What spot market should supply prices which are used for calculating payoffs with cash-settled security options?
An important principle here is that regardless of where the options trade, the payoffs from the option should be calculated using the market where the underlying is the most liquid. If we have options on Reliance trading on an exchange where Reliance is illiquid, and if the payoffs from the options are calculated using the cash market prices on that same exchange, then it would encourage market manipulation on that exchange. Hence, at the level of individual securities, options markets anywhere should only calculate payoffs using closing prices from an exchange which meets two conditions: (a) strong surveillance procedures, and (b) it should have the highest liquidity in the country (i.e. it should have the lowest impact cost at transactions of Rs.0.5 crore or so). A facility for borrowing and lending of shares will also greatly help reduce the risk of a short squeeze in the security options market.
