Equity Derivatives
CH1 · Basics of Derivatives
Hedger = wants to REDUCE risk | Speculator = wants to TAKE risk | Arbitrageur = wants ZERO risk (risk-free profit)
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Theme 1
Understand what derivatives are, why they exist, who uses them and how risk transfers.
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Equity Derivatives
Hedger = wants to REDUCE risk | Speculator = wants to TAKE risk | Arbitrageur = wants ZERO risk (risk-free profit)
Currency Derivatives
Cross rates, bid/ask, real INR returns, currency regimes
Interest Rate Derivatives
IRD market structure, FRA, swaps, OTC vs exchange and participant roles
Detailed notes
Equity Derivatives
Hedger = wants to REDUCE risk | Speculator = wants to TAKE risk | Arbitrageur = wants ZERO risk (risk-free profit)
NISM Series VIII — Equity Derivatives | 10% weightage | ~10 exam questions
This is the foundation chapter — the "why does this market even exist" chapter. Before you trade a single futures contract or buy a single option, you need to understand what derivatives are, who uses them, and why. The exam tests this chapter with straightforward definitional questions. No calculations. No traps involving formulas. Just clear concepts. Get these right and you've secured easy marks.
What is a Derivative? — A financial contract whose value is *derived* from an underlying asset. The underlying can be a stock, index, currency, commodity, or interest rate. The derivative itself has no independent value — it exists only in relation to something else.
Types of Derivatives:
OTC vs Exchange Traded:
Three types of market participants — this is heavily tested:
| Participant | What they do | Risk appetite | |-------------|-------------|--------------| | Hedger | Reduces existing risk using derivatives | Low — wants to avoid risk | | Speculator | Takes calculated risk for profit | High — wants to take risk | | Arbitrageur | Exploits price differences across markets | Zero — risk-free profit |
Risk transfer mechanism — The fundamental purpose of derivatives. Hedgers want to *offload* risk. Speculators want to *absorb* risk. Derivatives are the bridge between them. Without speculators, hedgers couldn't hedge — there'd be no one to take the other side.
Systematic vs Unsystematic Risk:
Counterparty Risk (Default Risk, Credit Risk) — all three terms mean the same thing. The risk that the other party to a contract fails to honour their obligation. Exchange-traded derivatives eliminate this through the clearing corporation.
Infosys is reporting quarterly results next week. A fund manager holds 10,000 shares of Infosys and is worried results might disappoint and the stock could fall 8-10%.
She doesn't want to sell the shares (tax implications, long-term conviction). Instead she hedges — sells Infosys futures at the current price. If the stock falls, the futures position profits, offsetting the loss on her physical holdings.
A speculator on the other side of that trade WANTS to take the risk — he thinks results will be good and buys the futures expecting to profit from a price rise.
The derivatives market made both transactions possible simultaneously. That's risk transfer in action.
Trap 1: "Speculators stabilise the market" → WRONG Speculators ADD LIQUIDITY, they don't stabilise. The question often gives you "stabilise" as an option to trip you up. The correct answer is always "add liquidity to the futures market."
Trap 2: "Systematic risk can be eliminated through diversification" → FALSE Only unsystematic risk can be diversified away. Systematic risk affects the entire market — you can't escape it by holding more stocks. This is why derivatives exist as a hedge tool.
Trap 3: "Counterparty risk exists in exchange-traded derivatives" → FALSE The clearing corporation eliminates counterparty risk in exchange-traded contracts by acting as the central counterparty. It's only OTC contracts that carry counterparty risk.
Trap 4: "Preference shares are derivative instruments" → FALSE Preference shares are equity instruments. Derivatives are futures, forwards, options, and swaps — contracts whose value derives from an underlying.
Trap 5: "Derivatives market transfers risk from speculators to hedgers" → WRONG ORDER It's the other way around — from hedgers TO speculators. Hedgers offload the risk, speculators absorb it.
10% of the exam = ~10 questions. All easy to medium difficulty. No numericals in this chapter. Questions are mostly definitional — "who is a hedger", "what is systematic risk", "what does a derivatives market do." Read this chapter once carefully and you should score full marks.
