Derivatives Markets

1What a derivative is and why it exists

A derivative gets its value from another asset, the underlying. Its main use is managing risk from an unknown future price.

A gold buyer fears prices will rise; a gold seller fears they will fall. If they agree today on the price for an exchange a year from now, they have a forward contract. They are counterparties with opposite interests, and one party's loss is the other's gain.

Example Buyer and seller fix 10 grams of gold at ₹30,000 for one year ahead. If gold ends at ₹35,000, the buyer gains (pays ₹30,000 for something worth ₹35,000) and the seller loses. At ₹25,000, the seller gains and the buyer loses. At ₹30,000, neither gains.

Remember

• A forward fixes today the price of a future exchange.
• One side's gain equals the other side's loss.

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2Structuring derivatives

A derivative is defined by its payoff. A forward pays the difference whichever way the price moves; other contracts pay off only on a rise or only on a fall. The aim is always to transfer risk.

Examples: a weather derivative pays a farmer if rainfall is poor; an interest rate swap lets a floating-rate borrower pay fixed; a currency derivative fixes an importer's future exchange rate; an index derivative pays a portfolio manager if the market falls.

Remember

• Different underlyings, same purpose: managing the risk of value changes.

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3Key ideas: zero sum, settlement, OTC versus exchange, arbitrage

• Zero sum: every long (buyer) has a matching short (seller); the net value of all positions is zero, and no new asset is created.
• Settlement: cash settlement exchanges the price difference without delivering the asset. Since October 2019, SEBI requires physical settlement for all stock futures and options open at expiry; index futures and options are still cash settled.
• OTC derivatives are private, non-standard contracts between known institutions that rely on trust. Exchange-traded derivatives are standard contracts cleared through a clearing corporation, so anonymous parties can trade safely. Forwards are OTC; futures are exchange-traded.
• Arbitrage: by the law of one price, identical goods should not sell at different prices in two markets beyond transaction costs. Arbitrageurs buy in the cheaper market and sell in the dearer one, closing the gap. Derivative prices differ from cash prices only by costs such as interest and storage.

Remember

• Stock F&O: physical settlement since October 2019. Index F&O: cash settlement.

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4Forwards, futures, options and swaps

Forwards are OTC agreements on terms set by the parties (for example a farmer selling wheat to a miller in six months). They carry counterparty risk, so they are done between parties who know each other.

Futures are exchange-traded forwards with terms (lot size, quality, delivery dates and centres) set by the exchange. The clearing corporation is the counterparty to every trade and both sides post margins, which removes counterparty risk.

Options give the buyer (holder) the right but not the obligation to buy (call) or sell (put) the underlying at the strike (exercise) price on or before a date, for a premium. The seller (writer) has the obligation to honour the contract if exercised.

Example Arvind buys a Nifty call from Salim with a strike of 10,000 for a premium of ₹100. If Nifty ends at 10,200, the option is in the money: Arvind exercises and Salim must sell at 10,000. If Nifty ends at 9,800, it is out of the money: Arvind lets it lapse and Salim keeps the ₹100.

Swaps are agreements to exchange cash flows in future, common in interest rates and currencies. In an interest rate swap only the interest on an agreed principal is exchanged. A borrower paying T-bill plus a spread can pay fixed to a swap dealer and receive T-bill plus spread, turning floating-rate debt into a fixed obligation. Swaps are OTC but follow dealer association rules.

Remember

• Option buyer: right. Option seller: obligation.
• Call = right to buy; put = right to sell.

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5The derivatives market in India

Exchange-traded products: index and stock options, index and stock futures, currency futures and options on select pairs, interest rate futures and options, and commodity futures and options. Agricultural forwards and interest rate swaps trade OTC.

Exchange-traded derivatives began in June 2000 with index futures on BSE and NSE; index options, stock options and stock futures followed in 2001. India is one of few markets with single stock futures, and derivatives volumes far exceed cash market volumes.

Trading is fully automated, screen-based and anonymous; settlement is through the clearing corporation and guaranteed by capital norms, position limits and margins. Trades go through registered trading members, who settle through clearing members. Exchanges charge transaction fees (on contract value for futures, on premium for options), and STT applies. Exchanges choose eligible indices and stocks using SEBI criteria on size and liquidity, and may be stricter.

Remember

• Index futures first: June 2000. Options and stock futures: 2001.

