📘 10.1 Basics of Derivatives
📌 Definition of Derivatives
A derivative is a financial instrument whose value is derived from the value of one or more underlying assets or benchmarks, such as stocks, bonds, commodities, currencies, interest rates, or market indices.
Derivatives serve as tools for investors to hedge risks associated with price fluctuations of underlying assets, speculate on price movements, or gain access to otherwise hard-to-trade assets and markets.
They are structured through contracts, and their prices fluctuate as the underlying assets move.
🔹 Futures
Standardized contracts traded on exchanges to buy or sell an asset at a predetermined price at a future date.
🔹 Options
Contracts granting the holder the right, but not the obligation, to buy or sell an underlying asset at a specific price within a set timeframe.
🔹 Forwards
Customized agreements between two parties to buy or sell an asset at a specific price on a future date.
🔹 Swaps
Agreements between parties to exchange sequences of cash flows for a set period of time, typically interest rates or currencies.
| Feature | Exchange-Traded Derivatives | Over-the-Counter (OTC) Derivatives |
|---|---|---|
| Standardization | Highly Standardized | Customized |
| Regulation | Strongly Regulated | Less Regulated |
| Counterparty Risk | Low (Clearing Corporations) | High (Counterparty Dependent) |
| Liquidity | High | Lower |
📈 Real-World Example
Scenario: An investor expects the stock price of ABC Ltd. to increase significantly. Instead of buying stocks directly, the investor purchases call options, giving them the right (without obligation) to buy ABC Ltd. shares at a fixed price. This provides leveraged exposure, increasing potential returns while limiting risk to the premium paid for the option.
📘 10.2 Underlying Concepts in Derivatives
🎲 Zero Sum Game
In derivative markets, particularly futures, counterparties hold opposing views. Gains made by one party are exactly offset by losses of another party, resulting in a net effect of zero. Hence, derivatives trading is described as a “Zero Sum Game”. This assumes no transaction costs or taxes.
🔄 Settlement Mechanism
Derivative contracts can be settled either through cash or physical delivery of the underlying asset. Previously, cash settlement (settlement through exchange of price differentials) was predominant.
However, SEBI has now mandated physical settlement (actual delivery of underlying stocks) for all stock derivatives, transitioning in a phased manner.
💰 Margining Process
Margins are securities or funds deposited as collateral by Clearing Members to mitigate trading risk. Margins ensure financial commitments can be met.
Initial Margin
Deposited upfront, it includes SPAN margins (calculated by Standard Portfolio Analysis of Risk software) and Extreme Loss Margin (ELM). It should cover potential losses in 99% scenarios.
Premium Margin (Options)
Charged to option buyers, equal to the options premium multiplied by the quantity purchased, ensuring buyers fulfill premium obligations upfront.
📊 Open Interest
Open interest refers to the total outstanding futures and options contracts that have not been settled. It represents active positions held by market participants, indicating money flow and market activity.
- Increasing Open Interest: Indicates additional money entering the market (bullish or bearish positions).
- Decreasing Open Interest: Indicates money exiting the market, potentially signaling trend reversals.
📘 10.3 Types of Derivative Products
The four commonly used derivative products are Forwards, Futures, Options, and Swaps.
📅 Forwards
A forward is a customized contract between two parties agreeing to buy or sell an asset at a fixed future date and price, traded Over-The-Counter (OTC).
🔸 Limitations
- Liquidity Risk: Difficult to trade due to customization.
- Counterparty Risk: Risk of default by either party.
📈 Futures
Standardized forward contracts traded on exchanges, eliminating many forward limitations.
- Exchange traded
- Standardized terms
- Guaranteed by clearing houses
- Margin required from both parties
⚖️ Options
Contracts providing the right but not the obligation to buy or sell an asset at a specified price within a certain timeframe for a premium.
🔸 Call Option
Right to buy the underlying asset.
🔸 Put Option
Right to sell the underlying asset.
Option Moneyness:
- In-The-Money (ITM): Exercising is profitable.
- At-The-Money (ATM): Market price equals strike price.
- Out-of-The-Money (OTM): Exercising is not profitable.
🔁 Swaps
Agreements between two parties to exchange sequences of cash flows at future dates, commonly interest rate and currency swaps.
🏛️ Role of FIMMDA
FIMMDA (Fixed Income Money Market and Derivatives Association of India) interfaces with regulators, standardizes market practices, provides training, and supports smooth market functioning.
📘 10.3 Features of Mutual Fund Products
📌 Overview
Mutual fund products are designed to meet the varying investment objectives, risk tolerance, and time horizons of investors. These products are classified based on asset class, investment objectives, and associated risks.
💡 Types of Mutual Fund Products
📈 Investment Categories
Mutual funds can be classified into categories such as equity funds, debt funds, money market funds, and commodity funds. Each category has a distinct investment focus.
