Basics of Derivatives — the ground floor

One sentence, then everything else

A derivative is a contract or a product whose value is derived from the value of some other asset, known as the underlying.

That is the whole idea. The derivative has no independent worth. It borrows its value from something else, and when that something else moves, the derivative moves with it.

The workbook lists the underlyings in four groups:

Series VIII is about the last row — specifically equity derivatives. But the exam will still ask you what else can be an underlying, so read that table twice.

Eight centuries of the same idea

Derivatives feel modern. They are not. The workbook's timeline runs a long way back, and the dates are directly examinable.

Three sequencing facts hide in that table and get tested. Forwards came before futures at CBOT — 1848 then 1865. Currency futures (1972) came before listed options (1973). And stock index futures (1982, Kansas City) came before stock index options (1983, CBOE) — futures first, options after, in that order.

Why the market exploded

Over the last five decades, the derivatives market has seen phenomenal growth. The workbook names five drivers:

• Increased fluctuations in underlying asset prices in financial markets
• Integration of financial markets globally
• Use of latest technology in communications, which has helped reduce transaction costs
• Enhanced understanding by market participants of sophisticated risk management tools
• Frequent innovations in the derivatives market and newer applications of products

Notice they are not all demand-side. Two are about need (volatility, global integration), one about cost (technology), one about knowledge, and one about supply of products.

How India got here

This section is a sequence of committees, an amendment and a set of launch dates. Every one of them is a potential question.

18 November 1996 — SEBI set up a 24-member committee under the chairmanship of Dr. L. C. Gupta to develop an appropriate regulatory framework for derivatives trading in India.

17 March 1998 — the Gupta committee submitted its report, recommending that derivatives should be declared as "securities", so that the regulatory framework applicable to the trading of securities could also govern the trading of derivatives.

June 1998 — SEBI set up a group under the chairmanship of Prof. J. R. Varma to recommend measures for risk containment in the derivatives market.

October 1998 — the Varma committee submitted its report. It worked out the operational details of the margining system, the methodology for charging initial margins, membership details and net-worth criterion, deposit requirements and real-time monitoring of positions requirements.

1999 — the Securities Contract (Regulation) Act (SCRA) was amended to include "derivatives" within the domain of "securities", and a regulatory framework was developed for governing derivatives trading.

March 2000 — the government repealed a three-decade-old notification which had prohibited forward trading in securities.

June 2000 — exchange-traded derivatives started in India, with SEBI permitting BSE and NSE to introduce the equity derivatives segment. The first products approved were index futures contracts based on Nifty and Sensex.

Then the product launches, in this exact order:

February 2013 — Metropolitan Stock Exchange of India Limited (MSEI) started trading in derivative products.

Read that launch order once more, because it is deliberately counter-intuitive. In India, stock options came BEFORE stock futures — July 2001 before November 2001. For indices it was the other way round: futures first (2000), options later (2001). Candidates who assume "futures always before options" get one of the two wrong.

The four products

Forwards. A contractual agreement between two parties to buy or sell an underlying asset at a certain future date for a price pre-decided on the date of the contract. Both parties are committed and obliged to honour the transaction irrespective of the price of the underlying at the time of delivery. Because they are negotiated between two parties, the terms are customised. These are over-the-counter (OTC) contracts.

Futures. Similar to a forward, except that the deal is made through an organised and regulated exchange rather than being negotiated directly between two parties. Futures are standardised — lot size, maturity date and so on — so that they can be traded on the exchange. The workbook's own summary: futures are exchange-traded forward contracts.

Options. A contract that gives the right, but not an obligation, to buy or sell the underlying on or before a stated date and at a stated price. The buyer pays the premium and buys the right; the writer/seller receives the premium with the obligation to sell or buy the underlying if the buyer exercises his right.

Swaps. An agreement made between two parties to exchange cash flows in the future according to a prearranged formula. Broadly speaking, swaps are a series of forward contracts. They help participants manage risks associated with volatile interest rates, currency exchange rates and commodity prices.

That "series of forward contracts" line is the most useful thing to remember about swaps at this level — a swap is not a fifth kind of animal, it is many forwards stacked in a row.

