A Project Report

On

“Study of Risk Management in Stock Broking Firm”

For

“Pune Stock Exchange Securities Limited, Pune”

By

“Mr. Prasad Dipak Deshmukh”

Under the guidance of

“Dr. Yashwant Vaishampayan”

Submitted to

“University of Pune”In partial fulfillment of the requirement for the award of the degree of

Master of Business Administration (MBA) 2007-2009

Through

Vishwakarma Institute of ManagementPune-48.

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ACKNOWLEDGEMENT

It gives me great pleasure to express my sincere gratitude towards all

the individuals who have directly or indirectly helped me in completing the project.

First of all I am extremely grateful to Mrs. Nihali Mitra, M.D. Pune Stock Exchange

Ltd. for providing me an opportunity to work with such an esteemed organization. I

feel immense pleasure to thank Mrs. Archana Gorhe, Officiating C.E.O., PSE

Securities Ltd. and Ms. Darshana Deshpande, Senior Manager, PSE Securities Ltd.

. I would also like to express my sincere thanks to Dr. Sharad L. Joshi,

Director, Vishwakarma Institute of Management, Prof. Shailesh Kasande, Executive

Director, Vishwakarma Institute of Management and my project guide Dr. Yashwant

Vaishampayan for providing valuable guidance and inputs which helped a lot for the

completion of project in a true sense.

I would also like to thank the whole staff of PSE Securities Ltd., my

parents and all my friends for their kind co-operation and support.

Prasad Dipak Deshmukh

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CERTIFICATE

This is to certify that Mr. Prasad Dipak Deshmukh has completed the Summer

Project Titled “Study of Risk Management in Stock Broking Firm” to my

satisfaction and as per the requirements of the two year full-time MBA programme.

Project Guide Director

Date:

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LIST OF ABBREVIATIONS

Following is the list of abbreviations used during the study.

BCFM – BSE’s Certification in Financial Markets

BSE – Bombay Stock Exchange

CDSL – Central Depository Services Limited

DP – Depository Participant

DRF – Dematerialization Request Form

FDR – Fixed Deposit Receipt

FII – Foreign Institutional Investors

ISIN – International Securities Identification Number

KYC – Know Your Client

MTM – Mark to Market

NCFM – NSE’s Certification in Financial Markets

NSCCL – National Securities Clearing Corporation Limited

NSDL – National Securities Depository Limited

NSE – National Stock Exchange

RRF – Rematerialization Request Form

RSE – Regional Stock Exchange

SEBI – Securities and Exchange Board of India

VaR – Value at Risk

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INDEX

Sr. No. Title Page Number

I Executive Summary 1

II Company Profile 3

III Objectives of the Study 7

IV Research Methodology 8

V Data Analysis 9

VI Findings 60

VII Suggestions and Conclusion 62

VIII Limitations 65

IX Bibliography 66

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EXECUTIVE SUMMARY

Title of the Project: Study of Risk Management in Stock Broking Firm.

Duration of the Project: 2nd June 2008 to 2nd August 2008.

The capital market in India is an emerging market with a great

potential. Indian capital market has got a strong foundation and therefore has gained a

confidence of Indian investors as well as Foreign Institutional Investors. In India there

are two Stock Exchanges (National Stock Exchange and Bombay Stock Exchange)

through which securities are traded. Stock exchange is a body formed for the purpose

of assisting, regulating or controlling the business of buying, selling or dealing in

securities.

An investor has to trade in stock market through a registered stock

broker. A stock broker is a member of a recognized stock exchange who is permitted

to do trades on the floor of the exchange. ‘Study of Risk Management in Stock

Broking Firm’ the title, shows that the project revolves around the risks managed by

Stock Brokers while handling their Sub brokers, branches, franchisees and investors.

The study was carried out in PSE Securities Ltd., Pune during the period of 2nd June

2008 to 2nd August 2008.

Risk can be defined as-

‘Risk is the possibility of happening uncertain events.’

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Risk is the chance of happening of something that may affect the desired results.

Therefore, the concept of Risk Management comes into picture.

Risk Management can be defined as-

‘Risk Management is the structured approach towards managing the uncertainties.’

Risk Management involves risk identification and risk assessment. Further to avoid

the unpredictable outcomes arising out of risk, the risk can be avoided, reduced or

transferred. However, best possible solution has to be chosen to tackle the risk.

Risk can be broadly categorized as Systematic Risks and Unsystematic

Risks. Risk and uncertainty go together. However, risk and return have a direct

relationship, higher the risk, higher the chances of good return and vice versa. In stock

broking industry risks are high due to the volatility of the market. The risk may cause

due to its sub brokers, branches, investor clients etc. There are uncertainties about

payments from clients or from clients to sub brokers and then sub brokers to the

broker. The high volatility of the market may cause the clients or sub brokers not to

make payments in specified time. Thus brokers are always exposed to market risks,

financial risks, credit risks, liquidity risk and operational risks. To cope up with such

events brokers have to collect certain amount of margins and maintain the same with

the exchange.

To manage such risks Value at Risk margin, Mark to Market margin

and extreme loss margin is maintained. Also, the brokers are allowed intra day

turnover and gross exposure limits. Brokers have to maintain minimum base capital

and additional base capital with the exchange. Exchanges, SEBI and NSCCL have

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taken steps like KYC, continuous surveillance, mandatory audit etc. Thus, every

broking firm has Risk Management department. In PSE Securities Ltd., there is a

surveillance department to deal with the risk management activities.

COMPANY PROFILE

PSE Securities Limited

History

Pune Stock Exchange Securities Ltd. is located at Shivleela Chambers,

752, Sadashiv Peth, R.B. Kumthekar Road, Pune-411030. It was founded in the year

1999 and is a subsidiary company of Pune Stock Exchange Ltd. PSE Securities Ltd. is

a leading Stock Broking Firm, member of NSE and BSE and also a Depository

Participant of CDSL. It commenced Live Trading in the BSE Cash Segment from

15th March 2004 and commenced depository operations with Central Depository

Services (I) LTD. from 16th Dec. 2003.

The company is also a CDSL Depository Participant and it witnessed

an increase in the handling of approximately 5600 Beneficiary accounts in the

previous year to 8400+ accounts this year.

PSE Securities Ltd. has the largest turnover in the cash market segment

in Pune. However the management still feels the need to generate more operational

income through Brokerage.

Founders and Promoters

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The founders and promoters of PSE Securities Ltd. are the members of

Pune Stock Exchange Ltd. All the members of Pune Stock Exchange Ltd. came

together and formed PSE Securities Ltd. According to the Articles of Association of

company and SEBI, only the members of the Pune Stock Exchange Ltd. which is the

parent company can register as sub broker of PSE Securities Ltd. Hence all the

present sub brokers of PSE Securities Ltd. are the members of Pune Stock Exchange

Ltd. There are total 152 sub brokers of PSE Securities Ltd.

Board of Directors

Dr. Sharad L. Joshi - Chairman & PR Director

Mr. Mahesh Athavale - PR Director

Me. Shaukat Merchant - PR Director

Mr. Shailendra Shah - Broker/Member Director

Mr. Arvind R. Shah - Broker/Member Director

Mr. Rajendra Nahar - Nominee Director-Pune Stock Exchange Ltd.

Products

The main business of the company is to provide a platform for trading

in securities market with the help of Stock Broking and Depository Services. PSE

Securities Ltd. has cash segment membership of the Bombay Stock Exchange and

National Stock Exchange and also is a depository participant of Central Depository

Services Limited.

Competitors

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Though the company deals in the cash segment only, it has to face

competition from following organizations.

Motilal Oswal

India Infoline

Sharekhan

Anand Rathi

Indiabulls

Religare

Angel Broking

Karvy Consultancy

Financial Data

The Authorized Capital of the company is Rs.7,80,00,000 divided into

390 equity shares or Rs. 2,00,000 each. The paid up capital is Rs.7,06,00,000 divided

into 353 equity shares or Rs. 2,00,000 each.

During the Financial Year 2007 – 2008, the total turnover of dealings

through BSE and NSE was Rs. 7451 Crores (Rs. 2885 Crores was delivery turnover

and Rs. 4556 was non delivery turnover).

The Profit before Taxes of PSE Securities Ltd. during the year was Rs.

494.80 Lacs of which Rs. 401.32 Lacs has been earned by way of Brokerage and Rs.

67.52 Lacs by way of interest on fixed deposits and short term deployment of funds.

The Net profit for the year was Rs. 367.04 Lacs.

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Organization Chart

New Projects

This year the company proposes to issue 25 equity shares to persons

other than existing share holders thus increase the number of sub brokers from 152 to

177.

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OBJECTIVES OF THE STUDY

Background

The stock prices in Indian capital market change very rapidly. It results

into high volatility in the market. Therefore, the brokers are always at a risk that

investors may not pay in the securities or funds due to increase or decrease in the

prices of shares. In the securities market the liquidity risks, financial risks and

operational risks also create hurdles in the smooth running of broking firm.

Need

Therefore, to tackle these situations need for risk management in stock

broking firm arises. To reduce such risks broking firms have risk management or

surveillance departments, which monitors the day to day activities of its sub brokers

and investors. Thus, this study is carried out to understand the measures taken to

reduce the risks at brokers’ end and the objectives of the study are as follows.

