Underlying Concepts in Derivatives

A derivative is a financial contract whose value is derived from the price movements of an underlying asset such as a stock, index, commodity, currency or interest rate. The contract itself does not own the asset; instead, it provides the right or obligation to buy, sell, or exchange the asset at a predetermined price and date.

Derivatives are used for hedging, speculation and arbitrage. In the context of Portfolio Management Services, distributors must be able to explain why a client would use a derivative to protect against market risk or to enhance returns, and how the underlying asset drives the derivative’s price.

For the NISM exam, remember that every derivative question begins with the underlying asset. Missing this link is a common trap that leads to incorrect payoff calculations or regulatory mis‑interpretations.

• Key benefit: risk transfer without direct ownership of the asset.
• Key risk: leverage amplifies both gains and losses.

The underlying asset is the reference instrument on which the derivative’s value is based. In India, common underlyings include equity shares, equity indices (e.g., NIFTY 50), commodities (e.g., gold, crude oil), foreign exchange pairs (e.g., USD/INR) and interest‑rate benchmarks (e.g., RBI repo rate).

Each underlying class has its own market conventions, contract specifications and regulatory treatment under SEBI (Securities and Exchange Board of India). For example, equity‑index futures settle in cash, whereas commodity futures may settle physically.

Exam questions frequently ask you to match a derivative type with its appropriate underlying or to identify which regulatory rule applies to a particular underlying class.

The spot price (S) is the current market price for immediate delivery of the underlying asset. The futures price (F) is the agreed‑upon price for delivery at a future date, quoted today on the exchange.

Because the futures contract postpones delivery, its price reflects the cost of carry – storage, financing and dividend yield – over the contract horizon. The difference between spot and futures price is called the basis.

In the NISM syllabus, the basis is a key concept for pricing and arbitrage questions. A positive basis (spot > futures) may indicate convenience yield, while a negative basis suggests cost of carry dominates.

A futures contract has a linear payoff: the holder gains when the spot price at expiry exceeds the futures price they locked in, and loses when it is lower. The payoff is multiplied by the contract size (Q), which is fixed by the exchange (e.g., one NIFTY futures lot equals 75 units of the index).

Because futures are marked‑to‑market daily, gains and losses are realised each trading day, affecting the trader’s margin account. This daily settlement is a distinctive feature that exam questions test, especially in contrast with options.

Understanding the payoff formula helps you quickly compute profit or loss for a given price movement, a skill frequently examined in scenario‑based items.

Derivatives can settle either physically or in cash. Physical settlement requires the actual delivery of the underlying asset on the contract's expiry date, while cash settlement involves a monetary transfer equal to the price difference.

In India, equity‑index futures and most currency futures are cash‑settled, simplifying the process for investors who do not wish to handle the underlying asset. Commodity futures, on the other hand, may have both settlement options depending on the contract specifications.

Exam questions often test your ability to identify the settlement mode for a given derivative, because it influences margin requirements and tax treatment.

Mark‑to‑market (MTM) is the daily process of revaluing a futures position to the prevailing market price. Any profit or loss is settled in the trader’s margin account, ensuring that credit risk is limited.

Two types of margin are required: Initial Margin, which is a security deposit to open a position, and Variation Margin, which covers daily MTM fluctuations. If the variation margin falls short, a margin call is issued and the trader must top up the account.

For the NISM exam, remember the sequence: open position → initial margin → daily MTM → variation margin → possible margin call. Questions may present a scenario where the market moves against a position and ask what additional funds are required.

Leverage in futures arises because the trader only needs to post a fraction of the contract’s notional value as margin. The effective exposure is therefore the full notional amount (Spot price × Contract size), while the capital outlay is much smaller.

Higher leverage magnifies both potential returns and potential losses. Regulators, including SEBI, impose limits on position size and margin percentages to protect market participants.

Exam items frequently ask you to compute the leverage ratio or to identify the impact of a price move on the notional exposure versus the margin posted.

SEBI governs all derivative trading in India through the Securities and Exchange Board of India (Derivatives) Regulations, 2021. Key provisions include mandatory registration of PMS distributors, prescribed margin percentages, position limits, and disclosure requirements for client suitability.

For PMS distributors, the exam expects you to know that any recommendation of derivatives must be documented, risk‑profile matched, and aligned with the client’s investment objectives as per SEBI (IC) Guidelines.

Failure to adhere to these regulations can result in penalties, so exam questions may test your awareness of compliance obligations alongside technical concepts.