Forwards, futures, options, swaps — market structure, purposes, benefits/costs/risks, equity/currency/commodity derivatives, strategies
A derivative is a contract or product whose value is derived from an underlying asset (metals, energy, agri-commodities, financial assets like shares/bonds). Under SC(R)A, 1956, derivatives are treated as securities; under RBI Act 1934, Section 45U(a), a derivative is an instrument settled at a future date whose value derives from interest rates, FX rates, credit ratings/index, or security prices — including IRS, FRAs, currency swaps and options.
| Concept | Explanation |
|---|---|
| Zero Sum Game | One party's gain = other's loss (assuming no taxes/transaction costs); net position across both sides is zero |
| Settlement Mechanism | SEBI mandates physical settlement for stock derivatives; Index derivatives are cash-settled (price differential exchanged, no underlying delivered) |
| Margining | Funds/securities deposited as collateral. Initial Margin = SPAN® margin + ELM (Extreme Loss Margin), should cover losses in 99% of cases. Premium Margin charged to option buyers = premium × quantity |
| Open Interest | Total outstanding (unsettled) derivative contracts — a measure of money flow into/out of the market, NOT trading volume |
SPAN® (Standard Portfolio Analysis of Risk) is margin-calculation software developed by the Chicago Mercantile Exchange (CME), widely used by global exchanges.
A bilateral OTC agreement to buy/sell an asset at a future date at a price decided today; both parties are obliged to perform.
Spot price of gold on 9-Mar-2018 = ₹30,425/10g (cash transaction). Instead, agree today to take delivery in 1 month at ₹30,450 (forward price) — no money/gold changes hands now. The buyer is "long forward"; the goldsmith is "short forward".
| Limitation | Explanation |
|---|---|
| Liquidity Risk | Tailor-made, not exchange-listed — hard to find counterparties |
| Counterparty (Default/Credit) Risk | Either party may default if market moves against the contracted price (e.g., rice contract example: buyer/seller may walk away if spot price moves favourably for them) |
Standardized forward contracts traded on an organized exchange; the exchange (via clearing house) becomes counterparty to both sides, eliminating counterparty risk. Buyer = long position; seller = short position.
Gives the buyer the right but not the obligation to buy/sell the underlying at a stated price (strike) on/before a date, for a premium. The seller/writer has the obligation.
| Type | Right Granted to Buyer |
|---|---|
| Call Option | Right to buy the underlying |
| Put Option | Right to sell the underlying |
| Moneyness | Condition (Call) / Outcome |
|---|---|
| In-The-Money (ITM) | Underlying price > strike price — exercising is profitable |
| At-The-Money (ATM) | Underlying price = strike price — no gain |
| Out-of-The-Money (OTM) | Underlying price < strike price — loss if exercised |
Intrinsic Value = excess of current price over strike price (positive for ITM options). Time Value = extra premium paid above intrinsic value, reflecting potential for the option to gain value before expiry.
A contract where two parties exchange specified cash flows on future dates — commonly Interest Rate Swaps and Currency Swaps. The notional principal is never exchanged; only interest amounts are exchanged on settlement dates.
A borrower owes a floating (T-bill + spread) quarterly payment but prefers fixed. She enters a swap: pays fixed to dealer, receives floating (T-bill + spread) from dealer. The received floating leg cancels her floating obligation, leaving a net fixed-rate obligation — effectively converting floating-rate debt into fixed-rate debt.
FIMMDA (Fixed Income Money Market and Derivatives Association of India) — a voluntary body of banks, FIs and PDs that interfaces with regulators, develops benchmark rates/instruments, standard documentation and market practices for bond, money & derivatives markets.
| Market Type | Features |
|---|---|
| OTC Markets | Privately negotiated, non-standard, depend on mutual trust between institutions; e.g., forwards, interest-rate swaps |
| Exchange Traded Markets | Standardized contracts settled via clearing house; margining enables anonymous counterparties to trade safely; e.g., futures, options |
Derivative products available in India: indices, stocks, interest rates and commodities (plus OTC forward markets for agri-commodities and interest-rate swaps).
Protecting the value of an existing investment/portfolio from adverse future price movements to achieve a desired return objective.
Taking a position based purely on a view of future prices, without an underlying exposure — e.g., buying futures expecting prices to rise.
Exploiting price differences for the same asset across markets (Law of One Price) for riskless profit; such activity itself narrows the gap.
Being leveraged instruments, derivatives may not suit investors with limited resources/experience/risk tolerance. Brokers must provide the Model Risk Disclosure Document before clients trade in F&O.
Used for risk management (reduction/transfer), price discovery and transactional efficiency — help farmers, traders, processors hedge against price volatility. Contracts are standardized (quantity, quality, delivery date/place, price-fluctuation limits). Traded on SEBI-registered exchanges: MCX, NCDEX, ICEX, NSE, BSE. Categories: Bullion, Metals, Energy, Agriculture.
A biscuit manufacturer needing wheat in future can buy wheat futures on a commodity exchange to lock in today's price for future delivery, regardless of the spot price then prevailing.
Underlying = an exchange rate; instruments include forwards, futures, swaps and options on currency pairs (USD, EUR, GBP, JPY, plus cross-currency pairs EUR-USD, GBP-USD, USD-JPY).
| Instrument | Description |
|---|---|
| Currency Future (FX Future) | Exchange one currency for another at a fixed future date and rate |
| Currency Option | Right (not obligation) to buy/sell currency at specified rate in a period, for a premium |
Derivatives trading was introduced in India in June 2000; India's equity derivatives markets are now among the largest globally.
Spot price (S) = ₹100; Futures price (F, 20-day delivery) = ₹120. The ₹20 difference equals the interest cost of carrying the position for 20 days: 120 = 100 + (interest for 20 days).
If the actual cost of borrowing to buy spot & carry equals exactly ₹20, there is no arbitrage profit — the law of one price holds (net of costs).
Basis = Spot Price − Futures Price (positive basis when futures > spot). On expiry, spot and futures converge (spot-future convergence) since carry cost becomes zero.
3-Mar-2017: XYZ cash market price = ₹3,984; XYZ futures (expiry 30-Mar) = ₹4,032.
Buy cash ₹3,984, sell futures ₹4,032 → locked difference = ₹48.
Profit is locked-in because of guaranteed spot-future convergence at settlement.
| Position | Right/Obligation | Max Loss | Max Gain |
|---|---|---|---|
| Long on Option (Buyer) | Right, no obligation | Limited to premium paid | Depends on underlying price at exercise/expiry (theoretically unlimited for calls) |
| Short on Option (Writer) | Obligation, no right | Theoretically unlimited | Limited to premium received |
In India, equity options are mostly European-style (exercised only on expiry); American options can be exercised/assigned any time before expiry.
1. Which of the following best describes a "zero sum game" in derivatives?
2. As per SEBI's settlement mandate, how are equity Index derivatives settled in India?
3. The maximum loss for the buyer (holder) of a call option is:
4. The pricing relationship between a stock's spot price (S) and its futures price (F) based on cost of carry is expressed as:
5. Which voluntary market body interfaces with regulators on bond, money and derivatives market issues and develops standardized practices/documentation?