NISM Series VII Chapter I (Part 2): Derivatives, Debt Markets, and Alternative Asset Classes

This study guide covers the second part of Chapter I of the NISM Series VII curriculum. It focuses on derivative markets, debt market structures (government and corporate), and alternative asset classes like Real Estate Investment Trusts (REITs), Infrastructure Investment Trusts (InvITs), and Sovereign Gold Bonds (SGBs).

1. The Derivative Market and its Products

A derivative is a financial contract whose value is determined by (or derived from) one or more basic variables, known as bases or underlying assets. These underlying variables can include tangible assets, market indices, or reference rates. Derivatives are structured contractually to allow market participants to manage risk, speculate, or leverage positions.

Major Derivative Products and Their Structures

A. Forward Contracts

• Definition: A forward contract is a bilateral agreement containing a promise to deliver a specific asset at a predetermined future date and at a price agreed upon today.
• Trading Venue: These are informal, non-standardized contracts that are traded and settled over-the-counter (OTC) directly between the two counterparties.
• Settlement: Settlement occurs bilaterally between the buyer and the seller at the contract's maturity.

B. Futures Contracts

• Definition: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price.
• Trading Venue: Unlike forward contracts, futures are highly standardized and trade actively on recognized, regulated stock exchanges.
• Key Properties: Standardisation of contract sizes, maturity dates, and centralized clearing through exchange clearing corporations minimize counterparty credit risks.

C. Options Contracts

• Definition: Options are derivative instruments that grant the buyer (also called the holder) the right, but not the obligation, to buy or sell an underlying asset in the future at a set price.
• Types of Options:
  1. Call Option: Grants the holder the right to buy the underlying asset.
  2. Put Option: Grants the holder the right to sell the underlying asset.
• Positions: The buyer pays a premium to acquire this right, while the seller (writer) of the option takes on the obligation and receives the premium.

D. Swap Contracts

• Definition: A swap is a derivative contract in which two counterparties agree to exchange cash flows of one party's financial instrument for those of the other party's financial instrument over a specified period.
• Common Use: Typically used to exchange interest rate cash flows (e.g., fixed rate for floating rate) or foreign currency cash flows.

Comparison Matrix: Key Derivative Products

2. Derivatives Traded in India

The Indian capital markets support a robust suite of exchange-traded derivative contracts. The primary categories of derivatives cleared and traded on recognized Indian exchanges include:

• Index Futures and Options: Contracts where the underlying asset is a domestic stock market index (such as NIFTY or SENSEX).
• Stock Futures and Options: Derivatives structured around individual corporate equity shares traded on the exchange.
• Currency Derivatives: Contracts that allow hedging or trading based on foreign exchange rate fluctuations.
• Interest Rate Derivatives / Interest Rate Futures (IRF): Instruments tied to interest rates or specific government bond yields.
• Derivatives on Foreign Stock Indices: Exchange-traded products that allow Indian investors to trade movements in overseas market indices.
• Commodity Derivatives: Futures and options contracts where the underlying assets are physical commodities (such as metals, energy, or agricultural products).
• Bond Futures: Contracts based on the future pricing of specific debt securities.

3. The Debt Market and its Products

The debt market consists of bonds and debentures, which provide structured financing through the issuance of debt instruments and facilitate subsequent trading of those securities. Debt instruments can be traded through both Over-the-Counter (OTC) channels and formal Exchange-traded markets.

In India, the debt market is broadly segmented into two key sectors based on the nature of the issuer:

A. The Government Securities Market

The government requires vast amounts of capital to perform essential public functions, including:

• Maintaining law and order and the justice system.
• Funding national defence and security.
• Enabling central banking and monetary policies.
• Constructing critical physical infrastructure (roads, bridges, ports, etc.).

To fund these extensive expenditures, the government raises revenues through taxation and by borrowing from banks, financial institutions, and the public by issuing Government Securities (G-Secs).

B. The Corporate Bond Market

The corporate bond or corporate debt market is the financial arena where private and public sector companies issue and trade debt securities to meet their business requirements.

• Purpose of Issuance: Firms issue corporate bonds to finance business expansion, operational modernization, corporate restructuring, and mergers and acquisitions (M&As).
• Key Corporate Debt Instruments: The corporate debt market facilitates the trading of various short-term and long-term securities, including corporate bonds, Treasury bills (T-bills), commercial papers (CPs), and certificates of deposits (CDs).
• Issuance Routes: Corporates can raise debt resources in the primary market using two distinct methods:
  1. Public Offering Route: Debt instruments are offered openly to the general investing public.
  2. Private Placement Route: Debt securities are offered exclusively to a select, restricted group of investors.

4. Other Asset Classes: REITs, InvITs, and SGBs

To provide retail and institutional investors with diversified investment vehicles, the Indian regulatory framework supports specialized structured products.

A. Real Estate Investment Trusts (REITs)

• Structure: REITs are specialized investment trusts registered with the Securities and Exchange Board of India (SEBI).
• Investment Objective: They pool capital from investors to invest directly in income-generating commercial real estate assets.
• Assets Definition: REIT assets refer to real estate assets and any other assets held by the trust, whether held on a freehold or leasehold basis. These holdings can be owned directly, through a holding company, or via a special purpose vehicle (SPV).

B. Infrastructure Investment Trusts (InvITs)

• Structure: InvITs are collective investment trusts registered with SEBI designed for the infrastructure sector.
• Investment Objective: They pool money from investors to invest in completed or ongoing infrastructure projects (such as highways, power transmission lines, and pipelines).
• Fundraising Channels: InvITs are permitted to raise capital through the public issue route (open to all investors) or through the private placement route (restricted to select groups).

C. Sovereign Gold Bond Scheme (SGB)

• Inception: Launched by the government in 2015.
• Primary Objective: To offer investors a safe, systematic alternative to holding physical gold as an investment asset.
• Nature of the Instrument: SGBs are government securities denominated in grams of gold.
• Key Features:
  • Denomination: The bonds are issued in denominations of one gram of gold and multiples thereof.
  • Tenor: The maturity period (tenor) of an SGB is strictly 8 years.
  • Transaction Currency: Investors buy the bonds using Indian Rupees (INR) and, upon redemption at maturity, are paid the equivalent value in Indian Rupees (INR) based on the prevailing gold price.

5. Exam-Focused Highlights: Key Terms & Definitions

• Underlying Asset (Base): The core asset, index, or interest rate from which a derivative contract derives its financial value.
• Standardisation vs. Customisation: Futures are standardized and exchange-traded, making them highly liquid. Forwards are non-standardized and negotiated bilaterally OTC, exposing parties to direct counterparty settlement risk.
• Corporate Bond Purposes: Corporate debt is issued explicitly for expansion, modernization, restructuring, or mergers.
• SGB Maturity (Tenor): Ensure you memorize that Sovereign Gold Bonds have a fixed maturity period of 8 years.
• REIT Ownership Structure: REIT assets can be held directly by the trust or indirectly through a holding company or a Special Purpose Vehicle (SPV).