Derivatives: forwards, futures, options, swaps and CDS

Detail

1. What a derivative is

• Derivative = a contract whose value comes from an underlying asset, such as shares, currencies, commodities or interest rates.
• The contract has no value of its own. If the underlying price moves, the contract's value moves too.

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

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

• Notional principal = the amount used only to calculate payments. It usually does not change hands, for example in a swap.
• Over-the-counter (OTC) derivative = a private deal between two parties, made without an exchange. Its terms can be tailored to the 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 other's default risk.

2. The five main instruments at a glance

Instrument	Key feature	Where traded	Counterparty risk
Forward contract	Customised deal to buy or sell at a fixed price on a future date	OTC	High
Futures	Standardised forward. Settled daily (MTM) and backed by margins	Exchange	Low (clearing corporation)
Options	Right but not obligation to buy (call) or sell (put) at a strike price. Buyer pays a premium	Exchange and OTC	Low on exchanges
Swap	Exchange of cash-flow streams	Mostly OTC	Medium
Credit default swap	Protection against a borrower's default	OTC	High (seller may fail)

3. Forward contracts

• Forward contract = a customised OTC agreement to buy or sell an asset at a price fixed today for delivery on a future date.
• Counterparty risk = the risk that the other side will not honour the deal.

• If prices move a lot, the losing party has a reason to walk away.

• Worked example (exporter hedge):

• Today an exporter expects USD 1 lakh in 3 months. The spot rate is ₹84/USD.
• The exporter sells USD 1 lakh forward at ₹84.50. Receipt is locked at ₹84.50 lakh.
• If the rupee rises to ₹82/USD, the exporter still gets ₹84.50 lakh instead of ₹82 lakh, so ₹2.5 lakh is protected.
• If the rupee falls to ₹87, the exporter misses the extra gain. Hedging removes risk in both directions.

4. Futures

• Futures = a standardised, exchange-traded forward. The exchange fixes the lot size, expiry date and settlement rules.
• Margin = a deposit that the trader keeps with the broker or clearing house as a safety cushion.
• Initial margin is paid at the time of entry.

• Maintenance margin is the minimum balance that must be kept.

• Mark-to-market (MTM) = at the end of each day, gains and losses are settled in cash at that day's closing price.

• Losses cannot pile up unseen, which cuts default risk.

• Worked example (MTM):

• 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.

• Index futures in India since June 2000. This was part of the capital-market reforms that began in the 1990s.

• Cost-of-carry formula (fair futures price):
• F = S × (1 + r × t), where S = spot price, r = interest rate per year and t = time to expiry in years.
• Example: S = ₹1,000, r = 6%, t = 3 months (0.25). F = 1,000 × 1.015 = ₹1,015.

5. Options

• Option = the right but not the obligation to buy or sell an asset at a fixed price (strike price) on or before expiry.
• Call option = the right to buy.

• Put option = the right to sell.

• Premium = the price the buyer pays the seller (writer) for this right.

• Writer = the seller of the option. The writer has the obligation to deliver or take delivery if the buyer uses the option.
• The buyer's loss is limited to the premium.

• The writer's gain is limited to the premium, but the writer's loss can be very large.

• Payoff formulas at expiry (S = spot price at expiry, K = strike price):

• Call buyer: max(S − K, 0) − premium

• Put buyer: max(K − S, 0) − premium

• Worked example (call):

• 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. Loss = ₹5, the premium only.

• Break-even = strike + premium = ₹105.

• Worked example (put, used as insurance):

• An investor holds a share at ₹500 and buys a put with strike ₹480 for a ₹10 premium.

• If the share crashes to ₹400, the put pays 480 − 400 = ₹80. Net protection = ₹70.

• Moneyness = where the strike price stands against today's 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.

6. Swaps

• Swap = an agreement to exchange streams of cash flows over a period.
• Interest rate swap (IRS) = one party pays a fixed interest rate and the other pays a floating rate. Both are calculated on the same notional principal. Only the net difference is paid.

• Worked example: notional ₹100 crore. Company A pays fixed 7% and receives floating (MIBOR).

  • If MIBOR = 7.5%, A receives (7.5 − 7)% × 100 crore = ₹50 lakh a year, net.
  • If MIBOR = 6.5%, A pays ₹50 lakh.
  • Use: a borrower with a floating-rate loan can turn it into a fixed-rate cost.