Introduction to Capital Market.

To get familiar with the working of broking firm.

To understand the concept and types of risk.

To find out the risks involved in stock broking firm.

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To study the measures to reduce the risk.

RESEARCH METHODOLOGY

During the project, the necessary inputs taken were primary as well as

secondary. The primary data collection and secondary data collection form an integral

part of the study. They are explained as below.

Primary Data

Primary data is the one which is collected specifically for the purpose

of the project, and can be obtained from various people working in the organization.

For this study the primary data was collected from following sources.

» Discussion with Surveillance department officers.

» Discussion with manager.

» Discussion with sub brokers.

» Discussion with employees of the organization.

Secondary Data

Secondary data is the one which is not specifically collected for a

certain work. It is a data collected by somebody else for their own purposes.

However, it plays a significant role in the project. For this study the secondary data

was collected from the following sources.

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» Books related to risk management and capital market.

» Magazines related to the stock market.

» Websites related to risk management and stock market.

DATA ANALYSIS

Capital Markets

The capital markets deal in financial assets, which comprise shares,

debentures, mutual funds, insurance policies, bank accounts, pension funds, provident

funds and other securities. A capital market deals in financial assets, excluding coins

and currency. Capital market is a market for long-term debt and equity shares. In this

market, the capital funds comprising of both equity and debt are issued and traded.

Transfer of resources from those with idle resources to others who

have a productive need for them is perhaps most efficiently achieved through the

Capital Markets. They provide channels for reallocation of savings to investments and

entrepreneurship and thereby decouple these two activities. As a result, the savers and

investors are not constrained by their individual abilities, but by the economy’s

abilities to invest and save respectively, which inevitably enhances savings and

investment in the economy. It is not that the users and suppliers of funds meet each

other and exchange funds for securities. It is difficult to accomplish such double

coincidence of wants. The amount of funds supplied by the supplier may not be the

amount needed by the user. Thus, there are intermediaries who may act as agents to

match the needs of users and suppliers of funds for a commission. In this way, the

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Capital market moves the money of investors who have a surplus to the entrepreneurs

who needs it with the help of intermediaries.

The capital market in a country is very valuable indicator of its

soundness. Capital markets are evaluated while judging the performance of any

economy. Every decision or event related to economy of the country is reflected and

influenced by the capital market thus; it carries a huge weightage for the economic

development of any country.

Indian Capital Market – An Overview

Indian Stock Markets are one of the oldest in Asia. Its history dates

back to nearly 200 years ago. The East India Company was perhaps the most

dominant and powerful institution in those days and business in its loan securities

used to be transacted in an unorganized for at Bombay and Calcutta in early

Nineteenth century. Later on the business on corporate stocks and shares in bank and

cotton presses took place in Bombay and gradually the number of companies listed

increased from 1125 in 1946 to 8593 in 1995.

The tail of Twentieth Century made the Indian Capital Market change

drastically. During 1990’s with the introduction of computers, Indian Market started

prospering. On line trading, transparency, strict surveillance, depository system,

investor protection and regulations were some of the key activities which reflected the

growth of the Indian Capital Market. With the Dematerialization of shares and

introduction of SEBI (Securities and Exchange Board of India) Indian Capital market

provided protection to its investors.

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With the liberal policy of India and investments of Foreign

Institutional Investors, the confidence of investors is increased to a great extent. In

January 2008 the BSE Sensex touched the 21000 points, which is the highest up till

now.

SEBI Act (Securities and Exchange Board of India Act), 1992

The Act had its origin during the war in 1943 when the objective was

to channel resources to support the war effort. It was retained with some changes as a

means of controlling the raising of capital by companies and to ensure that national

resources were channeled into proper lines, i.e., for desirable purposes to serve goals

and priorities of the government, and to protect the interests of investors. Under the

Act, any firm wishing to issue securities had to obtain approval from the Central

Government, which also determined the amount, type and price of the issue.

As a part of the liberalization process, the Act was repealed in May

1992 paving way for market determined allocation of resources. To ensure effective

regulation of the market, SEBI Act, 1992 was enacted in establish SEBI with statutory

powers for (a) protecting the interests of investors in securities, (b) promoting the

development of the securities market, and (c) regulating the securities market.

It can conduct enquiries, audits and inspection of all concerned and adjudicate

offences under the Act. It has powers to register and regulate all market intermediaries

and also to penalize them in case of violations of the provisions of the Act. SEBI has

full autonomy and authority to regulate and develop and orderly securities market.

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Market Segments

A) Primary Market

The primary market provides the channel for sale of new securities.

Primary market provides opportunity to issuers of securities, Government as well as

corporates, to raise resources to meet their requirements of investment and/or

discharge some obligation. In this market the securities are offered for subscription

for the purpose of raising capital or fund. The investors and the company come into

direct contact in the primary market. The entrepreneurs or corporates as well as

Government may issue the securities at face value, or at as discount / premium and

these securities may take a variety of forms such as equity, debt etc. They may issue

the securities in domestic and/or international market.

(B) Secondary Market

Secondary Market refers to a market where securities are traded after

being initially offered to public in the primary market and/or listed on the Stock

Exchange. Majority of the trading is done in the secondary market. This market

comprises of equity markets and the debt markets.

For the general investor, the secondary market provides an efficient

platform for trading of securities. For the management of the company, secondary

equity markets serve as a monitoring and control conduit-by facilitating value-

enhancing control activities, enabling implementation of incentive-based management

contracts, and aggregating information (via price discovery) that guides management

decisions.

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Stock Exchange

As seen earlier, securities are traded or exchanged in secondary

market. A Stock Exchange is an organized platform where securities are traded or

exchanged. Securities are defined as any monetary claims and include stock, shares,

debentures, bonds etc. Under the Securities Contract Regulation Act, 1956, securities

trading are regulated by the Central Govt. and such trading can take place only in

Stock Exchanges recognized by the Govt. under this Act. At present there are 23 such

recognized Stock Exchanges in India. Of these, major Stock Exchanges are Bombay,

Kolkata, Delhi, Chennai etc. As per the Act, trading in securities permitted to be

traded would be in normal trading hours (09:55 A.M. to 03:30 P.M on working days).

National Stock Exchange (NSE)

The National Stock Exchange (NSE) is India’s leading stock exchange

covering various cities and towns across the country. NSE was set up in November

1992 with an equity capital of Rs. 25 crores by leading institutions to provide a

modern, fully automated screen-based trading system with national reach. The

Exchange has brought about unparalleled transparency, speed & efficiency, safety and

market integrity and its index NIFTY has got worldwide recognition.

NSE has played a catalytic role in reforming the Indian securities

market in terms of microstructure, market practices and trading volumes. The market

today uses state-of-art information technology to provide an efficient and transparent

trading, clearing and settlement mechanism, and has witnessed several innovations in

products & services viz. demutualization of stock exchange governance, screen based

trading, professionalism of trading members, fine-tuned risk management systems,

emergence of clearing corporations to assume counter party risks, market of debt and

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derivative instruments and intensive use of information technology. IDBI & other

financial institution with paid equity capital of Rs. 25 cores set up NSE. It started

operation in Wholesale debt market in June 1994 & in equity, in Nov 1994.

Bombay Stock Exchange (BSE)

Bombay Stock Exchange Limited is the oldest stock exchange in Asia

with a rich heritage. Popularly known as ‘BSE’, it was established as ‘The Native

Share & Stock Brokers Association’ in 1875. It is the first stock exchange in country

to obtain permanent recognition in 1956 from the Government of India under the

Securities Contracts (Regulation) Act, 1956. The Exchange’s pivotal and pre-eminent

role in the development of the Indian capital market is widely recognized and its

index, SENSEX, is tracked worldwide. The Exchange has a nation-wide reach with a

presence in 417 cities and towns of India. The systems and processes of the Exchange

are designed to safeguard market integrity and enhance transparency in operations.

The Exchange provides an efficient and transparent market for trading in equity, debt

instruments and derivatives. The BSE On Line Trading System (BOLT) is a

proprietary system of the Exchange and is BS 7799-2-2002 certified. The surveillance

and clearing and settlement functions of the Exchange are ISO 9001:2000 certified.

Regional Stock Exchanges (RSEs)

There are 23 stock exchanges in India. Among them two are national

level stock exchanges namely Bombay Stock Exchange (BSE) and National Stock

Exchange of India (NSE). The rest 21 are Regional Stock Exchanges (RSE). The

Regional Stock Exchanges started clustering from the year 1894, when the first RSE,

the Ahmedabad Stock Exchange (ASE) was established. In the year 1908, the second

in the series, Calcutta Stock Exchange (CSE) came into existence.

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During the early sixties, there were only few recognized RSEs in India

namely Calcutta, Madras, Ahmedabad, Delhi, Hyderabad and Indore. The number

remained unchanged for the next two decades. 1980s was the turning point and many

RSEs were incorporated. The latest is Coimbatore Stock Exchange and Meerut Stock

Exchange.

Stock Broker

The Stock Broker is a member of a recognized stock exchange, who is

permitted to do trades on the floor of the exchange. A broker is an intermediary who

arranges to buy and sell securities on behalf of clients (the buyer and the seller).

