NISM Series X-A · Chapter 10: Understanding Derivatives

L1 · Foundation

Foundation — Derivative basics, underlying concepts and the four products

The two statutory definitions of a derivative, the zero sum game, settlement mechanism, the margining process and open interest, and the four products — forwards with their limitations, futures, options and swaps, plus the role of FIMMDA.

14 min read · Worth 5% of the paper · Written from pages 185–198 of the official NISM workbook · Updated 18 September 2026

10.1 Basics of derivatives

"Derivative is a contract or a product whose value is DERIVED FROM THE VALUE OF SOME OTHER ASSET known as UNDERLYING."

"Derivatives are based on a wide range of underlying assets such as METALS (Gold, silver), ENERGY RESOURCES (oil, coal, gas), AGRI COMMODITIES (wheat, coffee) and FINANCIAL ASSETS (shares, bonds)."

The SCRA definition

"In the Indian context the SECURITIES CONTRACTS (REGULATION) ACT, 1956 defines 'derivative' to include:

"A security DERIVED FROM A DEBT INSTRUMENT, SHARE, LOAN whether SECURED OR UNSECURED, RISK INSTRUMENT OR CONTRACT FOR DIFFERENCES or any other form of security"
"A contract which DERIVES ITS VALUE FROM THE PRICES, OR INDEX OF PRICES, OF UNDERLYING SECURITIES"

The RBI Act definition

"Section 45U(a) of the RBI ACT 1934: "An instrument, TO BE SETTLED AT A FUTURE DATE, whose value is derived from CHANGE IN INTEREST RATE, FOREIGN EXCHANGE RATE, CREDIT RATING OR CREDIT INDEX, PRICE OF SECURITIES (also called 'underlying'), OR A COMBINATION OF MORE THAN ONE OF THEM, and includes INTEREST RATE SWAPS, FORWARD RATE AGREEMENTS, FOREIGN CURRENCY SWAPS, FOREIGN CURRENCY-RUPEE SWAPS, FOREIGN CURRENCY OPTIONS, FOREIGN CURRENCY-RUPEE OPTIONS or such other instruments as may be SPECIFIED BY RBI FROM TIME TO TIME."

10.2 Underlying concepts

Zero sum game

"the counterparties who enter into the contract have OPPOSING VIEWS AND NEEDS. The SELLER of gold futures thinks PRICES WILL FALL... The BUYER thinks PRICES WILL RISE."

"On maturity the market price of the underlying would be THE SAME FOR BOTH the futures contracts, leading to PROFITS TO ONLY ONE OF THEM. But when the NET POSITIONS of both the buyer and seller are considered, IT ALWAYS AMOUNTS TO ZERO."

"However, there are TWO USUAL ASSUMPTIONS to this conclusion, that there are NO TAXES AND NO TRANSACTION COSTS."

Settlement mechanism

"Cash settlement is a settlement method where upon expiration or exercise, the counterparties SETTLE THEIR POSITION THROUGH EXCHANGE OF THE PRICE DIFFERENTIALS and DO NOT DELIVER THE ACTUAL (PHYSICAL) UNDERLYING ASSET."

The margining process

"Margin is defined as the FUNDS OR SECURITIES WHICH MUST BE DEPOSITED BY CLEARING MEMBERS AS COLLATERAL BEFORE EXECUTING A TRADE. The provision of collateral is intended to ensure that ALL FINANCIAL COMMITMENTS related to the OPEN POSITIONS of a Clearing Member CAN BE OFFSET WITHIN A SPECIFIED PERIOD OF TIME."

Margin	Details
Initial margin	"charged ON THE ASSUMPTION THAT THE POSITION WILL BE CARRIED OUT TILL THE EXPIRY of the contract. It has TWO COMPONENTS: SPAN MARGINS and ELM (EXTREME LOSS MARGIN) MARGINS based on exposure. BOTH MARGINS HAVE TO BE MANDATORILY DEPOSITED BEFORE TAKING A TRADE"
Premium margin	"charged to trading members TRADING IN OPTION CONTRACTS... PAID BY THE BUYERS of the Options contracts and is EQUAL TO THE VALUE OF THE OPTIONS PREMIUM MULTIPLIED BY THE QUANTITY of Options purchased"

On SPAN: "The margin calculation is carried out using a software called SPAN (Standard Portfolio Analysis of Risk). It is a product developed by CHICAGO MERCANTILE EXCHANGE (CME) and is extensively used by leading stock exchanges of the world."

