NISM Series V-D · Chapter 13: Basics of Derivatives

L1 · Foundation

Foundation — What a derivative is, where it came from, and the four products

The definition of a derivative and the underlyings it is built on, the milestones from twelfth-century European trade fairs to the S&P 500 options of 1983, how India built its derivatives market through the L C Gupta and J R Varma committees, and the four basic products — forwards, futures, options and swaps.

13 min read · Worth 7% of the paper · Written from pages 324–329 of the official NISM workbook · Updated 18 September 2026

13.1 What a derivative is

"A derivative is a contract or a product WHOSE VALUE IS DERIVED FROM THE VALUE OF SOME OTHER ASSET known as THE UNDERLYING".

That single sentence contains the whole idea. A derivative has no value of its own. It is a claim whose worth rises and falls because something else rises and falls. Take the underlying away and the contract is worth nothing at all.

"Derivatives are based on a WIDE RANGE of underlying assets. These include:

Metals such as Gold, Silver, Aluminium, Copper, Zinc, Nickel, Tin, Lead, etc.
Energy resources such as Oil (crude oil, products, cracks), Coal, Electricity, Natural Gas, etc.
Agri commodities such as Wheat, Sugar, Coffee, Cotton, Pulses etc., and
Financial assets such as Shares, Bonds and Foreign Exchange."

Note how wide that list is. A derivative is not a stock market invention. The oldest derivatives in the world were agricultural — a farmer and a merchant agreeing today on the price of a crop that will be harvested months later.

13.2 The history — the milestones to memorise

"The history of derivatives may be mapped back to several centuries".

Period	Milestone
12th Century	"In EUROPEAN TRADE FAIRS, sellers signed contracts promising FUTURE DELIVERY of the items they sold"
13th Century	"contracts entered into by ENGLISH CISTERCIAN MONASTERIES, who frequently sold their WOOL UP TO 20 YEARS IN ADVANCE, to foreign merchants"
1634–1637	"TULIP MANIA IN HOLLAND: Fortunes were lost after a speculative boom in TULIP FUTURES BURST"
Late 17th Century	"In JAPAN at DOJIMA, near OSAKA, a futures market in RICE was developed to protect rice producers from BAD WEATHER OR WARFARE"
1848	"The Chicago Board of Trade (CBOT) facilitated trading of FORWARD contracts on various commodities"
1865	"the CBOT went a step further and listed the FIRST 'EXCHANGE TRADED' DERIVATIVE CONTRACT in the US. These contracts were called 'FUTURES CONTRACTS'"
1919	"Chicago Butter and Egg Board, a SPIN-OFF of CBOT, was REORGANISED to allow futures trading. Later its name was changed to CHICAGO MERCANTILE EXCHANGE (CME)"
1972	"CME introduced INTERNATIONAL MONETARY MARKET (IMM), which allowed trading in CURRENCY FUTURES"
1973	"Chicago Board Options Exchange (CBOE) became the FIRST MARKETPLACE FOR TRADING LISTED OPTIONS"
1975	"CBOT introduced TREASURY BILL FUTURES contract. It was the FIRST SUCCESSFUL PURE INTEREST RATE FUTURES"
1977	"CBOT introduced T-BOND FUTURES contract"
1982	"CME introduced EURODOLLAR FUTURES contract"
1982	"Kansas City Board of Trade launched the FIRST STOCK INDEX FUTURES"
1983	"CBOE introduced OPTION ON STOCK INDICES with the S&P 100 (OEX) and S&P 500 (SPX) Indices"

Two things are worth reading out of this table. First, 1848 gave forwards and 1865 gave futures — the seventeen-year gap between a negotiated contract and a standardised, exchange-listed one. Second, the products arrived in a logical order: commodities first, then currencies (1972), then options (1973), then interest rates (1975, 1977, 1982), then equity indices (1982, 1983).

Why the market grew

"Over the last five decades, the derivatives market has seen a PHENOMENAL GROWTH. Some of the factors driving the growth of financial derivatives are:

Increased FLUCTUATIONS in underlying asset prices in financial markets.
INTEGRATION of financial markets GLOBALLY.
Use of LATEST TECHNOLOGY IN COMMUNICATIONS has helped in REDUCTION OF TRANSACTION COSTS.
ENHANCED UNDERSTANDING of market participants on SOPHISTICATED RISK MANAGEMENT TOOLS to manage risk.
Frequent INNOVATIONS in derivatives market and NEWER APPLICATIONS of products."

13.3 The Indian derivatives market

The Indian story is told through two committees and two legal changes, and the dates are heavily examined.

