Derivative
Also written Derivatives · Derivative contract · Derivative product · Derivative (SCRA definition)
A contract whose value is derived from the value of something else — the underlying — rather than from anything the contract itself owns or produces.
In plain language
A share is worth something because it is a slice of a company. A bond is worth something because somebody owes you money. A derivative owns nothing and lends nothing. It is a contract, and its price moves only because the price of the thing it refers to moves.
That referenced thing is the underlying. It can be a metal (gold, silver, copper), an energy resource (crude oil, coal, natural gas, electricity), an agricultural commodity (wheat, sugar, cotton), or a financial asset — shares, bonds, an index, or foreign exchange.
Four building blocks cover almost everything: forwards, futures, options and swaps. More complex products are assembled from those four.
How it works
The four products differ on two axes — who is obliged, and where it trades.
- A forward is a private, customised agreement between two parties to buy or sell at a price fixed today. Both sides are obliged. It is OTC.
- A future is the same obligation, standardised in lot size and maturity and traded on an exchange, with a clearing corporation guaranteeing settlement. The workbook's phrasing: futures are exchange traded forwards.
- An option gives the buyer a right and no obligation; the writer has the obligation and keeps the premium.
- A swap is an agreement to exchange cash flows on a prearranged formula — in effect a series of forwards.
Three kinds of participant use them. Hedgers hold an exposure and want rid of it. Speculators hold a view and want leverage. Arbitrageurs exploit a price difference between two markets and, by doing so, close it.
The Indian regulatory path is examinable in dates. SEBI appointed the L C Gupta committee on 18 November 1996; it reported on 17 March 1998, recommending that derivatives be declared securities. The J R Varma group was set up in June 1998 and reported in October 1998 on risk containment and margining. The SCRA was amended in 1999 to bring derivatives within "securities". Exchange-traded derivatives began in June 2000 with index futures on Nifty and Sensex; index options in June 2001, stock options in July 2001, stock futures in November 2001. MSEI started in February 2013.
A worked example
Take the same market view three ways, on 3 October 2025, when Nifty spot is 24,894.25 and the near-month Nifty future is 25,006.60, at a lot size of 25.
Buy the index itself. To get Rs 6.25 lakh of exposure you commit roughly Rs 6,25,000 of your own money.
Buy one futures contract.
Contract value = 25,006.60 × 25 = Rs 6,25,165
Initial margin at 10% = Rs 62,517
You control Rs 6.25 lakh of index for Rs 62,517. If the index rises 1%, the contract gains roughly Rs 6,250 — about 10% on the margin. If it falls 1%, you lose the same 10%, and the loss is collected the same evening.
Buy one call option. You pay a premium and nothing else. The most you can lose is that premium; the upside is open.
All three positions have the same underlying and wildly different risk. The derivative did not create the index exposure — it repackaged it, which is precisely why the workbook insists that leverage is a double-edged sword.
Why NISM asks about it
Chapter 13 (Basics of Derivatives) is short and almost entirely factual, which makes it a reliable source of easy marks: the definition, the four products, the three participant types, the ETD-versus-OTC comparison, the list of risks, and the committee-and-date chronology above. Chapter 19 repeats the framework for interest rate derivatives. Expect at least one date or committee-name question and one "which of these is not a derivative product" question.
Common exam traps
- Forwards and futures are not synonyms. Forwards are customised, OTC and carry counterparty risk; futures are standardised, exchange-traded and guaranteed by a clearing corporation.
- A derivative is a security in India. That was the point of the 1999 SCRA amendment — it is why SEBI, not some separate regulator, governs the segment.
- OTC is less regulated, not unregulated. The workbook's list is specific: no centralised position limits, decentralised counterparty risk management, private transactions with little disclosure.
- Do not confuse price risk with counterparty risk. Exchange trading removes the second, not the first.
- Arbitrage opportunities do not persist. Any question implying a risk-free profit that lasts is testing whether you know arbitrageurs close the gap.