Open interest

"the TOTAL NUMBER OF OUTSTANDING DERIVATIVE CONTRACTS THAT HAVE NOT BEEN SETTLED."

"The open interest number ONLY CHANGES when a NEW BUYER AND SELLER ENTER THE MARKET, creating a new contract, OR when a buyer and seller MEET — thereby CLOSING BOTH POSITIONS."

10.3 The four derivative products

"The four commonly used derivative products are FORWARDS, FUTURES, OPTIONS AND SWAPS."

10.3.1 Forwards

"an agreement made DIRECTLY BETWEEN TWO PARTIES to buy or sell an asset ON A SPECIFIC DATE IN THE FUTURE, AT THE TERMS DECIDED TODAY. Forwards are widely used in COMMODITIES, FOREIGN EXCHANGE, EQUITY AND INTEREST RATE MARKETS."

The gold example: on 9 March 2018, gold is Rs 30,425 for 10 gram in the spot market — "This is a CASH MARKET TRANSACTION at a price referred to as SPOT PRICE."

"Now suppose you want to agree to buy gold on 9 March 2018, but TAKE DELIVERY AND PAY ONLY AFTER 1 MONTH. Goldsmith quotes you Rs 30,450 for 10 grams to be delivered after 1 month... THERE IS NO EXCHANGE OF MONEY OR GOLD ON MARCH 9TH. After 1 month, you come back, pay him Rs 30,450 and collect your gold."

"Forwards are BILATERAL OVER-THE-COUNTER (OTC) TRANSACTIONS where the terms — PRICE, QUANTITY, QUALITY, TIME AND PLACE — ARE NEGOTIATED between two parties. Any alteration is possible IF BOTH PARTIES AGREE."

"The ESSENTIAL IDEA of entering into a forward is to FIX THE PRICE AND THEREBY AVOID THE PRICE RISK."

The two major limitations:

Limitation	Explanation
Liquidity risk	"As forwards are TAILOR MADE contracts... other market participants MAY NOT BE INTERESTED. Forwards are NOT LISTED OR TRADED ON EXCHANGES, which makes it DIFFICULT for other participants to easily access these contracts"
Counterparty risk	"the risk of an ECONOMIC LOSS FROM THE FAILURE OF COUNTERPARTY TO FULFIL ITS CONTRACTUAL OBLIGATION... also called DEFAULT RISK OR CREDIT RISK"

The rice illustration: A agrees to buy 100 kg of rice at Rs 20 per kg from B after 6 months. "After 6 months, if the price of rice is Rs 30, then B MAY FOREGO HIS OBLIGATION to deliver at Rs 20. Similarly, if the price falls to Rs 15 then A MAY PURCHASE FROM THE MARKET at a lower price, instead of honouring the contract."

"In addition, there are issues like LACK OF TRANSPARENCY, SETTLEMENT COMPLICATIONS as it is to be done directly between the contracting parties. SIMPLE SOLUTION TO ALL THESE ISSUES LIES IN BRINGING THESE CONTRACTS TO THE CENTRALIZED TRADING PLATFORM. THIS IS WHAT FUTURES CONTRACTS DO."

10.3.2 Futures

"Futures markets were innovated TO OVERCOME THE LIMITATIONS OF FORWARDS. A futures contract is an agreement made THROUGH AN ORGANIZED EXCHANGE to buy or sell a FIXED AMOUNT of a commodity or financial asset on a future date at an agreed price. Simply, FUTURES ARE STANDARDISED FORWARD CONTRACTS TRADED ON AN EXCHANGE."

"EXCHANGE BECOMES COUNTERPARTY TO BOTH BUYER AND SELLER of a futures contract THROUGH A CLEARING HOUSE. Futures create an OBLIGATION on BOTH buyer and seller's part... The CLEARING CORPORATION associated with the exchange GUARANTEES SETTLEMENT."

"The words BUY AND SELL ARE FIGURATIVE ONLY because NO MONEY OR UNDERLYING ASSET CHANGES HANDS when the deal is signed."

The six features: "In the futures market, EXCHANGE DECIDES ALL THE CONTRACT TERMS OTHER THAN PRICE":

Contract between two parties is THROUGH EXCHANGE
CENTRALISED TRADING PLATFORM i.e. exchange
PRICE DISCOVERY through FREE INTERACTION of buyers and sellers
MARGINS are payable BY BOTH THE PARTIES
QUALITY decided today (standardized)
QUANTITY decided today (standardized)

10.3.3 Options

"a contract that gives its buyers the RIGHT, BUT NOT AN OBLIGATION, to buy or sell the underlying asset ON OR BEFORE A STATED DATE/DAY, AT A STATED PRICE, FOR A PREMIUM."

