the relevant underlying security in the underlying segment of the relevant exchange, or, 10% of the number of shares held by non-promoters in the relevant underlying security i.e., 10% of the free float, in terms of number of shares of a company.

NSCCL has developed a comprehensive risk containment mechanism for the F&O segment. The sailent features of risk containment mechanism on the F&O segment are: ¾ The financial soundness of the members is the key to risk management. worth, security deposits) are quite stringent. Therefore, the requirement for membership in terms of capital adequacy (net ¾ NSCCL charges an upfront initial margin for all the open positions of a CM. It specifies the initial margin requirement for each futures contract on a daily basis. It also follows value at risk (VAR) based margining through SPAN. The CM is turn collects the initial margin from the TMs and their respective clients.

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M P Birla Institute of Management ¾ The open positions of the members are marked to market based on contact settlement price for each contract. The difference is settled in cash on a T+1 ¾ NSCCL’s online position monitoring system monitors a CM’s open position on a real time basis. Limits are set for each CM based on his capital deposits. The online position monitoring system generates alerts whenever a CM reaches a position limit set up by NSCCL. NSCCL, monitors the CM’s for MT M value ¾ CMs are provided a trading terminal for the purpose of monitoring the open positions of all the TMs clearing and settling through him. A CM may set exposure limits for a TM clearing and settling through him. NSCCL assists the CM to monitor the intra-day exposure limits set up by a CM and whenever a TM ¾ member is alerted of his position to enable him to adjust his exposure or bring A in additional capital. Position violations result in withdrawal or trading facility ¾ separate settlement gurantee fund for this segment has been created out of the A capital of members. The fund has a balance of Rs. 13002 million at the end of march 2003/ The most critical component of risk management mechanism for F&O segment is the margining system and online position monitoring. The actual position monitoring and margining is carried out online through Parallel Risk Management System (PRISM). PRISM uses SPAN ® (Standard Portfolio Analysis of Risk) system for the purpose of computation of online margins, based on the parameters defined by SEBI. for all TMs of a CM in case of a violation by the CM. exceed the limits, it stops that particular TM from further trading. violation, while TMs are monitored for contract wise position limit violation. basis.

The stocks which are eligible for futures trading should meet the following criteria:

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¾ The stock should be amongst the top 200 scrips, on the basis of average market capitalization during the last six months and the average free float market capitalization should not be less than Rs. 750 crore. The free float market ¾ The stock should be amongst the top 200 scrips on the basis of average daily volume (in value terms), during the last six months. Further, the average daily ¾ The stock should be traded on atleast 90% of the trading days in the last six months, with the exception of cases in which a stock is unable to trade due to ¾ The non promoter holding in the company should be at least 30%. corporate actions like de-mergers etc., volume should not be less than Rs. 5 crore in the underlying cash market. capitalization means the non-promoter holding in the stock.

¾ The ratio of the daily volatility of the stock vis-à-vis the daily volatility of the index (either BSE 30 sensex or S&P CNX Nifty) should not be more than 4, at any time during the previous six months. For this purpose the volatility would be The ¾ stock on which options contracts are permitted to be traded on one derivative exchange/segment would also be permitted to trade on other derivative exchange/segments. computed as per the exponentially weighted moving average formula.


1. The Exponentially Weighted Moving Average Method The successful use of value at risk models is critically dependent upon estimates of the volatility of underlying prices. The principal difficulty is that the volatility is not constant over time - if it were, it could be estimated with very high accuracy by using a

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M P Birla Institute of Management sufficiently long sample of data. Thus models of time varying volatility become very important. Practitioners have often dealt with time varying parameters by confining attention to the recent past and ignoring observations from the distant past. Econometricians have on the other hand developed sophisticated models of time varying volatility like the GARCH (Generalised Auto-Regressive Conditional Heteroscedasticity) model. Straddling the two are the exponentially weighted moving average (EWMA) methods popularised by J. P. Morgan’s Risk Metrics system. EWMA methods can be regarded as a variant of the practitioner’s idea of using only the recent past because the practitioners’ idea is essentially that of a simple moving average where the recent past gets a weight of one and data before that gets a weight of zero. The variation in EWMA is that the observations are given different weights with the most recent data getting the highest weight and the weights declining rapidly as one goes back. Effectively, therefore, EWMA is also based on the recent past, in fact, it is even more responsive than the simple moving average to sudden changes in volatility. EWMA can also be regarded as a special case of GARCH in which the “persistence parameter” is set to unity. This means that unlike GARCH, EWMA does not have a notion of long run volatility at all and is therefore more robust under regime shifts. EWMA is computationally very simple to implement (even simpler than a simple moving average). The volatility at the end of day t, during day t: 6'WA  6'W-1)^2 + (1 -UWA  ZKHUH LVD  SDUDPHWHUZKLFK HWHUPLQHVKRZ G UDSLGO\ YRODWLOLW\ HVWLPDWHVFKDQJH WLVHVWLPDWHG VLQJ SUHYLRXV X WKH volatility estimate SDt-1 (as at the end of day t-1), and the return rt observed in the index

