Part 6: NISM Series I – Chapters 6 & 7: Clearing, Settlement, Risk Management and Currency Options

NISM Series I Currency Derivatives – Chapters 6 & 7: Clearing, Settlement, Risk Management and Currency Options

Welcome to Part 6 of our NISM Series I Currency Derivatives short notes series on PassNISM.in. This is one of the most detail-heavy chapters in the entire syllabus. We cover clearing and settlement mechanisms, the different types of margins required, and then move into the world of exchange-traded currency options — including option terminology, pricing, Greeks, and pay-off structures.

Missed Part 5? Read it here: Chapter 5 – Trading in Currency Futures.

Part A: Clearing and Settlement in Currency Futures What is Clearing? What is Settlement?

• Clearing: The process of computing open positions and financial obligations of all clearing members in the trading system. It tells you WHO owes WHAT to WHOM.
• Settlement: The actual act of honoring those obligations — the physical transfer of funds (pay-in or pay-out) to fulfill the contract.

Clearing Entities

Clearing Members: In the Currency Derivatives segment, Trading-cum-Clearing Members handle their own trades and the trades of other Trading Members. Professional Clearing Members (PCMs) — typically banks and custodians — clear and settle for TMs without trading themselves.

Clearing Banks: All funds settlement for currency futures takes place through clearing banks designated by the Clearing Corporation. Every clearing member must open a separate bank account with this designated clearing bank specifically for the currency derivatives segment.

The Clearing Mechanism

The clearing mechanism involves computing the net open positions and settlement obligations of all clearing members:

• A Clearing Member's open position = Sum of open positions of ALL Trading Members and custodial participants clearing through that CM
• A TM's open position = Proprietary open position + all client open positions
• Proprietary positions are calculated on a net basis (buy – sell) for each contract
• Client positions are each calculated on a net basis per client, but positions are NOT netted across different clients — they are added up across clients

So a TM's total open position = Proprietary open position + Client open long positions + Client open short positions

While placing orders, TMs must tag every order as either "Pro" (proprietary) or "Cli" (client) using the indicator on the order entry screen.

Settlement Mechanisms Mark-to-Market (MTM) Settlement

At the end of every trading day, all futures positions are marked to market — meaning they are revalued at the day's settlement price. Profits are credited and losses are debited from each member's clearing account. The calculation method depends on the nature of the position:

Final Settlement for Futures

On the last trading day of a futures contract (expiry day), after market close, the Clearing Corporation marks all positions to the final settlement price — which is the RBI Reference Rate for that day. The resulting profit or loss is settled in cash. This amount is credited or debited to the clearing member's designated bank account on T+2 working days after the last trading day.

Exam Key Point: The final settlement price for currency futures is always the RBI Reference Rate on the last trading day. This is a very frequently tested fact. Margin Requirements and Types

Because futures are leveraged instruments, a robust margin framework is essential to prevent systemic failures during volatile periods and to discourage excessive speculation.

Initial Margin

The deposit a member must maintain in their margin account before taking any exposure in currency futures. The initial margin requirement is calculated based on the worst-case loss of a member's portfolio across various price scenarios. Every member's initial allowable exposure is proportional to their initial deposit.

Portfolio-Based Margin (SPAN)

The Standard Portfolio Analysis of Risk (SPAN) methodology is used to take an integrated, portfolio-wide view of risk. Instead of calculating margin for each position individually, SPAN considers the entire portfolio — including all positions across different maturities — to determine the overall risk and the margin requirement.

Real-Time Computation

The worst-scenario loss calculation has two stages:

1. The portfolio is valued under multiple hypothetical price movement scenarios
2. These scenario values are then applied to each member's actual portfolio in real time

The latest scenario contract values are applied to member and client portfolios on a continuous, real-time basis throughout the trading day.

Calendar Spread Margin

For positions that qualify as calendar spreads (same currency pair, different maturities — one long, one short), a reduced margin applies. The extreme loss margin for a calendar spread is charged on one-third of the mark-to-market value of the far month (longer maturity) contract.

Extreme Loss Margin

This is an additional margin layer applied as a percentage of the mark-to-market value of the Gross Open Position. It covers scenarios that fall outside the range of normal SPAN scenarios. It is deducted from the liquid assets of the Clearing Member.

Liquid Net Worth

After deducting both the initial margin and the extreme loss margin from a clearing member's liquid assets, the remaining liquid net worth must be at least ₹50 lakh at all times. This is a regulatory floor — a Clearing Member cannot fall below this level.

Liquid Assets

Liquid assets maintained for currency futures trading are kept separately from other segments in the designated currency futures segment of the clearing corporation. This ensures there is no cross-contamination between segments.

Margin Type Summary:
Initial Margin → based on worst-case loss across price scenarios
SPAN → portfolio-level integrated view; uses multiple price scenarios
Extreme Loss Margin → % of MTM value of Gross Open Position; deducted from liquid assets
Calendar Spread Margin → extreme loss on 1/3 of MTM value of far month contract
Minimum Liquid Net Worth → must be ≥ ₹50 lakh at all times Part B: Exchange Traded Currency Options What is an Option?

