NISM Series VIII: Equity Derivatives | Chapter 1: Basics of Derivatives | Complete Notes
CHAPTER 1: BASICS OF DERIVATIVES
1.1 BASICS OF DERIVATIVES
Derivatives are contracts whose worth comes from the 'underlying'
Examples of common 'Underlyings':
Metals: Gold, silver, and copper
. Energy sources: Oil, coal, and natural gas
. Farm products: Wheat, sugar, and cotton
. Financial items: Stocks, bonds, and money from different countries (currencies)
.
1.2 DERIVATIVES MARKET AND HISTORY
| Year | Event | Description |
| 1996 | Gupta Committee Formation | SEBI sets up a committee to draft a regulatory framework for derivatives |
| 1998 | Gupta Committee Report | Recommends derivatives be classified as 'securities' to bring them under the same regulatory framework as other securities |
| 1998 | Varma Committee Report | Focus on risk containment measures; details operational requirements (margin, deposits, position monitoring etc.) for derivatives trading |
| 1999 | Amendment of SCRA | Derivatives included under securities regulation |
| 2000 | Repeal of Forward Trading Ban | Legal barriers to derivatives trading (three-decade-old notification prohibiting forward trading) removed |
| 2000 | Start of Exchange Traded Derivatives | SEBI enables BSE and NSE to offer index futures |
| 2001 | Expansion in Derivatives Trading | Introduction of index options and options/futures on individual stocks |
| 2013 | MSEI Trading Derivatives | MSEI begins offering derivative products, further expanding market options |
1.3 TYPES OF DERIVATIVE PRODUCTS
1. Forwards
Private agreements between two parties to buy or sell an asset at a specified price on a future date
. Not traded on exchanges; these are over-the-counter (OTC) deals traded directly between parties without public exchange
.
2. Futures
Similar to forwards but are traded on an exchange, making them standardized in terms of contract size, expiration, and other terms
. Require a margin deposit to honor the transaction or maintain a position in a futures contract
.
3. Options
Contracts that give you the right to buy or sell something at a set price within a specific time frame, but you don't have to use them if you don't want to
. Offer more flexibility because the buyer is not obligated to complete the transaction
.
4. Swaps
An agreement to trade (swap) cash flows or snacks every day (e.g., swapping an apple for a banana with a friend)
. Provide flexibility as the buyer is not obligated to complete the transaction
.
1.4 MARKET PARTICIPANTS
Hedgers: Individuals or companies that use derivatives to protect themselves against potential losses due to price fluctuations in underlying assets (e.g., an airline using fuel derivatives to hedge against rising jet fuel prices)
Speculators (Traders): They engage in the market to profit from fluctuations in the price of derivatives
. They seek leverage, lower transaction costs, and faster execution . Arbitrageurs: They exploit price differences for the same asset in different markets
. The primary goal is to make profits with minimal/zero risk by reacting instantly to market opportunities .
1.5 TYPES OF DERIVATIVES MARKET
| Aspect | OTC Derivatives | Exchange-Traded Derivatives |
| Participants | Banks, hedge funds, corporations, HNIs | General public and various financial entities |
| Venue | No specific location; done via brokers & dealers | Organized exchanges |
| Regulation | Less regulated & transparent; private transactions | Highly regulated; transactions are public |
| Customization | Tailor-made to fit specific needs | Standardized contracts |
| Risk Mgmt | Each party manages its own risk; no centralized oversight | Centralized risk management through clearing houses |
| Enforcement | Relies on bilateral agreements/trust; no central guarantee | Guaranteed by clearing corporations |
1.6 SIGNIFICANCE & FACTORS OF GROWTH
Factors Influencing Growth
Increased Volatility: Financial markets have become more unpredictable
. Risk Management: Derivatives offer quick ways to protect investments against rapid market changes
. Technology & Connectivity: Advances have made trading cheaper and easier, attracting global participation
.
Market Significance
Price Discovery: Helps understand the probable fair value of assets based on future market expectations
. Market Stability: Regulating trading maintains order and integrity, helping to prevent crises
.
1.7 VARIOUS RISKS IN DERIVATIVES MARKET
Counterparty Risk: The risk that the other party will not fulfill their obligations
. Price Risk: The risk of losing money due to unfavorable movements in the underlying asset's price
. Liquidity Risk: The risk of not being able to quickly exit a position without significant losses
. Legal or Regulatory Risk: The risk that changes in laws will impact the contract's value or enforceability
. Operational Risk: Risks from operational failures such as fraud, errors in trading, or inadequate documentation
.
Dhaval Visariya
AMFI Registered Distributor (ARN-327925) | Software Developer & Finance Enthusiast
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Disclaimer: I am an AMFI Registered Mutual Fund Distributor. Views expressed here are for educational purposes. Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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