Equity Derivatives
CH5 · Strategies using Equity Futures & Options
Hedging = reducing existing risk | Speculation = taking new risk | Arbitrage = risk-free profit
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Theme 5
Connect derivatives to hedges, spreads, straddles, strangles, arbitrage and risk control.
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Equity Derivatives
Hedging = reducing existing risk | Speculation = taking new risk | Arbitrage = risk-free profit
Currency Derivatives
Exporter/importer hedges, spreads, straddles, arbitrage
Interest Rate Derivatives
Short/long hedges, duration hedge ratio, spreads, cash-and-carry arbitrage
Detailed notes
Equity Derivatives
Hedging = reducing existing risk | Speculation = taking new risk | Arbitrage = risk-free profit
NISM Series VIII — Equity Derivatives | 10% weightage | ~10 exam questions
This is where theory meets real trading. You've learned what futures and options are — now you learn how to combine them to express specific market views, hedge portfolios, and exploit arbitrage. The exam tests whether you can identify the right strategy for a given scenario. No heavy calculations here — it's mostly about understanding which strategy suits which market view.
Three types of strategies: 1. Hedging — reducing an existing risk 2. Speculation — taking a directional view for profit 3. Arbitrage — exploiting price inefficiency for risk-free profit
Long Hedge — you PLAN to BUY something in future and fear prices will RISE. Buy futures now to lock in price. Example: Mutual fund manager has collected ₹300 crore in NFO and will buy stocks over next month. Fears market will rise before he can invest. Buys index futures now → if market rises, futures profit offsets higher stock purchase price.
Short Hedge — you OWN something and fear prices will FALL. Sell futures now to lock in price. Example: Portfolio manager holds ₹500 crore in equities. Expects market volatility before RBI policy. Sells index futures → if market falls, futures profit offsets portfolio loss.
Beta Hedging — hedging a portfolio using index futures, accounting for the portfolio's beta.
Number of contracts to sell = (Portfolio Value × Portfolio Beta) / (Index Value × Lot Size)Speculative strategies using futures:
Cash and Carry Arbitrage — when futures are overpriced vs fair value. Buy in cash market, sell futures simultaneously. Profit = mispricing (risk-free).
Reverse Cash and Carry — when futures are underpriced. Sell in cash market (short sell), buy futures. Requires securities lending facility.
Covered Call — you OWN the stock + SELL a call option on the same stock.
Protective Put — you OWN the stock + BUY a put option.
Naked Call — SELL a call without owning the underlying.
Option Spreads — combine two options of the SAME type (both calls or both puts) on the SAME underlying but with DIFFERENT strikes or different expiries. Always limited profit AND limited loss.
Vertical Spreads — same expiry, different strikes:
Calendar Spreads (options) — same strike, different expiries.
Straddle — Buy BOTH a call AND a put at the SAME strike, SAME expiry.
Strangle — Buy an OTM call + OTM put at DIFFERENT strikes.
Butterfly — Combination of spreads. Limited risk, limited reward. Profits when market stays near middle strike.
Put-Call Parity — fundamental relationship between call and put prices with same strike and expiry. If violated, arbitrage opportunity exists.
It's January. Kiran manages a ₹50 crore equity portfolio with a beta of 1.2. Union Budget is in February and he's worried about volatility.
Nifty is at 25,000. Lot size = 75.
Contracts to sell = (50,00,00,000 × 1.2) / (25,000 × 75) = 6,00,00,000 / 18,75,000 = 32 contractsHe sells 32 Nifty futures contracts. If budget disappoints and Nifty falls 5%:
The hedge works — portfolio loss is offset by futures gain.
Trap 1: "Buying an OTM index call and selling an OTM index put is a hedge" → FALSE This is a SPECULATIVE strategy (synthetic long), not a hedge. A hedge offsets an EXISTING position. If you have no underlying exposure, it's speculation.
Trap 2: "Bull call spread results in cash inflow" → FALSE Bull call spread = buy lower strike call (pay) + sell higher strike call (receive). Net = OUTFLOW (you pay more than you receive because the lower strike call is more expensive).
Trap 3: "Bear call spread results in cash outflow" → FALSE Bear call spread = sell lower strike call (receive more) + buy higher strike call (pay less). Net = INFLOW.
Trap 4: "Short straddle profits from high volatility" → FALSE SHORT straddle profits from LOW volatility and range-bound markets. LONG straddle profits from HIGH volatility and big moves.
Trap 5: "Calendar spread = same underlying, same expiry, different strikes" → FALSE That's a vertical spread. Calendar spread = same underlying, DIFFERENT expiry months, same strike.
10% of exam = ~10 questions. Mix of scenario-based questions ("what strategy should Mr X adopt") and true/false on spread mechanics. The cash inflow/outflow on spreads is frequently tested and frequently wrong. Straddle vs strangle is another common topic.
