Structure of Derivative Markets

Exchange‑traded derivatives are contracts that are listed on a recognised stock exchange such as NSE or BSE. SEBI mandates a uniform contract specification, daily price discovery, and a transparent order book. All trades are cleared through a central clearing corporation (NSE‑CC, BSE‑CC) which guarantees settlement, thereby reducing counter‑party risk.

Over‑the‑counter (OTC) derivatives are privately negotiated agreements between two parties without a central exchange. They are customised in terms of notional amount, maturity, and underlying asset. Because they are bilateral, OTC contracts carry higher counter‑party risk and are subject to less public disclosure, although SEBI’s OTC‑derivatives framework imposes reporting and margin requirements for certain products.

Exam relevance: NISM frequently asks you to pick the correct market type for a given contract feature (e.g., “standard contract size” vs. “custom maturity”). Remember that standardisation and clearing are hallmarks of exchange‑traded products.

• Standardisation – fixed contract size, tick size, expiry dates (exchange‑traded).
• Customisation – flexible notional, bespoke payoff (OTC).

Hedgers use derivatives to offset price risk in an underlying exposure – for example, a farmer locking a future price for wheat. Their primary motive is risk reduction, not profit.

Speculators take on risk in anticipation of profit from price movements. They provide liquidity, enabling hedgers to enter and exit positions easily.

Arbitrageurs exploit price discrepancies between related contracts (e.g., futures vs. spot) to earn risk‑free returns. Their activity aligns prices across markets.

Intermediaries such as brokers, clearing members and depositories facilitate trade execution, margin collection and settlement. In India, brokers must be SEBI‑registered and clearing members belong to the exchange’s clearing corporation.

• Hedger – risk mitigation.
• Speculator – profit seeking.
• Arbitrageur – price convergence.
• Broker/Clearing Member – trade facilitation and guarantee.

Futures contracts are standardized agreements to buy or sell an asset at a predetermined price on a future date. They are exchange‑traded, margin‑based and settled daily through mark‑to‑market.

Options contracts grant the holder the right, but not the obligation, to buy (call) or sell (put) the underlying at a strike price before expiry. Premiums are paid upfront, and the payoff is asymmetric.

Swaps are bilateral OTC agreements where two parties exchange cash flows (e.g., fixed vs. floating interest rates) over a period. They are highly customised and typically used by corporates for interest‑rate or currency risk management.

Exam tip: Remember that only futures and listed options are exchange‑traded; swaps are always OTC in India.

When a client places an order through a SEBI‑registered broker, the order enters the exchange’s electronic order‑matching system. The best‑bid and best‑ask prices determine the execution price, ensuring transparent price discovery.

Post‑trade, the exchange’s clearing corporation becomes the central counter‑party (CCP). It collects initial margin from both sides, performs daily mark‑to‑market, and calls for variation margin if positions move against a participant. This process limits systemic risk.

Settlement can be physical (delivery of the underlying asset) or cash‑settled (payment of the price difference). Index futures in India are cash‑settled, whereas commodity futures may be physically settled. Understanding the settlement type is essential for answering questions on delivery obligations and cash flow timing.

The cost‑of‑carry model links the forward (or futures) price to the spot price by accounting for the financing cost of holding the underlying (risk‑free rate), any storage or insurance expenses (c), and the convenience yield (y) which reflects the benefit of physically holding the asset.

In the Indian context, equity index futures have negligible storage and convenience yield, so the formula simplifies to F ≈ S_{0} × (1 + r)^{T}. For commodity futures, storage costs become significant and must be added.

Exam relevance: Many NISM questions present spot price, risk‑free rate and time to maturity and ask you to compute the theoretical futures price. Remember to convert the rate to a decimal, use the correct time unit (years), and apply the exponent T correctly.