📊 Investment Objectives
Funds can also be classified by their investment objectives, such as growth funds (focused on capital appreciation), income funds (focused on generating regular income), and balanced funds (combining growth and income).
📋 Risk-Based Classification
📉 Risk Categories
Equity funds are generally more risky compared to debt funds, with liquid funds being the least risky. The risk level of mutual funds varies based on the investment approach and asset classes.
📅 Investor Preferences
Investors choose products based on their risk appetite, investment horizon, and market outlook. For example, short-term investors may prefer debt funds, while long-term investors may lean towards equity funds.
📘 10.4 Product Labelling
📌 Overview
All mutual fund schemes are labelled based on their nature, investment objectives, and risk levels. The ‘Risk-o-meter’ is used to classify and communicate the risk associated with the fund.
💡 Key Features of Product Labelling
📈 Nature of the Scheme
The label includes details about the scheme’s objective, such as whether it is designed to generate wealth (growth) or provide regular income (debt-oriented). It also indicates the investment horizon (short, medium, or long term).
💡 Risk-o-meter
The ‘Risk-o-meter’ visually represents the risk level of the scheme. This is categorized into six levels: Low, Low to Moderate, Moderate, Moderately High, High, and Very High risk.
📋 Risk-o-meter Classification
The ‘Risk-o-meter’ categorizes mutual fund schemes into one of the following six levels of risk: Low Risk, Low to Moderate Risk, Moderate Risk, Moderately High Risk, High Risk, and Very High Risk.
📘 10.5 Strategy-based Classification
📌 Overview
Some mutual funds follow specific investment strategies to differentiate themselves from others. These strategies can involve stock selection, sector-based investments, or passive index tracking.
💡 Key Strategies
📈 Stock Selection Strategy
Some equity funds focus on stock selection strategies to achieve superior performance, such as investing in turnaround stocks or special situations companies.
📊 Thematic and Sector Funds
Thematic funds invest in sectors that are expected to perform well based on a specific theme (e.g., infrastructure). Sector funds focus on particular sectors, such as technology or healthcare.
📋 Index Funds and ETFs
📊 Index Funds
Index funds aim to replicate the performance of a market index, selecting the same stocks in the same proportions. These are passive funds with lower management costs.
💡 Exchange-Traded Funds (ETFs)
ETFs are similar to index funds but trade on stock exchanges. They can be bought and sold like individual stocks, providing liquidity and flexibility to investors.
💡 Debt Fund Strategies
Debt funds may adopt strategies such as flexible or dynamic allocation between short-term and long-term securities. Flexible funds balance risk and return by adjusting their exposure based on market conditions.
📘 10.6 Product Creation Process
📌 Overview
The process of creating a mutual fund product involves defining the portfolio, determining investment objectives, and setting the operational guidelines. After the product is defined, an offer document is created and filed with SEBI for approval.
💡 Key Steps in Product Creation
📈 Defining the Portfolio
The portfolio is described based on the asset class, investment objectives, and risk profile. The fund manager will begin constructing the portfolio once money is collected during the NFO.
📋 Approval Process
The draft offer document is approved by the trustees and filed with SEBI. After incorporating SEBI’s feedback, the final offer document is issued, and the product is open for subscription.
📘 10.6.1 Scheme-related Documents
📌 Overview
SEBI mandates that Asset Management Companies (AMCs) provide complete and relevant information to help investors make informed decisions. This information is provided through various scheme-related documents.
💡 Key Scheme-related Documents
📑 Statement of Additional Information (SAI)
The SAI provides statutory information about the mutual fund and AMC. It contains details of the sponsor, trustee, and key personnel.
📄 Scheme Information Document (SID)
The SID provides detailed information about the specific scheme, including its investment objective, risk factors, fees, and performance benchmarks.
💡 Key Information Memorandum (KIM)
The KIM is a summary of the SID and SAI, providing investors with key information about the scheme. It is available alongside the application form for investment in the scheme.
📘 10.6.2 Statement of Additional Information (SAI)
📌 Overview
The SAI contains common information about all schemes offered by a mutual fund. It is a one-time filing and includes details about the sponsor, trustees, and the fund’s rights and responsibilities.
💡 Key Information in SAI
- Details of sponsor, trustee, and AMC
- Financial information of schemes launched in the last 3 years
- Rights of unit holders and grievance redressal procedures
- Investment valuation norms
💡 SAI Updates
The SAI must be updated annually, with material changes incorporated immediately. Updated versions are uploaded on the mutual fund’s website and AMFI’s website.
📘 10.6.3 Scheme Information Document (SID)
📌 Overview
The SID provides detailed information about a specific mutual fund scheme, including its objectives, risks, performance, and investment strategy.
💡 Key Features of SID
📉 Investment Objective
Details of the fund’s investment objective, asset allocation pattern, and liquidity provisions.