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M P Birla Institute of Management 2. Empirical Tests on the Indian Stock Market 3. Whatever intuitive or theoretical merits a value at risk model may have, the ultimate test of its usability is how well it holds up against actual data. For example, tentative results3 indicate that foreign exchange markets in India are best modelled by processes that allow jumps and that EWMA methods do not perform well in that market at all. Empirical tests of the EWMA model in the Indian stock market are therefore of great importance. The EWMA model was therefore tested using historical data on the Indian stock market indices - the NSE-50 Index (Nifty) and the BSE-30 Index (Sensex). 2.1 Sample Period The data period used is from July 1, 1990 to June 30, 1998. The long sample period reflects the view that risk management studies must attempt (wherever possible) to cover at least two full business cycles (which would typically cover more than two interest rate cycles and two stock market cycles). It has been strongly argued on the other hand that studies must exclude the securities scam of 1992 and must preferably confine itself to the period after the introduction of screen based trading (post 1995). The view taken in this study is that the post 1995 period is essentially half a business cycle though it includes complete interest rate and stock market cycles. The post 1995 period is also an aberration in many ways as during this period there was a high positive autocorrelation in the index which violates weak form efficiency of the market. (High positive autocorrelation is suggestive of an administered market; for example, we see it in a managed exchange rate market). The autocorrelation in the stock market was actually low till about mid 1992 and peaked in 1995-96 when volatility reached very low levels. In mid-1998, the autocorrelation dropped as volatility rose sharply. In short there is distinct cause for worry that markets were artificially smoothed during the 1995-97 periods. Similarly, this study takes the view that the scam is a period of episodic volatility (event risk) which could quite easily recur. If we disregard issues of morality and legality,

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M P Birla Institute of Management the scam was essentially a problem of monetary policy or credit policy. Since both the bull and bear sides of the market financed themselves through the scam in roughly equal measure, the scam was roughly neutral in terms of direct buy or sell pressure on the market. What caused a strong impact on stock prices was the vastly enhanced liquidity in the stock market. The scam was (in its impact on the stock market) essentially equivalent to monetary easing or credit expansion on a large scale. The exposure of the scam was similarly equivalent to dramatic monetary (or credit) tightening. Any sudden and sharp change in the stance of monetary policy can be expected to have an impact on the stock market very similar to the scam and its exposure. A prudent risk management system must be prepared to deal with events of this kind. 2.2 Logarithmic Return The usual definition of return as the percentage change in price has a very serious problem in that it is not symmetric. For example, if the index rises from 1000 to 2000, the percentage return would be 100%, but if it falls back from 2000 to 1000, the percentage return is not -100% but only -50%. As a result, the percentage return on the negative side cannot be below - 100%, while on the positive side, there is no limit on the return. The statistical implication of this is that returns are skewed in the positive direction and the use of the normal distribution becomes inappropriate. For statistical purposes, therefore, it is convenient to define the return in logarithmic terms as rt = ln(It/It-1) where It is the index at time t. The logarithmic return can also be rewritten as rt = ln(1+Rt) where Rt is the percentage return showing that it is essentially a logarithmic transformation of the usual return. In the reverse direction, the percentage return can be recovered from the logarithmic return by the formula, Rt = exp(rt)-1. Thus after the entire analysis is done in terms of logarithmic return, the results can be restated in terms of percentage returns. It is worth pointing out that the percentage return and the logarithmic return are very close to each other when the return is small in magnitude. However, when there is a large return (positive or negative) the logarithmic return can be substantially different from the percentage return. For example, in the earlier illustration of the index rising from 1000 to 2000 and then dropping back to 1000,

