Derivatives

Topic: Financial Markets, Instruments, Insurance and Pensions · NCERT: Beyond NCERT

Meaning

A derivative is a financial contract between two parties whose value comes from something else, called the underlying. The underlying can be an asset, a rate or an index, such as shares, currencies, commodities or interest rates. The contract has no value of its own. When the price of the underlying moves, the contract's value moves with it.

Derivatives matter because they let firms, farmers and banks pass price risk to people who are willing to carry it. They also let traders bet on prices with only a small amount of money. That is why they are both a hedging tool and a source of large retail losses.

The fair price of a futures contract comes from the cost-of-carry formula: F = S × (1 + r × t), where S = spot price (today's price), r = interest rate per year and t = time to expiry in years.

Explanation

How a derivative works

• Underlying means the asset, rate or index that the contract is based on.

• Example: a Nifty future rises and falls with the Nifty index.

• Notional principal is an amount used only to calculate payments. It usually does not change hands, for example in a swap.

• Where derivatives are traded:
• Over-the-counter (OTC) derivative: a private deal between two parties, made without an exchange. The terms can be tailored to the two parties.

• Exchange-traded derivative: a standard contract traded on an exchange such as NSE, BSE, MCX or NCDEX. A clearing corporation stands between buyer and seller, so neither side carries the risk that the other side defaults (fails to pay).

• Counterparty risk is the risk that the other side will not honour the deal. It is high in OTC deals and low on exchanges.

• Worked example (cost of carry): S = ₹1,000, r = 6%, t = 3 months (0.25). F = 1,000 × 1.015 = ₹1,015.

The five main instruments

Instrument	Key feature	Where traded	Counterparty risk
Forward	A customised deal to buy or sell at a price fixed today, for delivery on a future date	OTC	High
Futures	A standardised forward, settled daily and backed by margins	Exchange	Low
Options	A right but not obligation to buy (call) or sell (put) at a strike price	Exchange and OTC	Low on exchanges
Swap	Two parties exchange streams of cash flows	Mostly OTC	Medium
Credit default swap (CDS)	Protection against a borrower's default	OTC	High

• Forward, used as an exporter hedge:
• An exporter expects USD 1 lakh in 3 months. The spot rate is ₹84/USD.
• The exporter sells the dollars forward at ₹84.50, so the receipt is locked at ₹84.50 lakh.
• If the rupee rises to ₹82/USD, the exporter still gets ₹84.50 lakh. The forward has protected ₹2.5 lakh.

• If the rupee falls to ₹87/USD, the exporter misses the extra gain. Hedging removes risk in both directions.

• Futures and mark-to-market (MTM):

• Margin is a deposit kept with the broker or clearing house as a safety cushion.
  • Initial margin is paid when the trader enters.
  • Maintenance margin is the minimum balance the trader must keep.
• MTM means gains and losses are settled in cash at the end of each day, at that day's closing price. Losses cannot pile up unseen.

• Example: a trader buys 1 lot of 75 units of index futures at 24,000.

  • Day 1 close is 24,100. Gain = 100 × 75 = ₹7,500, credited.
  • Day 2 close is 23,900. Loss = 200 × 75 = ₹15,000, debited.
  • If the margin falls below the maintenance level, a margin call follows. The trader must deposit more money.

• Options:

• Premium is the price the buyer pays the seller (writer) for the right.
• The buyer's loss is limited to the premium. The writer earns at most the premium, but the writer's loss can be very large.
• Payoffs at expiry (S = spot price at expiry, K = strike price):
  • Call buyer: max(S − K, 0) − premium
  • Put buyer: max(K − S, 0) − premium
• Call example: strike ₹100, premium ₹5.
  • If the share ends at ₹120, profit = (120 − 100) − 5 = ₹15.
  • If the share ends at ₹90, the buyer lets the option lapse. The loss is only the ₹5 premium.
  • Break-even = strike + premium = ₹105.

• Moneyness shows where the strike price stands against the spot price:

  • In-the-money: a call with S > K, or a put with S < K.
  • At-the-money: S = K.
  • Out-of-the-money: the reverse of in-the-money.

• Swaps:

• Interest rate swap (IRS): one side pays a fixed rate and the other pays a floating rate. Both are calculated on the same notional principal, and only the net difference is paid.
  • Example: notional ₹100 crore. Company A pays a fixed 7% and receives MIBOR.
  • If MIBOR = 7.5%, A receives ₹50 lakh a year, net. If MIBOR = 6.5%, A pays ₹50 lakh.
• Overnight index swap (OIS): an IRS whose floating leg is an overnight rate. In India this rate is MIBOR (Mumbai Interbank Offered Rate, the rate at which banks lend to each other).

• Currency swap: the two sides exchange principal and/or interest payments in two different currencies. For example, an Indian firm can turn its dollar loan into rupee payments.

• CDS:

• The protection buyer pays regular premiums. If the named borrower (the reference entity) has a credit event such as a default, the seller pays compensation.
• Example: a bank holds ₹100 crore of Company X bonds and buys protection at 2% a year, which is ₹2 crore yearly. X defaults and the bonds recover only ₹40 crore. The CDS seller pays ₹60 crore.

Why people use derivatives

• Hedging means taking an offsetting position to reduce risk.
• A farmer sells futures before harvest.
  • If prices fall at harvest, the farmer gains on the futures.
  • That gain makes up for the lower price of the crop.

• An investor holds a share at ₹500 and buys a put with strike ₹480 for a ₹10 premium. The share crashes to ₹400. The put pays ₹80, so the net protection is ₹70.

• Speculation means betting on price moves without owning the underlying.

• Leverage means a small margin controls a large contract. Gains and losses both get bigger.

