Financial Derivatives-NATIONAL CLEARANCE AND DEPOSITORY SYSTEM - Part 2-Notes-Financial Management, Study notes of Financial Management

Download Financial Derivatives-NATIONAL CLEARANCE AND DEPOSITORY SYSTEM - Part 2-Notes-Financial Management and more Study notes Financial Management in PDF only on Docsity! Regulatory framework Regulatory control should envisage modern systems for fool-proof and fail- proof regulation. Regulatory framework for derivatives trading envisaged two -level regulation i.e. exchange-level and SEBI-level, with considerable emphasis on self- regulatory competence of derivative exchanges under the overall supervision and guidance of SEBI. There will be complete segregation of client money at the level of trading /clearing member and even at the level of clearing corporation. Other recommendations are as under: Regulatory Role of SEBI SEBI will approve rules, bye-laws and regulations. New derivative contracts to be approved by SEBI. Derivative exchanges to provide full details of proposed contract, like - economic purposes of the contract; likely contribution to the market's development; safeguards incorporated for investor protection and fair trading. Specifications Regarding Trading Stock Exchanges are to stipulate in advance trading days and hours. Each contract is to have pre-determined expiration date and time. Contract expiration period may not exceed 12 months. The last trading day of the trading cycle is to be stipulated in advance. Membership Eligibility Criteria The trading and clearing member will have stringent eligibility conditions. The Committee recommended for separate clearing and non-clearing members. There should be separate registration with SEBI in addition to registration with the stock exchange. At least two persons should have passed the certification program approved by SEBI. A higher capital adequacy for Derivatives segment recommended than prescribed for cash market. The clearing members should deposit minimum Rs. 50 lakh with the clearing corporation and should have a net 157 F 0 B 7F 0 2 0Maximum brokerage rates shall be prescribed by the exchange F 0 B 7F 0 2 0Brokerage to be separately indicated in the contract note Margins From Clients 159 F 0 B 7F 0 2 0Margins to be collected from all clients/trading members F 0 B 7F 0 2 0Daily margins to be further collected F 0 B 7F 0 2 0Right of clearing member to close out positions of clients/TMs not paying daily margins F 0 B 7F 0 2 0Losses if any to be charged to clients/TMs and adjusted against margins Other Recommendations F 0 B 7F 0 2 0Removal of the regulatory prohibition on the use of derivatives by mutual funds while making the trustees responsible to restrict the use of derivatives by mutual funds only to hedging and portfolio balancing and not for speculation. F 0 B 7F 0 2 0Creation of derivatives Cell, a derivative Advisory Committee, and Economic Research Wing by SEBI. F 0 B 7F 0 2 0Declaration of derivatives as securities under section 2(h)(ii a) of the SCRA and suitable amendment in the notification issued by the Central Government in June 1969 under section 16 of the SCRA F 0 B 7F 0 2 0Consequent to the committee's recommendations the following legal amendments were carried out: Legal Amendments F 0 B 7F 0 2 0Securities Contract Regulation Act F 0 B 7F 0 2 0Derivatives contract declared as a 'security' in Dec 1999 F 0 B 7F 0 2 0Notification in June 1969 under section 16 of SCRA banning forward trading revoked in March 2000. 160 162 recommendation keeping in mind the issues relating to estimation of volatility discussed. It is decided that SEBI should authorise the use of a particular VAR estimation methodology but should not make compulsory a specific minimum margin level. Initial Methodology (Clause 3.1.2) The group has evaluated and approved a particular risk estimation methodology that is described in 3.2 below and discussed in further detail in Appendix 1. The derivatives exchange and clearing corporation should be authorised to start index futures trading using this methodology for fixing margins. Continuous Refining (Clause 3.1.3) The derivatives exchange and clearing corporation should be encouraged to refine this methodology continuously on the basis of further experience. Any proposal for changes in the methodology should be filed with SEBI and released to the public for comments along with detailed comparative back testing results of the proposed methodology and the current methodology. The proposal shall specify the date from which the new methodology will become effective and this effective date shall not be less than three months after the date of filing with SEBI. At any time up to two weeks before the effective date, SEBI may instruct the derivatives exchange and clearing corporation not to implement the change, or the derivatives exchange and clearing corporation may on its own decide not to implement the change. Initial Margin Fixation Methodology (Clause 3.2) The group took on record the estimation and back testing results provided by Prof. Varma (see Appendix 1) from his ongoing research work on value