According to Rule 2 (e) of SEBI (Stock Brokers and Sub brokers) Rules, 1992, a

stock broker means a member of a recognized stock exchange. No stockbroker is

allowed to buy, sell or deal in securities, unless he or she holds a certificate of

registration granted by SEBI.

No investor can invest in the stock market directly, they have to

register themselves with a registered broker of recognized stock exchange. The broker

then trades in securities on behalf of its investors.

Sub broker

A Sub broker is a person who intermediates between investors and

stock brokers. He acts on behalf of a stock broker as an agent or otherwise for

assisting the investors for buying, selling or dealing in securities through such stock

broker. No sub broker is allowed to buy, sell or deal in securities, unless he or she

holds a certificate of registration granted by SEBI. A sub broker may take the form of

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a sole proprietorship, a partnership firm or a company. Stock brokers of the

recognized stock exchange are permitted to transact with sub brokers.

Depository

A depository is an organization which holds securities of investor in

electronic form at the request of the investor through a registered Depository

Participant. It also provides services related to transactions in securities. Depository

transfers securities between accounts on the instructions given by the account holder.

The fear of loosing of securities is removed through depository as it facilitates

safekeeping of shares. It transfers the ownership of the securities without having to

handle the securities.

Depositories in India

There are two depositories in India.

1. National Securities Depository Limited (NSDL)

2. Central Depository Services Limited (CDSL)

Depository Participant

A Depository Participant (DP) is an agent of the depository through

which it interfaces with the investor. A DP can offer depository services only after it

gets proper registration from SEBI. A Depository can be compared with a bank, like

wise a DP may be compared with a branch of a bank. Presently there are

approximately 390 DPs are registered with SEBI. To avail the services of a depository

an investor has to open an account with any of the depository participant of any

depository.

Dematerialization

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Dematerialization is the process by which physical certificates of an

investor are converted to an equivalent number of securities in electronic form and

credited to the investor’s account with his Depository Participant (DP).

Working of Stock Broking Firm

Stock Broker

As seen earlier, According to Rule 2 (e) of SEBI (Stock Brokers and

Sub brokers) Rules, 1992, a Stock Broker means a registered member of a recognized

stock exchange. A broker is an intermediary who arranges to buy and sell securities

on behalf of clients (the buyer and the seller). No stockbroker is allowed to buy, sell

or deal in securities, unless he or she holds a certificate of registration granted by

SEBI. The constitution of a broking firm may be a Proprietary Concern, a Partnership

firm or a Corporate.

Departments in Stock Broking Firm

(A) Central Depository Services Ltd (CDSL) Department

CDSL Department

Demat Account Dematerialization & Transmission Settlement

Opening Rematerialization & Nomination of Trade

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The CDSL department performs the above stated functions. An

investor has to first open an account with the DP in order to hold the securities in a

dematerialized form. An investor can open an account with any DP of CDSL or

NSDL. The CDSL department also converts the physical shares into demat form and

also shares in demat form into physical share certificate. The activities like

transmission and nomination and trade settlement are also done at CDSL department.

Importance of Demat Account

Demat account is a safe and convenient way to hold the securities as compared

to holding them in physical form.

No stamp duty is levied on transfer of securities held in demat form.

Change of name, address, registration of power of attorney, deletion of

deceased name etc. can be effected across companies by one single instruction

to the DP.

It eliminates thefts, deface, delays, and subsequent misuse of the certificates.

Any number of securities can be transferred and delivered with one delivery

order. Therefore heavy paperwork and headache of signing multiple transfer

forms is eliminated.

(1) Demat Account Opening

The CDSL department performs the basic function of demat account

opening. To hold the securities an investor has to open the demat account with any of

the DP of either Central Depository Services Ltd. or National Securities Depository

Limited. It is mandatory of open a demat account with any of the DP in order to hold

the securities in an electronic form.

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To open a demat account client has to submit identity proof, address

proof, PAN Card, statement of bank account, cheque and two latest photographs.

Absence of any of the above document create hurdles in the procedure of demat

account opening.

(2) Dematerialization and Rematerialization

(a) Dematerialization

Dematerialization is the process in which the physical form of holding

securities is replaced with electronic (book-entry) form of holding. Shares in demat

form do not bear any distinguishable feature like distinctive number, certificate

number. Each security is identified in depository system by ISIN (International

Securities Identification number).

To convert the physical shares certificates in the dematerialized form,

an investor has to submit the DRF (Dematerialization Request Form) along with the

shares certificate. DP enters the DRF in its system and dispatches the Physical

certificates along with the DRF to the R&T agent. R&T agent, on receiving the

physical documents and the electronic request verifies them. Once the R&T agent is

satisfied, dematerialization of the concerned securities is electronically confirmed to

the Depository. Depository credits the dematerialized securities to the beneficiary

account of the investor and intimates the DP electronically. The DP issues a statement

of transaction to the client.

(b) Rematerialization

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Rematerialization is exactly opposite of dematerialization. It refers to

the process of converting the shares held in electronic form with a DP into the

physical shares certificate. Under this process the depository account of a beneficial

owner is debited for the securities sought to be rematerialized and physical share

certificates for the equivalent number of securities issued.

To convert the shares in dematerialized form into physical form, a

client has to submit the RRF (Rematerialization Request Form) with its DP. DP

checks all the details of RRF and also verifies that client has a sufficient balance of

shares in his account. RRF is then entered in the system. DP sends it to the R & T

agent for further procedure. R & T agent scrutinizes of shares and after being satisfied

a certificate is issued to respective DP which is later passed on to the client.

(3) Transmission and Nomination

(a) Transmission

The Companies Act 1956 distinguishes Transmission of shares from

transfer of shares. Transfer of shares relates to a voluntary act of the shareholder

while Transmission is brought about by the operation of law. The word

“Transmission” means devolution of title to shares. Such kind of transmission takes

place due to devolution by death, succession, inheritance, bankruptcy, and marriage

etc. The person on whom the shares devolve has to prove his entitlement by

submitting appropriate documents and seek transmission. If the securities are held in

the depository system, documents have to be submitted to the DP. If the securities are

held in physical form, the documents have to be sent to the company for effective

transmission of shares.

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(b) Nomination

The Companies (Amendment) Act 1999 has introduced provisions for

nomination in respect of shares, Debentures, Fixed Deposits etc. Under the provision

the security holder can nominate a person in whom the shares, debentures, bonds or

deposits would vest, in the event of original investor’s death.

If the shares are held jointly, all the joint holders are required to sign

the nomination form. A holder can even nominate a minor, represented by one of the

parents or guardian. However, Trusts, Societies, Body Corporate, Partnership Firms,

Kartas’ of Hindu Undivided Family, or Power of Attorney holder cannot be appointed

as nominee.

(4) Settlement of Trade

One of the basic services provided by the Depository is to facilitate

transfer of securities from one account to another on the instruction of the account

holder. Transfer of securities from one account to another may be done for any of the

following purposes.

Transfer due to a transaction done on a person-to-person basis.

Transfer arising out of transaction done on a stock exchange.

Transfer arising out of transmission and account closure.

(B) Compliance Department

Compliance Department

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Reg. Of Client Reg. of Sub Broker

Individual Non-individual

Joint Stock Co. Partnership firm Sole Proprietor

The main function of the compliance department is to open a trading

account of clients and registration of sub brokers and franchisees. As a client has to

open demat account to hold the securities, a trading account is opened to trade into

securities. Such account enables the client to trade in the securities held in the demat

account. Such account is opened with the registered member broker.

The compliance department has to comply with the rules and

regulations of SEBI while opening account of clients and registering the sub brokers.

An individual client has to submit identity proof, address proof, PAN card, broker

client agreement on stamp paper along with application form. In case of non

individuals Joint Stock Company, Partnership Firm or Sole Proprietor the documents

required are application form, broker client agreement, certified copy of Articles and

Memorandum of Association, certified copy of resolution to open account, bank

certifying letter whichever is applicable.

While registering for sub broker compliance department has to comply

with the criteria laid down by the SEBI. The applicant should not be less than 21

years of age, he should have at least passed HSC exam, he should not be convicted to

any offence involving fraud or dishonesty etc. An application for the grant of

certificate shall be made in form B, application shall be accompanied by a

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recommendation letter from a stock broker of recognized stock exchange with whom

he is affiliated to along with two references including one from his banker. The stock

exchange on receipt of application shall verify the information contained and then

shall also certify that the applicant is eligible for registration.

(C) Dealing Department

Dealing Department

Buying Securities Selling Securities

Entering Order Order Order

Orders Modification Cancellation Matching

The most basic and important function of stock broking firm i.e.

buying and selling of securities on behalf of its clients is performed by the Dealing

Department. The employees who carry out this function are known as dealers. Dealer

is the person who performs the function of buying and selling of securities of

securities for clients. The clients have to inform the dealer to buy or sell securities

who then enters the order in the system. Generally, the ODIN software is used for

such purposes. The functions carried out at dealing department are explained below in

detail.