Currency Derivatives
Exporter/importer hedges, spreads, straddles, arbitrage
NISM Series I — Currency Derivatives | ~12% weightage | ~77 questions
This is where everything comes together — you use futures and options to hedge, speculate, and arbitrage across currency pairs. The exam loves scenario-based questions: "An exporter expects to receive USD — what should they do?" or "USDJPY is moving from 105 to 108 — which futures do you use in India?" Cross-currency views using Indian futures pairs is unique to Series I and heavily tested. Master the exporter/importer hedge logic and the cross-currency trade construction.
Exporter (will RECEIVE foreign currency in future):
Importer (will PAY foreign currency in future):
Exchange traded preferred when: Multiple banks are quoting different prices and the company wants transparent, standardised pricing.
OTC preferred when: Need exact maturity match (e.g., 70-day exposure but exchange only has 30, 60, 90 day contracts — basis risk from mismatch).
Every option strategy question gives you TWO inputs: market view + volatility view.
| Market View | Volatility View | Best Strategy | |------------|----------------|--------------| | Strongly bullish | Rising | Buy Call | | Mildly bullish, zero outgo | Any | Sell Put | | Strongly bearish | Rising | Buy Put | | Mildly bearish, zero outgo | Any | Sell Call | | Bullish + falling vol | Falling | Sell Put | | Bearish + falling vol | Falling | Sell Call |
Rule: If you want maximum profit potential → BUY options. If you want zero cash outgo → SELL options (receive premium). The "zero cash outgo" constraint always eliminates buying.
India doesn't trade USDJPY or EURUSD directly as futures. But you can construct any cross-currency view using USDINR, EURINR, GBPINR, JPYINR combinations.
Logic:
Buy USDINR = long USD, short INR
Sell JPYINR = short JPY, short INR (wait — INR cancels)
Combined: long USD, short JPY = bullish USDJPY viewReference table:
| View | Action in India | |------|----------------| | USD rises vs JPY | Long USDINR + Short JPYINR | | EUR rises vs USD | Long EURINR + Short USDINR | | GBP falls vs USD | Short GBPINR + Long USDINR | | EUR rises vs GBP | Long EURINR + Short GBPINR | | JPY rises vs EUR | Long JPYINR + Short EURINR |
Example: EURUSD moving from 1.18 to 1.30 means EUR strengthening vs USD. → In India: Long EURINR (EUR up vs INR) + Short USDINR (USD down vs INR) = EUR up vs USD. ✓
When futures trade at a premium to spot AND you expect spot to remain unchanged at expiry:
Example: USDINR spot = 82, one-month futures = 82.50 (50p premium) View: spot stays at 82 at expiry Trade: Sell one-month futures at 82.50 At expiry: close at 82.00 → profit = 0.50 × 1,000 = Rs 500 per lot
When futures price ≠ OTC price for same maturity:
Futures overpriced vs OTC:
Example: OTC one-month USDINR: 86.60/86.75 Futures one-month USDINR: 87.10/87.20
Buy in OTC at 86.75 (ask), Sell in futures at 87.10 (bid) Profit = 87.10 − 86.75 = 0.35 per USD = 35 paise
When interest rate differential between countries changes, the spread between near and far month futures changes.
If India rates rise (or US rates fall): Interest rate differential widens → futures premium widens → far month futures becomes more expensive relative to near month. Trade: Sell far month (expensive) + Buy near month (cheap) = Short calendar spread
Example from exam: 3M at 60.20, 6M at 61.10 (current spread = 0.90) Expected: 3M at 59.90, 6M at 60.50 (expected spread = 0.60) Spread narrows → profitable to: Buy 3M + Sell 6M P&L = (0.90 − 0.60) × 1,000 = Rs 300 profit per lot
Indian investor buys gold in INR. Gold prices are determined by: 1. USD/GOLD (international gold price) 2. USDINR exchange rate
To hedge currency risk on gold investment: Sell USDINR futures (short USDINR) If USD weakens (USDINR falls), gold profit in USD terms gets compressed in INR → futures profit offsets.
Example: Mrs. Soni invests Rs 1,00,000 in Indian bond at 9% for 1 year. Wants to convert proceeds to USD for daughter's education abroad. Spot USDINR = 73, one-year premium = 5%.
After one year: Rs 1,00,000 × 1.09 = Rs 1,09,000 IRP gives futures: 73 × 1.05 = Rs 76.65
USD she can send = 1,09,000 / 76.65 = 1,422 USD
Trap 1: "Exporter should buy USDINR futures to hedge" — WRONG Exporter will receive USD — they want to lock in the SELLING rate for USD. Sell USDINR futures. (An importer who has to PAY USD should buy USDINR futures.)
Trap 2: "Zero cash outgo = buy options" — WRONG Buying options requires paying premium = cash outgo. Zero cash outgo = SELL options (receive premium instead).
