📘 10.1 Basics of Derivatives
📌 What is a Derivative?
A Derivative is a financial contract whose value depends on or is derived from an underlying asset. These underlying assets could be commodities such as metals (gold, silver), energy resources (oil, gas), agricultural commodities (wheat, coffee), or financial assets like shares and bonds.
⚖️ Legal Definitions of Derivatives in India
Securities Contracts (Regulation) Act, 1956 [SC(R)A] defines a derivative broadly, including:
- Securities derived from debt instruments, shares, loans (secured/unsecured), risk instruments, contracts for differences, or other forms of securities.
- Contracts deriving value from the prices or indices of underlying securities.
Thus, derivatives are treated as securities under SC(R)A, and their trading is regulated accordingly.
Additionally, the Reserve Bank of India (RBI) Act, 1934 (section 45U(a)) defines derivatives explicitly as instruments that:
- Are settled at a future date.
- Derive their value from changes in interest rates, foreign exchange rates, credit ratings or indices, prices of securities, or combinations thereof.
📑 Common RBI-defined Derivatives
- Interest Rate Swaps
- Forward Rate Agreements
- Foreign Currency Swaps & Rupee Swaps
- Foreign Currency Options & Rupee Options
💡 Practical Understanding:
For instance, a gold futures derivative contract’s value directly depends on fluctuations in gold prices. If gold prices rise, the value of a gold futures contract also rises correspondingly.
📘 10.2: Underlying Concepts in Derivatives
📌 Zero Sum Game
In a futures contract, the counterparties enter with opposing views and needs. For instance, the seller of a gold futures contract believes prices will fall, benefiting if the price falls below the agreed price. Conversely, the buyer of the contract thinks the price will rise and benefits if the price rises above the agreed purchase price.
At maturity, the market price of the underlying asset will match for both contracts, but only one party will make a profit. This scenario is called a Zero Sum Game, as the gain for one party is the exact loss for the other.
Note: This conclusion assumes no taxes or transaction costs, which could otherwise affect the net result.
🔹 Settlement Mechanism
Previously, most derivative contracts were settled in cash. In a Cash Settlement, the counterparties exchange price differentials upon contract expiration or exercise, without delivering the underlying asset.
However, SEBI has mandated a shift to Physical Settlement for all stock derivatives. This transition, from cash settlement to physical settlement, is being implemented in phases according to SEBI guidelines.
🔖 Key Points on Settlement
- Cash Settlement: Exchange of price differences, no physical delivery.
- Physical Settlement: Actual delivery of the underlying asset.
- SEBI Mandates: All stock derivatives must transition to physical settlement.
🔹 Margining Process
Margin is the collateral that must be deposited by Clearing Members before executing a trade. The purpose of this margin is to ensure that all financial obligations are met for open positions.
💼 Types of Margins
- Initial Margin: Ensures the position remains open until expiry.
- SPAN Margin: A component of the initial margin based on risk exposure.
- ELM Margin: Covers extreme loss scenarios based on exposure.
🔎 Margin Calculation
The margin calculation is done using SPAN® (Standard Portfolio Analysis of Risk), a software developed by the Chicago Mercantile Exchange (CME), used globally by stock exchanges.
🔹 Premium Margin
The Premium Margin is charged to traders engaging in options contracts. It is calculated as the value of the options premium multiplied by the quantity of options purchased.
🔹 Open Interest
Open interest refers to the total number of outstanding derivative contracts that have not yet been settled. It changes when new contracts are created or when existing contracts are closed.
💡 Open Interest Insights
- Increasing Open Interest: Indicates new money entering the market.
- Decreasing Open Interest: Reflects money leaving the market.
📘 10.3 Types of Derivative Products
📌 Types of Derivatives
The four commonly used derivative products are Forwards, Futures, Options, and Swaps.
🔹 10.3.1 Forwards
A Forward Contract is an agreement made directly between two parties to buy or sell an asset at a specific future date at a price decided today. Forwards are primarily used in commodities, foreign exchange, equity, and interest rate markets.
💡 Example: Cash vs Forward Market
– In a cash market (spot market), assume on March 9, 2018, you want to buy gold from a goldsmith at the market price of ₹30,425 for 10 grams. You pay and take the gold immediately. This is a cash market transaction at the spot price.