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Entering Order

The trading member can enter orders in the normal market during the

trading hours. When an order enters the trading system it is an active order, it tries to

find out on the other side of the books if it finds the match, trade is generated. If it

does not find a match, the order becomes passive order and appears in the order book.

Order Modification

All orders can be modified in the system till the time they do not get executed and

only during the market hours. Once an order is modified, the branch order values limit

for the branch and get adjusted automatically.

Order Cancellation

Order cancellation functionality can be performed only for orders

which have not been fully or partially executed (for the unexecuted part of partially

traded orders only) and only during the market hours.

Order Matching

The buy and sell orders are matched on book type, symbol, series,

quantity and price. The best sell order is the order with lowest price and best buy

order is the order with highest price. The unmatched orders are queued in the system

by the following priority.

(D) Settlement Department

Settlement Department

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Pay In Of Pay Out Of Pay In Pay Out

Securities Securities Of Funds Of Funds

Settlement department performs the back office function i.e. settling of

trades that takes place every day. This settling is done under ‘T+2’ rolling settlement

system. NSE/BSE provides a platform for trading to its trading members; the National

Securities Clearing Corporation LTD (NSCCL) determines the funds/securities

obligation of the trading members and ensures that trading members meet their

obligations. The clearing banks and depositories provide the necessary interface

between the custodians and clearing members (who clear for trading members or their

own transactions) for settlement of funds/securities obligation of trading members.

Rolling Settlement

Under Rolling settlement all the trades executed on a trading day are

settled X days later this is called ‘T+X’ rolling settlement where ‘T’ is the trade date

and ‘X’ is the number of working days after trade date in which settlement takes

place. The rolling settlement has started in T+5 bases in India, now it is T+2.

Pay In Of Securities and Funds

The members bring in their securities/funds to the NSCCL; they make

available required securities in designated accounts with the depositories by the

prescribed pay in time. If they fail to do so the securities go for auction.

Pay Out Of Securities and Funds

NSCCL sends electronic instructions to the depositories/clearing banks

to release pay out of securities/funds. These securities/funds reach to the respective

members account. This settlement is based on rolling system which is T+2 days.

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(E) Risk Management Department / Surveillance Department

Risk Management Department

Capital On Line Off Line Margin Circuit

Adequacy Monitoring Monitoring Requirements Filters

A sound risk management system is integral to an efficient clearing

and settlement system. The NSCCL ensures that trading members’ obligations are

commensurate with their net worth. It monitors the track record and performance of

members and their net worth, undertakes on-line monitoring of members’ positions

and exposure with the market collects margins from members and automatically

disables members if the limits are breached. Thus, in order to keep a continuous check

on market risk management department performs the following functions.

Capital Adequacy

The stock exchanges mention their own capital adequacy requirements.

The members have to pay Base Minimum Capital and Additional Base Capital. Base

minimum capital of the member is taken to determine the member’s intra-day trading

limit and/or gross exposure limit only whereas the amount provided as additional

capital is allowed to be utilized towards margin payment if not used up for taking

exposure/turnover.

On-line Monitoring

NSCCL has put in place an online monitoring and surveillance system

whereby exposure of the members is monitored on a real time basis. A system of

alerts has been built in so that both the member and NSCCL are alerted as per pre-set

levels (reaching 70%, 85%, 90%, and 100%) when the members approach their

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allowable limits. It enables to further check the micro-details of members’ positions,

if required and take pro-active action.

Off-line Monitoring

Off-Line surveillance activity Consists of inspection and investigations

as per regulatory requirement a minimum of 10% of the active trading members are to

be inspected every year to verify the level of compliance with various rules, bye laws

and regulations of the exchange. Generally, inspection of more members than the

regulatory requirement is undertaken every year. It also verifies if investor interests

are being compromised in the conduct of business by the members.

Margin Requirements

As per SEBI directive, in T+2 rolling settlement, all stock exchanges

have imposed stringent margin requirements as a part of their risk containment

measures. The daily margin in rolling settlement comprises of Value at Risk - based

Margin (VaR Margin) and Mark to Market margin (MTM Margin). Margins are

computed at client level. A member entering an order needs to enter the client code.

Based on this information margin is computed at the client level which will be

payable by the trading member on T+1 basis.

Circuit Filters

An index based market wide circuit breakers system applies at three

stages of the index movement either way at 10%, 15%, and 20%. These circuit

breakers bring about a coordinated trading halt in all equity derivatives market

nationwide. These breakers are triggered by movement of either S&P CNX Nifty or

Sensex whichever is breached earlier. As an additional measure of safety, individual

scrip – wise price bands of 20% for all scrips and 10% for scrips for which derivative

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products are available or those included in indices on which derivative are available,

have been imposed.

Risk

Risk has been known to man ever since he first faced adversity. It is an

integral part of the evolution of man. Risk has been encountered primarily in his

physical environment, later on in his social environment. With time, risk has evolved

along with man. The main risk man faced was an attack by animals. This risk was

mitigated by the discovery of fire. Here also risk is mitigated not eliminated. From

that time to the twenty first century man has faced n number of risks. Whether it is

walking on the road or flying in the plane, buying the video game or a bunglow every

person is exposed to the risk involved in the situation.

Risk can be defined as-

‘Risk is the possibility of happening uncertain events.’

Risk is the chance of happening of something that may affect the desired results.

Risk exists if there is something you don’t want to happen – having a

chance to happen. The risk can also be explained as a probability that some event will

cause an undesirable outcome on the financial health of your business and/or other

business/family goals. In the same way risk is involved in the investments also. All

investments are risky, whether in stock, capital market, banking, financial sector, real

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estate, bullion, gold etc. The degree of risk however varies on the basis of the features

of the assets, investments instrument, the mode of investment, time frame or the issuer

of the security etc. However, the risk and return goes hand in hand. Higher the risk,

higher is the possibility of better returns and vice versa. Thus, the degree of risk plays

a vital role in any kind of investment.

Types of Risk

Risks are broadly divided into 2 categories.

Risk

Systematic Risk Unsystematic Risk

(1) Systematic Risk

Systematic risks are out of external and uncontrollable factors, arising

out of the market, nature of the industry and the state of the economy and a host of

other factors. The examples of systematic risk are as follows.

(a) Market Risk

This arises out of changes in demand and supply pressures in the

markets, following the changing flow of information or expectations. The market

risks also arise due to ups and downs in the prices of securities. The economic

changes affect the prices of securities to go up or down, and make the market more

volatile. The totality of investor perception and subjective factors influence the events

in the market which are unpredictable and give rise to risk, which is not controllable.

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(b) Interest Rate Risk

The return on an investment depends on the interest rate promised on it

and changes in market rates of interest from time to time. The cost of funds borrowed

by companies or stockbrokers depends on interest rates. These interest rates depend

on nature of instruments, stocks, bonds, loans etc., maturity of the periods and the

creditworthiness of the issuer of securities.

(c) Purchasing Power Risk

Inflation or rise in prices lead to rise in costs of production, lower

margins, wage rises and profit squeezing etc. The return expected by investors will

change due to change in real value of return. The element of purchasing power risk is

inherent in all investments and cannot be controlled.

(2) Unsystematic Risk

Unsystematic risks emerge out of the known and controllable factors,

internal to the issuer of the securities or companies. The examples of unsystematic

risk are as follows.

(a) Business Risk

Business risk relates to the variability of the business, sales, income,

profits etc., while in turn depend on the market conditions for the product mix, input

supplies, and strength of competitors. It is sometimes external to company due to

changes in Govt. policy or strategies of competitors etc. It may internal due to labour

problems, raw material problems, fall in production etc.

(b) Financial Risk

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Financial risk relates to the method of financing, adopted by the

company, high leverage leading to larger debt servicing problems or short-term

liquidity problems due to bad debts, delayed receivables and fall in current assets or

rise in current liabilities. Proper financial planning and other financial adjustments can

be used to correct this risk and as such it is controllable.

(c) Default or Insolvency Risk

The borrower or issuer of securities may become insolvent or may

default, or delay the payments due, such as interest installments or principal

repayments. The borrower, in extreme cases, may get bankrupt in short span of time,

may be due to mistakes of management. In such cases, the investor may get no return

or negative returns.

Risk vs. Return

The risk and return go hand in hand. They have a direct relationship.

Higher the risk, higher is the possibility of better returns and lower the risk, lower is

the possibility of better returns. Investors’ personality, lifestyle, and their financial

position play a big role on how much risk they can comfortably bear. The risk/return

tradeoff is the balance, an investor must decide on between the desires for the lowest

possible risk for the highest possible returns. It is important to keep in mind that low

levels of uncertainty (low risks) are associated with low potential return and high

levels of uncertainty (high risks) are associated with high potential returns.

The diagram given below explains the relationship between the risk

and return. As the risk increases the probability of getting higher returns also

increases and vice versa.

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RISK/ RETURN TRADEOFF

Returns Low Risk Higher Risk

Low Return High Return

Risk

Different securities have different degrees of risk. Insurance is the

safest mode of investment, whereas there is very high risk in equity. The below

diagram shows the degree of risk contained in various investments.