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M P Birla Institute of Management the logarithmic returns would be +69.3% and -69.3% respectively as compared to the percentage returns of +100% and -50% respectively. 2.3 Maximum Likelihood Estimation



itself statistically by the method of maximum likelihood. This process yielded an estimate for RI IRUWKH 1L fty and 0.929 for the Sensex. These values are not statistically XVHG -30RUJDQ¶V5LVN LQ 0HWULFV -squares with 1 df of 1.89 VLJQLILFDQWO\ GLIIHUHQWIURP YDOXH WKH RIIRU 


for the Sensex and 4.46 for the Nifty which are not significant at the 1% level even though we have a sample size of over 1750). The analysis was therefore carried out using D RIWR HUPLWHDVLHUFRPSDUDELOLW\ G   S DQIDFLOLWDWH IXUWKHUH[WHQVLRQVWR PRGHO WKH 2.4 Conditional Normality It is well known that stock market returns are not normally distributed even if one uses logarithmic returns to induce symmetry. However, the time varying volatility itself is one major cause for non-normality. It is to be expected therefore that the “conditional distribution” of the return given the volatility estimate is approximately normal. In other words, the returnon each day divided by the estimated standard deviation for that day should be roughly normally distributed. The results do indicate significant reduction in non normality. The unconditional distribution has an excess kurtosis6 of 5.42 for Nifty and 4.77 for Sensex while the “conditional distribution” has an excess kurtosis of only 1.75 for Nifty and 1.13 for Sensex. Thus over two-thirds of the excess kurtosis is eliminated by the time varying volatility estimation process. Nevertheless, the kurtosis (which is a measures the fat tails) is still too large for use of the normal distribution values without modification. For example, the normal distribution would imply applying a value of 2.58 SD IRUD VLGHG WZR ³YDOXH WULVN´ D OLPLW of 1%. However, the presence of fat tails even in the conditional stock market returns implies that it is necessary to use a higher value to get the same degree of protection. A .

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M P Birla Institute of Management common rule of thumb for distributions with a moderate degree of kurtosis is to use a value of 3 SD IRUD WDLODQWKLVYDOXH  G LVXVHG WKH LQ UHVWRIWKLVVWXG\ 2.5 Margins

Since the volatility estimates are for the logarithmic return, the +or-  


a 99% VAR would specify the maximum/minimum limits on the logarithmic returns not the percentage returns. To convert these into percentage margins, the logarithmic returns would have to be converted into percentage price changes by reversing the logarithmic transformation. Therefore the percentage margin on short positions would be equal to 100(exp(3SDt)-1) and the percentage margin on long positions would be equal to 100(1exp(-3SDt)). This implies slightly larger margins on short positions than on long positions, but the difference is not significant except during periods of high volatility where the difference merely reflects the fact that the downside is limited (prices can at most fall to zero) while the upside is unlimited. 2.6 Back Testing Results Backtesting this model for the period over a 8 year period showed that the 1% VAR limit was crossed 22 times in the case of Nifty and 23 times in the case of Sensex as against the expected number of 18 violations. The hypothesis that the true probability of a violation is 1% cannot be rejected at even the 5% level of statistical significance though we have a sample size of over 1750. The actual number of violations is therefore well within the allowable limits of sampling error. In the terminology of the Bank for International Settlements (“Supervisory framework for the use of ‘backtesting’ in conjunction with the internal models approach tomarker risk capital requirements”, Basle Committee on Banking Supervision, January 1996),these numbers are well within the “Green Zone” where the “test results are consistent with an accurate model, and the probability of accepting an inaccurate model is low”. The market movements, margins and margin shortfalls are shown graphically in Figures 1 and 2. The summary statistics about the actual margins on the sell side are

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M P Birla Institute of Management tabulated below while year by year details of the sell side and buy side margins are given in Tables 1 and 2.