• Arbitrage means buying and selling the same asset in different markets at the same time, to profit from a price gap with little or no risk.

• Example: the spot price is ₹1,000 and the futures price is ₹1,030, but the fair price by cost of carry is ₹1,015.
  • Buy in the cash market, sell the futures and hold until expiry.
  • This locks in about ₹15 more than the cost of carry.
• Arbitrage pushes prices in different markets back into line.

In India

• Regulators:
• SEBI regulates exchange-traded securities and commodity derivatives.
• The Forward Markets Commission (FMC), set up in 1953, used to regulate commodity derivatives. It merged into SEBI in 2015.

• RBI regulates credit derivatives such as CDS.

• Exchanges:

• NSE and BSE trade equity F&O (futures and options on stocks and indices).
• MCX trades mostly metals and energy.

• NCDEX trades mostly farm produce.

• Index futures have been traded in India since June 2000, as part of the capital-market reforms that began in the 1990s.

• CDS framework:
• RBI issued the first CDS guidelines in 2011.
• It widened them in the Master Direction – Reserve Bank of India (Credit Derivatives) Directions, 2022, issued on 10 February 2022. [6]
• Under these Directions, retail users may use CDS only for hedging, with physical settlement. Protection cannot exceed the face value of the exposure they hold. [6]
• Market-makers include:
  • scheduled commercial banks (but not small finance, payment, local area or regional rural banks);
  • NBFCs, SPDs and HFCs with net owned funds of at least ₹500 crore, with RBI approval;
  • EXIM Bank, NABARD, NHB, SIDBI and NaBFID. [6]

• RBI released a draft revised Master Direction and invited comments till 27 February 2026. [7]

• Farm futures:

• Futures trading in seven farm commodities has been suspended since December 2021, to curb food inflation and speculation. The seven are wheat, non-basmati paddy, chana, mustard, soybean, crude palm oil and moong.

• SEBI issued a consultation paper in May 2026 on the phased introduction of physical settlement in select agricultural commodity derivatives. [8]

• Retail F&O boom:

• India is the world's largest derivatives market by number of contracts traded. Most of this volume is short-dated index options, often traded on expiry day.
• 93% of individual F&O traders lost money in FY22–FY24. Their aggregate losses were over ₹1.8 lakh crore. [1]
• In FY25, about 91% lost money. Net losses rose 41% to ₹1,05,603 crore, up from ₹74,812 crore in FY24. [2]

• SEBI published two new studies in August 2026 on the profitability and trading behaviour of individual traders for FY25–FY26. [3]

• SEBI circular of 1 October 2024: [4]

• The contract size was raised to ₹15–20 lakh, up from ₹5–10 lakh.
• Each exchange now has only one weekly index expiry.
• The option premium is collected upfront from buyers.
• There is no calendar-spread margin benefit on expiry day. A calendar spread means holding positions in two expiries of the same contract.
• Position limits are now checked during the day (intraday), under a separate October 2024 circular. [5]
• Separately, Budget 2024-25 raised the STT (Securities Transaction Tax, a tax on each trade on the exchange) on F&O.

Don't confuse with

• Forward vs Futures: a forward is a customised OTC deal with high counterparty risk. Futures are standardised, exchange-traded and marked to market daily.
• Futures vs Options: both sides of a futures contract carry an obligation. An option buyer has a right but not an obligation, and only the writer is obliged.
• Call vs Put: a call is the right to buy. A put is the right to sell. A put bought on a share you own works like insurance.
• Interest rate swap vs Currency swap: an IRS swaps fixed and floating interest in one currency, and only the net amount is paid. A currency swap exchanges payments in two different currencies.

Prelims Hooks

• An option buyer pays the premium and has a right, not an obligation. The writer (seller) has the obligation.
• Call payoff = max(S − K, 0) − premium. Futures fair price = F = S × (1 + r × t).
• Index futures in India began in June 2000. In India, the floating leg of an OIS is MIBOR.
• FMC (1953) merged into SEBI in 2015. RBI, not SEBI, governs CDS, through its Credit Derivatives Directions, 2022. Under these, retail users may use CDS only for hedging. [6]
• The trap in the list of suspended farm futures: it has wheat, non-basmati paddy, chana, mustard, soybean, crude palm oil and moong. It does not have basmati rice or sugar.
• SEBI's October 2024 circular set the index derivative contract size at ₹15–20 lakh, up from ₹5–10 lakh. [4]

Mains Points

• Hedging vs speculation:
• Derivatives help price discovery, market depth and risk transfer for farmers, exporters and banks.
• But about 9 in 10 retail F&O traders lose money every year [1][2]. This shows the market serves speculation more than hedging.

• SEBI has chosen to make access harder (bigger contracts, upfront premium, fewer expiries) rather than ban products. [4]

• Household savings and financial stability:

• Retail losses of over ₹1 lakh crore a year [2] shift household savings to proprietary and algorithmic trading firms. This leaves less money for long-term investment, a trend the Economic Survey has warned about.
• OTC products carry a separate risk. In 2008, AIG sold huge amounts of CDS protection that it could not pay out, and the firm nearly failed. This shows how OTC products can spread risk across the whole system.

• India's cautious CDS design protects users [6][7], but it slows the growth of a deep corporate bond market.

• Agricultural futures:

• The suspension since 2021 aims to control food inflation and speculation.
• But it takes away a price-discovery and hedging tool from farmers and FPOs.
• SEBI's 2026 move towards physical settlement [8] points to a gradual reopening. The trade-off is inflation control against market development.

Related concepts

• Forward contract
• Futures
• Options
• Swap
• Interest rate swap
• Credit default swap
• Commodity derivatives
• Hedging
• Arbitrage
• Futures and options trading

Read more

• Derivatives: forwards, futures, options, swaps and CDS