Basics of derivatives

Every question in this exam, whether it is about a Nifty option, a USD/INR future or a bond future, rests on the same handful of ideas: a contract whose value comes from something else, a date on which it settles, and a counterparty on the other side. Get those ideas straight now and the later chapters are arithmetic. The exam opens with definitions, participants and history, and these are the cheapest marks on the paper.

What a derivative is

A derivative is a contract whose value is derived from the price of an underlying asset, rate or index. The underlying can be a share (Reliance), an index (Nifty 50), a currency pair (USD/INR), an interest rate (the 10-year G-Sec yield) or a commodity. The derivative itself has no value of its own; if the underlying did not exist, neither would the contract.

In India the Securities Contracts (Regulation) Act, 1956 was amended in 1999 to include derivatives within the definition of securities. A derivative under the Act includes a security derived from a debt instrument, share, loan, risk instrument or contract for differences, and a contract that derives its value from the prices or index of prices of underlying securities. The practical effect is that derivatives traded on a recognised stock exchange and settled through its clearing corporation are legal, and anything else in securities is not.

The four building blocks

• Forward: a private agreement to buy or sell an asset on a future date at a price fixed today. Customised, traded over the counter (OTC), settled only at maturity, and each side carries the risk that the other does not perform.
• Futures: a forward that has been standardised (fixed lot size, fixed expiry dates, fixed settlement rules) and moved onto an exchange, with a clearing corporation guaranteeing both sides and daily mark-to-market settlement.
• Option: a contract that gives the buyer the right, but not the obligation, to buy (a call) or sell (a put) the underlying at a fixed strike price on or before expiry. The buyer pays a premium for this right; the seller (writer) receives the premium and takes on the obligation.
• Swap: an exchange of two streams of cash flows, for example a fixed interest rate against a floating one on the same notional amount. Swaps in India are largely OTC and dominated by banks.

Forwards and futures are linear: profit and loss move one for one with the underlying. Options are non-linear: the buyer's loss is capped at the premium while the gain is open-ended, which is why options need their own pricing chapter.

OTC versus exchange-traded

An OTC contract is negotiated bilaterally. The terms can be anything the two parties agree, which is its strength, and nobody else guarantees performance, which is its weakness. Exchange-traded contracts give up flexibility to gain four things:

1. Standardisation: everyone trades the same contract, so there is a single price for it.
2. Liquidity and price discovery: orders from thousands of participants meet in one order book, and the resulting price is public.
3. Counterparty guarantee: the clearing corporation becomes the buyer to every seller and the seller to every buyer (novation), backed by margins and a settlement guarantee fund.
4. Transparency and regulation: trades are reported, positions are limited, and SEBI oversees the whole chain.

Who trades derivatives and why

The exam sorts participants into three groups by motive, not by size.

• Hedgers already hold a risk and want to reduce it. A fund manager holding ₹50 crore of large-cap shares who fears a fall over the next month can sell Nifty futures; an importer with a dollar payment due in three months can buy USD/INR futures.
• Speculators have no underlying position and take a view on direction for profit. They supply the liquidity hedgers need and accept the risk hedgers shed.
• Arbitrageurs take no directional view. They exploit a price difference between two markets for the same thing, for example buying a share in the cash market and selling its futures when the futures trade above fair value. Their trading pulls prices back into line.

The same person can be in different groups on different days. The exam classifies the trade, so read the motive given in the question.

How India got here

Forward trading in securities had been banned by a 1969 government notification. SEBI set up the L.C. Gupta committee in November 1996 to design a regulatory framework for derivatives; it reported in 1998 and recommended a phased introduction, starting with index futures. The J.R. Varma committee (1998) laid down the risk containment measures: margining, position limits, and the clearing corporation's role. The SCRA was amended in December 1999 to bring derivatives under the definition of securities, the 1969 ban was withdrawn in March 2000, and index futures began trading in June 2000. Index options followed in June 2001, options on individual stocks in July 2001 and single-stock futures in November 2001. Exchange-traded currency futures arrived in August 2008 and interest rate futures, after two false starts, in their current form in 2014.

Reading a contract specification

Every exchange-traded contract has a specification sheet, and the exam expects you to work with its terms.

• Underlying: the asset or index the contract is written on.
• Lot size (contract size or market lot): the number of units in one contract. For Nifty 50 futures and options the lot is 75 units at present, revised by the exchange from time to time.
• Contract value: lot size multiplied by the price; the number you need for margins and hedge ratios.
• Expiry: the last trading day of the contract, as specified by the exchange. Index contracts have weekly and monthly expiries; stock contracts expire monthly. At any time the near, next and far month series are available.
• Tick size: the minimum price move, ₹0.05 for most equity derivatives.
• Settlement: cash for index contracts; physical delivery for single-stock contracts.