• Overnight index swap (OIS) = an IRS whose floating leg is an overnight rate. In India the floating leg 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.
• Example: an Indian firm with a dollar loan swaps it into rupee payments to avoid exchange-rate risk.
• Central-bank swap lines are covered in balance-of-payments-exchange-rate.

7. Credit default swap (CDS)

• CDS = the protection buyer pays regular premiums to the protection seller. If a named borrower (the reference entity) defaults, the seller pays compensation.
• A default or similar trigger is called a credit event.

• A CDS works like insurance on a loan or bond.

• RBI's official definition: a credit derivative in which the protection seller "commits to pay to the other counterparty (protection buyer) in the case of a credit event", in return for periodic premium payments. [7]

• Worked example:
• A bank holds ₹100 crore of Company X bonds. It buys CDS protection at 2% a year and pays ₹2 crore yearly.

• If X defaults and the bonds recover only ₹40 crore, the CDS seller pays ₹60 crore.

• Indian regulatory timeline:

• RBI issued the first CDS guidelines in 2011.
• RBI widened them in the Master Direction – Reserve Bank of India (Credit Derivatives) Directions, 2022, issued on 10 February 2022 and updated as on 1 January 2025. [7]

• RBI released a draft revised Master Direction and invited comments till 27 February 2026. [8]

• Key features of the 2022 Directions [7]:

• Market-makers:
  • Scheduled commercial banks, except small finance, payment, local area and 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.
• Non-retail users:
  • NBFCs, insurers, pension funds, mutual funds and AIFs.
  • FPIs.
  • Resident companies with a net worth of ₹500 crore or more.
• Retail users (all other users):
  • They may use CDS only for hedging. They must first hold the underlying exposure.
  • Protection cannot exceed the face value of that exposure.
  • Settlement must be physical.
• Reference entities: resident entities that issue eligible debt.

• Permitted debt: money market instruments, rated rupee corporate bonds and unrated bonds of infrastructure SPVs.

• AIG in 2008: AIG had sold huge amounts of CDS protection on mortgage-linked securities. When those securities collapsed, it could not pay, and the firm nearly failed. This showed how OTC derivatives can spread risk across the system.

8. Commodity derivatives

• Commodity derivatives = futures and options on metals, energy and farm produce.
• Forward Markets Commission (FMC):
• Set up in 1953. It regulated commodity derivatives.

• It merged into SEBI in 2015. Since then SEBI regulates both securities and commodity derivatives.

• Main exchanges: MCX (mostly metals and energy) and NCDEX (mostly farm produce).

• Suspension of farm futures:
• Futures trading in seven farm commodities has been suspended since December 2021, and the suspension has been extended (verify current).
• The seven: wheat, non-basmati paddy, chana, mustard (and its derivatives), soybean (and its derivatives), crude palm oil, moong.

• Reason given: to curb food inflation and speculation.

• SEBI issued a consultation paper in May 2026 on the phased introduction of physical settlement in select agricultural commodity derivatives contracts. [9]

9. Uses of derivatives

• Hedging = taking an offsetting position to reduce risk.
• A farmer sells futures before harvest to lock in a price.
  • If prices fall at harvest, the gain on futures makes up for the lower sale price.
• An exporter sells dollars forward to guard against a rupee rise.

• An investor buys a put to protect a share portfolio.

• Speculation = betting on price moves without owning the underlying asset.

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

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

• Cash-futures arbitrage example:
  • The spot share price is ₹1,000 and the futures price is ₹1,030. The fair price by cost of carry is ₹1,015.
  • Buy in the cash market, sell the futures, and hold until expiry. You lock in about ₹15 more than the cost of carry.
• Arbitrage pushes prices in different markets back into line.

10. The retail F&O boom

• F&O trading = exchange-traded futures and options on stocks and indices.
• 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 (the last day of a contract).

• SEBI studies on losses:

• FY22–FY24: 93% of individual F&O traders lost money. Aggregate losses were over ₹1.8 lakh crore across the three years. SEBI released this in September 2024 (PR No. 37/2024). [2]
• FY25:
  • About 91% of individual traders lost money, roughly the same share as in earlier years.
  • Net losses rose 41% to ₹1,05,603 crore, up from ₹74,812 crore in FY24, after counting transaction costs. [3]
  • (NCIRT scaffold: "over ₹1.05 lakh crore". Same figure.)

