The eligibility criteria laid down above for single stock derivatives can be extended to the case of narrow stock indices as well. A stock index would normally be eligible for derivatives trading if most of the weightage in the index (say 90%) is accounted for by constituent stocks that are themselves eligible for derivatives trading. This would also of course be subject to the right of SEBI to refuse permission in exceptional cases under paragraph 4.10 of the LCGC report.

The ACD also endorses futures and options on dollar-denominated indexes, which are  cash-settled in rupees provided the index meets the above eligibility criteria.

3.5 Minimum Contract Size

The LCGC Report did not make any recommendation regarding minimum contract size. However, the Standing Committee on Finance of Parliament while considering the amendment to SC(R)A pertaining to derivatives recommended that the threshold limit of the derivative transactions should be pegged not below Rs. 0.2 million. Based on this recommendation SEBI has specified that the value of a derivative contract should not be less than Rs. 0.2 million at the time of introducing the contract in the market.

SEBI has been receiving various representations on the issue of minimum contract size. The following reasons have been cited for withdrawing the stipulation of minimum contract size:-

• At the time when the decision to stipulate a minimum contract size of Rs. 0.2 million was taken, there were other products/systems like, Badla, ALBM, BLESS available to investors through which they could take a long term view on the markets. However, in the present scenario, with rolling settlement in place, investors can take a long term view only through derivative products. The stipulation of minimum contract size of Rs. 0.2 million is a deterrent for many investors to participate in the derivative market, as the cost of entering the derivative markets is high.
• Derivative products provide investors with an efficient and a cost-effective tool for risk management and hedging the market risk on their portfolio. However, the minimum contract size of Rs. 0.2 million may not match with the size of the portfolio of every investor.
• One of the economic purposes of the Derivative markets is that they provide an efficient mechanism for future price discovery. Price is arrived on the basis of the collective perception of all players in the market who have diversified views on the market. A large cross section of persons participating in the market would increase the diversity of the views expressed, which would lead to fair price discovery. The stipulation of minimum contract size may act as a deterrent to many investors and may exclude them for expressing their views in the mechanism of price discovery.

The Committee sees merit in some of these arguments. More importantly, it recognizes that globally the contract size is determined by the exchanges without any intervention from the regulators. The environment under which the Rs 0.2 million limit was introduced has undergone a dramatic change and the time has now come to do away with the minimum contract size in value terms.

3.6 Adjustment for Corporate Actions

At the time of recommending introduction of stock options, SEBI laid down procedures for adjustment in derivative contracts at the time of corporate action in line with international best practices. It was decided that the adjustment for corporate action on the same underlying should be uniform across markets and should be based on the following principles:

• The basis for any adjustment for corporate action shall be such that the value of the position of the market participants on cum and ex-date for corporate action shall continue to remain the same as far as possible. This will facilitate in retaining the relative status of positions viz. in-the-money, at-the-money and out-of-money. This will also address issues related to exercise and assignments.
• Any adjustment for corporate actions shall be carried out on the last day on which a security is traded on a cum basis in the underlying cash market.
• Adjustments may be carried out by modifying the Strike Price, Position or Market Lot / Multiplier. The adjustments shall be carried out on any or all of the above based on the nature of the corporate action.
• The adjustments for corporate actions shall be carried out on all open, exercised as well as assigned positions.

The adjustment methodology for certain corporate actions like rights, bonus, and stock split was also laid down at that time. At the same time a group was set up comprising NSE, BSE and other knowledgeable persons which would decide a uniform course of.16 action for adjusting stock option contracts on corporate actions, taking into account best practices followed internationally, where a uniform criterion was not already laid down. The detailed adjustment methodology laid down by SEBI as well as the decisions taken by the sub-group are summarized in the Appendix.

On the basis of the experience accumulated so far, the ACD is of the view that the task of deciding on adjustments for corporate action should now be left to the exchanges with the stipulation that:

• The basis for any adjustment for corporate action shall be such that the value of the position of the market participants on cum and ex-date for corporate action shall continue to remain the same as far as possible.
• The exchanges should take into account best practices followed internationally.
• The exchanges must act consistent with SEBI’s circular on adjustment for corporate actions as well as the decisions of the erstwhile subgroup on corporate actions.
• The Exchanges must consider the circumstances of the particular case and the general interest of investors in the market

4 Risk Containment

4.1 VaR Framework

The LCGC Report laid down the fundamental principle of 99% VaR based margins:

"The level of initial margin required on a position should be related to the risk of loss on the position. The concept of "value at risk" should be used in calculating required levels of initial margin. The initial margin should be large enough to cover the one-day loss that can be encountered on the position on 99% of the days." (Paragraph 6.13(3)).

