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Risk In Derivatives Markets

1. What are the various Risks associated with trading in equity derivatives ?

The different types of risks associated with derivative instruments are as follows:
  • Credit Risk : These are the usual risks associated with counterparty default and which must be assessed as part of any financial transaction. However, in India the two major stock exchanges that offer equity derivative products have Settlement / Trade Guarantee Funds that address this risk
  • Market Risk : These are associated with all market variables that may affect the value of the contract, for e.g. A change in price of the underlying instrument.
  • Operational Risk : These are the risks associated with the general course of business operations and include:
    • Settlement Risk arises as a result of the timing differences between when an institution either pays out funds or deliverables assets before receiving assets or payments from a counterparty and it occurs at a specific point in the life of the contract.
    • Legal Risk arises when a contract is not legally enforceable, reason being the different laws that may be applicable in different jurisdictions - relevant in case of cross border trades.
    • Deficiencies in information, monitoring and control systems, which result in fraud, human error, system failures, management failures etc. Famous examples of these risks are the Nick Lesson case, Barings' losses in derivatives, Society General's debacle etc.
  • Strategic Risk : These risks arise from activities such as:
    • Entrepreneurial behavior of traders in financial institutions
    • Misreading client requests
    • Costs getting out of control
    • Trading with inappropriate counterparties
  • Systemic Risk : This risk manifests itself when there is a large and complex organization of financial positions in the economy. "Systemic risk" is said to arise when the failure of one big player or of one clearing corporation somehow puts all other clearing corporations in the economy at risk. At the simplest, suppose that an index arbitrageur is long the index on one exchange and short the futures on another exchange. Such a position generates a mechanism for transmission of failure - the failure of one of the exchanges could possibly influence the other. Systemic risk also appears when very large positions are taken on the OTC derivatives market by any one player. Neither of these scenarios is in the offing in India. Hence it is hard to visualize how exchange traded derivatives could generate systemic risk in India.

2. What is meant by the terms Short Squeeze and Long Squeeze ?

A Short Squeeze is a rapid increase in the price of a stock that occurs when there is a lack of supply and an excess of demand for the stock.

Short squeezes result when short sellers cover their positions on a stock. This can occur if the price has risen to a point where these people simply decide to cut their losses and get out. (This may happen in an automated manner if the short sellers had previously placed sTop-loss orders with their brokers to prepare for this eventuality.) Since covering their positions involves buying shares, the short squeeze causes an ever further rise in the stock's price, which in turn may trigger additional covering.

Short squeezes are more likely to occur in stocks with small market capitalization and small floats.

A Long Squeeze is a situation in which investors who hold long positions feel the need to sell into a falling market to cut their losses. This pressure to sell usually leads to a further decline in market prices. This situation is less common than the opposite, a Short Squeeze, because a rapid decline in price is seen as a buying opportunity more often than a rapid rise in price seen as a shorting opportunity.

3. Is it possible to manipulate in terms of Index Derivatives ?

Derivatives market in India is presently cash settled, so short squeeze conditions are less likely to occur. Typically, the index derivatives are more liquid than the underlying stocks. If the manipulator will try to manipulate the index than the process would be something like this - firstly he will take the position on the index in the derivatives market and then try to move the index to maximize the profits by trying to influence the price of certain large weighted stocks comprising that Index.

The exchange's surveillance department normally observes this kind of behavior and would take appropriate corrective action on this. Importantly, this is where the composition of an Index and its methodology becomes very crucial.

Usually the two major methods of market wide Index construction are the Full Market Capitalisation Method and the Free-float Methodology. Under the Free-float Methodology, only the free float or the non-promoter holding is considered for the purpose of reckoning the share capital (for ascertaining market capitalisation i.e. share capital times the share price of that stock) and thus weightage of the particular stock in the Index. However, the Full Market Capitalisation Method includes the entire share capital (including the share capital of the promoters and promoter group, Government, etc. which is normally static in nature and is not available for trading) thus affecting the market capitalisation of that stock and resulting in different weights being attached to that stock in the Index. Thus an Index based on the Free-float Methodology is to that extent a better indicator of the market movement than a Full Market Capitalisation based Index and is less capable of being manipulated.