Purpose of Derivatives

Derivatives are contracts whose value is derived from an underlying asset such as equities, commodities, interest rates, or foreign exchange. The fundamental reason for their existence is to provide a mechanism for market participants to manage future price uncertainty.

In the Indian context, SEBI introduced derivatives on the NSE and BSE to enable hedgers—like exporters, importers, and commodity producers—to lock in prices and protect cash‑flows against adverse market movements. This aligns with the broader policy goal of deepening markets while safeguarding investor interests.

Exam‑writers often test your ability to match a purpose with a participant. Remember that a “hedger” seeks stability, a “speculator” seeks profit from price swings, and an “arbitrageur” seeks risk‑free profit from price differentials.

• Hedging – Reducing exposure to price risk.
• Speculation – Taking on risk to earn returns.
• Arbitrage – Exploiting price inefficiencies.

Hedging uses derivatives to offset potential losses in an underlying exposure. For example, an Indian exporter expecting USD receipts can sell USD futures to lock in the rupee value, thereby eliminating exchange‑rate risk.

SEBI’s regulations (Regulation 4 of the Derivatives (Market) Regulations) mandate that only eligible participants—such as listed entities, mutual funds, and institutional investors—can take on hedging positions in certain contracts. This ensures that hedging is used for genuine risk mitigation rather than speculative leverage.

In the exam, you may be asked to choose the correct instrument for a hedging need. Remember: futures and forwards are preferred for linear exposure, while options provide asymmetric protection (limited downside, unlimited upside).

• Linear hedges – Futures/Forwards.
• Non‑linear hedges – Options.

Speculators deliberately assume market risk to earn returns from price movements. Derivatives, because they require only a margin deposit, provide high leverage—allowing a small capital outlay to control a large notional exposure.

In India, retail investors can trade equity derivatives on NSE/BSE, but SEBI caps the leverage (e.g., 10% of contract value) to protect investors from excessive losses. Understanding these caps is useful for scenario questions that ask about permissible margin.

Exam focus: differentiate between a speculative long position (expecting price rise) and a hedging short position (protecting against price fall). The direction of the underlying exposure, not the contract type, determines the purpose.

• Speculative long – Buy futures expecting price increase.
• Speculative short – Sell futures expecting price decrease.

Arbitrageurs exploit price differentials of the same underlying across markets or contract types. Because derivatives are standardized, price mismatches are usually short‑lived, but the presence of arbitrage ensures market efficiency.

In the Indian market, a classic example is cash‑and‑carry arbitrage where a trader buys the underlying asset, sells a futures contract, and locks in a risk‑free profit when the futures price deviates from the cost‑of‑carry model.

For the exam, you may need to identify which participant can legally engage in arbitrage. SEBI permits arbitrageurs, but they must comply with position limits and reporting requirements.

• Cash‑and‑carry – Long spot, short futures.
• Reverse cash‑and‑carry – Short spot, long futures.

Different participants use derivatives for distinct objectives. Institutional investors (mutual funds, pension funds) primarily hedge portfolio risk, while proprietary traders focus on speculation. Export‑import businesses employ forwards and options to lock in exchange rates.

SEBI categorises participants into "eligible" and "ineligible" for certain contracts. For example, retail investors can trade equity futures and options but cannot enter into forward contracts directly.

Exam tip: When a question mentions a "corporate hedging its foreign‑exchange exposure", the correct answer will involve a forward or currency option, not an equity future.

• Hedgers – Corporates, fund managers.
• Speculators – Retail traders, proprietary desks.
• Arbitrageurs – Market makers, brokerage houses.

SEBI’s Derivatives (Market) Regulations outline the permissible purposes for each contract type. Hedging is explicitly allowed for entities with a genuine underlying exposure, while speculative positions are limited by position limits and margin requirements.

The regulator also mandates disclosure of large speculative positions (above 0.5% of the underlying’s free‑float) to prevent market manipulation. Understanding these thresholds helps answer compliance‑focused questions.

Remember: SEBI does not prohibit arbitrage, but arbitrageurs must adhere to reporting norms under the "Large Position Reporting" rules.