"Since market volatility changes over time, the Committee feels that the Clearing Corporation should continuously analyse this problem and may modify the margin requirements to safeguard the market." (Paragraph 6.4)

The methodology for operationalizing these recommendations in the context of index futures was laid down by another committee that submitted its report in November 1998.The principal elements of this framework were:

• SEBI should not lay down the margins but should approve a VaR estimation methodology under which the margins are automatically updated every day · The exponentially weighted moving average method (also known as the IGARCH or Risk Metrics method) should be used to estimate volatility daily.
• The 99% VaR should be operationalized by using three standard deviations to account for the fat tails
• Since even a 99% VaR implies a margin shortfall once every hundred trading days (approximately once every six months), it is necessary to have a second line of defence of 3% (an exposure limit of 33) in the form of a liquid net worth requirement.

• The derivatives exchange and clearing corporation should be encouraged to refine the VaR methodology continuously on the basis of further experience. 

This VaR framework was further extended when index options were introduced. Essentially, the VaR was now based on a portfolio approach similar to that of the SPAN system employed by leading derivative exchanges worldwide:

• The possible loss on the entire portfolio of any client is estimated under a variety of price and volatility scenarios.

• The range of prices considered for this purpose is set at three standard deviations in conformity with the value used when only index futures were traded.

• The range of volatility changes for option valuation was set at 4%. The Black-Scholes or other alternative models could be used for option valuation

• The margin is computed as the worst case loss under these various price and volatility scenarios

• The margin shall not however be less than 3% of the notional value of all short options. This minimum margin is intended to cover model risk and impacts option portfolios which are approximately delta, gamma and vega neutral and therefore attract very low margins under the Black-Scholes valuation model.

• The second line of defence was set at 3% for index options also on the basis of notional value.

When stock options were introduced the same framework was extended by stipulating:

• The range of price movements considered was set at 3.5 standard deviations to account for the fatter tails of movements of stock prices as compared to index movements.

• The range of volatilities to be considered was set at 10% to account for the higher volatility of stocks.

• The second line of defence was set at 5% to account for the higher volatility of stocks.

The ACD regards this risk containment framework as adequate except for changing the second line of defence to the higher of 5% or 1.5 standard deviations as already mentioned in 3.3 above. The underlying rationale for the multiplier 1.5 is that under the assumption of power law tails, the expected price change conditional on the change being greater than x is h/(h-1)x where h is the tail index. Since the first line of margins is equal to x, the second line must cover the excess over x or [h/(h-1)-1]x. If we assume h to be in the range of 3.25 to 3.75 and x is 3.5 standard deviations, then the second line is about 1.5 standard deviations. We put a floor of 5% on this to deal with situations where the estimated volatility is very low because of a long period of very low actual volatility 6 .

4.2 Cross Margining: Basic Principles

The LCGC was of the view that cross margining should be introduced only after the derivative markets have become fully established and the systems capability for adopting sophisticated systems has emerged:

“At the initial stage of derivatives market in India, the Committee does not favour cross-margining which takes into account a dealer’s combined position in the cash and derivative segments and across all stock exchanges. The Committee recognises that cross-margining is logical and would economise the use of a trading member’s capital, but a conservative approach would be more advisable until the reliability of systems has been fully established. The systems capability has to emerge before adopting sophisticated systems.” (Paragraph 6.9)

The ACD is of the view that the initial stage referred to by the LCGC is now over. Derivative markets are now well established and the systems capability for implementing complex margining systems now exists. Cross-margining is now the logical next step. The ACD recommends the following method of implementing cross margining without commingling the cash and derivative segments:

• Cross margining should be implemented at the client level. The margin should be computed on the integrated position of a client across cash and derivative market.

• To achieve efficiency in client level cross margining, it would be desirable that a client has the same clearing member across both the cash and derivative segment. In the event if a client chooses to settle trades through more than one clearing member, the client would decide by way of an agreement which clearing member would collect margin from the client and in event of a default what would be the obligation of other clearing members.

• In the event of default the clearing corporations 7 would liquidate the positions in their respective markets and under an agreement transfer the surplus, if any to the clearing corporation where there is a deficit.

• This method of cross margining avoids commingling the two segments of the exchange. However, it does involve each clearing corporation taking a credit exposure on the other. This must be limited by internal prudential guidelines and embodied in the agreement between the two clearing bodies.

• To achieve cross margining certain legal changes would have to be made in the cash / derivative markets. These are-

• Legal provisions as regard default, TGF/SGF would have to be modified.

• Agreement between clearing corporation, client/clearing member/ trading member to be framed and bye-laws suitably amended.

• Common client identification is necessary to implement cross margining at the client level. The quickest way to do this would be to make a global unique client identification (say PAN number) a pre-requisite for those clients who wish to avail of cross margining. Those who do not have this global unique client identification will still be able to trade but they will not get the benefit of cross margining.

From a risk management point of view, there are technical issues to be resolved for cross margining between an index derivative position and an offsetting cash market position in a basket of stocks that tracks the index.