– In a forward market, you agree today to buy the same 10 grams of gold for ₹30,450 but take delivery in 1 month. No money or gold changes hands on March 9th; you pay ₹30,450 and take delivery of the gold one month later.
📌 Key Features of Forwards
- Bilateral, over-the-counter (OTC) transaction.
- Customizable terms (price, quantity, quality, time, place).
- Obligation for both parties to fulfill the contract at the time of delivery, regardless of market conditions.
🔹 Limitations of Forward Contracts
Despite their flexibility, forwards have significant limitations:
Since forwards are custom contracts, they are not traded on exchanges, which limits liquidity and market access for other participants.
In case one party defaults (e.g., if market prices change unfavorably), the other party may face significant financial losses. This risk is also known as default or credit risk.
🔹 10.3.2 Futures
A Futures Contract is a standardized forward contract traded on exchanges. These contracts are designed to overcome the limitations of forwards by ensuring centralization, clearing, and guaranteed settlement.
📌 Key Features of Futures Contracts
- Traded on centralized exchanges (like NSE, BSE).
- Exchange guarantees the settlement via a clearing house.
- Requires margin payments from both parties.
- Terms of the contract are standardized, but price is determined by market supply and demand.
🔹 10.3.3 Options
An Option gives the holder the right (but not the obligation) to buy or sell an underlying asset at a specific price within a specified time frame, in exchange for a premium.
📊 Types of Options
| Option Type | Description |
|---|---|
| Call Option | Right to buy an underlying asset at a specified price. |
| Put Option | Right to sell an underlying asset at a specified price. |
📌 In-the-Money, At-the-Money, and Out-of-the-Money
– In-the-Money (ITM): When the option has intrinsic value (e.g., for a call option, the market price is higher than the strike price).
– At-the-Money (ATM): When the strike price equals the market price of the underlying asset.
– Out-of-the-Money (OTM): When the option has no intrinsic value (e.g., for a call option, the market price is lower than the strike price).
🔹 10.3.4 Swaps
A Swap is a financial contract where two parties agree to exchange cash flows on future dates, typically for interest rate or currency-related transactions.
💡 Example: Interest Rate Swap
A borrower who prefers to pay a fixed interest rate enters into an interest rate swap where they agree to:
- Pay a fixed rate to the swap dealer every quarter.
- Receive a floating rate (e.g., T-bill + spread) from the dealer every quarter.
Only the interest amounts are exchanged; the principal amount (notional value) is never exchanged between the parties.
🔹 Role of FIMMDA
FIMMDA (The Fixed Income Money Market and Derivatives Association of India) plays an important role in setting market standards for derivatives, ensuring the smooth functioning of the markets.
📌 FIMMDA Objectives
- Act as the principal interface with regulators.
- Develop and implement benchmark rates.
- Provide training for market participants.
- Adopt international best practices for market operations.
📘 10.4 Structure of Derivative Markets
📌 What is a Derivative Market?
A derivative market is a marketplace where different participants come together to manage their price risks. The goal is to secure against potential risks they foresee, such as fluctuations in commodity prices, stock prices, interest rates, or currencies.
🔹 Available Derivatives in India
In India, the following derivative products are available:
- Indices
- Stocks
- Interest rates
- Commodities
Additionally, the OTC markets also offer forward contracts for agricultural commodities and interest rate swap markets.
🔹 OTC Markets
OTC Derivatives are contracts that are settled directly between two counterparties, based on mutually agreed terms. These contracts are not standardized and depend on the trust between the parties involved. OTC markets are typically used by institutions that have a comfortable level of mutual trust and understanding.
📌 Key Features of OTC Derivatives
- Non-standardized contracts.
- Settlement depends on trust between counterparties.
- Predominantly used by financial institutions.
🔹 Exchange-Traded Markets
Exchange-Traded Derivatives are standardized contracts defined by an exchange. These contracts are settled through a clearinghouse, ensuring anonymity between parties. The clearinghouse guarantees the settlement, which is facilitated by margin payments from both the buyer and seller.
📌 Key Features of Exchange-Traded Derivatives
- Standardized contracts with predefined terms.
- Centralized trading platform (exchange).
- Settlement guaranteed through a clearinghouse.
📘 10.5 Purpose of Derivatives
📌 What is the Purpose of Derivatives?
Derivatives are primarily used as risk management tools to hedge against uncertainties in the value of investments. They serve three main purposes: Hedging, Speculation, and Arbitrage.
