Risk Management: formula sheet

Key formulas

Risk definition

Risk = chance that actual outcome differs from expected outcome (adverse side is the exam focus)

Not the same as certain loss. It is uncertainty about the result.

Five risk types

Market | Credit | Liquidity | Operational | Legal

Match the type to the cause of the loss, not to the size of the loss.

Risk management process

Identify → Measure → Mitigate (limits and controls) → Monitor and report → Review

Order matters. You cannot set limits before you identify and measure.

Credit risk also called

Credit risk = counterparty risk (default or non-performance by the other party)

In settlement, this is the risk that a party does not meet its pay-in obligation.

Novation

Clearing corporation = buyer to every seller and seller to every buyer

This is how it takes on counterparty risk and guarantees settlement.

Order of default resources (default waterfall)

Defaulter's own resources → clearing corporation's own contribution → remaining resources of the guarantee fund and non-defaulting members' contributions

The defaulter pays first. Check your workbook for the exact layers, as the order is a common question.

Exposure rule

Exposure allowed ≤ liquid assets or capital deposited by the member, as per the clearing corporation's norms

Higher risk needs more deposited capital. The exact multiples are set by the clearing corporation, so do not memorise a number unless the workbook gives it.

Funds of the guarantee fund

Contributions from clearing corporation + exchange + members + penalties and other specified sources

The fund is for completing settlement on default, not for member profits.

Cash market initial margin

Initial margin = VaR margin + Extreme loss margin (ELM)

Both are charged upfront on the position value. VaR is based on a statistical model; ELM is a flat percentage.

ELM amount

ELM = ELM rate × Position value

The rate depends on the security and exchange circular. The exam gives you the rate.

Derivatives initial margin

Initial margin = SPAN margin + Exposure margin

SPAN is the portfolio-based worst-case loss. Exposure margin is added on top for extreme moves.

MTM margin

MTM loss = (Current price − Trade price) × Quantity, for a long position

For a short position the sign reverses. Only losses are collected as margin; gains are not paid out as margin.

Margin purpose

VaR / SPAN = normal-condition risk; ELM / Exposure = extreme-condition risk; MTM = loss already incurred

Use this to sort any conceptual question.

Index circuit breaker triggers

10% | 15% | 20% movement in Sensex or Nifty, whichever is breached earlier, measured against the previous day's close

Applies to both equity and equity derivatives. A move in either direction, up or down, triggers it.

10% trigger halt

Before 1:00 pm: 45 minutes | 1:00 pm to before 2:30 pm: 15 minutes | 2:30 pm or later: no halt

Later in the day, a given move causes a shorter halt.

15% trigger halt

Before 1:00 pm: 1 hour 45 minutes | 1:00 pm to before 2:00 pm: 45 minutes | 2:00 pm or later: trading halted for the rest of the day

Do not mix the cut-off times of the 10% and 15% rules.

20% trigger halt

Trading halted for the rest of the day, at any time

Time of day does not matter at 20%.

Trigger level of the index

Trigger level = Previous close × (1 ± trigger %)

Use 1 + % for a rise and 1 − % for a fall.

MWPL ban rule

Open interest in stock ≥ 95% of MWPL → ban period; only position-reducing trades allowed

The stock exits the ban when open interest falls below 80% of MWPL.

Typical form of a position limit

Limit = higher of (fixed rupee amount or number of contracts) and (a % of market open interest)

Learn the exact figures for clients and members from the current NISM workbook, as they are revised by SEBI and exchanges.

Exposure limit idea

Exposure allowed ≤ multiple of collateral deposited with the clearing corporation

More collateral means more exposure room. A breach blocks new exposure-increasing orders.

Margin shortfall

Shortfall = Margin required − Margin available

If the result is positive, the client has a shortfall and the broker should act as per its policy and exchange rules.

Margin utilisation

Utilisation % = (Margin used ÷ Margin available) × 100

Used by the RMS to watch how much of a client's limit is consumed.

Exposure limit idea

Exposure allowed = Collateral × Multiple set by broker's risk policy

The multiple depends on client risk and security type. The broker's multiple must stay within exchange and SEBI requirements, and a higher-risk client gets a lower multiple.

Peak margin principle

Margin is checked against the highest intraday margin requirement, not only the end-of-day position

SEBI's peak margin framework requires margins to be collected from clients upfront for intraday positions as well. Brokers must not give uncovered intraday leverage beyond what rules allow. Do not rely on remembered percentages, learn the principle.