4.3 Cross Margining between single stock derivative and the underlying

The positions in the underlying that are eligible for cross margining against positions in single stock derivatives are:

• The underlying in dematerialized form transferred to or pledged with the clearing corporation

• Short or long positions in any cash market segment that has a cross margining agreement with the derivative market segment under consideration 

A position in the underlying offset by an equal opposite position in the stock future would be margined like a calendar spread. For the purpose of calculating the spread margin, the maturity difference between the underlying and the near month contract will be taken as one month and the maturity difference between the underlying and a far month contract will be taken as one month plus the maturity difference between the near month contract and the far month contract. Calendar spread treatment will also be accorded to stock option positions whose deltas are offset by opposite positions in the underlying in the same manner in which the calendar spread treatment is applied to option positions of one maturity delta-hedged with futures of a different maturity.

Just as for calendar spreads between two futures contracts, calendar spreads between the underlying and the derivative will also cease three days before expiry of the relevant derivative contract. This has to be done because of the basis risk that arises on settlement. The only possible exception would be where the derivative is a futures contract that is physically settled and the underlying position consists of a position in the cash market segment whose settlement obligations can be netted against the settlement obligations arising on expiry of the future.

Strictly speaking there is a settlement related basis risk whenever an American option is delta hedged with futures or with positions in the underlying. This is because the American option can be exercised at any time. This basis risk is ignored under the assumption that it can be managed by (a) requiring a one day notice before exercise, (b) imposing daily exercise and assignment limits, and (c) withdrawing the spread treatment when the option position has been given notice of assignment for exercise.

4.4 Cross margining between index futures and a basket of constituent stocks

Cross margining would be allowed between positions in index futures and a basket of positions in the constituent stocks provided the client designates the basket of positions as an index basket. The permissible positions in the constituent stocks would be:

• Actual holdings in the stock in unencumbered dematerialized form that are transferred or pledged with the clearing corporation

• Short or long positions in the stock in any cash market segment that has a cross margining agreement with the derivative market segment under consideration

• Short or long positions in the stock futures

• An exchange traded fund (ETF) that tracks the index could also be regarded as a basket of constituent stocks after applying an appropriate haircut to cover redemption costs and tracking error 

A basket of positions in index constituents can be decomposed into three portfolios:

(a) an exact index replica that has the same value as the basket at current market prices,

(b) a short deviation portfolio consisting of short positions in some constituent stocks and

(c) a long deviation portfolio consisting of long positions in some constituent stocks.

Portfolios (b) and (c) can be combined into a total deviation portfolio consisting of the absolute deviations between the index and basket. The construction of these portfolios is illustrated below with the following example of a hypothetical index that has only five stocks:  

It may be seen that the replica portfolio has the same value as the basket at current market prices because the short deviation portfolio and the long deviation portfolio have equal but opposite values. For the same reason, the value of the total deviation portfolio is twice that of the long or short deviation portfolios.

4.4.1 Eligibility Condition for Cross Margining with Basket

Cross margining between the basket and the index future will be permitted only if the following eligibility condition is satisfied:

The total deviation portfolio must have a value not exceeding 5% of the value of the basket. In other words, the basket must approximate the index quite closely.

The Committee recommends that the limit of 5% be reviewed after six months of experience of cross margining.

4.4.2 Margin offset between index futures and replica portfolio

The margin offset between index futures and the replica portfolio will be identical to that between single stock futures and the underlying. In other words, the position will be treated as a calendar spread and margined as such.

4.4.3 Margin on total deviation portfolio

There are two options here:

• The total deviation portfolio can be margined as a portfolio of positions on individual constituents of the portfolio. This would require that the volatility and other margin parameters must be computed for even those index constituents that do not have options or stock futures trading on them.

• A simpler solution is to margin the total deviation portfolio as if it were a position in a single hypothetical stock whose volatility is twice that of the index and which is assumed to be sufficiently liquid (impact cost less than 1%) not to require a 3 scaling for illiquidity. The smallness of the total deviation portfolio is a critical factor in using this approximation.

4.5 Cross margining between index options and options on constituent stocks

No cross margining will be permitted between positions in index options and a basket of positions in options on constituent stocks in the index. The reasons for this stand are:

• It is unlikely that any arbitrageur will delta hedge index options with a basket of constituent stock options. It is much easier to delta hedge index options with index futures and stock options with stock futures. Therefore, though it is not too difficult to give a cross margin benefit for the offsetting deltas of the two positions, there are little practical benefits from doing so.

• An arbitrageur might indeed to want vega hedge index options with a basket of constituent stock options under the belief that the index implied volatility must be a weighted average of constituent implied volatilities. Price discovery might indeed be aided by giving a cross margining benefit for such a vega hedge, but the methodology for doing so would be too complex to implement.

4.6 Cross margining between two indices

No cross margining will be permitted between two indices even if they are highly correlated.

4.7 Cross margining between two stocks

No cross margining will be permitted between two stocks even if they are highly correlated.

    
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