"The party taking a LONG position i.e. BUYING the option is called BUYER/HOLDER and the party taking a SHORT position i.e. SELLING the option is called the SELLER/WRITER."

Type	Right given
Call option	"gives buyer a RIGHT TO BUY the underlying asset"
Put option	"gives buyer a RIGHT TO SELL the underlying asset"

Moneyness: "In-The-Money, At-The-Money, and Out-of-The-Money, depending on whether the STRIKE PRICE is GREATER, EQUAL, OR LESSER THAN the underlying asset's market price, respectively."

"When the underlying asset's price is GREATER than the strike price, in the case of a CALL option, the investor would benefit by exercising and BUY THE ASSET AT THE STRIKE PRICE, AND IMMEDIATELY SELL IT IN THE MARKET AT A HIGHER PRICE. In the same manner THERE IS NO GAIN in the case of AT-THE-MONEY and there would be a LOSS in the case of OUT-OF-THE-MONEY."

The two values:

Time value — "the EXCESS PRICE a buyer is ready to pay OVER AND ABOVE THE INTRINSIC VALUE... with an intention that the value WOULD INCREASE IN THE FUTURE, especially when there is ADEQUATE TIME FOR MATURITY"
Intrinsic value — "the EXCESS OF THE CURRENT PRICE OVER AND ABOVE THE STRIKE PRICE. Essentially IN-THE-MONEY OPTIONS HAVE POSITIVE INTRINSIC VALUE and hence CAN GENERATE GAINS for option holders"

10.3.4 Swaps

"a contract in which TWO PARTIES AGREE TO A SPECIFIED EXCHANGE OF CASH FLOWS ON A FUTURE DATE(S). INTEREST RATE SWAPS AND CURRENCY SWAPS ARE MOST COMMON."

The chapter's example. A borrower pays a quarterly floating rate defined as the Treasury bill rate plus a spread, but "PREFERS TO PAY A FIXED RATE." She enters a swap to:

"PAY A FIXED RATE to the swap dealer every quarter"
"RECEIVE T-BILL PLUS SPREAD from the swap dealer every quarter"

"The borrower will USE THE FLOATING RATE SHE RECEIVED from the swap market and PAY THE FLOATING RATE DUES ON HER BORROWING. THESE TWO LEGS ARE THUS CANCELLED, and her NET OBLIGATION IS THE PAYMENT OF A FIXED INTEREST RATE. By using the swap market, the borrower has CONVERTED HIS FLOATING RATE BORROWING INTO A FIXED RATE OBLIGATION."

"Though swap transactions are OTC, they are GOVERNED BY RULES AND REGULATIONS ACCEPTED BY SWAP DEALER ASSOCIATIONS."

The role of FIMMDA

"The FIXED INCOME MONEY MARKET AND DERIVATIVES ASSOCIATION OF INDIA (FIMMDA) is an Association of COMMERCIAL BANKS, FINANCIAL INSTITUTIONS AND PRIMARY DEALERS. FIMMDA is a VOLUNTARY MARKET BODY for the BOND, MONEY AND DERIVATIVES MARKETS."

The eight objectives:

"To function as the PRINCIPAL INTERFACE WITH THE REGULATORS"
"To undertake DEVELOPMENTAL ACTIVITIES, such as, introduction of BENCHMARK RATES AND NEW DERIVATIVES INSTRUMENTS"
"To provide TRAINING AND DEVELOPMENT SUPPORT to dealers and support personnel"
"To ADOPT/DEVELOP INTERNATIONAL STANDARD PRACTICES AND A CODE OF CONDUCT"
"To devise STANDARDIZED BEST MARKET PRACTICES"
"To function as an ARBITRATOR FOR DISPUTES between member institutions"
"To develop STANDARDIZED SETS OF DOCUMENTATION"
"To assume ANY OTHER RELEVANT ROLE facilitating smooth and orderly functioning"

Think of it like this

The goldsmith example, and what "no exchange of money" really means

The chapter's forward is built from an ordinary Indian transaction. Spot: pay Rs 30,425 and walk out with gold. Forward: agree a price of Rs 30,450 for delivery in a month, and "THERE IS NO EXCHANGE OF MONEY OR GOLD ON MARCH 9TH." Only an agreement changes hands. And it binds absolutely — "BOTH THE PARTIES ARE OBLIGED TO GO THROUGH WITH THE CONTRACT IRRESPECTIVE OF THE VALUE OF THE UNDERLYING ASSET at the point of delivery." You are long forward; the goldsmith is short forward.