* Equity

* Mutual Funds

Rewards * Debentures

* Fixed Deposits

* Post Office Certificates

* Bank Deposits

* Insurance Schemes

Risk Taken By Investor

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Risks involved in a Stock Broking Firm

A stock broker has to deal with various risks while dealing with its sub

brokers, clients etc. Due to the high volatility of the market broker is always exposed

to the risks. The various risks borne by a broker can be classified as under.

Risks in broking firms

Market Financial Credit Liquidity Operational

Risks Risks Risks Risks Risks

(1) Market Risks

Market risks are the risks which cause due to the high volatility of

market and value of scrips. These risks arise due to adverse market rate movements

i.e. foreign exchange rate, interest rates, commodity prices and equity prices. The

value of investments may decline over a given time period simply because of

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economic changes or other events that impact large portions of the market. Proper

asset allocation and diversification can protect against market risk.

(2) Financial Risks

Financial risk is the risk that a company will not have adequate cash

flow to meet the financial obligations. Financial risk means fear of loss of money,

which is the biggest risk faced by a broking firm. Financial risk in respect of broking

firm can be of two types firstly loss of income i.e. brokerage secondly loss of capital.

It has a risk that it will go out of funds because of non payment by the clients, sub

brokers etc.

(3) Credit Risks

Credit risk is the risk that the counter party of financial transaction will

fail to perform according to the terms and conditions of the contract, thus causing the

other party to suffer a financial loss. Credit risk is the risk of loss due to a debtor's

non-payment of a loan or non fulfillment of terms and conditions of contract. Credit

risk is often due to bankruptcy or insolvency of the counter party which results in non

payment of dues.

(4) Liquidity Risk

Liquidity risk is a risk which arises from the difficulty of selling an

asset and realizing the money of it. Market liquidity is the risk that a financial

instrument cannot be sold quickly at a price, which equates to their market value.

An investment may sometimes need to be sold quickly. Unfortunately, an insufficient

secondary market may prevent the liquidation or limit the funds that can be generated

from the asset. Some assets are highly liquid and have low liquidity risk (such as

stock of a publicly traded company), while other assets are highly illiquid and have

high liquidity risk (such as a house).

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(5) Operational Risks

Operational risks are explained as Risk of loss arising due to procedure

errors, omission or failure of internal control system. These risks are defined as ‘The

risk of loss resulting from inadequate or failed internal processes, people and systems

or from external events.’ An operational risk is a risk arising from execution of a

company's business functions. As such, it is a very broad concept including fraud

risks, legal risks, physical or environmental risks, etc. Operational risks are very

common risks, which are found almost in every organization. All the organizations

face the risks that their activities and processes may be disrupted unexpectedly or fail

and this will stop the functioning of organization. Such events may cause an

organization certain problems like-

Direct financial losses, which arise from failing to meet an obligation (e.g.

penalty interest payments or restitution loss).

Direct financial losses, attributable to an absence of income (e.g. loss of sales,

transaction fees, direct fees or commission)

Statutory or regulatory penalties resulting to revocation of licenses.

Opportunity costs, arising from adverse publicity, being unable to trade or

because of processing delays, backlogs, and poor customer service delivery or

poor product or service quality.

In stock broking firms the operational risks are found at various levels

of departments. They are as follows.

Operational Risks

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CDSL Compliance Dealing Settlement Risk Management

Department Department Department Department Department

(a) CDSL Department

Following are the risks involved in CDSL department.

Failure in receipt of transaction slip.

Wrong entry of DRF and RRF.

Punching error.

Networking problem with the exchange.

Failures in maintaining records for demat and remat account.

Effects

CDSL department directly deals with the clients. If services are not

provided properly to the clients, it may mar the reputation of the broker. If transaction

slip is not received, it will result in the problems with recording the transaction. The

errors in entering the details of DRF and RRF will cause problems to security holder.

Errors in CDSL department will directly affect the clients and this may cause a bad

client broker relationship.

(b) Compliance Department

Following are the risks involved in compliance department.

Non-eligibility of the applicant.

Non-compliance of various agreements and forms.

Absence of bank certification.

Absence of identity proof.

Absence of reference letter from chartered accountant.

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Absence of undertaking from sub broker that he/she has not been involved in

any criminal offence and no trail is pending against him/her.

Effects

Compliance department is responsible for the acceptance to the new

clients and sub brokers. Therefore compliance department must verify all the

documents while opening the trading accounts of investors and approving to new sub

brokers. On the event of non compliance of documents a broker can be penalized or

terminated. This will result in the bad publicity and loss of clients. Also the

compliance department has to verify all the details about person applying for the sub

broker ship. If a wrong person is appointed as sub broker it may mar the reputation of

the broker.

(c) Dealing Department

Following are the risks involved in dealing department.

Placing of wrong order i.e. instead of buy order sell order is given.

Placing of wrong quantity.

Trading done from wrong account i.e. buying and selling from wrong clients

account.

Trading in wrong scrip i.e. instead of trading in L & T, trading is done in ABB

Effects

In all the above cases mentioned a broker has to face financial loss. If

the trading is done from wrong client account i.e. if buy order is put from Mr. A in

place of Mr. B and Mr. B does not give a cheque a broker has to face the loss from is

own pocket. Thus, such kinds of events result in loss of money as well as loss of

reputation for a broker. If such things happen on regular basis the client may change

the broker and it will create problems for broker in the long term.

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(d) Settlement Department

Following are the risks involved in settlement department.

Failure of client in Pay in of shares or funds.

Payout of shares to wrong account.

Failure in deciding brokerage slab for a client.

Wrong preparation of statement of funds.

Failure in sending confirmation of account opening to the client.

Failure in sending contracts.

Failure in preparing bills.

Failures in preparing pay in and pay out slips.

Effects

The work of settlement department is of utmost importance and full of

responsibility. All the good work done by different departments can be nullified by an

incompetent or casual work of settlement department. Wrong payout of shares, wrong

payout of funds, failure in preparing bills in time, failure in preparing pay in and pay

out of slips can not only create chaos in a broking firm, it can result in huge financial

losses to the broker and a bad image in the minds of clients.

(e) Risk Management Department

Following are the risks involved in risk management department.

Failure in calculating the limits and margins.

Giving wrong limits to the client.

Failure in collecting margins.

Failure in sending daily reports to franchisee and sub broker.

Failure in sending daily reports to management.

Effects

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The risk management department directly comes into contact with sub

brokers and franchisees. If risk management department does not give enough limits

where it is due and is required it can result in loss to investor or a sub broker leading

to dispute and financial loss. On the contrary giving wrong limits have the same

effect. Failure in collecting margins attracts two types of risks regulatory and

financial. If the margins are not collected according to SEBI guidelines it can result in

financial penalty, suspension or termination of broker ship.

Risk Management

Risk management is a structured approach to managing uncertainty

related to a threat, a sequence of human activities including: risk assessment,

strategies development to manage it, and mitigation of risk using managerial

resources. The complexity of our modern lives and the numerous decisions we are

able to take are only made possible by our ability to manage risks - the risk of house

fire; the risk of losing a job; the risk to the entrepreneur who invests in a business; the

risk to the farmer who plants a crop that will have an uncertain yield and be sold at an

uncertain price in several months time; the risk to the investor in the stock market;

and so on.

Ways to deal with Risk

Ways to deal with Risk

Avoid Retain Reduce Transfer

(a) Avoid the Risk

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Avoidance of risk Includes not performing an activity that could carry

risk. Avoidance may seem the answer to all risks, but avoiding risks also means losing

out on the potential gain that accepting the risk may have allowed. Not entering a

business to avoid the risk of loss also avoids the possibility of earning profits.

(b) Retain the Risk

Retention of risk involves accepting the loss when it occurs. Risk

retention is a viable strategy for small risks where the cost of insuring against the risk

would be greater over time than the total losses sustained. All risks that are not

avoided or transferred are retained by default. This includes risks that are so large that

they either cannot be insured against or the premiums would be infeasible.

(c) Reduce the Risk

Reduction in risk involves methods that reduce the severity of the loss

or the likelihood of the loss from occurring. Outsourcing could be an example of risk

reduction. For example, a company may outsource its manufacturing of hard goods to

another company, while handling the business management itself. This way, the

company can concentrate more on business development without worrying much

about the manufacturing process.

(d) Transfer the Risk

Risk transference causes another party to accept the risk, typically by

contract or hedging. Insurance is one type of risk transfer which uses contracts.

Liability among construction or other contractors is very often transferred this way.

Such transference of risk may include certain cost like insurance premium.

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Process of Risk Management

Identify the areas of risk

Search for and locate the areas where there can be risk before they

become the actual problems for the organization.

Analyze the risk

Transform the risks data into decision-making information. Evaluate

impact, probability and time frame of it and classify the risks, and prioritize them.

Plan

On the basis of the data evaluated, plan for the management of risk

Planning is done according to whether the risk is to be avoided, retained, reduced

or transferred.

Control

Find out any deviations or variance and correct for the same during the

execution of risk mitigation plan.

Communicate

Communicate the internal and external information and feedback to

the project on the risk activities, current risks, and emerging risks.

