Basics of derivatives

Every SIF strategy that goes short does so with derivatives, and the exam gives Module 2 about 35% of its marks. This chapter lays the vocabulary you will use for the next nine chapters: what a derivative is, the four basic contracts, who trades them and why, and the leverage that makes a small move in the underlying a large move in your client's account.

Definition and the underlying

A derivative is a contract whose value is derived from the price of something else, the underlying. The underlying can be a share, a stock index, a government bond, an interest rate, a currency or a commodity. The Securities Contracts (Regulation) Act, 1956 defines derivatives and makes them legal only when traded on a recognised stock exchange and settled through a clearing corporation, with limited OTC exceptions for institutions. SEBI regulates the equity, interest rate and currency derivative segments; RBI oversees OTC interest rate and currency derivatives.

A derivative does not create new wealth. For every rupee one party gains, the counterparty loses a rupee before costs. That zero-sum nature is why derivatives are tools for transferring risk, not for creating it or removing it from the system.

The four basic contracts

• Forward. A private agreement to buy or sell the underlying at a fixed price on a future date. Customised, traded over the counter, with counterparty risk and no daily settlement.
• Futures. A forward standardised by an exchange: fixed lot size, fixed expiry dates, cleared through a clearing corporation that guarantees settlement, with margins and daily mark-to-market.
• Option. A contract that gives the buyer the right, not the obligation, to buy (call) or sell (put) the underlying at a fixed strike price on or before expiry. The buyer pays a premium; the seller (writer) receives it and takes on the obligation.
• Swap. An exchange of cash flows, for example a fixed interest rate for a floating one (interest rate swap) or one currency for another. Mostly OTC, used by banks and corporates.

In India's exchange-traded segment you will mostly deal with index futures, index options, single-stock futures and options, interest rate futures and currency futures and options.

OTC versus exchange-traded

An OTC contract is flexible and fits an exact need, but each party is exposed to the other's default and the position is hard to exit before maturity. An exchange-traded contract is standardised, so the exact quantity or date may not match the need, but it is liquid, transparently priced, and backed by the clearing corporation, which becomes the buyer to every seller and the seller to every buyer (a process called novation). The clearing corporation protects itself with margins, a settlement guarantee fund and daily mark-to-market.

Who trades derivatives and why

Three kinds of participants keep the market working:

1. Hedgers hold a position in the underlying and use derivatives to reduce the risk of price moves. A fund manager worried about a market fall sells index futures. An SIF long-short strategy is a hedger when its short offsets a long in the same index.
2. Speculators take a view on direction and accept risk to earn a return. A trader who expects a rally buys futures or calls. The unhedged short in an SIF, capped at 25% of net assets, is speculative in this sense.
3. Arbitrageurs exploit price differences between the cash and derivative markets, or between two derivatives, for a near-riskless profit. Their trading keeps futures prices close to fair value.

Markets need all three. Hedgers need speculators to take the other side; arbitrageurs keep prices honest. The exam often describes a scenario and asks which participant is acting.

Functions and milestones in India

Derivatives serve price discovery (futures prices reveal expectations), risk transfer (from those who do not want risk to those who will carry it), market efficiency (arbitrage links cash and futures) and leverage (a position in the underlying for a fraction of its value). India's exchange-traded equity derivatives began after the L.C. Gupta committee report of 1998. NSE launched index futures in June 2000, index options in June 2001, and single-stock options and futures later in 2001. Interest rate futures in cash-settled form followed in 2014.

Leverage, the double-edged feature

To open a futures position you deposit an initial margin, a fraction of the contract value set by the clearing corporation using the SPAN methodology. Because gains and losses are on the full contract value while your capital is only the margin, returns are multiplied in both directions.

A 2% fall would wipe out 20% of the margin, and a 10% fall would wipe out the whole margin. The clearing member issues a margin call when losses erode the deposit, and may square off the position if the call is not met.

The risks to name in front of a client

Beyond leverage, derivatives carry counterparty risk (mostly in OTC contracts), basis risk (the hedge instrument does not move exactly like the exposure), liquidity risk (wide spreads or no exit in far-month contracts), model risk in pricing options, and operational risk around margins and expiry. When a distributor explains an SIF strategy, naming these risks in plain words is part of suitability, not an optional extra.