The L C Gupta Committee. "As the initial step towards introduction of derivatives trading in India, SEBI set up a 24–MEMBER COMMITTEE under the Chairmanship of Dr. L. C. GUPTA on NOVEMBER 18, 1996 to develop appropriate REGULATORY FRAMEWORK for derivatives trading in India. The committee submitted its report on MARCH 17, 1998 recommending that DERIVATIVES SHOULD BE DECLARED AS 'SECURITIES' so that regulatory framework applicable to trading of 'securities' could ALSO GOVERN TRADING OF DERIVATIVES".

The J R Varma Group. "Subsequently, SEBI set up a group in JUNE 1998 under the Chairmanship of Prof. J. R. VARMA, to recommend measures for RISK CONTAINMENT in derivatives market in India. The committee submitted its report in OCTOBER 1998. It worked out the OPERATIONAL DETAILS of MARGINING SYSTEM, METHODOLOGY FOR CHARGING INITIAL MARGINS, MEMBERSHIP DETAILS AND NET-WORTH CRITERION, DEPOSIT REQUIREMENTS and REAL TIME MONITORING OF POSITIONS requirements".

Note the clean division of labour between the two: Gupta wrote the regulatory framework; Varma wrote the risk containment.

The legal changes. "In 1999, The SECURITIES CONTRACT REGULATION ACT (SCRA) WAS AMENDED to INCLUDE 'DERIVATIVES' WITHIN THE DOMAIN OF 'SECURITIES'... In MARCH 2000, the government REPEALED A THREE-DECADE-OLD NOTIFICATION, WHICH PROHIBITED FORWARD TRADING IN SECURITIES".

The product launches. "The exchange traded derivatives started in India in JUNE 2000 with SEBI permitting BSE and NSE to introduce the equity derivatives segment".

Product	Launch
Index futures (on Nifty and Sensex)	June 2000
Index options	June 2001
Options on individual stocks	July 2001
Futures on individual stocks	November 2001
MSEI (Metropolitan Stock Exchange of India) begins derivatives	February 2013

The order is the detail that catches people out: index futures → index options → stock options → stock futures. Options on individual stocks came before futures on individual stocks.

Products in the derivatives market

Forwards

"It is a contractual agreement between TWO PARTIES to buy/sell an underlying asset at a CERTAIN FUTURE DATE for a PARTICULAR PRICE THAT IS PRE-DECIDED on the date of contract. BOTH the contracting parties are COMMITTED AND ARE OBLIGED TO HONOUR THE TRANSACTION IRRESPECTIVE OF THE PRICE of the underlying asset at the time of delivery. Since forwards are NEGOTIATED BETWEEN TWO PARTIES, the terms and conditions of contracts are CUSTOMIZED. THESE ARE OVER-THE-COUNTER (OTC) CONTRACTS".

Futures

"A futures contract is SIMILAR TO A FORWARD, EXCEPT that the deal is made through an ORGANIZED AND REGULATED EXCHANGE rather than being negotiated directly between two parties. Futures are also STANDARDIZED CONTRACTS (in terms of their LOT SIZE, MATURITY DATE, etc.) so that they can be traded on the exchange. Indeed, we may say FUTURES ARE EXCHANGE TRADED FORWARD CONTRACTS".

Options

"An Option is 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. While the BUYER of an option PAYS THE PREMIUM AND BUYS THE RIGHT, the WRITER/SELLER of an option RECEIVES THE PREMIUM WITH THE OBLIGATION to sell/buy the underlying asset, IF THE BUYER EXERCISES HIS RIGHT".

This is the great dividing line of derivatives. In a forward or future, both sides are obliged. In an option, only one side is obliged — and that side is paid a premium for accepting the imbalance.

Swaps

"A swap is an agreement made between two parties to EXCHANGE CASH FLOWS IN THE FUTURE according to a PREARRANGED FORMULA. Swaps are, broadly speaking, a SERIES OF FORWARD CONTRACTS. Swaps help market participants MANAGE RISKS associated with VOLATILE INTEREST RATES, CURRENCY EXCHANGE RATES AND COMMODITY PRICES".

13.4 The three participants

"There are broadly THREE types of participants in the derivatives market - HEDGERS, TRADERS (also called SPECULATORS) and ARBITRAGEURS. AN INDIVIDUAL MAY PLAY DIFFERENT ROLES IN DIFFERENT MARKET CIRCUMSTANCES".

Hedgers. "They 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 their exposures to market variables such as INTEREST RATES, SHARE PRICES, BOND PRICES, CURRENCY EXCHANGE RATES AND COMMODITY PRICES".