Currency Derivatives
Cross rates, bid/ask, real INR returns, currency regimes
NISM Series I — Currency Derivatives | ~9% weightage | ~56 questions
Before you trade a single USDINR futures contract, you need to understand what currency markets are, how exchange rates are quoted, and why currencies move. This chapter is the foundation for everything else. It's also the chapter with the most calculation-based questions — cross rates, real returns on overseas investments, and gold standard math appear in almost every exam set. Get comfortable with currency arithmetic here and you'll find CH3 and CH5 much easier.
What is an exchange rate? The price of one currency expressed in terms of another. USDINR = 84 means 1 USD costs Rs 84.
Base currency vs Quotation currency:
Bid vs Ask (from the bank's perspective):
Currency systems:
Gold Standard — historical system where currency values were tied to gold.
Exchange rate = Gold price in Currency A / Gold price in Currency B
Example: If 1 oz gold = Rs 54,000 and 1 oz gold = USD 675
Then 1 USD = 54,000 / 675 = Rs 80Bretton Woods System — post-WW2 system where USD was pegged to gold at $35/oz, and all other currencies were pegged to USD. Collapsed in 1971 when the US abandoned the gold peg.
A cross rate is an exchange rate between two currencies derived via a third currency (usually USD).
Formula:
EURINR = EURUSD × USDINR
Cross rate bid = lower currency bid × lower USD bid
Cross rate offer = higher currency offer × higher USD offerExample: EURUSD = 1.1650/1.1655, USDINR = 85.35/85.40
EURINR bid = 1.1650 × 85.35 = 99.43 EURINR offer = 1.1655 × 85.40 = 99.54
GBPINR calculation: GBPUSD = 1.34/1.3425, USDINR = 86.5/86.52 GBPINR bid = 1.34 × 86.5 = 115.91 GBPINR offer = 1.3425 × 86.52 = 116.15
This type appears in every exam. The formula never changes.
Steps: 1. Convert INR → foreign currency at entry rate (divide) 2. Apply investment return in foreign currency terms 3. Convert back at exit rate (multiply) 4. Calculate % return in INR terms
Example: Indian investor puts Rs 3,90,000 in US stocks when USDINR = 65.
Key insight: Even if the investment grows in USD, if INR appreciates (USDINR falls), your INR returns get compressed. If INR depreciates (USDINR rises), your INR returns get boosted.
| Indicator | Higher Reading | Currency Impact | |-----------|---------------|----------------| | GDP growth | Better than expected | Currency appreciates | | CPI (inflation) | Higher than expected | Initially appreciates (rate hike expectations), then depreciates | | Nonfarm payrolls (US) | Higher = more jobs | USD appreciates | | Interest rates | Higher | Currency appreciates (capital inflows) | | Capital inflows (FPI) | More money coming in | Currency appreciates |
The simple rule: Things that attract foreign money into a country strengthen its currency. Things that push money out weaken it.
January 2024: RBI keeps rates steady while US Fed signals rate cuts. The interest rate differential between India and US narrows. This makes Indian assets slightly less attractive to foreign investors. Result: some capital outflow, mild INR depreciation, USDINR moves from 82 to 84.
Separately, strong US retail sales data comes out. This signals a robust US economy. Investors expect the Fed to delay rate cuts. USD strengthens globally — USDINR moves up further to 84.50.
Trap 1: "Bid price is always lower than ask price" — TRUE but don't confuse direction For USDINR, if quote is 83.10/83.12:
Trap 2: "Cross rate uses bid×offer and offer×bid" — WRONG EURINR bid = EURUSD bid × USDINR bid (both bids) EURINR offer = EURUSD offer × USDINR offer (both offers)
Trap 3: "A managed float currency has no central bank intervention" — FALSE Managed float = market + OCCASIONAL intervention. That's the whole point.
