Derivatives

Portfolio managers may use derivatives in a client's account, but only with written consent and without leverage. A distributor who cannot explain a futures price or an option's maximum loss cannot explain that consent form. The exam carries a full chapter on derivatives and expects the basic calculations.

What a derivative is

A derivative is a contract whose value derives from an underlying: a share, an index, a bond, a currency or a commodity. The four families are forwards (customised, over the counter), futures (standardised, exchange traded, margin backed), options (the right but not the obligation to buy or sell) and swaps (exchange of cash flows, such as fixed for floating interest). In India, NSE and BSE trade index and stock futures and options, currency derivatives and interest rate futures, all cleared through a clearing corporation.

Participants are hedgers (reducing an existing risk), speculators (taking a view with less capital) and arbitrageurs (locking in price differences between markets). A PMS mostly hedges.

Futures: pricing, margins and payoff

A futures contract commits both parties to trade the underlying at a set price on expiry. Contracts have a lot size fixed by the exchange, monthly expiries, and are settled in cash (indices) or by delivery (stocks). Both buyer and seller deposit an initial margin (SPAN plus exposure margin) and the contract is marked to market daily, so gains and losses are settled every day rather than at expiry.

The fair price comes from the cost of carry: buying the underlying today and holding it to expiry costs the financing rate, less any dividends received.

If the contract trades at 24,500, an arbitrageur sells the futures and buys the index basket, pocketing the 140-point excess. Futures above spot are at a premium (contango); below spot, at a discount (backwardation). At expiry the futures price equals the spot price. A futures buyer gains one rupee for every rupee the underlying rises above the trade price, and loses equally if it falls; losses are not capped.

Options: rights, premiums and payoffs

A call option gives the right to buy the underlying at the strike price; a put option gives the right to sell. The buyer pays a premium and can lose only that premium. The seller (writer) receives the premium, must deposit margin, and carries the larger risk. Indian index and stock options are European style: exercisable only at expiry.

An option's premium has two parts. Intrinsic value is what it is worth if exercised now (for a call, spot minus strike if positive; for a put, strike minus spot). Time value is the rest. A call is in the money when spot is above strike, at the money when equal, out of the money when below; the reverse holds for puts.

Option prices respond to five variables, summarised by the Greeks: delta (change in premium per unit change in spot), gamma (change in delta), theta (time decay, which hurts buyers every day), vega (sensitivity to volatility) and rho (sensitivity to interest rates). Calls and puts on the same strike and expiry are linked by put-call parity:

With spot 24,000, strike 24,000, 7% rate and three months, the present value of the strike is 24,000 ÷ 1.0175 = 23,587, so C − P should be about 413. If the call costs ₹700, the put should cost about ₹287; a large gap signals mispricing.

Derivatives in a PMS account

Under the SEBI (Portfolio Managers) Regulations, 2020, a portfolio manager may invest in derivatives only if the client agreement permits it and the client has given written consent after understanding the risks. The manager cannot leverage the client's portfolio: derivative positions must stay within the value of the client's funds, and the manager cannot borrow on the client's behalf. In practice, PMS use is defensive: buying index puts or selling futures to protect a portfolio before an event, or covered calls to earn premium on a holding. A distributor should read the investment approach to see whether derivatives are used and why, and should flag that premiums paid and margin blocked reduce the cash available for stocks.

Carry three numbers into the exam room: the futures price from cost of carry, the break-even of an option, and the put-call parity relation. Everything else in this chapter is vocabulary.