REGULATORY OBJECTIVE (a). Investor protection: Attention needs to be given to the following four aspects: (i) Fairness and Transparency: The trading rules should ensure that trading is conducted in a fair and transparent manner. Experience in other countries shows that in many cases, derivatives brokers/dealers failed to disclose potential risk to the clients. In this context, sales practices adopted by dealers for derivatives would require specific regulation. In some of the most widely reported mishaps in the derivatives market elsewhere , the underlying reason was inadequate internal control system at the user firm itself so that overall exposure was not controlled and the use of derivatives was for speculation rather than for risk hedging. These experiences provide useful lessons for us for designing regulations. (ii) Safeguard for client’s money: Moneys and securities deposited by clients with the trading members should not only be kept in a separate clients account but should also not by attachable for meeting the broker’s own debts. It should be ensured that trading by dealers on account is totally segregated from that for clients. (iii) Competent and honest service: The eligibility criteria for trading members should be designed to encourage competent and qualified personnel so that investors/clients are served well. This makes it necessary

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M P Birla Institute of Management to prescribe qualification for derivatives brokers/dealers and the sales persons appointed by them in terms of a knowledge base. (iv) Market integrity: The trading system should ensure that the market’s integrity is safeguarded by minimizing the possibility of defaults. This requires farming appropriate rules about capital adequacy, margins, clearing corporation, etc. (b) Quality of markets: The concept of “Quality of Markets” goes well beyond market integrity and aims at enhancing important market qualities, such as cost efficiency, price continuity, and price discovery. This is a much broader objective than market integrity. (c) Innovation : While curbing any undesirable tendencies, the regulation framework should not stifle innovation which is the source of all economic progress, more so because financial derivatives represent a new rapidly developing area, aided by advancements in information technology. Of course the ultimate objective of regulation of financial markets has to be promote more efficiency functioning of markets on the “real” side of the economy, i.e., economic efficiency.

The committee’s attention has been drawn to several important issues connecting with derivatives trading. The committee has considered such issues, some of which have a direct bearing on the design of the regulatory framework. They are listed below: ¾ Should derivatives exchange be organized as independent and separate form an ¾ What exactly should be the division of regulatory responsibility, including both framing and enforcing the regulations, between SEBI and the derivatives exchange? existing stock exchange?

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M P Birla Institute of Management ¾ How should ensure that the derivatives exchange will effectively fulfill its ¾ What criteria should SEBI adopt for granting permission for derivatives trading to ¾ What condition should the clearing mechanism for derivatives trading satisfy in ¾ What new regulations or changes in existing regulations will have to be introduced by SEBI for derivative trading? view of high leverage involved? an exchange? regulatory responsibility.


(a) The trading rules and entry requirements for futures trading would have to be different from those for cash trading. (b) The possibility of collusion among traders for market manipulation seems to be greater if cash and futures trading are conducted in the same exchange. (c) A separate exchange will start with a clean slate and would not have to restrict the entry to the existing members only but the entry will be thrown open to all potential eligible players.

Implicit Cost of Carry in Inter-Index Arbitrage
It is well known that since the BSE and NSE operate different settlement cycles it is possible to do a form of carry forward (or badla) trading by continuously shifting positions from one exchange to the other to avoid delivery. A person who has bought on

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M P Birla Institute of Management BSE can square his position on that exchange on or before Friday and simultaneously buy on NSE. Since he has squared up on BSE, he does not have to take delivery there. On or before Tuesday, he can square up on NSE and buy on BSE avoiding delivery at NSE. He can keep repeating this cycle as long as he likes. Since this is very similar to carry forward trading (or rolling a futures contract), it is clear that this person would implicitly pay a carry forward charge (contango or backwardation) in the form of a price difference between the two exchanges. To model this, this study assumes that a trade in the BSE could be regarded as a futures contract for Friday expiry while a trade on the NSE could be regarded as a futures contract for Tuesday expiry. The cost of carry model of futures prices tells us that the futures price equals the cash price plus the cost of carry till the expiry date. Two futures contract with different expiry dates will be priced to yield a price difference equal to the cost of carry for the difference between the two expiry dates.

The table below summarises the impact of the differing settlement cycles. (Throughout this study, day means trading day and yesterday means last trading day). Days of week BSE Monday Tuesday Wednesday Thursday Friday 0 4 3 2 1 Yesterday Days to expiry NSE 2 1 0 4 3 -2 3 3 -2 -2 DIFF. BSE 4 3 2 1 0 Today Days to expiry NSE 1 0 4 3 2 DIFF 3 3 -2 -2 -2 Change in differential Days to expiry 5 0 -5 0 0

The last column of this table is crucial. It tells us that the relation between BSE and NSE undergoes a change on Monday and Wednesday.

