Risk Management
Risk Management
This domain tests how a dealer measures and controls derivatives risk: margining, mark-to-market, position limits, stress testing and default management.
Core rules
- Initial margin is a performance deposit. For F&O it is commonly SPAN margin plus exposure margin. SPAN is a portfolio, scenario-based system that considers price and volatility moves and allows offsets between related positions; exposure margin is an additional buffer set by the exchange.
- Daily MTM is a cash-settlement risk control, not a substitute for initial margin. A dealer must fund losses even while holding a hedged position.
- Position limits operate at client, trading-member and market level. Large proprietary positions can breach member-level limits even if each client is within its own limit.
- Dealers also manage credit risk (client default), liquidity risk (margin calls and wide spreads), operational risk (order errors, settlement failures) and model risk (VaR and SPAN assumptions). Stress tests should include gap moves and volatility spikes.
- Client margins must be collected upfront and maintained; shortfalls can lead to penalties, position limits or close-out.
Worked example
A dealer is long 10 BankNifty futures lots at 48,000; assume lot size 15; notional ₹72,00,000. SPAN margin at 4% = ₹2,88,000; exposure margin at 3% = ₹2,16,000; total initial margin = ₹5,04,000. If the index falls 2%, the MTM loss is ₹1,44,000. The position still has margin cover, but a further fall or a margin-rate hike can trigger a call. The dealer should size the position against stress loss, not just the initial margin.
Traps
- Treating option premium as the maximum margin.
- Ignoring daily MTM when assessing liquidity.
- Assuming SPAN captures all risk, including liquidity and gap risk.
- Forgetting exposure margin and member-level limits.
- Using client collateral for proprietary margin.