The group took note of the international practice of levying very low margins on calendar spreads. A calendar spread is a position at one maturity which is hedged by an offsetting position at a different maturity: for example, a short position in the six month contract coupled with a long position in the nine month contract. The justification for low margins is that a calendar spread is not exposed to the market risk in the underlying at all. If the underlying rises, one leg of the spread loses money while the other gains money resulting in a hedged position. Standard futures pricing models state that the futures price is equal to the cash price plus a net cost of carry (interest cost reduced by dividend yield on the underlying). This means that the only risk in a calendar spread is the risk that the cost of carry might change; this is essentially an interest rate risk in a money market position. In fact, a calendar spread can be viewed as a synthetic money market position. The above example of a short position in the six month contract matched by a long position in the nine month contract can be regarded as a six month future on a three month T-bill. In developed financial markets, the cost of carry is driven by a money market interest rate and the risk in calendar spreads is very low.

In India, however, unless banks and institutions enter the calendar spread in a big way, it is possible that the cost of carry would be driven by an unorganised money market rate as in the case of the badla market. These interest rates could be highly volatile. The group took on record some results provided by Prof. Varma from his ongoing research into the behaviour of the implicit cost of carry between markets operating on different settlement cycles (Appendix 2).

Given the evidence that the cost of carry is not an efficient money market rate, prudence demands that the margin on calendar spreads be far higher than international practice. Moreover, the margin system should operate smoothly when a calendar spread is turned into a naked short or long position on the index either by the expiry of one of the legs or by the closing out of the position in one of the legs. The group therefore recommends that:

1. The margin on calendar spreads be levied at a flat rate of 0.5% per month of spread on the far month contract of the spread subject to a minimum margin of 1% and a maximum margin of 3% on the far side of the spread for spreads with legs upto 1 year apart. A spread with the two legs three months apart would thus attract a margin of 1.5% on the far month contract.
2. The margining of calendar spreads be reviewed at the end of six months of index futures trading.
3. A calendar spread should be treated as a naked position in the far month contract as the near month contract approaches expiry. This change should be affected in gradual steps over the last few days of trading of the near month contract. Specifically, during the last five days of trading of the near month contract, the following percentages of a calendar spread shall be treated as a naked position in the far month contract: 100% on day of expiry, 80% one day before expiry, 60% two days before expiry, 40% three days before expiry, 20% four days before expiry. The balance of the spread shall continue to be treated as a spread. This phasing in will apply both to margining and to the computation of exposure limits.
4. If the closing out of one leg of a calendar spread causes the members’ liquid net worth to fall below the minimum levels specified in 4.2 below, his terminal shall be disabled and the clearing corporation shall take steps to liquidate sufficient positions to restore the members’ liquid net worth to the levels mandated in 4.2.
5. The derivatives exchange should explore the possibility that the trading system could incorporate the ability to place a single order to buy or sell spreads without placing two separate orders for the two legs.
6. For the purposes of the exposure limit in 4.2 (b), a calendar spread shall be regarded as an open position of one third of the mark to market value of the far month contract. As the near month contract approaches expiry, the spread shall be treated as a naked position in the far month contract in the same manner as in 3.4 (c).