Equity Derivatives
CH7 · Clearing, Settlement & Risk Management
Clearing Corporation = central counterparty to ALL trades, guarantees settlement
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Theme 7
Study novation, margins, settlement, SGF, delivery, position limits and default risk.
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Equity Derivatives
Clearing Corporation = central counterparty to ALL trades, guarantees settlement
Currency Derivatives
Clearing, margins, liquid net worth, settlement guarantee
Interest Rate Derivatives
Clearing corporation, physical delivery, conversion factor, CTD, margins and SGF
Detailed notes
Equity Derivatives
Clearing Corporation = central counterparty to ALL trades, guarantees settlement
NISM Series VIII — Equity Derivatives | 10% weightage | ~10 exam questions
This is the most under-estimated chapter in the exam and the biggest surprise for most students. The bank has 69 questions on CH7 — more than any other chapter except CH4. Students assume "clearing and settlement" is boring admin stuff and skip it. Don't. This chapter has everything: who clears trades, how margin works, what MTM means, how much capital you need to be a clearing member, what liquid assets are, position limits. Get comfortable here and you'll pick up marks others leave on the table.
The Clearing Corporation — the central nervous system of the derivatives market:
Types of members:
| Member Type | Can Trade? | Can Clear? | Who they clear for | |------------|-----------|-----------|-------------------| | Trading Member (TM) | Yes | No | Cannot clear — must use a CM | | Self-Clearing Member | Yes | Yes | Own trades only | | Trading-cum-Clearing Member | Yes | Yes | Own trades + other TMs + institutional clients | | Professional Clearing Member (PCM) | NO | Yes | Other TMs + institutional clients only |
PCM critical fact: Professional Clearing Member does NOT trade. They ONLY clear and settle. Typically banks and custodians become PCMs. They have NO trading rights — this is heavily tested.
Initial Margin — deposited BEFORE you take a position. Both buyer and seller in futures pay initial margin. Based on VAR (Value at Risk) at 99% confidence level — as per L.C. Gupta Committee recommendations. Higher volatility = higher initial margin. Dynamic — recalculated continuously as volatility changes.
Mark to Market (MTM) Margin — daily settlement of profits and losses.
In options: Only the SELLER pays initial margin. The BUYER pays the premium — no separate initial margin.
Liquid Assets — what clearing members deposit with the clearing corporation to back their positions:
Net Worth requirements:
Net Worth calculation = Capital + Free Reserves − Non-allowable assets Non-allowable assets include: fixed assets, pledged securities, membership card, unlisted securities, doubtful debts, intangible assets, 30% of marketable securities.
Exposure limits — linked DIRECTLY to liquid assets deposited. More deposits = more exposure allowed. NOT based on education, number of TMs, or anything else.
Position Limits:
Calendar Spread margins — lower than two naked positions because the two legs largely offset each other's market risk. Only basis risk remains.
Trade Guarantee Fund (TGF) — fund maintained to guarantee settlement of bonafide exchange transactions. Purpose: protect investor interests, inculcate market confidence, guarantee settlement. All active exchange members contribute.
Settlement Guarantee Fund (SGF) / Core SGF — maintained by clearing corporation to cover defaults.
Broker-Members on Clearing Council — NOT allowed (conflict of interest).
Running account settlement — client funds must be settled on first Friday of the month (monthly) or first Friday of the quarter (quarterly). Cannot be delayed.
Volatility estimation — transparent and publicly disclosed by the exchange. Not a secret.
You buy 2 lots of Nifty futures at 24,000. Lot size 75. End of day, Nifty closes at 23,800.
MTM loss = (24,000 − 23,800) × 75 × 2 = 200 × 150 = ₹30,000
This ₹30,000 is debited from your margin account that evening. If your margin falls below maintenance margin, you get a margin call.
Next day Nifty closes at 24,100: MTM profit = (24,100 − 23,800) × 150 = 300 × 150 = ₹45,000 credited.
Both debits AND credits happen daily. Not just debits.
Trap 1: "MTM margin debits are daily but credits are weekly" → FALSE Both debits AND credits are daily. No differential treatment.
Trap 2: "Fixed deposits and bank guarantees are NOT liquid assets" → FALSE Both FDs and Bank Guarantees ARE valid liquid assets. Foreign Exchange is the one that's NOT allowed.
Trap 3: "Clearing Corporation gives exposure based on number of TMs using the CM" → FALSE Exposure is based on LIQUID ASSETS DEPOSITED — full stop. Not number of TMs, not education, not experience.
Trap 4: "A Professional Clearing Member provides trading facility to clients" → FALSE PCM has NO trading rights whatsoever. They only clear and settle — they don't trade.
Trap 5: "Initial margin = MTM margin" → FALSE Completely different. Initial margin = upfront deposit to take a position (VAR-based). MTM margin = daily P&L settlement.