Speculators / Traders. "They try to PREDICT THE FUTURE MOVEMENTS in prices of underlying assets and BASED ON THE VIEW, TAKE POSITIONS in derivative contracts. Derivatives are PREFERRED OVER UNDERLYING ASSET FOR TRADING PURPOSE, as they offer LEVERAGE, are LESS EXPENSIVE (cost of transaction is generally LOWER than that of the underlying) and are FASTER TO EXECUTE IN SIZE (high volumes market)".

Arbitrageurs. "Arbitrage is a deal that produces PROFIT BY EXPLOITING A PRICE DIFFERENCE in a product in TWO DIFFERENT MARKETS. Arbitrage 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, since arbitrageurs would RUSH INTO THESE TRANSACTIONS, THUS CLOSING THE PRICE GAP at different locations".

Think of it like this

The shadow and the object

A derivative "is a contract or a product whose value is DERIVED from the value of some other asset known as THE UNDERLYING." A shadow has a length, moves, and can be measured — but it has no existence apart from the object casting it. Move the object and the shadow follows; remove the object and the shadow is gone. This is why every question about a derivative eventually becomes a question about the underlying, and why the list of underlyings is so wide — metals, energy, agri commodities and financial assets, from aluminium and natural gas to wheat, shares, bonds and foreign exchange.

Monks selling wool twenty years early

The most memorable line of the history section is a 13th-century one: "English Cistercian Monasteries... frequently sold their WOOL UP TO 20 YEARS IN ADVANCE, to foreign merchants." That is a forward contract in everything but name, made seven centuries before Chicago. The monks wanted certainty of price for wool not yet grown on sheep not yet born; the merchant wanted certainty of supply. Exactly the same instinct built the Dojima rice market near Osaka in the late 17th century, "to protect rice producers from BAD WEATHER OR WARFARE" — and exactly the same instinct sends an Indian exporter to the currency futures market today.

Tulips, and what speculation can do

The workbook slips one cautionary tale into the timeline: "1634-1637 - TULIP MANIA in Holland: FORTUNES WERE LOST after a speculative boom in TULIP FUTURES BURST." Derivatives magnify — and what they magnify is not always wisdom. A contract on a flower bulb, traded on leverage, made and unmade fortunes in three years. The chapter returns to this theme at the end: derivatives are "leveraged instruments" carrying price risk, counterparty risk, liquidity risk, legal or regulatory risk and operational risk, and "may NOT be an appropriate avenue for someone of LIMITED RESOURCES, or having LIMITED TRADING EXPERIENCE, or with LOW RISK TOLERANCE."

1848 gave forwards; 1865 gave futures

Two dates, seventeen years apart, mark the single most important structural change in the history of this market. "In 1848, The Chicago Board of Trade (CBOT) facilitated trading of FORWARD contracts"; then "In 1865, the CBOT went a step further and listed the FIRST 'EXCHANGE TRADED' DERIVATIVE CONTRACT in the US. These contracts were called 'FUTURES CONTRACTS'." What changed in those seventeen years was not the economics but the plumbing — standard lot sizes, standard maturity dates, an exchange between the parties. That is exactly the distinction the workbook draws today: "futures are EXCHANGE TRADED FORWARD CONTRACTS."

Gupta wrote the rulebook; Varma wrote the safety net

India built its derivatives market with two committees doing two different jobs. The L C Gupta Committee (24 members, set up 18 November 1996, reported 17 March 1998) was asked to "develop appropriate REGULATORY FRAMEWORK" and recommended that derivatives be declared securities. The J R Varma Group (set up June 1998, reported October 1998) was asked "to recommend measures for RISK CONTAINMENT" and worked out margining, initial margins, membership and net worth, deposits and real-time position monitoring. One asked may we trade this? The other asked what stops it blowing up? Confusing the two is the commonest error in this chapter.

The order of the Indian launches

The sequence is not the one most people guess. Index futures (June 2000) → Index options (June 2001) → Options on individual stocks (July 2001) → Futures on individual stocks (November 2001). Stock options came a month before stock futures. India started with the index, the broadest and hardest thing to manipulate, and worked down to single stocks only once the market had a year of experience. MSEI joined much later, in February 2013. If an exam option puts stock futures before stock options, or puts index options first, it is wrong.

Both bound, or only one — the option divide

In a forward or a future, "BOTH the contracting parties are COMMITTED AND ARE OBLIGED to honour the transaction IRRESPECTIVE OF THE PRICE." In an option, "the BUYER... PAYS THE PREMIUM AND BUYS THE RIGHT", while "the WRITER/SELLER... RECEIVES THE PREMIUM WITH THE OBLIGATION". Think of a token paid to reserve a flat: you may walk away and lose only the token; the builder may not walk away at all. That asymmetry is the whole reason a premium exists — the seller is being paid to be the only one who is trapped.