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Measures to reduce the risk

Stock broking firm is highly exposed to the financial risks. Since it

poses maximum risk in the financial markets, risk management in stock broking firms

was felt most essential by the exchanges and its regulatory bodies. National Stock

Exchange introduced for the first time in India, risk containment measures that were

common internationally but were absent from the Indian Securities Market. NSCCL

has also put in place a comprehensive risk management system, which is constantly

upgraded to pre-empt market failures. These measures were taken to reduce the risks

at brokers’ end. SEBI has also suggested certain measures to manage the risks borne

by the brokers.

Margins

There is a lot of uncertainty in the movement of share prices. This

uncertainty leading to risk is sought to be addressed by margining systems by stock

markets.

Suppose an investor, purchases 1000 shares of ‘ABC’ company at

Rs.100 on July 1, 2008. Investor has to give the purchase amount of Rs.1,00,000

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(1000 x 100) to his broker on or before July 2, 2008. Broker, in turn, has to give this

money to stock exchange on July 3, 2008. There is always a small chance that the

investor may not be able to bring the required money by required date. As an advance

for buying the shares, investor is required to pay a certain portion (margin) of the total

amount of Rs.1,00,000 to the broker at the time of placing the buy order. Stock

exchange in turn collects similar amount from the broker upon execution of the order.

This initial token payment is called margin.

For every buyer there is a seller and if the buyer does not bring the

money, seller may not get the money. Margin is levied on the seller also to ensure that

he gives the shares sold to the broker who in turn gives it to the stock exchange.

Volatility

Volatility essentially refers to uncertainty arising out of price changes

of shares. It is important to understand the meaning of volatility a little more closely

because it has a major bearing on how margins are computed. Volatility has different

definitions and therefore different people compute it differently. For the margin

purposes, let us compute volatility based on close prices of a share over last 6 months.

Since it is based on historical data let us call it ‘historical volatility’.

The historical volatility can be easily calculated using an excel sheet.

First put down close prices of a share for the last six months in a column of the excel

sheet. Calculate the daily returns, that is, use ‘LN’ (natural log) function in excel. Use

the formula LN (today’s close price / yesterday’s close price) in the next column for

calculating daily returns for all the days. Go to the end of the second column (after the

last value) and use the excel function ‘STDEV’ (available under statistical formulas)

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to calculate the Standard Deviation of returns computed as above. The calculated

standard deviation expressed as percentage is the ‘historical volatility’ of the share for

the six months period.

Higher volatility means the price of the security may change dramatically over a short time

period in either direction. Lower volatility means that a security’s value may not change as dramatically.

Date

Closing price of shares of X

DailyLN returns

Closing price of shares of Y

Daily LN Returns

Closing price of share of Z

Daily LN Returns

1-July-08 2800 2420 2510

2-July-08 2850 1.77% 2480 2.45% 2515 0.20%

3-July-08 2700 -5.41% 2515 1.40% 2520 0.20%

4-July-08 2750 1.83% 2550 1.38% 2512 -0.32%

5-July-08 2900 5.31% 2565 0.59% 2508 -0.16%

6- July-08 2800 -3.51% 2592 1.05% 2514 0.24%

7-July-08 2650 -5.51% 2614 0.85% 2523 0.36%

8- July-08 2700 1.87% 2635 0.80% 2510 -0.52%

9-July-08 2750 1.83% 2667 1.21% 2505 -0.20%

10-July-08 2650 -3.70% 2686 0.71% 2515 0.40%

11-July-08 2640 -0.38% 2708 0.82% 2502 -0.52%

12-July-08 2520 -4.65% 2725 0.63% 2510 0.32%

13-July-08 2670 5.78% 2742 0.62% 2515 0.20%

14-July-08 2720 1.86% 2758 0.58% 2511 -0.16%

15-July-08 2790 2.54% 2825 2.40% 2514 0.12%

Volatility 3.85% 0.62% 0.32%

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Value at Risk Margin (VaR Margin)

The most popular and traditional measure of uncertainty/risk is

Volatility, while historical volatility tells us how the security price moved in the past,

VaR answers the question, ‘How much is it likely to move over next one day?’ VaR is

computed using exponentially weighted moving average (EWMA) methodology.

Based on statistical analysis, 94% weight is given to volatility on ‘T-1’ day and 6%

weight is given to ‘T’ day returns.

To compute, volatility for Trading Day (T), first we need to compute

day’s return for T by using LN (close price on T / close price on T-1).

Following formula is used to calculate volatility T.

Square root of [0.94*(T-1 volatility)*(T-1 volatility) + 0.06*(T LN return)*(T LN

return)]

To arrive at VaR margin rate, companies are divided into 3 categories

based on how regularly their shares trade and on the basis of liquidity (that is, by how

much a large buy or sell order changes the price of the scrip, what is technically called

as impact cost. Group I consists of shares that are regularly traded (that is, on more

than 80% of the trading days in the previous six months) and have high liquidity (that

is, impact cost less than 1%). Group II consists of shares that are regularly traded

(again, more than 80% of the trading days in the previous six months) but with higher

impact cost (that is, more than 1 %). All other shares are classified under Group III.

For Group I shares, the VaR margin rate would be higher of

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3.5 times volatility or

7.5% of value

For Group II shares, the VaR margin rate would be higher of

3.5 times volatility or

3.0 times volatility of index

The volatility of index is taken as the higher of the daily Index

volatility based on S&P CNX NIFTY or BSE SENSEX. At any point in time,

minimum value of volatility of index is taken as 5%.

For Group II shares, the number arrived at as above, is multiplied by 1.732051 (that

is, square root of 3). The number so obtained is the VaR margin rate.

For Group III securities VaR margin rate would be 5.0 times volatility of the Index

multiplied by 1.732051 (that is, square root of 3).

Mark to Market Margin (MTM Margin)

Mark to Market margin is calculated at the end of the day on all open

positions by comparing transaction price with the closing price of the share for the

day. In the above example a buyer purchased 1000 shares @ Rs.100 at 11 am on July

1, 2008. If close price of the shares on that day happens to be Rs.75, then the buyer

faces a notional loss of Rs.25,000 on his buy position. In technical terms this loss is

called as MTM loss and is payable by July 2, 2008 (that is next day of the trade). In

case price of the share falls further by the end of July 2, 2008 to Rs. 70, then buy

position would show a further loss of Rs.5,000. This MTM loss is payable.

In case, on a given day, buy and sell quantity in a share are equal, that is net quantity

position is zero, but there could still be a notional loss / gain (due to difference

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between the buy and sell values), such notional loss also is considered for calculating

the MTM payable.

MTM Profit/Loss = [(Total Buy Qty X Close price) - Total Buy Value] - [Total Sale

Value - (Total Sale Qty X Close price)]

Extreme Loss Margin

The extreme loss margin aims at covering the losses that could occur

outside the coverage of VaR margins. The Extreme loss margin for any stock is

higher of 1.5 times the standard deviation of daily LN returns of the stock price in the

last six months or 5% of the value of the position. This margin rate is fixed at the

beginning of every month, by taking the price data on a rolling basis for the past six

months.

According to the example mentioned above, the VaR margin rate for

shares of ABC Ltd. was 13%. Suppose the 1.5 times standard deviation of daily LN

returns is 3.1%. Then 5% (which is higher than 3.1%) will be taken as the Extreme

Loss margin rate. Therefore, the total margin on the security would be 18% (13%

VaR Margin + 5% Extreme Loss Margin). As such, total margin payable (VaR

margin + extreme loss margin) on a trade of Rs.10 lakhs would be Rs. 1,80,000.

Upfront Margin Co llection

Members are required to ensure collection of upfront margin from their

clients at rates mentioned below and deposit the same in a separate clients account, in

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respect of trades in normal market in which would result in a margin of Rs 50,000

more, after applying the margin percentages as given below.

Groups (Securities Covered) Upfront Margin Rate

Group I 15%

Group II 30%

Group III 45%

Failure to pay margins

Non-payment of either the whole or part of the margin amount due will

be treated as a violation of the Bye Laws of the Clearing Corporation and will attract

penal charges @ 0.09% per day of the amount not paid throughout the period of non-

payment. In case a member has a margin shortage of Rs. 10 lacs or above for more

than 10 occasions in the past 4 weeks, the gross exposure multiple of the member will

be reduced to one level lower at the time of re-activation of their trading terminals as

giver. Under

Slab Multiple

Full Exposure

1st level

2nd level

3rd level

4th level

8.50 times

7.00 times

5.00 times

3.00 times

2.00 times

If there is no margin shortage for the next I week of Rs. 10 lacs or

more, the exposure limits shall be restored to the previous levels. In addition, NSCCL

may, within such time as it may deem fit, advice the exchange to withdraw any or all

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of the membership rights of the member including the withdrawal of 'trading facilities

without any notice. In the event of withdrawal of trading facilities, the outstanding

positions of the member may be closed out, to the extent possible, forthwith or any

time thereafter by NSCCL, at its discretion by placing at the Exchange, counter orders

in respect of the outstanding position of the member, without any notice to the

member, and such action shall be final and binding on the member.

Margins based on turnover & Exposure limits (Initial margins)

Intra-day turnover limit

Members are subject to the intra-day trading limits. Gross turnover

(buy + sell) intra-day of the member should not exceed the thirty three and one-third

(33 1/3) times the base capital (cash deposit and other deposits in the form of

securities or bank guarantees with NSCCL and NSE).

