Risk Management in Cash Market and F&O

Risk Management in Cash market

To understand risk management in cashmarket, it is required to know what risk management is.

Risk management in financial field focuses on risks that can be managed using financial instruments. It is designed to reduce different risks related to a pre-selected domain to the level accepted by society.

Riskmanagement can objectively evaluate and express the acceptability of the inherent risk exposure and can explicitly state their intent regarding the continued acceptance of, or alterations to, the inherent risk exposure relative to a commonly understood reference point. It can also immediately separate the suitability of instruments, positions, strategies, and tactics into some action groups.

The guidelines of Security and Exchange Board of India's (SEBI) guidelines pay stress on the liquid assets deposited by members with the exchange/clearing corporation. These liquid assets are suggested to be covered by the following four requirements or margins:

1.Mark to Market (MTM) Losses: MTM losses are made on outstanding settlement obligations of the member. Some particular procedure through which they can be collected are:

  • The Stock Exchanges have the option that before the start of the next day trading, the mark to market margin (MTM) can be collected from the member/broker.
  • The cash/cash equivalent component of the liquid net worth, which is deposited with the Exchange, is important as the MTM margin needs to be collected/adjusted from/against it.
  • The margin is required to be collected on the gross open position of the member. The gross open position signifies the gross of all net positions across all the clients of a member, including the proprietary position of the member.
  • In the end, the collected MTM is released along with the pay-in, which also includes the early pay-in of securities.

2.Value at Risk (VaR) margins:The potential losses encountered on 99% of the days are covered by these margins. The VaR margins are computed using scrip sigma, scrip VaR, index sigma, and index VaR.

3.Extreme Loss Margin:The extreme loss margin covers the expected losses in those cases, which are beyond the losses estimated in 99% VaR estimates. Here, the VaR estimates refer to the estimates as per the VaR margin.

4.Base Minimum Capital:It is a capital required for all risks other than market risk such as operational risk and client claims.

Patterns in Volatility

While analyzing pattern of volatility of cash market in India, it was found that a sharp increase in the volatility of stocks that have derivatives traded on them, would have meant that investors have to tread cautiously, as the higher the volatility, the higher the risk. Higher risk does not necessarily mean higher return; it could also mean higher losses.

Risk Management in F&O Trading

For price risk management, the traditional practice employed by the producers was the diversification of their farm and income sources, which made them less reliant on single commodity. In the current scenario, their marketing agents help them to manage risk with fixed-price contracts. The contracts allow the producers to know the price estimated for their product. This price estimation helped them to effectively manage their respective farms, as there is no price risk.

Computation of Risk Management:

Standard Portfolio Analysis of Risk (SPAN): Developed by Chicago Mercantile Exchange, SPAN is used in margin computations and risk management in almost all the leading derivatives exchanges. In this, the Initial Margin is based on worst-case loss of the portfolio of a client to cover 99% VaR over two day's horizon.

Index Futures:Fund managers can use index futures as a risk management tool to protect their near-term downside. As required, the basic premise of index futures as a risk-management tool is that the stocks the fund manager wants to hedge, have a strong correlation with the index. Otherwise, the fund will run a basis risk. Along with this, the fund manager needs to get prior approval from unit-holders to trade in such instruments.

The use of risk management tools can give organizations and growers, the ability to make more efficient decisions on production and diversification, by allowing them to know their minimum revenue in advance, given an expected level of production. This will help them to adjust their time and inputs accordingly.