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M P Birla Institute of Management • From Friday close to Monday close the BSE contract changes from an expiry 2 days ahead of NSE to an expiry 3 days after NSE - a net positive change of 5 trading days or one week. From being priced two days’ carry below NSE, the BSE contract will now be priced three days’ carry above the NSE price causing a net change of 5 trading days’ or one week’s cost of carry in the difference between the two prices. Therefore Monday's return on BSE should exceed that in NSE by one week’s cost of carry • Similarly from Tuesday close to Wednesday close the BSE contract changes from an expiry 3 days after NSE to an expiry 2 days ahead of NSE - a net negative change of 5 trading days or one week. This is the reverse of the above situation and therefore Wednesday's return on BSE should be lower than that in NSE by one week’s cost of carry. To estimate the cost of carry, the Nifty index was used. The Nifty Index based on Last Traded Prices (LTP) at the NSE was obtained from the NSE and the returns on this index were computed. The returns on the Nifty Index was computed separately using BSE prices for the period from January 1, 1998 to June 30, 1998. It turns out that on average on Mondays, the return in BSE exceeds that in NSE by 0.61% while on Wednesdays, it is the other way around - the return in NSE exceeds that in BSE by 0.71%. This implies that one week’s cost of carry is approximately 0.6 -0.7% or that the annual cost of carry is about 30-35% on a simple interest basis or 35-45% on a compound interest basis. These rates are far above any money market rate and indicates very strong barriers to the flow of money into financing stock market transactions. A closer look at Table 1 suggests a way of measuring the volatility of the cost of carry as well: • Both on Monday close and on Tuesday close the BSE contract is for expiry 3 days after NSE. The difference in the returns between the two exchanges is therefore only due to the change in the cost of carry during Tuesday. Standard deviation of the differential return is

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M P Birla Institute of Management therefore the standard deviation of daily change in 3 days' cost of carry. • Similarly the standard deviation of the differential return on Thursday and Fridays is equal to the standard deviation of daily change in 2 days' cost of carry of carry. The critical assumption in the above is that the differences in prices between the BSE and NSE is due only to the difference in the two expiry dates and that various other differences in market microstructure in the two exchanges do not have any impact. In reality perhaps a lot of the fluctuation in the price differences is attributable to these microstructure differences.

In India derivatives are traded only on two exchanges. The details of trades on these exchanged during 2002-03 are presented in the table below. The total exchange traded derivatives witnessed a volume of Rs. 4423333 million during the current year as against Rs. 1038480 million during the preceding year. While NSE accounted for about 99.4% of total turnover, BSE accounted for less than 1%. It is believed that India is the second largest market in the world for stock futures. TRADE DETAILS OF DERIVATIVES MARKET

NSE Month/year No. of Contracts Traded OCT 02 NOV 02 DEC 02 JAN 03 1378088 1554551 1966839 2061155 Turnover ( Rs. mn.) 34413 398360 556201 591400 No. of

BSE Turnover ( Rs. mn) 140 132 160 6471

TOTAL No. of Contracts Traded 1378706 1555097 1967450 2097625 Turnover (Rs. mn) 334553 398492 556361 597871

Contracts Traded 618 546 611 36470

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M P Birla Institute of Management FEB 03 MAR 03 TOTAL 02-03 1863217 1950004 16768909 493948 493317 4398548 39513 43648 138037 6848 7182 24785 1902730 1993652 16906946 500796 500499 4423333

The product wise distribution of turnover in F&O segment for the year 2002-03 is presented in the chart below

Product w ise distribution of turnover of F&O segment of NSE 2002-03

Stock options 23% Stock futures 65% Index futures 10% Index options 2%

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CITYWISE DISTRIBUTION OF TURNOVER OF F&O SEGMENT OF NSE 2002-03 Sl No. Location Share in Turnover (%) 2001-02 1 2 3 4 5 6 7 8 Mumbai Delhi/Ghaziabad Calcutta/Howrah Cochin/Ernakulam/Parur/Kalamserry/Alwaye Ahamedabad Chennai Hydrabad/Secundrabad/Kukatpally Others TOTAL 49.08 24.28 12.6 2.44 2.25 2.01 1.54 5.2 100 2002-03 41.20 20.31 15.6 .63 2.1 2.24 .97 9.38 100

