Basics of Derivatives

A derivative is a financial contract whose value is derived from an underlying asset such as a stock, index, commodity, or currency. SEBI defines it as a contract whose price is contingent on the price of an underlying security or a group of securities.

Derivatives enable market participants to hedge risk, speculate on price movements, or arbitrage price differentials. Because the contract does not involve ownership of the underlying, the exposure can be magnified, making leverage a core feature.

For the exam, remember that the term “derivative” always implies a contract, not a security. Questions often test whether you can identify the underlying and the direction of risk transfer.

Every derivative possesses an underlying asset, a contract size, a maturity date, and a settlement mechanism. The contract size standardises the exposure, for example one Nifty futures contract represents 75 units of the index.

Leverage arises because the initial margin or premium is only a fraction of the notional exposure. This amplifies both gains and losses, a point frequently examined in risk‑management questions.

Settlement can be physical (delivery of the underlying) or cash‑based (payment of the price difference). SEBI mandates cash settlement for most equity index derivatives, which is a frequent source of confusion.

SEBI classifies four primary derivative contracts: forwards, futures, options, and swaps. Each differs in standardisation, trading venue, and settlement style.

Forwards are customised OTC contracts, while futures are exchange‑traded with daily mark‑to‑market. Options grant the right, but not the obligation, to buy or sell at a predetermined price. Swaps involve exchange of cash flows, typically interest rates, and are less common in equity‑derivative exams but appear in the basics.

Understanding these categories helps you eliminate wrong choices in multiple‑choice questions that compare standardisation or clearing mechanisms.

A forward contract is a bilateral agreement to buy or sell an underlying at a pre‑agreed price (forward price) on a future date. Because it is OTC, the parties can tailor the contract size, maturity, and settlement method.

In Indian equity markets, forwards are rarely traded directly, but the concept underpins futures pricing and is examined for its payoff logic.

Exam questions often present a forward price and ask for the profit of a long position at expiry. Remember that the long’s payoff equals the spot price at maturity minus the forward price.

Futures are exchange‑traded derivatives with standard contract specifications. The exchange acts as the central counter‑party, eliminating direct credit risk between buyer and seller.

Margin is required upfront, and positions are marked to market daily. Gains and losses are settled in cash each trading day, which reduces the need for large capital outlays.

Typical exam items ask you to calculate the margin requirement or to identify the effect of a price movement on a short futures position. Remember that a price rise benefits the long and harms the short.

Options give the holder the right, but not the obligation, to buy (call) or sell (put) the underlying at a predetermined strike price before or at expiry. The writer of the option receives a premium and is obligated to fulfill the contract if exercised.

For equity index options in India, settlement is cash‑based, while equity‑stock options settle physically. Premiums are quoted in rupees per share or per index point.

Exam questions frequently test the payoff diagram. For a call, the payoff is max(S_T – K, 0); for a put, it is max(K – S_T, 0). Knowing the max function prevents sign errors.

A swap is an OTC agreement to exchange cash flows based on different financial variables, most commonly interest rates. In equity‑derivative contexts, total‑return swaps on equity indices are occasionally referenced.

Although swaps are not a major focus of the equity‑derivatives certification, the basic definition appears in the syllabus to test breadth of knowledge.

Exam items may ask you to identify the type of exposure a swap provides (e.g., receiving total return of an index while paying a fixed rate). Recognise that swaps are bilateral and require credit risk mitigation under SEBI guidelines.

SEBI is the primary regulator for derivatives traded on Indian exchanges. It mandates registration of brokers, clearing members, and depositories, and enforces position limits to curb market manipulation.

All derivative contracts must be cleared through the National Securities Clearing Corporation Limited (NSCCL), which guarantees settlement and collects margin. Participants must report daily positions and adhere to the exposure norms prescribed in SEBI (Derivatives) Regulations, 2019.

Exam questions may ask which body provides the guarantee of settlement or which regulation introduced position limits. Remember: SEBI sets the rules; NSCCL handles clearing.