Trap 6: "Client positions can be netted for margin calculation" → FALSE Each client's position is calculated separately. If Client A is long 10 Nifty and Client B is short 10 Nifty, the broker must pay margin on ALL 20 contracts — not net zero.
Trap 7: "Institutional investors pay lower margins than retail" → FALSE Margin requirements are SAME for all — institutional or individual.
Trap 8: "Broker-members can sit on the Clearing Council" → FALSE Not allowed — conflict of interest. Clearing Council must be independent of trading members.
Initial Margin = Contract Value × Margin %
Contract Value = Price × Lot Size × No. of Contracts
MTM P&L = (Today's close − Yesterday's close) × Lot Size × Contracts
Net Worth = Capital + Free Reserves − Non-allowable assets
Security deposit = ₹50L base + ₹10L per additional TM
Calendar Spread open position = net of same underlying across months
(Long 8 near + Short 6 far = net 2 regular open positions)10% of exam = ~10 questions. But 69 questions in the question bank — the highest hidden concentration. Expect 3-4 questions on margin mechanics, 2-3 on member types (especially PCM), 2 on liquid assets, 1-2 on position limits. This chapter rewards time investment heavily.
Currency Derivatives
Clearing, margins, liquid net worth, settlement guarantee
NISM Series I — Currency Derivatives | ~13% weightage | ~84 questions
Second most tested chapter after CH3. Same core concepts as Series VIII CH7 — clearing corporation, margins, MTM, position limits — but with currency-specific numbers and rules. Three things that are unique to currency: the Core SGF (CC contributes 50% from own funds), the minimum liquid networth of Rs 50 lakhs, and the extreme loss margin on calendar spreads (1/3 of far month MTM value). Everything else maps directly from equity derivatives knowledge.
Acts as CENTRAL COUNTERPARTY to every trade through NOVATION — it becomes the buyer to every seller and the seller to every buyer. This eliminates counterparty risk completely.
What CC does:
Settlement vs Clearing:
Initial margin:
Extreme Loss Margin (ELM):
Liquid assets accepted:
Minimum liquid networth for clearing member = Rs 50 lakhs at all times (after adjusting for initial margin and ELM requirements)
Margins collected GROSS basis — not netted across clients. If Client A is long 10 lots and Client B is short 10 lots, broker must maintain margin on ALL 20 lots, not zero.
Daily MTM: Settled in cash before start of trading on T+1 day
Three MTM scenarios: 1. Squared off positions: (sell price − buy price) × lots × lot size 2. Open positions (not squared off): (day's settlement price − trade price) × lots × lot size 3. Brought forward positions: (today's settlement − yesterday's settlement) × lots × lot size
Final settlement: T+2 from last trading day. Cash-settled at FBIL/RBI reference rate.
Trading member open position = proprietary positions + ALL client positions (added, not netted)
Gross open position for monitoring: = |long positions| + |short positions| across all clients and proprietary
Example: Client A: short USD 2,000 Client B: long USD 6,000 Options client: long USD 5,000
Gross open position = 2,000 + 6,000 + 5,000 = 13,000 USD (absolute values — direction doesn't matter for gross calculation)
Position monitoring: Based on PREVIOUS day's total open interest (not real-time)
If a member has pay-in obligation but no margin requirement: → Trading is allowed but with REDUCED LIMIT (reduced with respect to pay-in amount) → NOT complete halt, NOT full limit — reduced limit
Enables a clearing member to choose a single clearing corporation for settlement even when trading on multiple exchanges. Applicable to ALL products EXCEPT commodity derivatives.
Key: Currency derivatives segment IS covered under interoperability.
1. Trade executed on exchange 2. CC interposes itself via novation (becomes counterparty) 3. Clearing banks receive pay-in/pay-out instructions from CC 4. CC debits/credits clearing member accounts 5. Clearing bank accounts used EXCLUSIVELY for CC settlement operations
Clearing bank account rules:
Trader buys 40 lots USDINR at 86.20 and sells 55 lots at 86.35 on Day 1. Settlement price Day 1 = 86.80. He pays MTM accordingly. Settlement price Day 2 = 87.10.
Net position from Day 1: 55 − 40 = short 15 lots at 86.80 (previous settlement) Day 2 MTM = (86.80 − 87.10) × 15 × 1,000 = Rs 4,500 loss (Short position loses when price rises)
Trap 1: "CC contribution to Core SGF can be from member contributions" — WRONG CC must contribute AT LEAST 50% of MRC from its OWN funds — not member money.
Trap 2: "ELM for currency options computed at end of day" — FALSE ELM is computed on intraday real-time basis.
Trap 3: "Calendar spread ELM = full MTM of far month" — FALSE Calendar spread ELM = 1/3 (one-third) of far month MTM value.
Trap 4: "Clearing bank account can be used for general banking" — FALSE Used EXCLUSIVELY for CC settlement operations — nothing else.