TAXABILITY OF INCOME ARISING FROM DERIVATIVE CONTRACTS The Income Tax Act does not have any specific provision regarding taxability of income from derivatives. Only provisions, which have an indirect bearing on derivative transaction, are section 73(1) and 43(5). Section 73(1) provides that any loss, computed in respect of a speculative business carried on by the assessee, shall not be set off expect against profits and gains, if any, of any speculative business. Section (43) of the Act defines a speculative transaction as a transaction in which contract for purchase or sale of any commodity, including stocks and shares, is periodically or ultimately settled otherwise than by actual delivery or transfer of the commodity or scrips. It excludes the following types of transactions from the ambit of speculative transaction: 1. A contract in respect of stocks and shares entered into by a dealer or investor therein to guard against loss in his holding of stocks and shares through price fluctuations; 2. A contract entered into by a member of a forward market or a stock exchange in the course of any transaction in the nature of jobbing or arbitrage to guard against loss, which arise in ordinary course of business as such member. A transaction is thus considered speculative if Page 54 of 68

M P Birla Institute of Management i. It is in commodities, shares, stock or scrips, ii. It is settled otherwise than by actual delivery iii. It is not for arbitrage, and iv. The participant has no underlying position In the absence of a specific provision, it is apprehended that the derivative contracts, particularly the index futures/options which are essentially cash settled, may be constructed as speculative transactions. Therefore, the losses, if any will not be eligible for set off against other incomes of the assessee and will be carried forward and set off against speculative income only up to a maximum of eight years. In fact, however, is that derivative contracts are not for purchase/sale of any commodity, stock, share or scrips. Derivatives are a special class of securities under the Securities Contracts (Regulation) Act, 1956 and do not any way resemble any other type of securities like shares, stock or scrips. Derivative contracts are cash settled, as these can not be settled otherwise. Derivative contracts are entered into by the hedgers, speculators and arbitrageurs. A derivatives contract has any of these two parties and hence some of the derivative contracts, (not all), have an element of speculation. All types of participants need to be provided level playing field so that the market is competitive and efficient. As regards taxability, the law should not treat income of the hedgers, speculators and arbitrageurs differently. Income of all the participants from derivatives need to be treated uniformly. This is all the more necessary as it is well neigh impossible to ascertain if a participant is trading for speculation, hedging or arbitrage. A transaction is thus considered speculative, if a participant enters into a hedging transaction in scrips outside his holdings. It is possible that an investor does not have all the 30 or 50 stocks represented by the index. As a result an investor’s losses or prof its out of derivatives transactions, even though they are of hedging nature in real sense, it is apprehended, may be treated as speculative. This is contrary to capital asset pricing model, which states that portfolios in any economy move in sympathy with the index although the portfolios do not necessarily contain any security in the index. The index derivatives are, therefore, used even for hedging the portfolio risk of non-index stocks.

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M P Birla Institute of Management An investor who does not have the index stocks can also se the index derivatives to hedge against the market risk as all the portfolios have a correlation with the overall movement of the market (i.e, index). In view of i. ii. iii. iv. practical difficulties in administration of tax for different purpose of the same transaction, inherent nature of a derivative contract requiring its settlement otherwise than by actual delivery, need to provide level playing field to all the parties to derivatives contracts, and need to promote derivatives markets, the exchange-traded derivatives contracts need to be exempted from the purview of speculative transactions. Thus must, however, be taxed as normal business income.

VOLATILITY: THE INDIAN EVIDENCE The Indian capital market has witnessed a major transformation and structural change during the past one decade or so as a result of on going financial sector reforms initiated by the Government of India since 1991 in the wake of policies of liberalization and globalization. The major objectives of these reforms have been to improve market efficiency, enhancing transparency, checking unfair trade practices, and bringing the Indian capital market up to international standards. As a result of the reforms several changes have also taken place in the operations of the secondary markets such as automated on-line trading in exchanges enabling trading terminals of the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) to be available across the country and making geographical location of an exchange irrelevant; reduction in the settlement period, opening of the stock markets to foreign portfolio investors etc. In addition to these developments, India is perhaps one of the real emerging markets in South Asian region that has introduced derivative products on two of its principal existing exchanges Page 56 of 68