🔹 Hedging
Hedging involves using derivatives to protect an existing investment from the risk of adverse price movements. An investor or institution with a specific investment goal can use derivatives to mitigate risks related to future price fluctuations.
💡 Example of Hedging:
An investor holding a portfolio of stocks can buy put options to protect against a potential drop in the stock market. This would allow the investor to limit the loss if the stock prices fall.
🔹 Speculation
Speculation involves taking positions in derivatives without any underlying asset. It is a betting strategy based on expectations about the future price of an asset. Traders can either buy or sell futures contracts or options to profit from price movements.
📌 Example of Speculation:
A trader buys a futures contract for a commodity expecting the price to rise. If the price of the commodity rises as predicted, the trader can sell the contract at a higher price and make a profit.
🔹 Arbitrage
Arbitrage refers to the practice of exploiting price differences in two or more markets for the same asset. By simultaneously buying in the cheaper market and selling in the more expensive one, arbitrageurs make risk-free profits.
📌 Example of Arbitrage:
If gold is priced at ₹30,000 per ounce in one market and ₹30,100 in another, an arbitrageur would buy gold in the cheaper market and sell it in the more expensive one, pocketing the difference (minus transaction costs).
🔹 Law of One Price
The Law of One Price states that identical goods should not trade for different prices in two different markets, once transaction costs are accounted for. This principle helps explain arbitrage opportunities, as the price differential will eventually close due to buying and selling actions.
📘 10.6 Benefits, Costs, and Risks of Derivatives
📌 Key Benefits of Derivatives
The use of derivatives in hedging, speculation, and arbitrage brings numerous benefits:
- Hedging and Risk Management: Derivatives enable market participants to hedge against price fluctuations, providing various ways to structure symmetrical and asymmetrical payoffs.
- Enhanced Liquidity: Derivatives increase the liquidity of underlying markets and reduce the overall trading costs for both cash and derivatives markets.
- Increased Participation: Derivatives promote wider market participation, better information dissemination, and efficient price discovery.
🔹 Risks and Costs of Derivatives
While derivatives offer significant advantages, they also come with substantial risks, especially due to their leveraged nature. Participants must be aware of the following risks:
⚠️ Counterparty Risk
Risk of financial loss due to the failure of a counterparty to meet their contractual obligations (default).
⚠️ Price Risk
Risk of losing money on a position due to unfavorable price movements in the underlying asset.
⚠️ Liquidity Risk
Risk of being unable to exit a position due to a lack of buyers or sellers in the market.
⚠️ Legal/Regulatory Risk
Risk arising from changes in laws and regulations that could affect the enforceability of contracts or introduce new compliance costs.
⚠️ Operational Risk
Risk related to fraud, inadequate documentation, poor execution, or other operational issues that could lead to financial losses.
🔹 Trading with Derivatives
Derivatives can be a high-risk investment strategy, and may not be suitable for all traders, particularly those with limited resources or experience. Market participants must carefully assess their risk tolerance before engaging in derivatives trading.
📑 Model Risk Disclosure Document
Before trading in derivatives, investors are advised to carefully read the Model Risk Disclosure Document provided by brokers. This document contains vital information on trading in equities and F&O (Futures & Options) segments of the exchange.
All prospective traders should familiarize themselves with the Model Risk Disclosure Document before participating in trading activities on the Capital Market/Cash Segment or F&O segment.
📘 10.7 Equity, Currency, and Commodity Derivatives
📌 Basic Concept of Derivative Contracts
The fundamental concept of a derivative contract remains the same regardless of the underlying asset. Whether the underlying asset is a commodity, currency, or equity, derivatives serve as contracts to manage risks associated with price fluctuations.
- Commodity Derivatives: When the underlying asset is a commodity, such as Oil or Wheat.
- Currency Derivatives: When the underlying is an exchange rate between two currencies.
Both futures and options contracts are available for commodities and currencies.
🔹 Commodity Derivatives
Commodity derivatives play a vital role in today’s commodity trading, offering solutions for risk protection and enabling innovative investment strategies. These markets perform critical functions such as risk reduction, price discovery, and improving transactional efficiency.
📌 Key Functions of Commodity Derivatives
- Risk Management: Participants can hedge against price volatility in the commodity markets.
- Price Discovery: Derivatives help determine the fair market value of a commodity.
