NISM Series VIII Equity Derivatives Certification Guide: Chapter 1 — Basics of Derivatives (Part 1)

1. Introduction to Derivatives

What is a Derivative?

A derivative is a contract or a product whose value is derived from the value of some other asset, which is known as the underlying. The derivative contract itself has no independent value; its price movements are entirely dependent on the price fluctuations of the underlying asset.

Types of Underlying Assets

Derivatives can be based on a very wide range of underlying assets across financial and commodity markets:

• Metals: Gold, Silver, Aluminium, Copper, Zinc, Nickel, Tin, Lead, etc.
• Energy Resources: Crude oil, oil products, cracks, Coal, Electricity, Natural Gas, etc.
• Agricultural Commodities: Wheat, Sugar, Coffee, Cotton, Pulses, etc.
• Financial Assets: Shares (individual stocks), Bonds (interest-bearing debt), and Foreign Exchange (currencies).

2. History and Evolution of Derivatives Markets

The practice of derivatives trading dates back several centuries, evolving from informal trade commitments to highly structured, exchange-traded financial instruments.

Global Milestones in Derivatives History

• 12th Century: In European trade fairs, sellers began signing contracts promising the future delivery of the goods they sold.
• 13th Century: English Cistercian Monasteries frequently sold their wool up to 20 years in advance to foreign merchants, demonstrating early long-term forward commitments.
• 1634–1637 (Tulip Mania): Holland experienced a massive speculative boom in tulip futures. The burst of this bubble resulted in devastating financial losses for speculators.
• Late 17th Century: In Japan at Dojima (near Osaka), a futures market in rice was developed to protect rice producers from the adverse economic impacts of bad weather or warfare.
• 1848: The Chicago Board of Trade (CBOT) was established in the US, facilitating the organized trading of forward contracts on various physical commodities.
• 1865: The CBOT listed the first "exchange-traded" derivative contracts in the United States, which were formally named futures contracts.
• 1919: The Chicago Butter and Egg Board (a spin-off of CBOT) was reorganized to allow futures trading. It was subsequently renamed the Chicago Mercantile Exchange (CME).
• 1972: The CME introduced the International Monetary Market (IMM), which launched the world’s first currency futures contracts.
• 1973: The Chicago Board Options Exchange (CBOE) was established, becoming the first marketplace in the world for trading standardized, listed option contracts.
• 1975: CBOT introduced the Treasury bill futures contract, marking the launch of the first successful pure interest rate futures contract.
• 1977: CBOT introduced the Treasury bond (T-bond) futures contract.
• 1982: The CME launched the Eurodollar futures contract. In the same year, the Kansas City Board of Trade launched the world’s first stock index futures contract.
• 1983: The CBOE introduced options on stock indices, launching contracts based on the S&P 100 (OEX) and S&P 500 (SPX) indices.

Factors Driving the Global Growth of Financial Derivatives

Over the past five decades, the global derivatives market has grown phenomenally. The key drivers behind this expansion include:

1. Increased Price Volatility: Sharp fluctuations in underlying asset prices (such as currencies, stocks, and interest rates) in global financial markets heightened the need for hedging tools.
2. Global Integration: Financial markets have become highly integrated across different countries, allowing capital and risk to be managed globally.
3. Technological Advancements: Developments in communication and information technology have dramatically reduced transaction costs and enabled real-time pricing.
4. Risk Management Sophistication: Market participants have developed a much stronger understanding of advanced, mathematical risk management tools to isolate and mitigate exposures.
5. Product Innovation: Financial engineers have introduced frequent innovations and customized applications of derivative products to meet specific consumer demands.

3. Evolution of the Indian Derivatives Market

The introduction of derivatives trading in India was a carefully planned, phased regulatory process initiated in the late 1990s.

Key Regulatory Committees and Milestones

1. The Dr. L.C. Gupta Committee (1996)

• Set up: Set up by the Securities and Exchange Board of India (SEBI) on November 18, 1996, under the Chairmanship of Dr. L.C. Gupta.
• Objective: To develop an appropriate regulatory framework for derivatives trading in India.
• Report Submitted: March 17, 1998.
• Key Recommendation: The committee recommended that derivatives should be declared as "securities" under the law so that the existing regulatory framework governing cash securities trading could also cover and govern derivatives trading.

2. The Prof. J.R. Varma Committee (1998)

• Set up: Set up by SEBI in June 1998 under the Chairmanship of Prof. J.R. Varma.
• Objective: To formulate risk containment measures for the Indian derivatives market.
• Report Submitted: October 1998.
• Key Contribution: The committee worked out the operational mechanics of the Indian margining system, initial margin calculations (using the Value at Risk approach), membership net-worth criteria, security deposits, and real-time position monitoring requirements.