The rice contract fails in both directions

Counterparty risk is usually explained as one side going bust. The chapter's illustration is sharper: it shows the contract failing whichever way prices move. Rice agreed at Rs 20. If the market goes to Rs 30, "B MAY FOREGO HIS OBLIGATION" to sell cheap. If it falls to Rs 15, "A MAY PURCHASE FROM THE MARKET at a lower price, instead of honouring the contract." The principle stated: "a party MAY DEFAULT ON HIS OBLIGATION IF THERE IS INCENTIVE TO DEFAULT." Honesty here is a function of price, not character — which is exactly why exchanges exist.

Zero sum, minus taxes and transaction costs

The chapter makes the standard claim and then quietly qualifies it. "When the NET POSITIONS of both the buyer and seller are considered, IT ALWAYS AMOUNTS TO ZERO" — one side's gain is exactly the other's loss. But note the footnote: "there are TWO USUAL ASSUMPTIONS to this conclusion, that there are NO TAXES AND NO TRANSACTION COSTS." In the real world derivatives are a negative sum game for the two participants taken together; the difference goes to the exchange, the broker and the exchequer.

Open interest is not volume

The chapter flags this explicitly: "HOWEVER, IT IS TO BE NOTED THAT IT IS NOT TRADING VOLUME." Open interest counts contracts still alive, and it "ONLY CHANGES when a NEW BUYER AND SELLER ENTER THE MARKET... OR when a buyer and seller MEET — thereby CLOSING BOTH POSITIONS." A contract merely passing from one holder to another raises volume and leaves open interest untouched. Hence the reading: "INCREASING open interest represents NEW OR ADDITIONAL MONEY COMING INTO the market while DECREASING open interest indicates MONEY FLOWING OUT."

Stock derivatives deliver; index derivatives cannot

A rule with an obvious reason once you see it. "SEBI HAS MANDATED PHYSICAL SETTLEMENT... FOR ALL STOCK DERIVATIVES whereas INDEX DERIVATIVES ARE CASH SETTLED." You can hand over 500 shares of a company; you cannot hand over "the Nifty", which is a calculation rather than a thing. So index contracts settle "through EXCHANGE OF THE PRICE DIFFERENTIALS", with no delivery of any underlying asset at all.

The initial margin is sized to cover 99 cases out of 100

Margin is not a deposit chosen by habit; it is calibrated. "The initial margin should be LARGE ENOUGH TO COVER THE LOSS IN 99 PER CENT OF THE CASES", with the corollary that "the GREATER THE VOLATILITY of the stock, GREATER THE RISK and therefore GREATER IS THE INITIAL MARGIN." It has two mandatory components — SPAN and ELM — and the software behind it, SPAN, was "developed by CHICAGO MERCANTILE EXCHANGE" and is used by leading exchanges worldwide.

A swap cancels one leg against another

The elegance of the chapter's swap example is in what happens after the trade. The borrower owes floating on her loan and now receives floating from the dealer: "THESE TWO LEGS ARE THUS CANCELLED, and her NET OBLIGATION IS THE PAYMENT OF A FIXED INTEREST RATE." She has not repaid the loan or renegotiated it — she has overlaid a second contract that converts its character. "the borrower has CONVERTED HIS FLOATING RATE BORROWING INTO A FIXED RATE OBLIGATION."

Notional means exactly that

In a swap "the principal amount... is AGREED UPON between counterparties and IS NEVER EXCHANGED. ONLY THE INTEREST RATE on this amount IS EXCHANGED on each settlement date. The principal amount is also known as NOTIONAL AMOUNT." A Rs 100 crore swap never involves Rs 100 crore moving anywhere. The figure exists solely to compute the interest that does move — which is why swap markets can be enormous in notional terms while the actual cash flows are modest.