Where this is taught
- Series IV · Chapter 2: Interest Rate Derivativesintroduced here
- Series XVI · Chapter 1: Introduction to Commodity Marketsintroduced here
- Series I · Chapter 2: Foreign Exchange Derivativesintroduced here
- Series XXI-B · Chapter 5: Derivativesintroduced here
- Series V-D · Chapter 13: Basics of Derivativesintroduced here
- Series XII · Chapter 6: Derivative Marketsintroduced here
- Series XIX-E · Chapter 1: Investments Landscapeintroduced here
- Series X-A · Chapter 10: Understanding Derivativesintroduced here
- Series XXI-A · Chapter 5: Derivativesintroduced here
- Series VIII · Chapter 1: Basics of Derivativesintroduced here
- Series V-D · Chapter 19: Interest Rate Derivatives
Related terms
- Futures contractA standardised forward traded on an exchange, where the exchange fixes every term except the price and the clearing corporation guarantees settlement, so neither side carries the other's default risk.
- Price discoveryThe process by which the free interaction of buyers and sellers produces a price that reflects every participant's expectation of what the underlying will be worth at a future date.
- OptionA contract giving the buyer the right, but not the obligation, to buy or sell the underlying at a stated price on or before a stated date, in exchange for a premium paid to the writer.
- UnderlyingThe asset a derivative contract derives its value from — the index, stock, bond or currency whose spot price drives the contract. The derivative has no value of its own without it.
- Exchange traded derivativeA derivative traded on an organised exchange on standardised terms, with prices set by anonymous auction and performance guaranteed by a clearing corporation — as against a bilateral, customised OTC contract.
- OTC derivativeA non-standard derivative contract settled directly between counterparties on mutually agreed terms, relying on trust between them rather than on an exchange and clearing house.
- Off-Balance Sheet ExposureExposure a fund takes through leverage and derivative contracts to assets that are not its direct obligation — only margin and premium show in the books, but the fund bears the full risk and return.
- Interest-rate derivativesContracts that let borrowers and investors hedge adverse interest-rate movements — interest-rate futures, interest-rate swaps, interest-rate options (caps and floors) and forward rate agreements.
- Offshore derivative instrumentsInstruments issued by an FPI that reference Indian securities; SEBI bars ODIs referencing derivatives and allows onshore derivative hedging only via a separate Category I registration, within limits.
- Securities under the SCRAThe statutory list in Section 2(h) of the SCRA, 1956 that decides what counts as a "security" in India — shares and debentures, but also derivatives, mutual fund units and zero coupon zero principal instruments.
- Mark to MarketThe daily settlement of a futures position at that day's closing price, so gains and losses are paid in cash every evening instead of accumulating until expiry.
- Equity Long-Short FundAn investment strategy under a Specialized Investment Fund: at least 80% in equity, with unhedged short exposure through derivatives capped at 25%. Minimum investment Rs 10 lakh across an AMC's SIF strategies.
- Delivery basisThe SEBI rule that a mutual fund must take or give actual delivery of securities it trades, with named exceptions for permitted short selling, exchange-traded derivatives, and RBI-permitted government security sales.
- Stock exchangeA body of individuals, or a body incorporated under the Companies Act, that assists, regulates or controls the business of buying, selling or dealing in securities.
- F&O turnoverThe ICAI-prescribed turnover figure for futures and options trading — the sum of favourable and unfavourable differences plus option premium received — that decides whether a tax audit or presumptive scheme applies.
- Cash settlementSettling a derivative on expiry or exercise by exchanging the price difference, without delivering the underlying asset. SEBI mandates physical settlement for stock derivatives, not index derivatives.
- Over-the-counterA bilateral market where two parties negotiate a contract's terms directly, with no exchange or clearing house between them, unlike a standardised, centrally cleared exchange-traded market.
- SwapA derivative in which two parties agree to a specified exchange on future dates — typically one pays a fixed interest rate and receives a floating one on an agreed principal that never itself changes hands.
- Zero sum gameThe principle that every derivative long has a matching short, so one side's gain is exactly the other side's loss and the net value of all derivative positions is zero.
- SecuritiesFinancial instruments — shares, bonds, derivatives, mutual fund units, government securities and more — issued to raise funds, as defined in Section 2(h) of the Securities Contracts (Regulation) Act, 1956.
- Structured productA pre-packaged instrument built on a traditional investment such as a bond or currency, with an embedded derivative such as an option or swap — complex, customised, illiquid and meant for high net worth investors.