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THE objective of SPAN is to identify overall risk in a portfolio of futures and options contracts for each member. The system treats futures and options contracts uniformly, while at the same time recognising the unique exposures associated with options portfolios such as extremely deep out-of-the-money short positions, inter-month risk and inter-commodity risk.

The SPAN risk array represents how a specific derivative instrument (for example, an option on Nifty index at a specific strike price) will gain or lose value, from the current point in time to a specific point in time in the near future (typically it calculates risk over a one-day period called the `look ahead time'), for a specific set of market conditions which may occur over this time duration.

The specific set of market conditions evaluated, are called the risk scenarios, and these are defined in terms of : * how much the price of the underlying instrument is expected to change over one trading day, and * how much the volatility of that underlying price is expected to change over one trading day. The results of the calculation for each risk scenario - i.e. the amount by which the futures and options contracts will gain or lose value over the look-ahead time under that risk scenario - is called the risk array value for that scenario.

The set of risk array values for each futures and options contract under the full set of risk scenarios, constitutes the risk array for that contract. In the risk array, losses are represented as positive values, and gains as negative values. Risk array values are typically represented in the currency (Indian Rupees) in which the futures or options contract is denominated.SPAN further uses a standardised definition of the risk scenarios, defined in terms of * the underlying `price scan range' or probable price change over a one-day period, * and the underlying price `volatility scan range' or probable volatility change of the underlying over a one-day period. These two values are often simply referred to as the `price scan range' and the `volatility scan range'.

There are sixteen risk scenarios in the standard definition. These scenarios are listed as under: * Underlying unchanged; volatility up * Underlying unchanged; volatility down * Underlying up by 1/3 of price scanning range; volatility up *Underlying up by 1/3 of price scanning range; volatility down * Underlying down by 1/3 of price scanning range; volatility up * Underlying down by 1/3 of price scanning range; volatility down * Underlying up by 2/3 of price scanning range; volatility up * Underlying up by 2/3 of price scanning range; volatility down * Underlying down by 2/3 of price scanning range; volatility up * Underlying down by 2/3 of price scanning range; volatility down * Underlying up by 3/3 of price scanning range; volatility up * Underlying up by 3/3 of price scanning range; volatility down * Underlying down by 3/3 of price scanning range; volatility up * Underlying down by 3/3 of price scanning range; volatility down * Underlying up extreme move, double the price scanning range (cover 35% of loss) * Underlying down extreme move, double the price scanning range (cover 35 per cent of loss) SPAN uses the risk arrays to scan probable underlying market price changes and probable volatility changes for all contracts in a portfolio, in order to determine value gains and losses at the portfolio level.

This is the single most important calculation executed by the system. As shown above in the sixteen standard risk scenarios, SPAN starts at the last underlying market settlement price and scans up and down three even intervals of price changes (`price scan range'). At each `price scan point', the program also scans up and down a range of probable volatility from the underlying market's current volatility (`volatility scan range').

SPAN calculates the probable premium value at each price scan point for volatility up and volatility down scenario. It then compares this probable premium value to the theoretical premium value (based on last closing value of the underlying) to determine profit or loss. Deep-out-of-the-money short option positions pose a special risk identification problem. As they move towards expiration, they may not be significantly exposed to `normal' price moves in the underlying. However, unusually large underlying price changes may cause these options to move into-the-money, thus creating large losses to the holders of short option positions.

In order to account for this possibility, two of the standard risk scenarios in the Risk Array (sr. no. 15 and 16) reflect an `extreme' underlying price movement, currently defined as double the maximum price scan range for a given underlying. However, because price changes of these magnitudes are rare, the system only covers 35 per cent of the resulting losses. After SPAN has scanned the 16 different scenarios of underlying market price and volatility changes, it selects the largest loss from among these 16 observations. This `largest reasonable loss' is the `Scanning Risk Charge' for the portfolio - in other words, for all futures and options contracts.

(To be continued..)

SPAN@shy is a registered trademark of the Chicago Mercantile Exchange, used herein under License. The Chicago Mercantile Exchange assumes no liability in connection with the use of SPAN by any person or entity.

Source: website of the National Stock Exchange of India (www.nseindia.com)

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