Basics of Derivatives

A derivative is a financial instrument whose value is derived from the price of an underlying asset such as equities, indices, commodities, currencies or interest rates. The contract itself does not have intrinsic value; it merely reflects changes in the underlying.

Derivatives enable market participants to transfer risk, speculate on price movements, or arbitrage price differentials. For an Investment Adviser, knowing why a client would use a derivative is crucial for suitability assessment under SEBI (Investment Advisers) Regulations.

In the NISM exam, you will often be asked to identify the underlying, distinguish between a derivative and its underlying, or select the correct definition from multiple choices. Remember: the derivative is the contract; the underlying is the asset that drives its price.

• Derivatives are contracts, not assets.
• Underlying can be a single security, a basket, or a rate.

Every derivative contract contains a set of standardized components: the underlying asset, the contract size (e.g., 75 NIFTY points per futures contract), the expiry date, and the settlement mechanism (physical or cash).

The strike price (for options) or the initial price (for futures) determines the payoff at expiry. Margin requirements, either initial or variation, are also part of the contract and are mandated by the exchange and SEBI.

Exam tip: questions often mix these components. Identify each term in the stem before choosing an answer. A common mistake is to treat the strike price as a “premium”; the premium is the price paid to acquire the option, not the strike itself.

The three primary categories of derivatives used in Indian markets are futures, options, and swaps. Futures are standardized contracts obligating the buyer and seller to transact at a pre‑determined price on a future date. Options give the holder a right, but not an obligation, to buy (call) or sell (put) the underlying at a specified strike price.

Swaps are over‑the‑counter (OTC) agreements where two parties exchange cash flows based on different financial variables, the most common being interest‑rate swaps. While futures and options are exchange‑traded and have daily mark‑to‑market, swaps are customized and settled according to the contract terms.

For the exam, remember the key distinction: futures = obligation, options = right, swaps = exchange of cash flows. Questions may present a scenario and ask you to label the derivative type; focus on the presence or absence of an obligation.

A futures contract is an exchange‑traded agreement to buy or sell an underlying asset at a predetermined price on a specific future date. The contract size, tick size, and expiry are standardized by the exchange (e.g., NSE). Because the contract is marked‑to‑market daily, gains and losses are settled each trading day through the margin account.

The payoff for a long futures position at expiry is simply the difference between the spot price at expiry (S_T) and the futures price at initiation (F_0). If S_T > F_0, the long trader profits; if S_T < F_0, the trader incurs a loss. The short position has the opposite payoff.

Exam relevance: NISM frequently asks for the formula of futures payoff, the impact of margin, and the difference between cash‑settled and physically settled contracts. Do not confuse the initial margin (collateral) with the eventual payoff.

An option provides the holder the right, but not the obligation, to buy (call) or sell (put) the underlying asset at a predetermined strike price (K) on or before expiry. The price paid for this right is called the premium. Options are also exchange‑traded in India, with standard contract specifications for indices (e.g., NIFTY) and stocks.

The payoff for a long call option is the excess of the spot price over the strike, if positive; otherwise it is zero. Conversely, the long put payoff is the excess of the strike over the spot price, if positive. These payoff structures are central to many NISM questions on option valuation and breakeven analysis.

Exam tip: always separate the premium (cost) from the payoff. A question may give the premium and ask for the net profit; subtract the premium from the payoff to obtain the correct answer.

In India, derivatives are regulated by SEBI under the Securities Contracts (Regulation) Act, 1956 and the SEBI (Derivatives) Regulations, 2015. All exchange‑traded derivatives must be cleared through a Central Counterparty (CCP) and are subject to position limits, margin requirements, and reporting obligations.

Investment Advisers must ensure that any derivative recommendation complies with the client’s risk profile, investment objectives, and suitability guidelines prescribed by SEBI (Investment Advisers) Regulations, 2017. Non‑compliance can lead to penalties, suspension of registration, or disgorgement of fees.

Exam focus: questions may ask about the role of SEBI, mandatory disclosures, or the difference between exchange‑traded and OTC derivatives. Remember that swaps are OTC and therefore fall under separate reporting norms (e.g., reporting to RBI for certain interest‑rate swaps).

Derivatives are primarily used for hedging (risk mitigation), speculation (profit from price movements), and arbitrage (exploiting price differentials). An Investment Adviser should evaluate the client’s exposure and recommend the appropriate instrument – for example, using NIFTY futures to hedge a portfolio’s equity exposure.

When advising on derivatives, consider the client’s risk tolerance, investment horizon, and liquidity needs. The adviser must also disclose the potential for margin calls, leverage effect, and the possibility of total loss of premium in options.

Exam tip: scenario‑based questions often describe a client’s objective and ask which derivative is most suitable. Match the objective (hedge vs. speculate) with the instrument’s payoff profile and regulatory constraints.