at risk 163 is essentially an interest rate risk in a money market position. In fact, a calendar spread can be viewed as a synthetic money market position. The above example of a short position in the six month contract matched by a long position in the nine month contract can be regarded as a six month future on a three month T-bill. In developed financial markets, the cost of carry is driven by a money market interest rate and the risk in calendar spreads is very low. In India, however, unless banks and institutions enter the calendar spread in a big way, it is possible that the cost of carry would be driven by an unorganised money market rate as in the case of the badla market. These interest rates could be highly volatile. Given the evidence that the cost of carry is not an efficient money market rate, prudence demands that the margin on calendar spreads be far higher than international practice. Moreover, the margin system should operate smoothly when a calendar spread is turned into a naked short or long position on the index either by the expiry of one of the legs or by the closing out of the position in one of the legs. The group therefore recommends that: F 0 B 7F 0 2 0The margin on calendar spreads is levied at a flat rate of 0.5% per month of spread on the far month contract of the spread subject to a minimum margin of 1% and a maximum margin of 3% on the far side of the spread for spreads with legs upto 1 year apart. A spread with the two legs three months apart would thus attract a margin of 1.5% on the far month contract. F 0 B 7F 0 2 0The margining of calendar spreads is reviewed at the end of six months of index futures trading. F 0 B 7F 0 2 0A calendar spread should be treated as a naked position in the far month contract as the near month contract approaches expiry. This change should 165 be affected in gradual steps over the last few days of trading of the near month contract. Specifically, during the last five days of trading of the near month contract, the following percentages of a calendar spread shall be treated as a naked position in the far month contract: 100% on day of expiry, 80% one day before expiry, 60% two days before expiry, 40% three days before expiry, 20% four days before expiry. The balance of the spread shall continue to be treated as a spread. This phasing in will apply both to margining and to the computation of exposure limits. F 0 B 7F 0 2 0If the closing out of one leg of a calendar spread causes the members' liquid net worth to fall below the minimum levels specified in 4.2 below, his terminal shall be disabled and the clearing corporation shall take steps to liquidate sufficient positions to restore the members' liquid net worth to the levels mandated in 4.2. F 0 B 7F 0 2 0The derivatives exchange should explore the possibility that the trading system could incorporate the ability to place a single order to buy or sell spreads without placing two separate orders for the two legs. F 0 B 7F 0 2 0For the purposes of the exposure limit in 4.2 (b), a calendar spread shall be regarded as an open position of one third of the mark to market value of the far month contract. As the near month contract approaches expiry, the spread shall be treated as a naked position in the far month contract in the same manner as in 3.4 (c). Margin Collection and Enforcement (Clause 3.5) Apart from the correct calculation of margin, the actual collection of margin is also of equal importance. The group recommends that the clearing corporatio n should lay down operational guidelines on collection of margin and standard 166 guidelines for back office accounting at the clearing member and trading member level to facilitate the detection of non-compliance at each level. Transparency and Disclosure (Clause 3.6) 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. Key Regulations In India the National Stock Exchange of India (NSE) and the Bombay Stock Exchange (BSE) offer options trading on stock indices as well as individual securities. Options on stock indices are European in kind and settled only on the last of expiration of the underlying. NSE' offers index options trading on the NSE Fifty index called the Nifty, While BSE: offers index options on the country's widely used index Sensex, which consists of 30 stocks. Options on individual securities are American. The number of stock options contracts to be traded on the exchanges will be based on the list of securities as specified by Securities and Exchange Board of India (SEBI). Additions/ deletions in the list of securities eligible on which options contracts shall be made available shall be notified from time to time. Underlying: Underlying for the options on individual securities contracts shall be the underlying security available for trading in the capital market segment of the exchange. Security descriptor: The security descriptor for the options on individual securities shall be: 167 on individual securities contracts the closing underlying value shall be rounded off to the nearest multiplier of the strike price interval. The in- the-money strike price