M P Birla Institute of Management viz., BSE and NSE in June 2000 to provide tools for risk management to investors. There had, however, been a considerable debate on the question of whether derivatives should be introduced in India or not. The L.C. Gupta Committee on Derivatives, which examined the whole issue in details, had recommended in December 1997 the introduction of stock index futures in the first place (1). The preparation of regulatory framework for the operations of the index futures contracts took another two and a halfyear more as it required not only an amendment in the Securities Contracts (Regulation) Act, 1956 but also the specification of the regulations for such contracts. Finally, the Indian capital market saw the launching of index futures on June 9, 2000 on BSE and on June 12, 2000 on the NSE. A year later options on index were also introduced for trading on these exchanges. Later, stock options on individual stocks were launched in July 2001. The latest product to enter in to the derivative segment on these exchanges is contracts on stock futures in November 2001. Thus, with the launch of stock futures, the basic range of equity derivative products in India seems to be complete. Despite the existence of a well-developed stock market for over a hundred years, trading on derivative contracts in India (index futures) started only in June 2000. It is but natural that the market players took time to understand the intricacies involved in the operations of these new instruments. This is clearly reflected in the growth of business in the index futures contracts during the period June 2000 to June 2002. The growth can at the best be said to be modest not only in terms of the number of contracts involved but also in terms of value of such contracts. As far as developed capital markets are concerned, a number of in-depth studies have been carried out to examine various issues relating to financial derivatives. In recent years, some attempts have also been made to study various aspects of index futures relating to emerging markets . Since the introduction of index futures in India is a recent phenomenon, there has hardly been any attempt to examine the impact of their introduction on the underlying stock market volatility .

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1. INITIAL MARGIN FIXATION METHODOLOGY: The exponential moving average method would be used to obtain volatility estimate everyday. The estimate at the end of day t, is based using the previous volatility estimate and the returns observed in the futures market during day t. The margins for 99% Value at risk would be based on 3 sigma limits. There should be slightly large margin on short positions than on long positions, but the difference is significant only during period of high volatility where the difference merely reflects the fact that the downside is limited while the upside is unlimited. The derivative exchange may apply higher margins on both buy and sell side in such situation. For a transactional measure, for first six months of trading (until futures market stabilizes with reasonable level of trading) a parallel estimation of volatility would be done using the cash index prices instead of index futures prices and the higher of the two volatility measure would be used to get margins for the first 6 months initial margin should not be less than 5%. 2. DAILY CHANGES IN MARGIN:] 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 positions. Trading software should provide volatility estimation and margin fixation on a realtime basis on trading work station screen. Page 58 of 68

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3. MARGINING FOR CALENDER SPREADS: International Markets levy very low margins on calendar spreads. A calendar spread is a position at one maturity which hedged by an offsetting position at different maturity like a short position in 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 underlying at all in India. However, unless banks and institutions enter the calendar spread in a bigway, it would be possible that the cost of carry would be driven by an unorganized money market rate as in the case of badla market. These interest rate could be highly volatile. 4. MARGIN COLLECTION AND ENFORCEMENT: A part from correct calculation, the actual collection of margin is also of equal importance. The group recommended that the clearing corporation should lay down operational guidelines on collection of margins and standard guidelines for back office accounting at the clearing member and trading member level to facilitate the detection of non compliance at each level.

From the purely regulatory angle, a separate exchange for futures trading seems to be a neater arrangement. However, considering the constraints in infrastructure facilities, the existing stock exchanges having cash trading may also be permitted to trade derivatives provided they meet the minimum eligibility conditions as indicated below: 1. The trading should take place through an online screen based trading system which also has a disaster recovery site. The per half hour capacity of the computers and the network should be atleast 4 to 5 times of the anticipated peak load in any half hour or of the actual peak load seen in any half hour