Core pairing

Client default → margin + limits + RMS; Unauthorised demat transfer → verified instructions + records

Use this pairing to eliminate wrong options quickly.

Operational risk definition

Operational risk = loss from failed processes, people, systems or external events

It excludes pure price risk (market) and counterparty default (credit).

Segregation of duties

Initiator ≠ Approver ≠ Reconciler

Core internal control against error and fraud.

Control types

Preventive | Detective | Corrective

Prevent errors, find them, fix them. Classify the control in a question by its purpose.

BCP versus DR

BCP = whole-business continuity; DR = IT recovery of systems and data

DR is a part of BCP, not the other way round.

Surveillance alert

Alert → review → explanation sought → escalation

An alert is a trigger for enquiry, not proof of manipulation.

Quick revision

• Main risk types: market, credit, liquidity, operational and settlement risk.
• Credit or counterparty risk is the risk that the other party fails to pay or deliver.
• Operational risk comes from failed processes, people, systems or external events.
• Clearing corporations manage risk mainly through margins, limits and a settlement guarantee fund.
• Margins are collected upfront to cover potential loss if a member defaults.
• Initial margin is the upfront margin. It comprises VaR margin, extreme loss margin and, in derivatives, other margins such as SPAN margin.
• VaR margin is a component of initial margin. It estimates likely loss over a time horizon at a stated confidence level.
• ELM (extreme loss margin) is also a component of initial margin, not a separate margin. It covers losses beyond what VaR is expected to cover.
• Position limits cap the open positions a participant can hold.
• Exposure limits restrict the exposure a member can take relative to the collateral deposited.
• Circuit filters stop prices moving beyond a set band in one day.
• Brokers should assess client risk and apply margins and limits to clients.
• Surveillance monitors unusual price, volume and trading patterns to detect misuse.

Common mistakes

• Treating credit risk and market risk as the same because both cause a loss of money. Fix: Ask what failed. If the price moved, it is market risk. If a party did not honour its obligation, it is credit risk.
• Calling a trading system failure or a wrong order entry a market risk. Fix: Errors in people, process or systems are operational risk, even if they occur during trading.
• Saying the settlement guarantee fund is the first resource used on default. Fix: Remember that the defaulter's own margins and deposits are used first. The fund covers what is left.
• Thinking the clearing corporation only checks members at admission. Fix: Link criteria to admission and monitoring to the ongoing period. Members can be restricted or suspended later.
• Treating VaR margin and MTM margin as the same thing. Fix: VaR is forward-looking and charged upfront. MTM is backward-looking and covers losses already incurred.
• Giving VaR alone as the cash market initial margin. Fix: Write initial margin = VaR + ELM every time.
• Treating a price band and a market-wide circuit breaker as the same thing. Fix: A price band is for one stock's daily range. The market-wide breaker is triggered by Sensex or Nifty and halts the whole market.
• Mixing up the cut-off times of the 10% and 15% rules. Fix: For 10% the cut-offs are 1 pm and 2:30 pm. For 15% they are 1 pm and 2 pm, and a 15% hit at or after 2 pm ends trading for the day.
• Thinking margin is collected only at end of day. Fix: Remember the peak margin approach: intraday exposure needs margin upfront, and the highest requirement matters.
• Assuming the exchange bears client default risk. Fix: The broker is responsible to the clearing system for its client's trades, so it controls risk through margin and limits.

Exam tips

• Most questions are one-line scenarios. Underline the cause word and match it to the risk type before reading the options.
• Watch the pair credit risk and market risk, and the pair operational risk and legal risk. These are the usual trap options.
• Remember that Series VII has negative marking of 25% of the marks assigned to a question, so skip a question rather than guess blindly when you cannot narrow the options.
• Learn the process order and the independence of the risk function as fixed points. Governance questions often test only these.
• Expect scenario questions on who pays first in a default. Learn the order of resources and say it to yourself before choosing.
• Watch for options that give the guarantee fund the wrong role, such as preventing price movement or replacing margins.
• Do not memorise numeric limits from memory. Use only the figures given in the current workbook, since SEBI revises them.
• On negative-marked questions, skip if two options look right and you cannot separate them by the stage of defence.