📊 Risk Factors
The SID outlines the risks associated with the scheme and the strategies to mitigate these risks.
💡 SID Updates
The SID must be updated within six months of the financial year-end, reflecting the latest data and information. Any changes in the scheme’s fundamental attributes must be communicated through an addendum.
📘 10.6.4 Key Information Memorandum (KIM)
📌 Overview
The KIM is a summary document that provides the most crucial information about the mutual fund scheme. It helps investors understand the investment opportunities, fees, and risks involved in a scheme.
💡 KIM Features
- Summary of the SID and SAI
- Contains details needed to fill the application form
- Must be updated at least once every half year
💡 KIM Availability
The KIM is available to investors alongside the application form for investment in a scheme. It is available at mutual fund offices and through AMCs’ websites.
📘 10.7 Types of Mutual Funds
📌 Overview
Mutual funds can be classified based on the asset classes they invest in, their investment strategy, risk level, and their objectives. Investors can select the type of fund based on their investment goals, risk tolerance, and market outlook.
📘 10.7.1 Equity Funds
📌 Overview
Equity funds invest in the equity shares of companies. These funds carry a higher level of risk compared to debt funds but can offer higher returns based on the performance of the stock market.
💡 Types of Equity Funds
📈 Diversified Equity Funds
Invest in multiple sectors and companies, offering a lower risk compared to funds that focus on a single sector.
💹 Large Cap Funds
Focus on equity shares of large, well-established companies, offering lower risk due to their stable performance.
📉 Mid Cap Funds
Invest in medium-sized companies with growth potential but higher risk due to market volatility.
📊 Small Cap Funds
Invest in small, emerging companies. These funds have a high potential for growth but also carry a significant risk.
🌐 Thematic & Sector Funds
Invest in specific sectors or themes (e.g., infrastructure), suitable for investors with a targeted outlook on particular industries.
📘 10.7.2 Debt Funds
📌 Overview
Debt funds primarily invest in debt instruments, offering more stability and predictable returns than equity funds. They come with varying levels of risk, depending on the type of debt instrument they invest in.
💡 Types of Debt Funds
📉 Liquid and Money Market Funds
Invest in very short-term debt instruments, offering low risk and high liquidity with minimal price fluctuations.
📊 Short Term Debt Funds
Invest in securities with slightly longer maturity than liquid funds, offering moderate returns with minimal risk.
📈 Medium & Long Term Debt Funds
Invest in medium to long-term debt instruments, with higher potential returns but increased interest rate risk.
🏦 Gilt Funds
Invest primarily in government securities, offering low credit risk but higher interest rate risk depending on maturity.
🔄 Floating Rate Funds
Invest in debt instruments with interest rates that adjust based on a market benchmark, offering protection from interest rate fluctuations.
💳 Credit Risk Funds
Invest in corporate bonds with a lower credit rating, offering higher returns but higher risk of default.
📘 10.7.3 Hybrid Funds
📌 Overview
Hybrid funds invest in a mix of equity and debt securities. These funds aim to provide a balance of growth and income, suited to investors who want both capital appreciation and regular income.
💡 Types of Hybrid Funds
📊 Predominantly Debt-oriented Hybrids
Invest mostly in debt, with a small allocation to equity to generate some growth while minimizing risk.
📈 Predominantly Equity-oriented Hybrids
Invest primarily in equities, with a small portion allocated to debt to reduce overall risk.
🔄 Dynamic Asset Allocation Funds
These funds adjust the allocation between equity and debt based on market conditions, offering flexibility in managing risk.
📘 10.7.4 Solution Oriented Schemes
📌 Overview
Solution-oriented schemes are designed to help investors achieve specific goals, such as retirement or children’s education. These schemes typically have a lock-in period and tax benefits.
💡 Types of Solution Oriented Schemes
💼 Retirement Fund
Invests to build a corpus for retirement, with a lock-in period of at least 5 years or until retirement age.
🎓 Children’s Fund
Designed to fund children’s education, with a lock-in period until the child reaches adulthood or a minimum of 5 years.
📘 10.7.5 Other Types of Funds
📌 Overview
Other mutual fund types include Fixed Maturity Plans (FMPs), Real Estate Mutual Funds (REMFs), Exchange-Traded Funds (ETFs), and more, each serving specific investment needs or strategies.
💡 Types of Other Funds
🏠 Real Estate Mutual Funds (REMFs)
Invest in real estate projects or securities related to housing, property, and infrastructure.
💎 Exchange-Traded Funds (ETFs)
Track indices or commodities, like gold, and are traded on stock exchanges like regular stocks.
💰 Fixed Maturity Plans (FMPs)
Closed-end funds that invest in debt instruments matching the maturity of the scheme, offering protection against interest rate risk if held to maturity.