and the out-of-the-money strike price shall be based on the at-the-money strike price interval. Expiry day: Options contracts on individual securities as well as index options shall expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts shall expire on the previous trading day. Order type: Regular lot order, stop loss order, immediate or cancel, good till day, good till cancelled good till date and spread order. Good till cancelled (GTC) orders shall be cancelled at the end of the period of 7 calendar days from the date of entering an order. Permitted lot size: The value of the option contracts on individual securities shall not be less than Rs 2 lakh at the time of its introduction. The permitted lot size for the options contracts on individual securities shall be in multiples of 100 and fractions if any shall be rounded off to the next higher multiple of 100. Price steps: The price steps in respect of all options contracts admitted to dealings on the exchange shall be Re 0.05. Quantity freeze : Orders which may come to the exchange as a quantity freeze shall be the lesser of the following: 1 per cent of the market wide position limit stipulated of options on individual securities as given in (h) below or Notional value of the contract of around Rs 5 crore. In respect of such orders, which have come under quantity freeze, the member shall be required to confirm J the exchange that there is no inadvertent error in the order entry and that the order is genuine. In such confirmation, the exchange at its discretion may approve such order subject to availability of turnover/exposure limits, etc. 169 Base price: Base price of the options contracts on introduction of new contracts shall be the theoretical value of the options contract arrived at based on Black- Scholes model of calculation of options premiums. The base price of the contracts on subsequent trading days will be the daily close price of the options contracts. However in such of those contracts where orders could not be placed because of application of price ranges, the bases prices may be modified at the discretion of the exchange and intimated to the members. Price ranges: There will be no day minimum/maximum price ranges applicable for the options contract. The operating ranges and day minimum/maximum ranges for options contract shall be kept at 99 per cent of the base price. In view of this the members will not be able to place orders at prices which are beyond 99 per cent of the base price. The base prices for option contracts, may be modified, at t he discretion of the exchange, based on the request received from trading; members as mentioned above. Exposure limits: Gross open positions of a member at any point of time shall not exceed the' exposure limit as detailed hereunder: F 0 B 7 Index Options: Exposure Limit shall be 33.33 times the liquid net worth. F 0 B 7 Option contracts on individual Securities: Exposure Limit shall be 20 times the liquid net worth. Member wise position limit: When the open position of a Clearing Member, Trading Member or Custodial Participant exceeds 15 per cent of the total open interest of the market or Rs 100 crore, whichever is higher, in all the option contracts on the same underlying, at any time, including during trading hours. For option contracts on individual securities, open interest shall be equivalent to the open positions multiplied by the notional value. Notional Value 170 shall be the previous day's closing price of the underlying security or such other price as may be specified from time to time. Market wide position limits: Market wide position limits for option contracts on individual for securities shall be lower of: *20 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 per cent of the number of shares held by non- promoters in the relevant underlying security i.e. 10 per cent of the free float in terms of the number of shares of a company. The relevant authority shall specify the market wide position limits once every month, on the expiration day of the near month contract, which shall be applicable till the expiry of the subsequent month contract. Exercise settlement: Exercise type shall be American and final settlement in respect of options on individual securities contracts shall be cash settled for an initial period of 6 months and as per the provisions of National Securities Clearing Corporation Ltd (NSCCL) as may be stipulated from time to time. 2.21. Warrants and Convertibles Warrant is a contract/option entered into by the issuing company giving the holder the right to purchase or subscribe to the stated number of equity shares of that company within a predetermined specified period of time at a predetermined price. Warrants are somewhat similar to call options but they also have the following differences: While the warrants are issued by companies, options are created by investors, and, as was said earlier, the companies do not have to do anything with such a creation. Warrants usually have lo ng maturities (of several years), while options expire in short periods of time such as nine months. Unlike 171