Arbitrage closes the door behind itself

Arbitrage is "a deal that produces profit by exploiting a price difference in a product in TWO DIFFERENT MARKETS" — buying cheap in one place and simultaneously selling dear in another. The crucial second half is what makes markets work: "SUCH OPPORTUNITIES ARE UNLIKELY TO PERSIST FOR VERY LONG, since arbitrageurs would RUSH INTO THESE TRANSACTIONS, THUS CLOSING THE PRICE GAP." The arbitrageur is not a parasite on the market; he is its price-equaliser. Every trade he makes destroys the very opportunity he traded on — which is why the chapter lists him alongside the hedger and the speculator as one of the three necessary participants.

Key terms in this chapter

Arbitrageur: A participant who profits from a price difference for the same product in two markets, buying cheap in one and simultaneously selling dear in the other. Such opportunities close quickly because arbitrageurs rushing in narrow the gap themselves.
Clearing corporation guarantee: The single structural difference that most distinguishes an exchange from the OTC market — the clearing corporation guarantees settlement, so counterparty risk is centralised rather than left inside each institution.
Counterparty risk: The risk of default by the counterparty. On an exchange it is absorbed by the clearing corporation; in the OTC market its management is decentralised and sits within individual institutions.
Derivative: A contract or product whose value is derived from the value of some other asset, known as the underlying. It has no independent value of its own.
Exchange traded derivative: A standardised contract traded on an organised exchange, with prices set by the interaction of buyers and sellers through an anonymous auction platform, and with a clearing corporation guaranteeing contract performance.
Forward: A contractual agreement between two parties to buy or sell an underlying at a future date for a price fixed today. Both parties are obliged to honour it whatever the price at delivery, the terms are customised because the contract is negotiated privately, and it is an over-the-counter contract.
Future: A forward made through an organised and regulated exchange rather than negotiated directly, and standardised in lot size and maturity date so that it can be traded. "Futures are exchange traded forward contracts."
Hedger: A participant who faces risk from the price of an underlying asset and uses derivatives to reduce it. Corporations, investing institutions and banks hedge exposures to interest rates, share and bond prices, currency rates and commodity prices.
J R Varma Group: The group set up by SEBI in June 1998 to recommend measures for risk containment. It reported in October 1998, working out the margining system, the methodology for charging initial margins, membership and net-worth criteria, deposit requirements and real-time monitoring of positions.
L C Gupta Committee: The 24-member committee set up by SEBI on 18 November 1996 to develop a regulatory framework for derivatives trading in India. It reported on 17 March 1998, recommending that derivatives be declared securities so that the securities framework would govern them.
Legal or regulatory risk: The risk that a contract may not be enforceable.
Liquidity risk: The inability to exit from a position.
Model Risk Disclosure Document: A document issued by members of exchanges and given by the broker to the client at the time of signing the agreement, containing important information on trading in both the equities and F&O segments. All prospective participants should read it before trading in either segment.
Operational risk: Loss from fraud, inadequate documentation, improper execution and similar internal failures — risks of how the business is run, as distinct from market or regulatory risks.
Option: A contract giving the right, but not the obligation, to buy or sell the underlying on or before a stated date at a stated price. The buyer pays the premium and acquires the right; the writer receives the premium and carries the obligation if the buyer exercises.
Over-the-counter (OTC) market: Not a physical marketplace but a collection of broker-dealers linked by telephone and electronic media — "more a way of doing business than a place" — where contracts are matched through negotiated bidding.
Price discovery: The first function of the derivatives market — improving the discovery of prices based on actual valuations and expectations.
Risk transfer: The second function — moving risk from those exposed to it but with a low risk appetite to participants with a high risk appetite. Hedgers want to give risk away; traders are willing to take it.
Speculator or trader: A participant who predicts future price movements and takes derivative positions on that view. Derivatives are preferred for trading because they offer leverage, cost less to transact than the underlying, and are faster to execute in size.
Swap: An agreement between two parties to exchange future cash flows according to a prearranged formula — broadly, a series of forward contracts. Swaps help manage risks from volatile interest rates, currency exchange rates and commodity prices.
Underlying: The asset from which a derivative takes its value. Every question about a derivative is ultimately a question about its underlying.

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Original explanatory writing based on the official NISM workbook for Series V-D, which is published and copyrighted by NISM. Check figures against the current edition at nism.ac.in.

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