Derivatives — contracts that borrow their value

What is a derivative?

A derivative is a contract whose value is derived from the value of something else. That something else is called the underlying.

The underlying can be almost anything with a price:

• Metals — gold, silver, aluminium, copper, zinc, nickel, tin, lead
• Energy — crude oil and products, coal, electricity, natural gas
• Agricultural commodities — wheat, sugar, coffee, cotton, pulses
• Financial assets — shares, bonds, foreign exchange

Two legal definitions

Securities Contracts (Regulation) Act, 1956 [SC(R)A]. A derivative includes:

1. A security derived from a debt instrument, share, loan (secured or unsecured), risk instrument, contract for differences, or any other security.
2. A contract which derives its value from the prices, or index of prices, of underlying securities.

Because derivatives are securities under the SC(R)A, their trading is governed by the SC(R)A framework.

RBI Act, 1934 — section 45U(a). A derivative is an instrument, to be settled at a future date, whose value comes from a change in interest rate, foreign exchange rate, credit rating or credit index, price of securities, or a combination. It includes interest rate swaps, forward rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign currency options, foreign currency-rupee options, and others RBI may specify.

The four basic products

Forwards

A forward is an agreement made directly between two parties to buy or sell an asset on a future date, at terms fixed today.

The workbook's example: on 9 March 2018, gold costs ₹30,425 per 10 grams. You pay and take the gold the same day. That is a cash market trade at the spot price.

Instead, the goldsmith quotes ₹30,450 for delivery after one month. You agree. No money or gold changes hands today. You are long forward; the goldsmith is short forward. After a month you pay ₹30,450 and collect the gold — whatever gold's price is then. Both sides are bound.

Features:

• Bilateral — just two parties
• Over-the-counter (OTC) — all terms (price, quantity, quality, time, place) negotiated privately
• Changed only if both parties agree
• The point: fix the price and avoid price risk

Limitations:

• Liquidity risk — tailor-made and unlisted, so others rarely want them
• Counterparty risk (also called default risk or credit risk) — the other side may walk away when it pays them to
• Lack of transparency and settlement complications

The rice example: A agrees to buy 100 kg of rice at ₹20/kg from B in six months. If rice goes to ₹30, B may refuse to deliver. If rice falls to ₹15, A may buy in the market instead. A party defaults when it has an incentive to.

Futures

Futures were created to fix the problems of forwards. A futures contract is an agreement through an organised exchange to buy or sell a fixed amount of an asset on a future date at an agreed price. In short: standardised forwards traded on an exchange.

• The exchange sets all terms except price
• The exchange becomes counterparty to both sides through a clearing house
• The clearing corporation guarantees settlement
• Margins are paid by both parties to discourage default
• Price discovery comes from free interaction of buyers and sellers
• Buyer is long, seller is short. Both are obliged

Options

An option gives the buyer a right, but not an obligation, to buy or sell the underlying on or before a stated date at a stated price, for a premium.

• Buyer / holder — long; has the right; exercises only when favourable
• Seller / writer — short; has the obligation; must honour the contract if the buyer exercises

Two types:

Swaps

A swap is a contract in which two parties agree to exchange cash flows on future dates. Common in interest rate and currency markets.

Example: a borrower pays a floating rate — the Treasury bill rate plus a spread — every quarter. She prefers a fixed rate. So she enters an interest rate swap: she pays a fixed rate to the swap dealer and receives T-bill plus spread. The principal, called the notional amount, is never exchanged. Only interest is exchanged on each settlement date.

Where derivatives trade

Exchange-traded in India: equity index options and futures; individual stock options and futures; currency options and futures on select pairs; interest rate futures; commodity futures for select commodities.

OTC in India: forwards on agricultural commodities; interest rate swaps.

Why use derivatives? Three purposes

Hedging — you already own an asset and want to protect it against adverse price moves.

Speculation — no underlying investment; you trade on a view of future prices. Workbook example: spot ₹100, one-month futures ₹102. You expect ₹105 and buy futures. If right, you gain ₹3 (105 − 102). If the price stays at 100, you lose ₹2 (102 − 100).

Arbitrage — the law of one price says identical assets cannot trade at different prices in two markets. If they do, buy cheap, sell dear, and earn a riskless profit. That buying and selling itself closes the gap. In theory, prices differ only by transaction costs (transport, storage, insurance, interest). Small windows still appear, mainly because of information asymmetry.

Commodity and currency derivatives

Commodity derivatives are based on gold, crude oil, agricultural products and metals. Producers hedge; traders speculate. Prices depend on supply-demand, geopolitics, weather and economic trends. In India they trade on MCX and NCDEX, regulated by SEBI.

Currency derivatives are based on pairs like USD/INR, EUR/USD, GBP/INR. Businesses use them to reduce foreign exchange risk. Prices depend on interest rate differentials, inflation, geopolitics and central bank policy. The workbook names NSE, BSE and MCX-SX as exchanges, regulated by SEBI and RBI.

Three underlying concepts

Zero-sum game. The buyer of a future thinks prices will rise; the seller thinks they will fall. On maturity the price is the same for both, so one gains exactly what the other loses. The net of both positions is zero — assuming no taxes and no transaction costs.

Settlement. Most derivative contracts are settled in cash — only the price difference is paid. But SEBI has mandated physical settlement (delivery of the stock) for all stock derivatives not squared off before expiry. Index derivatives (Nifty, Bank Nifty) are excepted.

Margins. Both parties deposit margin money with the clearing house before trading. The amount depends on the underlying's price volatility and the contract's value-at-risk — a statistical measure of loss within a defined confidence interval.

Derivatives in a PMS

• Portfolio managers may invest in derivatives, including for hedging and portfolio rebalancing, through recognised stock exchanges.
• Only on terms in the Portfolio Management Agreement. The agreement must detail: quantum of exposure (in absolute terms and as a percentage of other investments), instrument types, purpose, position types, how contracts are valued and liquidated if the portfolio is liquidated, and prior permission from investors for changes.
• A client's total derivatives exposure must not exceed the client's portfolio value.
• If the agreement's terms are breached, the portfolio manager is held responsible.
• Derivatives use must be disclosed in the Disclosure Document.
• Portfolio managers may trade exchange-traded commodity derivatives for clients, subject to regulations and client consent.

Beyond the book

SEBI has studied who wins in equity futures and options. Its study published in January 2023 found that about 89% of individual traders in equity F&O lost money in FY 2021-22. A follow-up in September 2024 found that about 93% lost money over FY 2022 to FY 2024. That is speculation. The hedging a PMS may do — protecting a client's existing portfolio, within the agreement and within portfolio value — is a different activity with a different purpose.