• FY25–FY26: SEBI published two new studies in August 2026, on the Profitability and the Trading Behaviour of individual traders in equity derivatives. [4]

• Cash market comparison: SEBI found that 7 out of 10 individual intraday traders in the equity cash segment make losses (July 2024). [3]

11. SEBI's October 2024 measures

• The circular is titled "Measures to Strengthen Equity Index Derivatives Framework for Increased Investor Protection and Market Stability". It is dated 1 October 2024 (SEBI/HO/MRD/TPD/P/CIR/2024/132). [5]
• Minimum contract size raised:
• The contract value is now set between ₹15 lakh and ₹20 lakh at the time of review. The old range was ₹5–10 lakh. [5]
• (NCERT scaffold: "minimum ₹15 lakh". This is consistent.)

• Why: a bigger contract keeps out small traders who cannot afford the risk.

• Only one weekly index expiry per exchange. Earlier, a different weekly expiry fell on almost every weekday.

• Option premium collected upfront from buyers. Buyers can no longer trade on borrowed intraday money.
• No calendar-spread margin benefit on expiry day. A calendar spread means holding positions in two expiries of the same contract. On expiry day, traders no longer get lower margin for such positions.
• Position limits monitored during the day (intraday), not only at close. A separate circular on this was issued in October 2024. [6]
• Budget 2024-25 raised STT (Securities Transaction Tax, a tax on each trade on the exchange) on F&O. See the taxation note.

12. The debate

• For F&O:
• Price discovery: futures prices show what the market expects about future prices.
• Hedging tools for investors, exporters and farmers.

• Market depth and liquidity: more buyers and sellers mean lower trading costs.

• Against:

• For most retail traders it works like gambling.
• It drains household savings that could have gone into long-term investment.
• Money mostly moves from retail traders to proprietary traders and algorithmic firms, which have better technology and speed.
• The Economic Survey has warned about this trend.

Prelims Hooks

• An option buyer has a right, not an obligation. The writer (seller) has the obligation. The buyer pays the premium.
• Call = right to buy. Put = right to sell. Call payoff = max(S − K, 0) − premium.
• Futures are exchange-traded, standardised and marked to market daily. Forwards are OTC and customised, and carry counterparty risk.
• Index futures in India started in June 2000.
• OIS floating leg in India = MIBOR.
• CDS: the buyer pays premiums and the seller pays on a credit event. RBI governs CDS through its Credit Derivatives Directions, 2022. Retail users may use CDS only for hedging. [7]
• FMC (1953) merged into SEBI in 2015. Commodity exchanges: MCX, NCDEX.
• The seven suspended farm commodities: wheat, non-basmati paddy, chana, mustard, soybean, crude palm oil, moong (not basmati rice, not sugar).
• SEBI's October 2024 circular: index derivative contract value ₹15–20 lakh, up from ₹5–10 lakh. [5]
• SEBI study: 93% of individual F&O traders lost money in FY22–FY24 [2]. About 91% lost in FY25, with net losses of ₹1,05,603 crore [3].

Mains Points

• Hedging vs speculation:
• Derivatives let farmers, exporters and banks move risk to those willing to carry it. This helps price discovery and market depth.
• But when about 9 in 10 retail traders lose money every year [2][3], the market is serving speculation more than hedging.

• SEBI's approach is to make access harder (bigger contracts, upfront premium, fewer expiries) rather than to ban products.

• Household savings and financial stability:

• Losses of over ₹1 lakh crore a year [3] mean household savings are being moved to proprietary and algorithmic firms.

• This links to financial literacy, investor protection, and how the Economic Survey sees household savings as a source of investment funds.

• OTC risk and systemic risk:

• AIG in 2008 showed that CDS can hide and spread risk.
• India's cautious CDS design limits retail use to hedging and requires physical settlement [7]. It also keeps revising the framework: see the draft revision of 2026 [8].

• The trade-off: stronger safeguards make a deep corporate bond market slower to develop.

• Agricultural futures:

• The suspension of seven commodities since 2021 aims to control inflation and speculation.
• But it takes away a price-discovery and hedging tool from farmers and FPOs.
• The debate: inflation control vs market development. SEBI's 2026 move towards physical settlement [9] points to a gradual reopening.