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6Futures contract specifications and trading

• Expiry: monthly contracts expire on the last Tuesday or last Thursday of the month, depending on the exchange (each exchange uses one day for all its equity derivatives). If that day is a holiday, expiry moves to the previous trading day. Three monthly contracts trade at a time: near, next and far month.
• Longer contracts: quarterly (March, June, September, December) and semi-annual (June, December) maturities. Weekly index options have seven serial weekly expiries.
• Lot size: set so that the lot value at introduction is at least ₹5 lakh (as per the workbook; SEBI periodically revises minimum contract values, so check the current figure).
• Base price: the theoretical futures price on the first day, then the previous daily settlement price. Tick size: ₹0.05.
• Price and quantity freeze: orders outside set ranges need confirmation from the member that they are genuine.
• Hours (NSE): 9:15 a.m. to 3:40 p.m.; trade modification until 4:15 p.m.
• Orders: regular lot (market or limit), stop loss, immediate or cancel, day orders, and spread orders that execute when the difference between two contracts reaches a set level. Unmatched orders are cancelled at day end.
• Corporate actions are adjusted so the value of the position is the same on the cum and ex dates.

Remember

• Three monthly contracts: near, next, far.
• Tick size: 5 paise.

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7Clearing and settlement of futures

Three kinds of clearing members:

• Trading member clearing member (TM-CM): clears own trades and those of other trading members.
• Professional clearing member (PCM): banks or custodians that only clear.
• Self-clearing member (SCM): clears only its own trades.

Daily (mark-to-market) settlement: every day, positions are valued at the daily settlement price (the weighted average price of the last 30 minutes), and profits or losses are paid on T+1 in cash.

Example Buy Nifty futures at 10,000; settlement price that day 9,900. Loss = 100 points × lot size 50 = ₹5,000 to be paid in.

Final settlement happens on expiry at the closing price of the underlying in the cash market. Money moves through clearing banks and dedicated clearing accounts.

Remember

• Daily settlement price = weighted average of the last 30 minutes.
• Final settlement uses the underlying's closing price.

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8Options trading and settlement

Options are available on the same indices and stocks as futures and expire on the same days. European options can be exercised only on expiry; American options any time up to expiry. India trades only European options (CE = call European, PE = put European). The market trades the premium for each strike. Lot value and tick size are as for futures; base prices are theoretical values using MIBOR; price bands are set daily by the exchange.

Differences from futures: daily settlement is of the premium, paid T+1 to the seller; on expiry, exercised in-the-money options are settled and assigned to short positions, aggregated client-wise and member-wise.

Remember

• Only European options in India.
• Premium is settled T+1.

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9Risk management in derivatives

Tools: capital adequacy, margins, position limits, online monitoring and automatic disabling of terminals when limits are breached. (A SEBI study published in January 2023 found that 9 out of 10 individual F&O traders made net losses.)

• Base capital and liquid net worth: part of members' capital and margins must be in liquid assets (liquid net worth); the rest is base capital. The clearing corporation can use these to settle a member's obligations.
• Margins flow from clients to trading members to clearing members to the clearing corporation. For futures: initial margin (estimating risk over a 2-day horizon) and exposure margin (a percentage of notional value), both upfront. Non-payment brings penalties, suspension or closing out. For options: initial margin on premium value; exposure margin on notional value only for option sellers; plus premium margin (until premium pay-in) and assignment margin (until exercise settlement).
• Position limits apply to clients, trading members, clearing members and the market as a whole. Near the limit, only reducing trades are allowed; at the limit, the terminal is deactivated.

Remember

• Initial margin covers 2-day risk.
• Exposure margin on options is charged only to sellers.

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10Uses, benefits and costs

• Hedging: protecting an existing position from price moves.
• Speculation: taking a view on price without holding the underlying, at the cost of the margin.
• Arbitrage: locking in a price difference between markets that exceeds the cost of borrowing; the profit is fixed regardless of the final price as long as both legs settle at the same price.

Benefits: flexible ways to hedge (symmetric and asymmetric payoffs), more liquidity, lower trading costs, wider participation and better price discovery. Costs: poorly regulated or OTC markets have caused liquidity crises and counterparty failures when large positions had to be unwound quickly.

Remember

• Three uses: hedging, speculation, arbitrage.

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11Market indicators: open interest and put-call ratio

Open interest is the number of contracts still outstanding, counted one side only. If A sold to B and later A buys from C to close, A has no position but open interest is unchanged (B is long, C is short). Open interest differs from trading volume. Rising open interest suggests fresh money and better liquidity.

Formula Put-call ratio (PCR) = Number of put options outstanding ÷ Number of call options outstanding

PCR above 1 means more puts than calls; below 1, more calls. Traders read it as a bullish or bearish signal in different ways.

Remember

• Open interest counts outstanding contracts, one side only.
• PCR > 1: more puts outstanding.

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