Members violating the intra-day gross turnover limit at any time on

any trading day are not being permitted to trade forthwith. Member’s trading facility

is restored from the next trading day with a reduced intraday turnover limit of 20

times the base capital till deposits in the form of additional deposits (additional base

capital) is deposited with NSCCL. Members are given a maximum of 15 days time

from the date of the violation to bring in the additional capital. Upon members failing

to deposit the additional capital within the stipulated time, the reduced turnover limit

of 20 times the base capital would be applicable for a period of one month from the

last date for providing the margin deposits.

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Upon the member violating the reduced intra-day turnover limit, the

above-mentioned provisions apply and the intra-day turnover limit will be further

reduced to 15 times. Upon subsequent violations, the intra-day turnover limit will be

further reduced from 15 times to 10 times and then from 10 times to 5 times the base

capital. Members are not permitted to trade if any subsequent violation occurs till the

required additional deposit is brought in.

Gross Exposure Limits

Members are also subject to gross exposure limits. Gross exposure for

a member, across all the securities in rolling settlements, is computed as the absolute

(buy value - sell value), i.e. ignoring +ve and -ve signs, across all open settlements.

Open settlements would be all those settlements for which trading has commenced

and for which settlement pay in is not yet completed. The total gross exposure for a

member on any given day would be the sum total of the gross exposure computed

across all the securities in which the member has an open position.

Gross exposure limit would be:

Total Base Capital Gross Exposure Limit

Up to Rs. 1 crore

> Rs. 1 crore

8.5 times the total base capital

8.5 crores +

10 times the total base capital in excess of Rs 1 crore

Or any such lower limits as applicable to the members.

The total base capital being the base minimum capital (cash deposit and security

deposit) and additional deposits, not used towards margins, in the nature of securities,

bank guarantee, FDR or cash with NSCCL and NSE.

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Security-wise Differential Exposure Limits

In case of securities that are traded in the Rolling settlement (Type 'N'

and security series 'EQ'), the GE multiple for each security are as under:

Groups (Securities Covered) Covered Multiple

Group I

Group II

Group III

1 time

2 times

5 times

All new securities to be traded on the Exchange shall be subject to

exposure multiple of 2 times. It is clarified that while computing the gross exposure at

any time for a particular trading day, for the purpose of the above limits, members are

required to add the net outstanding positions of the previous settlement period to the

cumulative net outstanding positions as of that particular trading day until the

securities pay in day for the previous settlement period. Members exceeding the gross

exposure limit are not permitted to trade with immediate effect and are not permitted

to do so until the cumulative gross exposure is reduced to below the gross exposure

limits (as defined above or any such lower limits as applicable to the members) or

they increase their limit by providing additional base capital.

Members who desire to reduce their gross exposure may submit their

order entry requirements as per the prescribed format and if members desire to

increase their limits additional deposits by way of bank guarantee or Fixed Deposit

Receipt (FDR) have to be submitted to NSCCL. Additional deposits by way of

56

securities in electronic form (demat securities) may be deposited as per procedures.

The additional deposits of the member are used first for adjustment against gross

exposure of the member. After such adjustments, the surplus additional deposits, if

any, excluding deposits in the form of securities is utilized for meeting the margin

requirements.

Violation Charges

Members exceeding the gross exposure limit are not permitted to trade

with immediate effect (trading terminals are disabled automatically. A penalty of

Rs.5,000 is levied for each violation of gross exposure limit and Intra Day Turnover

limits, which shall be paid by next day. The penalty is debited to the clearing account

of the member. Non-payment of penalty in time will attract penal interest of 15 basis

points per day till the date of payment. In respect of violation of stipulated limits on

more than one occasion on the same day, each violation would be treated as a separate

instance for purpose of calculation of penalty. The penalty as indicated above would

be charged to the members irrespective of whether the member brings in additional

capital subsequently.

Additional Base Capital

Members may provide additional margin/collateral deposit (additional

base capital) to NSCCL, over and above their minimum deposit requirements (base

capital), towards margins and/ or exposure / turnover limits. Members may submit

such deposits in any one form or combination of the following forms:

Cash

Fixed Deposit Receipts (FDRs) issued by approved banks and deposited with

Approved Custodians or NSCCL

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Bank Guarantee in favour of NSCCL from approved banks in the specified

format.

Approved securities in demat form deposited with approved Custodians.

All Additional Base Capital (ABC) given in the form of cash / FDR

(hereinafter referred to as 'Cash Component) should be at least 30% of the total ABC

and cash margins in respect of every trading member. Incase where non - cash

component is more than 70 % of the total additional base capital, the excess non-cash

component is ignored for the purpose of exposure limits requirements and / or

margins requirements.

Exemption for institutional deals

Deals executed on behalf of the following entities are considered as

institutional deals:

Financial Institutions

SEBI registered FII’s

Banks

SEBI registered Mutual Funds

While computing margins, institutional deals are excluded. Deals are

identified by the use of the participant code in the trades reported. Deals entered into

on behalf of custodial participants i.e. carrying custodial participant code are

considered as institutional deals unless not confirmed by the respective custodians in

which case the deals shall attract margins.

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Non-Custodial Institutional Deals are identified by the use of the

participant code `NCIT'. The NCIT' deals will be exempted for margin purposes

(However, VaR based margin which is charged on institutional trades on the net

outstanding sale position, in securities shall be applicable in this case also) and the

settlement obligation will remain with TM clearing member. Non Custodial

Institutional deals, which are not marked as 'NCIT' at the time of order entry, will not

be exempted. All TM clearing members are required to provide details of the contract

notes for all Non-Custodial Institutional Trades through a file upload as per the

procedure.

Exemption upon delivery of securities

If members deliver the securities prior to the securities pay in day, then

the margin payable by the member will be recomputed after considering the above

pay in of securities. The margin benefit on account of early pay in of securities shall

be given to the extent of the net delivery position across all clients of the member.

The early pay in would be allocated to clients having net deliverable position, on a

random basis, till such time that the system is developed to provide the early pay in

benefit on a client basis. However, members are required to ensure to pass on

appropriate early pay in benefit of margin/exposure to the relevant client, until the

above system is in place.

The value of the advance pay in made is reduced from the cumulative

net outstanding sale position of the member for the purpose of gross exposure limits.

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Members may note that early pay in of securities only up to the

working day prior to the scheduled settlement pay in day shall be considered for the

purpose of early pay in benefits. In case any member makes early pay in on the

scheduled day of pay in for the settlement, no benefit will accrue to the member. Such

early pay in shall not be adjusted against the settlement pay in obligation and it would

be treated as short delivery. Members are therefore alerted to ensure that no early pay

in is made on the scheduled day of settlement pay in.

Pay in of funds and securities prior to scheduled pay in day

The relevant authority may require members to pay in funds and

securities prior to the scheduled pay in day for funds and securities. The relevant

authority would determine from time to time, the members who would be required to

pay in funds and securities prior to the pay in day. The relevant authority would also

determine securities and funds which would be required to be paid in and the date by

which such pay in shall be made by the respective members.

The value of such prior pay in of funds and securities will not be

reduced from the cumulative net position of the member for the purpose of gross

exposure reduction. There will be no margin exemption available for such pay in of

funds and securities.

Measures taken by BSE for risk management

Certain steps or measures are taken by BSE towards the reduction of

risks of stock brokers.

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Know your client (KYC)

According to know your client scheme the member brokers of the

exchange are required to obtain detailed information of clients prior to

commencement of any transactions with new clients. A similar procedure is also to be

followed for existing clients. This information is to be made available to the exchange

authorities whenever called for. In case the member broker fails to furnish the same, it

may result in penalties to the member brokers.

Surveillance / Inspection

Surveillance / Inspection department carries out inspection of the

member brokers records and keep a regular check on the activities of member brokers

as well as sub brokers as regards the compliance of the risk management procedures.

Insurance

The exchange presently has in place insurance policies to protect itself

in the event of losses on account of fire, damage to computer systems and a

comprehensive policy that covers risks faced by the exchange, its member brokers

and the clearing houses.

The risks covered under the basic cover of the policy are detailed as below.

» Loss of member on account of fake / forged / stolen shares being

introduced by the clients.

» Loss to members on account of fraud by employees.

» Direct financial losses suffered by the member broker on account of

physical loss, destruction, theft or damage to securities and cash.

» Loss on account of securities lost in transit.

» Loss suffered on account of incomplete transaction.

» Loss on account of errors and omission.

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Verification of shares members’ office

The exchange has outlined the process i.e. in case the transaction in a

script with one particular client in a settlement exceeds Rs. 10 lacs then the member

has to send the photocopies of the transfer deeds and the share certificates to the

company / registrar for verification of the material particulars. The basic idea behind

the introduction of this procedure is to prevent the fake / forged / stolen shares from

being introduced in the market.

Measures taken by SEBI

The Securities and Exchange Board of India (SEBI) along with

Government have been stressing upon the need for strict regulation of secondary

market and bringing the transparency on the floor of stock exchanges. The steps taken

by the SEBI and Government in order to regulate and control the activities of stock

exchanges and reduce the risk of investors and sock brokers are as follows.

