Index derivatives
Derivative contracts — chiefly index futures and index options — that have a stock index as the underlying asset. In India they are cash settled and used to hedge market risk.
In plain language
Index derivatives are derivative contracts which have the index as the underlying asset. The workbook names index options and index futures as the most popular derivative contracts worldwide, and says index derivatives are useful as a tool to hedge against market risk.
The underlying is a number, not a thing you can hand over. You cannot deliver "the Nifty". So index derivatives in India are settled in cash: on expiry the difference between the contract price or strike and the index's final settlement value is paid, and that is the end of it.
They were also the first exchange-traded derivatives in India. SEBI accepted the L. C. Gupta committee's recommendations and approved phased introduction beginning with stock index futures, which started trading on Nifty and Sensex in June 2000, followed by index options in June 2001.
How it works
What they hedge. Price risk splits into unsystematic (company-specific) risk, which diversification reduces, and systematic (market) risk, which it cannot. Systematic risk is "separable from the investment and tradable in the market with the help of index-based derivatives". The number of index futures contracts to hedge a portfolio is Vp × βp ÷ Vi.
Settlement. Index futures and options are cash settled; stock derivatives have been physically settled since October 2019. Index options are European — exercisable only on expiry.
Eligibility of an index (section 6.3). At least 80% of the index weight must be in individually eligible stocks, with no ineligible stock above 5%. An index failing for three consecutive months gets no fresh contracts. Non-flagship index derivatives must also meet the product success framework: 15% of active trading members or 20, whichever is lower, trading each month; trading on at least 75% of days; average daily turnover of Rs 10 crore; average daily open interest of Rs 4 crore. An excluded index is not considered for re-inclusion for at least six months.
Position limits. Trading member limit: higher of Rs 7,500 crore or 15% of total open interest, separately for index futures and index options. PAN-level index options limits on a FutEq basis: net end of day Rs 1,500 crore, gross Rs 10,000 crore; intraday net Rs 5,000 crore, gross Rs 10,000 crore.
SEBI's measures on index derivatives (section 7.10): upfront collection of option premium (1 February 2025); no calendar spread benefit on the expiry day (1 February 2025); intraday position limit monitoring (1 April 2025); contract value of Rs 15–20 lakh for new contracts, weekly expiries on one benchmark index per exchange, and an additional 2% extreme loss margin on short options on expiry day (all 20 November 2024).
A worked example
Cash settlement of an index option — the workbook's Example 3 (Chapter 7). A client holds a call on an index, strike 17,500; the index closes at 17,800 on expiry; lot size 50.
Final settlement value = (17,800 − 17,500) × 50 = Rs 15,000, paid in cash on T+1
No shares move. The seller of that call pays Rs 15,000 through the clearing corporation.
Hedging a portfolio with index futures (illustrative portfolio). An investor holds a diversified portfolio worth Rs 50,00,000 with a beta of 1.2. Nifty futures trade at 25,006.60 and, using the workbook's assumed lot size of 65, one contract is worth:
Vi = 25,006.60 × 65 = Rs 16,25,429
Number of contracts = Vp × βp ÷ Vi = 50,00,000 × 1.2 ÷ 16,25,429 = 3.69
Futures trade in whole lots, so the investor shorts 4 (slightly over-hedged) or 3 (under-hedged). If the market falls 5% and the portfolio falls 6% (beta 1.2), the portfolio loses Rs 3,00,000; four short lots gain about 25,006.60 × 5% × 65 × 4 = Rs 3,25,086.
Notice the one-lot value — Rs 16.25 lakh — sits inside SEBI's Rs 15–20 lakh band for index derivative contracts.
Why NISM asks about it
Chapter 2, section 2.7, defines index derivatives. Chapter 1, section 1.3, gives the June 2000 and June 2001 launch dates. Chapter 3, section 3.9, uses index futures to hedge systematic risk. Chapter 6, section 6.3, sets out index eligibility, the product success framework and surrogate indices. Chapter 7 covers cash settlement (section 7.4), position limits (7.7) and SEBI's 2024–25 measures (7.10). Expect settlement-type questions, launch-sequence questions and the hedge ratio calculation.
Common exam traps
- Index derivatives are cash settled; stock derivatives are physically settled. This is the most common confusion.
- Index futures hedge systematic risk, not company-specific risk.
- Index futures came first (June 2000), then index options (June 2001), stock options (July 2001) and stock futures (November 2001).
- The hedge ratio for a portfolio is Vp × βp ÷ Vi, not 1:1.
- The PSF thresholds for index derivatives — Rs 10 crore turnover, Rs 4 crore open interest, 20 trading members — are far lower than for stock derivatives. Do not mix them.
- Only one benchmark index per exchange may have weekly expiry from 20 November 2024.
Where this is taught
- Series VIII · Chapter 2: Understanding Indexintroduced here
- Series V-D · Chapter 14: Understanding Indexintroduced here
Related terms
- Hedge ratioThe number of futures (or options) needed to hedge a position. For one stock with its own futures it is 1:1; for a portfolio against index futures it is portfolio value × beta ÷ contract value.
- Systematic riskThe part of an investment's risk that comes from economy-wide forces moving every asset at once — it cannot be diversified away, and it is the only risk the market pays you to carry.
- 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.
- 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.
- IndexA statistical indicator that tracks a portfolio of securities representing a market or part of it, expressed as a change from a base value — so the percentage move matters, not the number itself.
- Index constructionChoosing an index's constituent stocks and deciding its calculation methodology — a trade-off between diversification and liquidity, with the final inclusion call taken by an Index Committee.
- Product Success FrameworkSEBI's exit-eligibility test for index and stock derivatives, based on trading-member participation, trading frequency and turnover, applied after a 6-month gestation period.
- 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.
- Cross hedgeHedging an exposure with futures on a different but closely associated asset, because no futures contract exists on the asset itself — for example, hedging a stock portfolio with index futures.
- Future Equivalent Open InterestOpen interest measured as the net delta-adjusted position across futures and options on an underlying, instead of adding up notional contracts — the basis for SEBI's index derivatives position limits.
- L. C. Gupta CommitteeThe 24-member SEBI committee under Dr. L. C. Gupta, set up in November 1996, that designed India's regulatory framework for derivatives and recommended they be declared securities.