Basics of Derivatives

The gist: The foundation chapter. Defines the vocabulary every later chapter uses.

• 10% weight in Equity workbook · 5% in Currency and Rates (those underlying-intro chapters take more weight) — combined ~20 units out of 300
• Lighter on math than later chapters
• Most-tested topic: forwards vs futures vs OTC vs exchange-traded distinctions
• SIF distributors are SEBI-tested on derivative basics because every SIF uses derivatives

Bottom line: Don't underweight this chapter — the vocabulary cascades into every later one.

The gist: A financial instrument whose value is derived from another asset.

• No standalone value — moves only when the underlying moves
• The underlying can be: equity, equity index, currency, interest rate, commodity, bond
• The derivative is a contract on the underlying, not the underlying itself
• Buying a derivative does not give you ownership of the underlying (unlike a share)

Test recall: 'A derivative gets its value from an underlying asset.' If you can state that in your sleep, the rest of derivatives makes sense.

The gist: Four building blocks. Everything else is a combination.

• Forward — bilateral agreement to trade at a future date, fixed price today. OTC, customised.
• Future — exchange-traded standardised forward. Cleared by a clearing house, daily MTM.
• Option — right (not obligation) to buy or sell at a strike price by expiry. Buyer pays premium.
• Swap — exchange of cash flows over time. E.g. interest rate swap: fixed for floating. Mostly OTC.

India's exchange-traded universe is dominated by index and stock futures + options. Swaps and forwards trade OTC, mostly between institutions.

The gist: Five major underlying classes drive India's derivative markets.

• Equity / stock index: Nifty 50, Bank Nifty, single stocks — most actively traded
• Currency: USD/INR (dominant), EUR/INR, GBP/INR, JPY/INR
• Interest rate: 10-year G-sec, MIBOR — IRFs and IRS
• Commodity: gold, silver, crude oil, agricultural commodities — on MCX, NCDEX
• Cross-asset / exotic: equity-bond hybrids, structured products — niche

What SIFs trade: exchange-traded equity, currency, and interest rate derivatives only. No commodities, no OTC, no exotics under the current SEBI framework.

The gist: Three reasons real economy needs derivatives.

• Risk transfer (hedging): a wheat farmer locks in a sale price before harvest; an importer locks in USD rate for a future payment; a SIF manager hedges market risk on a long stock book
• Price discovery: futures markets integrate expectations into forward-looking prices that often lead spot. The Nifty futures price 'tells you' where the market thinks Nifty is heading
• Leverage / capital efficiency: a trader controls ₹10L of notional with ₹1L of margin. Same exposure at one-tenth the capital — useful (and dangerous)

Each function attracts a different player. Hedgers do risk-transfer. Speculators chase leverage. Arbitrageurs harvest price discovery imbalances.

The gist: Every derivatives trade has at least one of these four roles.

• Hedger: has an existing exposure (or upcoming one) and uses derivatives to offset it. The point is to reduce risk, not make money on the derivative
• Speculator: takes a directional view on price, uses derivatives for leverage. Provides liquidity to hedgers
• Arbitrageur: exploits price misalignments between linked markets (spot vs futures, near-month vs far-month). Theoretically risk-free
• Market maker: continuously quotes both bid and ask, earning the spread. Ensures liquidity

Why this matters: NISM tests participant identification frequently. Given a scenario, identify whether the trader is hedging / speculating / arbitraging.

The gist: Two parallel derivative ecosystems. SIFs operate only in the exchange-traded one.

• Exchange-traded — standardised, regulated, clearing-house-cleared. Examples: Nifty futures, BankNifty options, USD/INR futures.
• OTC (over-the-counter) — bilateral, customised, no central clearing. Examples: interest rate swaps, FX forwards, FRAs.

Key differences:

• Counterparty risk: minimal in exchange-traded (clearing corp interposes); significant in OTC (bilateral)
• Pricing transparency: exchange prices are public; OTC prices are negotiated
• Liquidity: exchange contracts are fungible; OTC contracts need original counterparty to exit
• Regulation: exchange = heavy (SEBI + exchange rules); OTC = lighter (mostly RBI for currency/rates)

SIF mandate: exchange-traded derivatives only. No OTC. Per SEBI's framework.

The gist: 25 years of derivatives in India, summarised in 6 dates.

• June 2000: Nifty 50 index futures launched on NSE. India's first exchange-traded derivative.
• July 2001: Index options launched. Stock options follow within months.
• November 2008: Currency futures (USD/INR) launched. First non-equity derivative.
• 2009: Interest rate futures introduced; materially expanded in 2014.
• October 2019: Stock futures and options moved to physical settlement (single-stock; index remained cash).
• February 2025: SEBI notifies the SIF framework, enabling regulated mutual-fund-adjacent vehicles to use derivatives systematically. The reason this exam exists for SIF distributors.

The gist: Five risk categories every distributor must understand.

• Market risk: losses from adverse price moves in the underlying. Leverage amplifies it.
• Liquidity risk: inability to exit a position at the screen price. Acute in deep-OTM options and far-month contracts.
• Counterparty risk: in OTC contracts only. Near-zero in exchange-traded contracts via the clearing house.
• Operational risk: wrong order placement, missed margin calls, settlement failures, broker errors.
• Regulatory risk: SEBI rule changes can force position closure or re-margining (e.g. SEBI's 2024 F&O tightening).

What this means for SIFs: the manager's job is to take market risk in a controlled way (via net-exposure bands), while operational + counterparty + regulatory risks are managed by being exchange-traded only.

Trap 1 — Definition wording. 'A derivative is a financial instrument whose value is derived from the value of an underlying asset.' Memorise this exact phrasing — NISM uses it verbatim.

Trap 2 — OTC vs exchange-traded. Counterparty risk is in OTC, NOT in exchange-traded. Don't flip.

Trap 3 — Participant identification. Scenario question — 'A trader buys Nifty futures because she expects Nifty to rise.' This is a SPECULATOR (no existing exposure to hedge). If she held the underlying stocks and shorted futures to protect, she'd be a HEDGER.

Trap 4 — First exchange-traded derivative in India. June 2000, Nifty index futures. Not options, not currency. Easy gotcha.

Trap 5 — Swaps. Swaps are OTC. They are NOT typically exchange-traded. Watch for questions implying otherwise.

The gist: Without derivatives, SIFs couldn't exist as we know them.

• Equity LS SIF: long stocks + short Nifty futures = hedged equity exposure
• Hybrid LS SIF: long stocks + short futures + OTM put overlay = downside-protected equity
• Active Asset Allocator SIF: futures used to swing equity allocation up/down without buying/selling cash stocks
• None of these are possible with cash-only instruments

What you tell a client: 'SEBI's SIF framework specifically allows the fund to use exchange-traded derivatives. That's how the manager builds a long-short or asset-allocator portfolio. Without derivatives, you'd just have a mutual fund.'

Before moving on, you should be able to do each of these without your notes:

• 1. Define a derivative in one sentence
• 2. Name the 4 canonical derivative products and one example of each
• 3. State the 5 main underlying classes in Indian markets
• 4. State the 3 economic functions of derivatives
• 5. Identify a hedger, speculator, arbitrageur, market maker given a scenario
• 6. List 3 differences between OTC and exchange-traded derivatives
• 7. Recall the 3 founding dates of India's derivatives market (2000, 2008, 2025)
• 8. Name the 5 risks of derivatives trading