Uniform Trading hours at all the stock exchanges in the country to check the

arbitrage.

Registration of all market players such as brokers, sub brokers, registrars to

issues, merchant bankers, portfolio managers, underwriters, debenture trustees,

custodians etc so as to have access/inspection of their books, records and

verification of transactions.

Regulation on insider trading with the object to curb it completely and punish

the guilty.

Compulsory audit of accounts of all member brokers and registered

intermediaries by practicing chartered accountants.

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Indirect supervision through stock exchanges in day-to-day business by fixing

margins, imposing curbs, penalties and fines etc.

Systematization and computerization in order to reduce the paper work and

ensure transparency in transactions.

Mentioning of brokerage separately in broker contract notes.

Brokers have to notify all transaction to the stock exchanges including off the

floor trades.

Uniform good/bad delivery norms.

Capital adequacy norms prescribed for brokers.

Brokers have to keep the clients money in a separate bank account.

Forward trading being banned on stock exchanges.

Derivative trading in index based futures of 1, 2 or 3 months.

Dematerialization of almost all the securities.

Total transparency and automation of stock exchanges.

Effective margin system for smooth settlement.

Circuit breaker system to check volatility of particular scrip and the exchange.

Introduction of Internet and online trading.

Recent steps taken by SEBI

Compliance Officer

Each company is required to appoint the compliance officer who

would be able to verify the rumors and information floating in the market about the

company and inform the same to the stock exchanges. This will help reduce the

encouragement to rumors about companies, which aids in price control and stability.

Streamlining Investor protection fund

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The committee set up by SEBI to review the sources and utilization of

investor protection fund of stock exchanges has made following recommendations

» Funds should be on trust structure and set upon under Indian Trust Act,

1882 with independent trustees.

» Regular contributions from active member brokers and stock

exchanges.

» Fund to be utilized only for investor claims and not for broker claims.

» Trustees to ensure that fund is not deployed in risky instruments or for

the benefit of any member but only in prescribed avenues.

» Time schedule to be specified while setting investor claims.

Appointment of administrators

To get rid of bad deliveries, SEBI has decided to appoint administrator

to implement the signature guarantee and certificate authentication programs. The

administrators appointed by SEBI act on behalf regulator in resolving problems

arising out of signature mismatch.

Service centers for investors

SEBI has directed all stock exchanges to constitute service centers for

investors to enable the investors to have a form for recording and counseling of their

grievances as well as access financial and other information of companies on

government norms, policies, rules, regulations, etc.

Investor Education

SEBI has taken steps to educate the investors through various

awareness programmes, and publications etc.

Corporate Governance

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SEBI has prescribed the corporate governance norms for all listed

companies to ensure transparency and better disclosure practices.

FINDINGS

The study of risk management in stock broking firm was really an

interesting and informative project. Though the concept of risk management in stock

broking firm is a new concept in India, it is emerging as an utmost important practice.

Due to high volatility of market brokers are always exposed to the risk and they have

to suffer heavy financial losses. The findings drawn during the project are as follows.

Risk is the possibility of happening uncertain events. It is the chance of

happening of something that may affect the desired results. Risk may hamper

the pre determined outcomes and result into losses.

To cope up with the situation and reduce the evil effects of it such risks can be

avoided, retained, reduced or transferred.

The Indian capital market is very volatile and because of this brokers are

always at a risk of non receipt of payments from clients and sub brokers.

Stock broking firms face the market risks, financial risks, credit risks, liquidity

risks and operational risks.

65

To tackle such risks Value at Risk (VaR) Margin, Mark to Market (MTM)

Margin, Extreme Loss Margin are collected from clients and maintained at the

exchange.

Non payment of margins is treated as violation of the bye laws of NSCCL and

attracts penalties. In extreme cases NSCCL may withdraw the membership

rights of member broker.

Intra day turnover limit and gross exposure limit are allowed to member

brokers against the minimum base capital and additional base capital. The

members violating the limits are penalized and not permitted to trade

forthwith. Member’s trading facility is restored from the next trading day with

a reduced intra day and gross exposure limit.

If member delivers the securities prior to the scheduled securities pay in day,

the margin payable by broker is then recomputed and margin is released to the

extent of early pay in.

NSE, BSE, SEBI and NSCCL have taken various steps like KYC, circuit

filters, surveillance, inspection, compulsory audit of accounts etc. to ensure the

minimum risk.

The technological advancements and infrastructural development have helped

broking firms to keep a regular check on its clients and sub brokers. It has also

enabled the exchanges to monitor on line where the correct and immediate

position of members is monitored on real time basis.

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SUGGESTIONS AND CONCLUSION

Inspite of strict surveillance and stringent policies towards reducing the

risk, brokers have to suffer financial losses. Many times strict adherence to the

provisions laid down by the exchanges and SEBI is neglected and it results in to

losses. The one important reason behind this can be lack of proper implementation of

the rules and regulations. Therefore following are the suggestions which would help

reduce the risk and losses at exchanges and member brokers.

Every stock broking firm must have a Risk Management or Surveillance

Department to keep a strict watch on market and the activities of its sub

brokers, franchisees and investors etc.

There has to be minimum qualification criteria for the member broker, sub

broker and franchisee and employees especially dealers. The criteria can be

various modules of NCFM or BCFM (e.g. a dealer must pass the NCFM or

BCFM Dealer’s module.)

67

Such qualified staff would help in reducing the mistakes and errors as they

have a proper understanding of the procedure.

While providing acceptance to the limits it must be scrutinized that broker or

sub broker has a required amount of credit in his bank account.

Also while giving refunds to the broker or sub broker it must be checked that

he has maintained a minimum required balance (Minimum Base Capital).

In both the cases of acceptance to the limit and refund of capital the margins

must be recomputed and increased or decreased immediately.

The member brokers and sub brokers must strictly adhere to the limits and

gross exposure provided to them and in case of need a specified amount must

be deposited first with the exchange.

The clients should be asked to call dealers on the phones only on which the

conversation can be recorded. Thus, clients’ calls on personal phones should

be avoided. It helps to reduce the miscommunication and conflicts between

client and broker.

All the documents along with applications for client and sub broker must be

verified thoroughly and all the requirements (e.g. Letter from bank, copy of

passbook, signature, letter of landlord in case of tenant etc) must be fulfilled.

The senior officers of broker must visit periodically to its sub brokers and

franchisees to keep a check and understand their problems.

Risk Management or Surveillance Department should generate a report

containing the position, limits, gross exposure, acceptance, refund etc. The

report should be send to senior management for verification.

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CONCLUSION

Working with PSE Securities Ltd. for study of risk management in stock

broking firm was a great experience. The activities of risk management or

surveillance are the heart of the broking industry and they should be taken care of.

Prices of shares in Indian stock market change very swiftly, they are

very volatile and unpredictable too. The brokers are always at a risk that investors

may not pay in the securities or funds due to increase or decrease in prices of shares.

Therefore, broking firm is a very risky business and chance of financial losses lies in

almost each and every activity of the business. However, with the margin system and

use of advanced technology the transparency of market is growing.

Therefore to conclude it can be noted that though the business of stock

broking is always exposed to the risk of non receipt of payments or loss of money but

such risks can be managed and reduced through strict adherence to the rules and

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regulation mentioned by exchanges, SEBI and NSCCL. This will not only reduce the

risk but also help organization run smoothly and grow further.

LIMITATIONS

During the study certain limitations were faced, in the absence of

which the study could have been better. Those limitations are as follows.

The time period of 2 months was a very short span to complete the study.

The study was conducted in Pune city only, which restricted the scope of

study.

It was not possible to study certain confidential data.

The PSE Securities Ltd. deals in the cash segment only and not in the

derivatives segment, that put restrictions on the study.

The data provided by persons cannot be held 100% true.

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BIBLIOGRAPHY

Books

» V.K. Bhalla, (2002), Portfolio Analysis and Management, S. Chand

and Co. Ltd., New Delhi, pp1-24

» National Stock Exchange, (Oct. 2007), Capital Market (Basic) Module

Work Book NSE, Mumbai, pp 151-159

» V.A Avadhani, (2006), Securities Analysis and Portfolio Management,

Himilaya Publishing House, Mumbai, pp46-54.

» National Stock Exchange, (Oct. 2007), Capital Market (Dealers)

Module Work Book NSE, Mumbai, pp 84-95.

Journals or Magazines

» Jointly Published by NSE and BSE; Understanding Margins, pp 3-10

Internet sites

» <http://en.wikipedia.org/wiki/Risk_Management>

Assessed on 15th June 2008, 10 a.m.

» <http://www.nseindia.com/home/NSCCL/RiskManagement/

equities.htm> Assessed on 29th June 2008, 4 p.m.

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» <http://bseindia.com/mktlive/market_summ/margin.asp>

Assessed on 29th June 2008, 4:30 p.m.

» <http://punestockexchange.com/psescompanyprofile.html>

Assessed on 6th July 2008, 5:30 p.m.

» <http://www.investopedia.com/search/searchresults.aspx?q=risk>

Assessed on 12th July 2008, 6 p.m.

» <http://www.investopedia.com/terms/v/var.asp>

Assessed on 12th July 2008, 6:30 p.m.

72