Key terms in this chapter

Asymmetric payoff: The property of options that the upside and downside are not uniform. The buyer's loss is limited to the premium while profit is open-ended; the writer's profit is the premium while loss is theoretically unlimited.
Basis: The difference between spot price and futures price. If futures trade above spot, the basis is positive. Arbitrage profit exists when a trader's cost of carry differs from the basis.
Carry cost: The interest cost of holding the underlying to the futures delivery date, being the difference between spot and futures price. It is not a risk-free or fixed rate but market-driven, set by the risk lenders assume.
Cash settlement: Settling a derivative on expiry or exercise through exchange of price differentials, without delivering the actual physical underlying asset. Index derivatives are cash settled.
Counterparty risk: The risk of economic loss from the failure of a counterparty to fulfil its contractual obligation. Also called default risk or credit risk, and a party may default if there is incentive to do so.
Currency pair: The defining feature of the currency market, where every trade buys one currency with another. Indian currency derivatives cover USD, EUR, GBP and JPY, with cross currency contracts on EUR-USD, GBP-USD and USD-JPY.
Derivative: A contract or product whose value is derived from the value of some other asset known as the underlying, which may be metals, energy resources, agri commodities or financial assets.
Exchange traded derivative: A standard contract defined by an exchange and usually settled through a clearing house, with margins enabling anonymous parties to contract on the strength of the settlement process.
FIMMDA: The Fixed Income Money Market and Derivatives Association of India, a voluntary market body of commercial banks, financial institutions and primary dealers, serving as the principal interface with regulators and arbitrating disputes between members.
Forward contract: An agreement made directly between two parties to buy or sell an asset on a specific future date at terms decided today, with both parties obliged regardless of the underlying value at delivery.
Futures contract: An agreement made through an organized exchange to buy or sell a fixed amount of a commodity or financial asset on a future date at an agreed price. Futures are standardised forwards traded on an exchange.
Hedging: Using derivatives to protect the desired value of an existing investment from the risk of future price movements.
Initial margin: Margin charged on the assumption the position is held to expiry, comprising SPAN and ELM components, both mandatory, sized to cover the loss in 99 per cent of cases and rising with volatility.
Intrinsic and time value: Intrinsic value is the excess of current price over the strike price, positive only for in-the-money options. Time value is the excess price a buyer pays above intrinsic value, expecting the option to gain in value.
Law of one price: Two identical assets cannot trade at different prices in two markets, since arbitrage would otherwise produce riskless profit. Differences persist only to the extent of transaction costs.
Long and short forward: The buyer in a forward is long forward; the seller is short forward.
Margin: Funds or securities deposited by clearing members as collateral before executing a trade, so that financial commitments on open positions can be offset within a specified period.
Model Risk Disclosure Document: A document issued by exchange members and given by the broker to clients at the time of signing the agreement, containing important information on trading in the equities and F&O segments.
Notional amount: The principal amount in a swap on which interest is computed. It is agreed between counterparties and never exchanged; only the interest is exchanged on each settlement date.
Open interest: The total number of outstanding derivative contracts not yet settled. It is not trading volume; rising open interest means new money entering the market and falling open interest means money flowing out.
Option: A contract giving the buyer the right but not the obligation to buy or sell the underlying on or before a stated date at a stated price, for a premium. The writer has the obligation but no right.
OTC derivative: A contract settled between counterparties on mutually agreed terms, non-standard and dependent on trust, prevalent only between institutions comfortable dealing with each other.
Premium margin: Margin charged on option contracts, paid by the buyers, equal to the value of the option premium multiplied by the quantity purchased.
RBI Act definition: Under Section 45U(a), an instrument to be settled at a future date whose value derives from change in interest rate, foreign exchange rate, credit rating or index, or price of securities, including swaps, FRAs and currency options.
SCRA definition of derivative: A security derived from a debt instrument, share or loan, a risk instrument or contract for differences, and a contract deriving value from the prices or index of prices of underlying securities. Derivatives are securities under the SCRA.
SPAN: Standard Portfolio Analysis of Risk, the margin calculation software developed by the Chicago Mercantile Exchange and used by leading exchanges worldwide.
Speculation: A derivative trade not supported by any underlying existing investment, implementing a strategy based purely on a view about future prices. Its cost lies in managing the required margins.
Spot-future convergence: The property that on settlement date spot and futures prices are identical, because the carry cost to settlement is zero. It is what locks in an arbitrage profit.
Swap: A contract where two parties agree to a specified exchange of cash flows on future dates. Interest rate swaps and currency swaps are the most common.
Zero sum game: The property that the net positions of buyer and seller in a derivative always amount to zero, assuming no taxes and no transaction costs.

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

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