Types of Derivative Products

Derivatives can be broadly grouped by where they are traded and by the nature of the underlying contract. The two overarching buckets are exchange‑traded derivatives (ETDs) and over‑the‑counter (OTC) derivatives. ETDs, such as futures and listed options, are standardized, cleared through a central counterparty and regulated by SEBI under the Securities Contracts (Regulation) Act, 1956.

OTC derivatives include forwards, swaps and many exotic structures. They are customized to the counterparties’ needs, settled bilaterally, and fall under SEBI’s “Derivatives (Regulation) Order, 2015” which imposes reporting, margin and risk‑management requirements. The distinction matters for exam questions that test whether a product is subject to daily mark‑to‑market or settlement at maturity.

From an advisory perspective, the choice between ETD and OTC influences client suitability, cost, liquidity and operational risk. The NISM exam frequently asks you to match a client’s risk profile with the most appropriate derivative type, so keep the classification matrix in mind.

• Exchange‑traded: Futures, listed Options, Index Options.
• OTC: Forwards, Swaps, Exotic contracts (e.g., Warrants, ELNs).

A forward contract is a private agreement between two parties to buy or sell an asset at a predetermined price on a specified future date. Because it is OTC, the terms – quantity, price, settlement date and delivery method – are fully customized. No margin is posted upfront; instead, credit risk is managed through collateral agreements or netting arrangements.

In India, forwards are commonly used for currency hedging by importers/exporters and for commodity price certainty by manufacturers. SEBI requires that forward contracts on securities be reported to the exchange’s clearing corporation, and the parties must maintain adequate margins as per the “Forward Contract (Regulation) Rules”.

Exam relevance: NISM questions often present a scenario where an investor wants to lock in a price for a future purchase of a foreign currency. Recognising that the instrument is a forward – OTC, non‑standardised, settled at maturity – helps you eliminate futures or options as incorrect options.

A future is a standardized contract traded on a recognized exchange (NSE, BSE, MCX) to buy or sell an underlying asset at a fixed price on a future date. Standardisation covers contract size, tick size, expiry cycle and daily settlement (mark‑to‑market). Both parties post an initial margin and maintain a variation margin to cover daily price movements.

SEBI mandates that all futures contracts be cleared through a Central Counterparty (CCP), which eliminates direct counter‑party risk. The margin system, daily price limit, and position limits are designed to curb excessive speculation. Futures are widely used by Indian retail investors for equity index hedging and by corporates for commodity price management.

Exam tip: When a question mentions “initial margin”, “daily settlement” or “exchange‑listed”, the correct answer will be futures, not forwards. Also watch out for the difference between cash‑settled and physically settled futures – the former settles in cash based on the underlying’s closing price on expiry.

An option gives the holder the right, but not the obligation, to buy (call) or sell (put) the underlying asset at a predetermined strike price before or at expiry. The buyer pays a premium to the writer for this right. Options traded on Indian exchanges are standardized; OTC options can be customized.

Key distinctions are European vs. American style – European options can be exercised only at expiry, whereas American options allow exercise at any time before expiry. The premium reflects intrinsic value (if any) plus time value, which decays as expiry approaches. SEBI’s regulations require disclosure of the premium, strike, and expiry in the client agreement.

For the NISM exam, remember the payoff diagrams: a call’s payoff is max(S‑K,0) and a put’s payoff is max(K‑S,0). Questions often test your ability to compute the net payoff after accounting for the premium paid.

A swap is an OTC agreement where two parties exchange cash flows based on different financial variables. The most common types are interest‑rate swaps (exchanging fixed for floating rates) and currency swaps (exchanging principal and interest in different currencies). Swaps are not traded on exchanges but are subject to SEBI’s reporting requirements for derivatives.

In India, corporate treasuries use interest‑rate swaps to manage exposure to fluctuating loan rates, while exporters may employ currency swaps to lock in foreign‑exchange rates for future receivables. The notional principal is not exchanged; only the interest differentials are paid, which reduces credit exposure.

Exam focus: NISM questions may present a corporate client wanting to convert a floating‑rate loan to a fixed‑rate obligation. Recognising that an interest‑rate swap accomplishes this, and that swaps are OTC, will guide you to the correct answer.

Beyond the four core products, the market offers exotic derivatives such as warrants, equity‑linked notes (ELNs), and contracts for difference (CFDs). Warrants are long‑dated options issued by companies, often listed on Indian exchanges, providing leveraged exposure to the issuer’s equity.

ELNs combine a bond component with an embedded option, allowing investors to earn a fixed coupon while participating in upside potential of an underlying equity or index. CFDs are OTC agreements that let traders speculate on price movements without owning the underlying asset; they are popular among sophisticated retail clients but carry high leverage risk.

Regulatory note: SEBI treats warrants as listed securities, while ELNs and CFDs fall under the broader category of structured products and must be disclosed with clear risk‑profile statements. The exam may ask you to identify which of these instruments is suitable for a high‑risk‑tolerance client seeking leveraged equity exposure.