Who is in this market

Broadly three types of participants — and one sentence that catches people out: an individual may play different roles in different market circumstances. Hedger, trader and arbitrageur are roles, not licences. The same person can be all three in a week.

Hedgers face risk associated with the prices of underlying assets and use derivatives to reduce their risk. Corporations, investing institutions and banks all use derivative products to hedge or reduce exposure to market variables such as interest rates, share prices, bond prices, currency exchange rates and commodity prices.

Speculators / traders try to predict future movements in prices of underlying assets and take positions in derivative contracts based on that view. Why do they use derivatives rather than the underlying itself? Three reasons, all named:

• they offer leverage
• they are less expensive — the cost of transaction is generally lower than that of the underlying
• they are faster to execute in size, being a high-volume market

Arbitrageurs. Arbitrage is a deal that produces profit by exploiting a price difference in a product in two different markets. It originates when a trader purchases an asset cheaply in one location and simultaneously arranges to sell it at a higher price in another location. Such opportunities are unlikely to persist for very long, because arbitrageurs rush in and close the price gap.

Two kinds of market

Derivatives are either traded on organised exchanges (exchange-traded derivatives) or agreed directly between the contracting counterparties over the telephone or through electronic media (over-the-counter, or OTC, derivatives). A few complex products are constructed on simple building blocks like forwards, futures, options and swaps to meet specific customer requirements.

Here is the sentence worth quoting: the over-the-counter market is not a physical marketplace but a collection of broker-dealers scattered across the country. The main idea of the market is more a way of doing business than a place. Buying and selling are matched through a negotiated bidding process over a network of telephone or electronic media linking thousands of intermediaries.

Who is in the OTC market? Banks, financial institutions and sophisticated market participants like hedge funds, corporations and high net-worth individuals.

And why is it lightly regulated? Because these transactions occur in private among qualified counterparties, who are supposed to be capable enough to take care of themselves.

The five features of OTC derivatives, compared with exchange-traded ones:

• Contracts are tailor made to fit the specific requirements of the dealing counterparties
• The management of counterparty (credit) risk is decentralised and located within individual institutions
• There are no formal centralised limits on individual positions, leverage or margining
• There are no formal rules or mechanisms for risk management to ensure market stability and integrity, or to safeguard the collective interest of participants
• Transactions are private, with little or no disclosure to the entire market

On the contrary, exchange-traded contracts are standardised, traded on organised exchanges, with prices determined by the interaction of buyers and sellers through an anonymous auction platform. A clearing corporation guarantees contract performance — the settlement of transactions.

That last clause is the single biggest structural difference. In OTC, each institution manages its own counterparty risk. On an exchange, a clearing corporation stands in the middle and guarantees performance.

What the market is actually for

The workbook gives three specific functions:

• It helps in improving price discovery based on actual valuations and expectations.
• It enables the transfer of various risks from those who are exposed to risk but have a low risk appetite to participants with a high risk appetite. As the workbook puts it: hedgers want to give away the risk whereas traders are willing to take risk.
• It enables the shift of speculative trades from the unorganised market to the organised market. The risk management mechanism and surveillance of participants' activities in the organised space provide stability to the financial system.

That third point is often misread. The market's contribution is not that it eliminates speculation. It is that speculation which would happen anyway is moved into a supervised space where it can be margined, monitored and contained.

The risks

Derivatives are leveraged instruments, and the workbook lists the risks plainly:

And then a caution that is itself examinable: derivatives may not be an appropriate avenue for someone of limited resources, or having limited trading experience, or with low risk tolerance. A participant should carefully consider whether such trading is suitable for him or her based on these parameters.

The Model Risk Disclosure Document

Participants who trade in derivatives are advised to carefully read the Model Risk Disclosure Document, given by the broker to his clients at the time of signing the agreement.

The document is issued by the members of Exchanges and contains important information on trading in the Equities and F&O segments of exchanges. All prospective participants should read this document before trading on the Capital Market / Cash Segment or the F&O segment of the exchanges.

Three details to hold: who issues it (members of exchanges — that is, brokers, not SEBI and not the exchange itself), when it is given (at the time of signing the agreement), and what it covers (both the equities and the F&O segments, not F&O alone).