Markets regulator Securities and Exchange Board of India (SEBI) has lowered the Z-score threshold used for stress testing in the commodity derivatives market from 10 to 5, in a move aimed at easing compliance and improving capital efficiency for market participants.
Under the earlier framework, price movements corresponding to a Z-score of 10 were used to replace extreme price movements beyond that threshold in the peak historical returns of all commodities.
In a circular issued on Wednesday, SEBI revised the threshold to a Z-score of 5.
“Price movements corresponding to a Z-score of 5 will replace extreme price movements beyond that threshold in peak historical returns of all commodities,” SEBI said in the circular.
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The regulator added that the mean and sigma of returns over the applicable Margin Period of Risk (MPOR) across 15 years would be used to calculate the Z-score.
The revised framework came into force with immediate effect.
What Does The Z-Score Change Mean?
In simple terms, the Z-score measures how far a price movement is from its historical average.
Under the stress-testing framework, Clearing Corporations (CCs) look at commodity price movements over the past 15 years and assess how much prices could potentially rise or fall during the applicable MPOR.
Extremely large historical price movements can result in higher stress-test requirements and, consequently, higher capital requirements.
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By lowering the threshold from a Z-score of 10 to 5, SEBI has effectively reduced the impact of exceptionally large historical price shocks on the stress-testing calculation.
Importantly, the Z-score of 5 does not mean that commodity prices are now capped at a 5% rise or fall. It is a statistical measure based on the historical average and volatility of returns.
Impact On Clearing Corporations And Capital Requirements
The change applies to the standardised stress-testing framework prescribed under the Core Settlement Guarantee Fund (Core SGF) for commodity derivatives.
Aamir Makda, Commodity & Currency Analyst – Technical Research at Choice Broking, said the lower Z-score threshold would affect how Clearing Corporations determine the capital required in their Core SGF to withstand severe market shocks.
“The adjustment allows CCs to analyse 15 years of price data for each commodity, capping historical price shocks at 5 standard deviations, thus lowering capital requirements for high-volatility commodities,” Makda said.
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According to him, the move could improve capital efficiency by freeing up funds that can be deployed for trading activities, while maintaining a high level of protection against market shocks.
He noted that a Z-score of 5 covers more than 99.9999% of usual market conditions, suggesting that the revised threshold continues to provide substantial risk coverage.
Which Commodities Will Be Impacted?
The impact is likely to be greater for commodities that have experienced exceptionally large price shocks in the past.
“Commodities which have mega-shocks in past, this will reduce stress-test input and stable commodities will remain unaffected,” Makda said.
This means commodities with relatively stable historical price movements are unlikely to see a significant change in their stress-test requirements. However, commodities that have witnessed unusually sharp price swings could see a reduction in the extreme scenario used for stress testing.
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