3. Legislative Amendments (1999–2000)

• SCRA Amendment (1999): In 1999, the Securities Contracts Regulation Act (SCRA), 1956 was amended to officially include "derivatives" within the statutory definition of "securities".
• Repeal of Forward Trading Prohibition (2000): In March 2000, the Government of India repealed a three-decade-old notification that had prohibited forward trading in securities, clearing the path for exchange-traded equity derivatives.

Chronology of Indian Derivatives Market Launches

Exchange-traded equity derivatives officially commenced in India in June 2000 when SEBI permitted the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) to open their equity derivatives segments.

The products were introduced in the following chronological order:

• June 2000: Launch of Index Futures contracts based on the Nifty 50 and S&P BSE Sensex indices.
• June 2001: Commencement of trading in Index Options.
• July 2001: Commencement of trading in Options on Individual Stocks.
• November 2001: Launch of Futures contracts on Individual Stocks.
• February 2013: Metropolitan Stock Exchange of India Limited (MSEI) commenced trading in equity derivative products.

4. Key Products in the Derivatives Market

Derivatives can be categorized into four primary contract types: Forwards, Futures, Options, and Swaps.

Forwards

A forward contract is a bilateral, contractual agreement between two parties to buy or sell an underlying asset at a specified future date for a pre-decided price.

• Trading Venue: Over-the-counter (OTC) markets (not traded on organized exchanges).
• Contract Specifications: Highly customized, negotiated directly between the two counterparties to fit their exact specifications (e.g., exact quantity, quality, delivery date, and delivery location).
• Obligation: Both counterparties are committed and legally obliged to execute the transaction at maturity, regardless of the prevailing market price of the underlying asset at the time of delivery.
• Major Limitations of Forwards:
  • Liquidity Risk: Because contracts are highly customized and negotiated privately, there is no active secondary market. It is extremely difficult for a party to exit or transfer their position before maturity.
  • Counterparty (Credit) Risk: This is the default risk. Because there is no central clearing guarantor, either party might default on their obligation if they have a financial incentive to do so (e.g., if market prices move heavily in favor of one party).

Futures

A futures contract is an agreement to buy or sell a standardized quantity of an underlying asset on a specific future date at an agreed price, executed through an organized, regulated exchange.

• Trading Venue: Organized and regulated Stock Exchanges.
• Standardization: The exchange standardizes all contract terms (including lot size, tick size, and maturity dates), leaving only the price open to negotiation.
• Guaranteed Settlement: The Clearing Corporation associated with the exchange acts as the central counterparty to every trade (a legal process known as novation), guaranteeing the performance and settlement of all contracts and eliminating bilateral credit risk.
• Margins: Both the buyer (long position) and the seller (short position) must pay upfront margins to cover potential default risk, and positions are settled daily via Mark-to-Market (MTM) margins.

Options

An option contract provides the buyer with the right, but not the obligation, to buy or sell the underlying asset on or before a specified date at a predetermined price.

• Call Option: Gives the buyer the right to buy the underlying asset.
• Put Option: Gives the buyer the right to sell the underlying asset.
• Option Buyer/Holder: Pays an upfront price called the option premium to acquire this right. Their potential loss is strictly capped at the premium paid, while their profit potential is theoretically unlimited.
• Option Seller/Writer: Receives the premium upfront and assumes the legal obligation to buy or sell the underlying asset if the buyer decides to exercise their right. Their maximum profit is capped at the premium received, while their potential loss is theoretically unlimited.

Swaps

A swap is a private agreement made between two counterparties to exchange a series of cash flows in the future according to a prearranged, mathematical formula.

• Trading Venue: Over-the-counter (OTC) markets.
• Nature: Broadly speaking, a swap is structured as a series of forward contracts bundled together.
• Use Cases: Swaps are heavily utilized by corporations and financial institutions to manage and hedge long-term risks associated with volatile currency exchange rates, commodity prices, and interest rates.

5. Summary Table: Forwards vs. Futures

The operational and structural differences between Forwards and Futures are critical for both exam preparation and market operations:

6. Key Takeaways for Chapter 1 (Part 1)

1. Grounded Valuation: A derivative has no intrinsic physical value of its own; it inherits and mirrors the value of its underlying.
2. The L.C. Gupta Recommendation: The declaration of derivatives as "securities" under the SCRA in 1999 was the critical legal reform that allowed a formal regulatory structure to oversee derivatives trading in India.
3. Exchange-Traded Beginning: Indian derivatives started with index futures in June 2000 before expanding to stock-specific options and futures in late 2001.
4. Standardization is Key: Futures contracts eliminated the default and illiquidity issues of forward contracts by standardizing trade terms and introducing a central clearing guarantor.