Trap 4: "Vehicle currency increases number of exchange rates to deal with" — FALSE Vehicle currency (USD) REDUCES the number of exchange rates needed in a multilateral system. Instead of quoting every currency pair directly, you quote everything vs USD.
~9% = ~56 questions. Cross rate numericals appear in every single exam set — expect 3-4 per exam. Real returns calculation appears 1-2 times per exam. Currency movement analysis (appreciating/depreciating) appears 4-5 times per exam. Master the arithmetic and you'll score full marks on this chapter.
Interest Rate Derivatives
IRD market structure, FRA, swaps, OTC vs exchange and participant roles
NISM Series IV — Interest Rate Derivatives | ~5% weightage | ~20 questions
Conceptual bridge chapter. Derivatives definition, the three major economic functions, OTC vs exchange-traded, and why interest rate risk is the biggest risk for banks. Significant overlap with Series I (Currency) CH2 — same participant types, same derivative categories. IRD-specific additions: IRDs are regulated jointly by RBI and SEBI, interest rate risk is the most severe for banks and financial institutions, and the IRD market is the LARGEST derivatives market in the world.
A derivative where the underlying asset is the right to pay or receive money at a given interest rate.
Three categories:
All three are IRDs:
The largest derivatives market globally: Interest rate derivatives. As per BIS data, $500 trillion of $630 trillion total OTC derivatives is interest rate derivatives. Outstanding notional of OTC = 9 times exchange-traded.
Three functions — all are correct: 1. Risk management / Hedging — PRIMARY function. Protect against price/rate/currency movements. 2. Price discovery — Futures prices reveal market expectations about future rates. 3. Speculation — Taking directional views to profit from price movements.
Role of underlying markets (primary markets) = FINANCING — transferring cash from who has it to who needs it.
Role of derivative markets = RISK MANAGEMENT
Hedgers: Have real underlying interest rate exposure (e.g., bank with floating rate loans), use IRDs to REDUCE risk.
Speculators: No underlying exposure, take directional view on interest rates to PROFIT. Converting floating to fixed rate loan = hedging. Taking opposite bet on rates = speculation.
Arbitrageurs: Exploit price differences between markets (e.g., OTC vs exchange), zero directional risk.
Banks borrow short-term (deposits) and lend long-term (loans/mortgages). This maturity mismatch means:
Interest rate risk > Currency risk > Equity risk for banks and financial institutions.
The risk faced by the HIGHEST NUMBER of market participants = Interest rate risk (everyone with a loan, deposit, or bond has it)
| Feature | OTC (FRA, Swap) | Exchange (Futures, Options) | |---------|----------------|----------------------------| | Contract | Customized — perfect hedge possible | Standardized — basis risk | | Pricing | Bilateral negotiation between parties | Centralized market bids/offers | | Counterparty risk | Yes — bilateral | No — CC is central counterparty | | Accessibility | Not for all market participants | Widely accessible | | Settlement | Physical or bilateral cash | Cash (IRDs), may be physical (bonds) |
OTC market is larger globally (9x exchange-traded in notional outstanding)
FRA provides more precise hedge than futures (customized maturity, amount) — but less accessible.
Foreign Portfolio Investors (FPIs): Collectively can take net long position in IRF up to Rs 50 billion
Trap 1: "Derivative markets provide financing" — FALSE Underlying/primary markets provide FINANCING. Derivative markets provide RISK MANAGEMENT.
Trap 2: "Banks can trade IRFs on behalf of clients" — FALSE Banks can trade IRFs for own account (hedging + trading). NOT on behalf of clients.
Trap 3: "FRA provides same precision as futures" — FALSE FRA = more precise (customized). Futures = standardized, so basis risk exists.
Trap 4: "OTC derivatives are smaller than exchange-traded" — FALSE OTC is 9 times larger than exchange-traded globally.
Trap 5: "Insurance companies can participate in short hedge" — FALSE Insurance companies = long hedge ONLY.
Trap 6: "Non-residents can short sell for speculation" — FALSE Non-residents and FIIs = short position for HEDGING ONLY.
Next: revise cards and rules across the same chapters.
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2. Underlying Market