An option is a contract between two parties to buy or sell a specified amount of an underlying asset at a pre-agreed price on or before a specified date.

• Call Option: Gives the buyer the right to BUY the underlying asset
• Put Option: Gives the buyer the right to SELL the underlying asset
• Strike Price: The pre-agreed price at which the option can be exercised
• Expiration Date: The date on which the strike price is applicable and the right expires
• Time to Maturity: The period from the date the contract is entered into until the expiration date
• Option Buyer: Pays the premium; gets the RIGHT but not the obligation
• Option Seller/Writer: Receives the premium; takes on the OBLIGATION
• Option Premium: The price the buyer pays to the seller to acquire the right
• Long Position: Buying an option (call or put)
• Short Position: Selling/writing an option (call or put)

Futures vs. Options — Key Difference

In futures, both parties have an obligation to buy or sell — both face symmetric risk. In options, the buyer has only a right (no obligation) and risks only the premium paid. The seller/writer faces unlimited risk (in theory) but has limited upside capped at the premium received.

When Does an Option Buyer Exercise?

• Call option buyer exercises when the underlying price is above the strike price (plus premium paid)
• Put option buyer exercises when the underlying price is below the strike price (minus premium paid)

Currency Options in India: History and Regulations

• Exchange-traded equity index options started in India on June 4, 2001
• Single-stock options followed in July 2001
• RBI allowed banks to offer foreign currency-INR European options from July 7, 2003
• Banks could run an options book subject to meeting certain net worth, profitability, capital adequacy, and NPA criteria
• Exchange-traded currency options began from November 10, 2010

OTC Currency Options vs. Exchange-Traded Currency Options

European Options vs. American Options

• European Option: Can be exercised only on the expiration date. In India, all currency options are European-style.
• American Option: Can be exercised any time on or before the expiration date. Currently, American-style currency options are not permitted in India.

Moneyness of an Option

Moneyness describes whether exercising the option right now would result in a profit, a loss, or no gain:

Option Value: Intrinsic Value and Time Value

Intrinsic Value: The immediate exercise value of an option. For a call option, intrinsic value = Max(0, Spot Price – Strike Price). An option can never have negative intrinsic value — the minimum is zero.

Time Value: The portion of the option premium that is above intrinsic value. It reflects the probability that the option could become more valuable before expiry. Time value is directly proportional to time remaining until expiry — longer time = higher time value. As expiry approaches, time value decays to zero (this decay is called "theta decay").

Option Premium = Intrinsic Value + Time Value

Option Greeks

Option Greeks measure how the option's price responds to changes in market variables:

Option Pricing Methodologies

Two primary methodologies are used to price options:

• Black-Scholes Model: An analytical (formula-based) approach that is computationally fast. Mainly used for pricing European options.
• Binomial Pricing Model: A tree-based computational approach that models price movements step-by-step. More flexible but requires greater computing power. Mainly used for pricing American options.

Vanilla Option Positions (Four Basic Types)

All option strategies are built from combinations of these four basic positions:

1. Long Call (Buying a call option)
2. Short Call (Selling a call option)
3. Long Put (Buying a put option)
4. Short Put (Selling a put option)

In all exchange-traded currency option contracts, the final settlement happens at the RBI Reference Rate — same as currency futures.

Option strategies result in non-linear payoffs (curved or kinked lines, not straight lines) due to the option buyer's right without obligation. Study the payoff diagrams in the official NISM workbook carefully — they are frequently examined.

Quick Revision: Must-Know Points for the Exam

• Clearing = computing positions and obligations; Settlement = actual fund transfer
• Clearing banks are designated by the Clearing Corporation; CMs must have separate accounts with them
• MTM settlement happens daily at the closing settlement price
• Final settlement price for futures = RBI Reference Rate on last trading day
• Final settlement funds credit/debit on T+2 after last trading day
• Initial Margin = based on worst-case loss; SPAN = portfolio-level approach
• Extreme Loss Margin = % of MTM value of gross open position
• Calendar spread margin = Extreme loss on 1/3 of far month MTM value
• Liquid net worth after margins must be ≥ ₹50 lakh at all times
• Option buyer = right, no obligation; Option seller = obligation
• All currency options in India = European style (exercise only at expiry)
• American options currently not permitted in currencies in India
• ITM = positive cash flow if exercised; ATM = spot equals strike; OTM = negative if exercised
• Option Premium = Intrinsic Value + Time Value
• Delta = price sensitivity; Vega = volatility sensitivity; Theta = time decay; Rho = interest rate sensitivity
• Black-Scholes = European options; Binomial = American options
• Final settlement of exchange-traded options = RBI Reference Rate

Internal Links

• Chapter 5: Trading in Currency Futures
• Chapter 7: Accounting, Taxation, Regulatory Framework and Investor Protection
• Take a Free NISM Series I Mock Test
• Download NISM Series I Study Material
• NISM Derivatives Exams – Overview

This is Part 6 of our 7-part NISM Series I Currency Derivatives Short Notes series on PassNISM.in. The final part covers accounting, taxation, the regulatory framework, and investor protection.