- Transactional Efficiency: Reduces transaction costs and enhances market liquidity.
💡 Example of Commodity Futures
If a biscuit manufacturer wants to purchase 10 tonnes of wheat for future use, they can buy wheat futures contracts at a commodity futures exchange. These contracts guarantee the delivery of the commodity at an agreed price on a specified date in the future, regardless of the prevailing market price at that time.
📌 Indian Commodity Derivatives Exchanges
- Multi Commodity Exchange of India Limited (MCX)
- National Commodity & Derivatives Exchange Limited (NCDEX)
- Indian Commodity Exchange Limited (ICEX)
- National Stock Exchange of India Limited (NSE)
- BSE Limited (Bombay Stock Exchange)
Commodities traded on Indian exchanges can be grouped into four major categories: Bullion, Metals, Energy, and Agriculture.
🔹 Currency Derivatives
The currency market is unique in that it deals with currency pairs. In currency derivatives, the underlying asset is the exchange rate between two currencies.
📌 Types of Currency Derivatives
- Currency Futures: A futures contract to exchange one currency for another at a specified price and future date.
- Currency Options: An option that gives the buyer the right (but not the obligation) to exchange currencies at a specified price during a specified period.
💡 Currency Derivatives Available in India
Currency derivatives are available for four main currency pairs:
- US Dollar (USD) / Euro (EUR)
- US Dollar (USD) / Great British Pound (GBP)
- US Dollar (USD) / Japanese Yen (JPY)
💡 Cross Currency Futures & Options
Cross currency futures and options contracts are also available for currency pairs such as EUR-USD, GBP-USD, and USD-JPY, allowing traders to manage currency risks more efficiently.
📘 10.8 Derivative Markets, Products, and Strategies
📌 Introduction to Derivative Markets
Derivatives were introduced in India in June 2000, and since then, the turnover in derivative markets has increased significantly. India’s equity derivative markets are now among the largest in the world.
🔹 Pricing a Futures Contract
The pricing of a futures contract is based on the simple principle of carry cost. If a stock is trading at ₹100 in the spot market today, and the futures price is ₹120 with 20 days until the delivery date, the difference between the two prices represents the interest cost for those 20 days.
📌 Futures Price Formula
The relationship between spot price (S) and futures price (F) can be described as:
F = S + Carry Costs💡 Example of Futures Pricing:
– If the spot price is ₹100 and the futures price is ₹120, traders would want to buy the spot and sell the futures to profit from the difference. However, if the cost of borrowing funds to buy the spot and sell the futures is ₹20, there is no profit to be made.
📌 Basis and Carry Cost
- Basis: The difference between the spot and futures prices.
- Carry Cost: The cost of holding the asset, including interest rates and other risks involved in the trading position.
🔹 Spot-Future Arbitrage
Sometimes the spot price and futures price for the same asset differ more than what is justified by the normal cost of carry. This opens up opportunities for arbitrage, where traders can buy in the spot market and sell in the futures market, making a risk-free profit.
💡 Example of Arbitrage:
On March 3rd, 2017, stock XYZ was trading at ₹3,984 in the cash market, while futures for delivery on March 30th were trading at ₹4,032. The profit from this arbitrage would be ₹48 per share.
The profit percentage is calculated as: (₹48/₹3,984) * 365/27 = 16.287% per annum
🔹 Option Pay-offs
An option contract features an asymmetric pay-off, where the upside and downside are not uniform. The buyer of an option has the right but not the obligation to buy or sell the underlying asset at the contract’s specified price.
💡 Long on Option (Buyer)
When you are “long on an option” (i.e., you have bought an option), your maximum loss is limited to the premium paid. Your potential profit depends on the price of the underlying asset at the time of the option’s expiration.
💡 Short on Option (Seller)
When you are “short on an option” (i.e., you are the seller or writer of an option), your maximum profit is the premium received for selling the option. However, your potential loss is theoretically unlimited.
📌 Key Points for Short Position (Seller)
- Your maximum profit is limited to the premium received for writing the option.
- For American Options, you could be assigned an exercised option at any time during the contract’s life. In the Indian market, most options are European (exercised only at expiration).
- Your potential loss is unlimited if the market moves against your position.
🔹 Hedging with Futures and Options
Both futures and options contracts are effective tools for hedging. They allow investors to protect against potential losses in their underlying asset holdings by locking in prices for future transactions.