Trap 5: "For gross open position, long and short positions net out" — FALSE Gross = absolute values added. Long 6,000 + Short 2,000 = 8,000 (not 4,000).
Trap 6: "Interoperability covers commodity derivatives" — FALSE Interoperability is NOT applicable to commodity derivatives. All other segments including currency are covered.
~13% = ~84 questions. MTM calculations (2-3 per exam), open position calculations (2-3 per exam), Core SGF and liquid networth rules (1-2 per exam), novation and clearing definitions (2-3 per exam). The Rs 50 lakh liquid networth minimum and Core SGF 50% rule are repeatedly tested True/False questions.
Interest Rate Derivatives
Clearing corporation, physical delivery, conversion factor, CTD, margins and SGF
NISM Series IV — Interest Rate Derivatives | ~10% weightage | ~40 questions
The clearing and settlement chapter for IRD. Same novation/CC/MTM framework as Series I and VIII but with bond-specific additions: conversion factor, cheapest-to-deliver bond, delivery vs payment, buy-in, delivery margin, and the physical settlement process for single bond futures. Core SGF, liquid networth, and interoperability rules are also tested.
Acts as central counterparty to ALL trades via NOVATION — becomes buyer to every seller and seller to every buyer. Provides settlement guarantee for exchange-traded derivatives.
Exchange = separate legal entity from Clearing Corporation
Role of Clearing Corporation = settlement guarantee Role of Exchange = facilitate trading (not settle)
Three supporting entities: 1. Depositories — handle securities settlement (debit/credit of bonds) 2. Clearing Banks — handle funds settlement (pay-in and pay-out) 3. Clearing Members — responsible for settling obligations
Used EXCLUSIVELY for payments to/from Clearing Corporation. Cannot be used for general banking.
Rules:
Daily MTM settlement: Cash settled before start of trading the next day (T+1)
Final settlement: T+1 (next working day after last trading day) for IRDs
Settlement method:
When bond futures are physically settled:
Deliverable bonds: Seller can deliver ANY of the specified deliverable bonds (not any bond the seller holds — must be from the approved list).
Conversion Factor (CF):
Why conversion factor exists: Every bond in the deliverable basket has different coupon and remaining maturity, so direct comparison to the notional bond price isn't fair. CF standardizes them.
Cheapest to deliver (CTD) bond: Every futures seller prefers to deliver the cheapest-to-deliver bond because:
Delivery process:
Short delivery (seller fails to deliver):
Interoperability allows a Clearing Member to choose ONE Clearing Corporation to clear/settle trades across MULTIPLE exchanges.
Applies to: ALL products including IRDs and Currency Derivatives. Does NOT apply to: Commodity Derivatives
Basis Risk: Arises because futures contracts are standardized: 1. Contract amount is standardized (multiples of Rs 2L only — can't match odd amounts) 2. Expiry date is standardized (last Wed/Thu — may not match actual exposure date) Both create mismatch = basis risk
Basis risk = differential price changes between cash and futures prices
Yield Curve Spread Risk: Arises when term structure shift is NON-PARALLEL (steepening or flattening). Example: 10Y rate changes 0.30% but 15Y rate changes only 0.10% — if hedging 15Y exposure with 10Y futures, the hedge is imperfect.
No yield curve spread risk when shift is PARALLEL (all tenors change by same amount).
VaR (Value at Risk): Maximum likely loss over a given horizon at a given confidence level.
SPAN Margining: Portfolio-based margining system. Applied between TMs and their clients.
Extreme Loss Margin (ELM): Implemented by Clearing Corporation. Collected from liquid assets in real time.
Trap 1: "Seller can deliver any bond they hold" — FALSE Must deliver from the approved list of DELIVERABLE bonds. Can choose whichever one is cheapest for them.
Trap 2: "CF is same for same bond across different delivery months" — FALSE CF changes across delivery months for same bond (remaining maturity changes month to month).
Trap 3: "CF is different during the delivery month" — FALSE CF does NOT change DURING the delivery month (stays fixed). This is why seller prefers CTD.
Trap 4: "Buy-in = when seller fails to notify Intent to Deliver" — FALSE Buy-in = when there is a short delivery on SETTLEMENT DAY. Auction settlement = when seller fails to notify Intent to Deliver (next business day auction).
Trap 5: "CC provides trade guarantee, so does Exchange" — FALSE CLEARING CORPORATION provides the trade guarantee (via settlement guarantee fund). Exchange only facilitates trading.
Trap 6: "Core SGF: Stock Exchange contributes 50%" — FALSE CC contributes ≥50% | Stock Exchange contributes ≥25%
Trap 7: "Basis risk and yield curve spread risk are the same" — FALSE Basis risk = mismatch in amount/date. Yield curve spread risk = non-parallel yield curve shifts.
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