Trap 3: "Long EURINR + Short USDINR = bullish INR" — WRONG INR exposure cancels out. This is a bullish EUR vs USD view (INR is the vehicle currency).
Trap 4: "Short straddle profits from high volatility" — FALSE Short straddle (sell both call and put) profits from LOW volatility / range-bound market. Long straddle profits from high volatility.
~12% = ~77 questions. Mix of scenario-based (which strategy?) and numerical (how much profit?). Cross-currency construction appears in every exam 2-3 times. Exporter/importer scenarios appear 3-4 times. Calendar spread P&L appears 1-2 times. Arbitrage OTC vs futures appears 1-2 times.
Interest Rate Derivatives
Short/long hedges, duration hedge ratio, spreads, cash-and-carry arbitrage
NISM Series IV — Interest Rate Derivatives | ~15% weightage | ~60 questions
How to use IRD futures and options to hedge, speculate, and arbitrage. Three core hedging strategies: short hedge, long hedge, and portfolio hedging using duration. The duration-based hedge ratio is unique to IRDs and heavily tested. Calendar spreads and inter-bond spreads round out the chapter.
Who uses it: Anyone holding a fixed income security (bond portfolio, bank with loan book) who fears rates will rise → bond prices fall.
Action: SELL G-Sec bond futures (short position)
Why it works: If rates rise, bond prices fall. Short futures position profits as futures prices fall too, offsetting the loss on the bond portfolio.
Formula for hedging a bond position:
Number of contracts = (Portfolio MD × Portfolio Value) / (Futures MD × Futures price per contract)Or more commonly:
Hedge ratio = (Change in portfolio value for 1bp) / (Change in futures value for 1bp)
= Portfolio PVBP / Futures PVBPExample: If a bank holds Rs 10 crore in bonds with MD = 7, and futures MD = 6, futures price = Rs 2 lakhs:
N = (7 × 10,00,00,000) / (6 × 2,00,000) = 583 contracts (approximately)Who uses it: Anyone planning to invest money in the future and fears rates will fall → bond prices rise → will have to pay more.
Action: BUY G-Sec bond futures (long position)
Example: A fund expects to receive Rs 5 crore in 3 months and plans to invest in bonds. It fears rates will fall (bonds get more expensive). Buy futures now — if rates fall, futures profit offsets the higher price paid for bonds.
Insurance companies: Permitted for long hedge ONLY.
Duration-based hedge ratio = the standard approach for hedging a portfolio of multiple bonds.
Number of contracts to sell = (Target MD − Current MD) × Portfolio value / (Futures MD × Futures price)To reduce duration of portfolio (short hedge): Target MD < Current MD → negative number = SELL contracts
To increase duration of portfolio (long hedge): Target MD > Current MD → positive number = BUY contracts
Example: Portfolio = Rs 10 crore, Current MD = 6, Target MD = 0 (fully hedged), Futures MD = 5, Futures price = 2L:
N = (0 − 6) × 10,00,00,000 / (5 × 2,00,000) = −600 contracts → SELL 600 contractsCash-and-carry arbitrage (when futures overpriced):
Reverse arbitrage (when futures underpriced):
Exchange vs OTC arbitrage: Buy in one market, sell in other to exploit price difference.
Definition: Buy one month contract + sell different month contract on the SAME underlying and SAME quantity.
Also called: Time spread, horizontal spread.
Inter-commodity spread: Buy futures on one underlying + sell futures on different underlying, SAME quantity, SAME expiry month. Example: Buy March T-bill futures + sell March 10Y G-Sec futures.
Key difference from currency: IRD calendar spread = same underlying, different expiry.
Margin treatment: Calendar spreads have LOWER margin than outright positions because both contracts move in similar direction → lower net risk.
Speculating on LEVEL of interest rates:
Speculating on TIMING of rate change:
Converting floating to fixed = HEDGING (not speculation) Converting fixed to floating (expecting rates to fall) = SPECULATION
Bank asset-liability management:
Short-selling G-Sec futures:
Trap 1: "Long hedge = selling futures" — FALSE Long hedge = BUYING futures. Short hedge = SELLING futures.
Trap 2: "Holding fixed rate loan = exposed to interest rate risk" — FALSE Fixed rate = NO interest rate risk. Floating rate = YES.
Trap 3: "Calendar spread = different underlyings, same expiry" — FALSE Calendar spread = same underlying, DIFFERENT expiry. Inter-commodity spread = different underlyings, same expiry.
Trap 4: "Calendar spreads have higher margin than outright" — FALSE Calendar spreads have LOWER margin (less risk because both legs move together).
Trap 5: "Converting floating to fixed is speculation" — FALSE Converting floating → fixed = HEDGING. Converting fixed → floating (expecting fall) = SPECULATION.
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