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M P Birla Institute of Management during the preceding six months. This shall be reviewed from time to time on the basis of experience. 2. The clearing of the derivatives market should be done by an independent clearing corporation, which satisfies the conditions listed. 3. The exchange must have an online surveillance capacity which moniters positions, prices and volumes in realtime so as to deter market manipulation. Price and position limits should be used for improving market quality. 4. Information about trades, quantities and quotes should be disseminated by the exchange in real time over at least two information vending networks which are accessible to investors in the country. 5. The exchange should have atleast 50 members to start derivatives trading. 6. If derivatives trading is to take place at an existing cash market, it should be done in a separate segment with a separate membership i.e., all members of the existing cash market would not automatically become members of the derivatives market. 7. The derivatives market should have a separate governing council which shall not have representation of trading/clearing members of the derivatives Exchange beyond whatever percentage SEBI may prescribe after reviewing the working of the present governance system of exchanges. 8. The Chairman of the Governing Council of the Derivative Division/Exchange shall be a member of the Governing Council, if the chairman is a Broker/dealer, then, he shall not carry on any broking or dealing business on any Exchange during his tenure as Chairman. 9. The exchange should have arbitration and investor grievances redressal mechanism operative from all the four areas/regions of the country. 10. The exchange should have an adequate inspection capability. 11. No trading/clearing member should be allowed simultaneously to be on the governing council of both the derivatives market and the cash market. 12. If already existing, the exchange should have a satisfactory record of monitoring its members, handling investor complaints and preventing irregularities in trading.

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This study is for making the real Futures contracts taking Titan Industries as underlying. These contracts are mainly based on the information provided by technical analysis. Fundamental analysis is not included as these contracts for only one month and only technical analysis can be provided buying and selling points and the movement of this stock in one month. Where as fundamental analysis cannot predict the market

The above Graph which indicates the price movement of Titan shows that it is in bullish trend. This bullish is also supported by the huge volume of shares traded. Volume generally moves along with prices, and is indicative of the intensity of a price reaction. Both the price and volume are on the rise.

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M P Birla Institute of Management Thus above are the indicative signs for an investor to go bullish on Titan Industries Ltd., But whether to trade in Futures and Options of this underlying is yet to be seen on further evaluation through technical analysis.

Simple Moving Average of Titan Industries Ltd

All simple moving averages 13 days, 34days and 89days does not predict any reversal in the bullish trend. All the Moving Averages are below the price line and are moving in the same direction as the price line there fore showing no signs of trend reversal in near future and conforming bullishness of the stock in near future also. As far as these simple moving averages move in the same direction and are below the price line you can safely bet on the contracts. All this based on simple logic that as long as price at the end of a period is above the average that prevailed in the immediate past, prices are on an up trend. The converse is true for conforming end or a bear market.

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Exponential Moving averages of Titan Industries Ltd

Simple moving averages constructed over long time lags behind the trend so to minimize that more weightage is given to the present data and an Exponential moving average is constructed. This moving average is more sensitive to any price changes in the underling. Thus EMA provides a smooth base for analyzing price trends. The above graph studies the 34 days, 89days and 200days exponential moving averages. All averages do not show any trend reversal of bullish phase in prices of underlying in near future. All are moving along the price line and are below it, indicating no price fall in near future.

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Moving Average Convergence and Divergence (MACD)

The darker line in the MACD and lighter one is the signal line in the above chart below the price chart. Taking ratio of 9day EMA to 20 day EMA draws the chart and signal line is 9day EMA. The chart gives the buying and selling signals. Since the indicator crosses the reference line from below, we interpret that point as signal for buying the underlying. Signal line acts as the trigger, which alerts the trader to take an appropriate buy or sale decision. In the chart above signal line is also giving buy signal as it is above the indicator.

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M P Birla Institute of Management Relative Strength Index is another Oscillator which measures the momentum of the stock. It moves between 0 and 100. This indicator measures the relative internal strength of the stock. 7 day and 13 day’s Relative Strength Index is taken into consideration. The indicator is well within the two boundaries. But in both the above RSI charts the indicators are moving above the reference line in a direction indicating an uptrend. Only when the indicator crosses the overbought position or the oversold position line, it is a warning signal to the trader. Thus it shows that it is safe to enter into the F & O contracts at this point of time

Rate of Change Index (ROC)

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This is one of the simplest and widely used methods to measure momentum of the price change over a certain period of time. A rising index indicates a growth in momentum ( a bullish factor ) and falling index a loss in momentum ( a bearish factor). The line drawn 112 here is a reference line. In the above price chart ROC is well above the reference line and still raising indicating further rise in momentum in near future and the rate at which the price is increasing is growing. Based on above technical analysis a person can enter into either futures contracts or into options.

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NSE BSE MAGAZINES • • • Business world Dalal Street magazine Futures and Options --Derivatives core module The study material

WEB SITES • • • •

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