Table of Contents
Chapter 5: Derivatives
The Financial Architecture of Derivatives
A derivative is a financial contract whose economic value is derived from the price, level, or performance of an underlying asset, benchmark index, reference interest rate, or commodity:
Contractual Value Flow:
[ Underlying Asset (Equity, Index, G-Sec, USD/INR) ] ───> [ Derived Contract (Future, Option) ]
Core Economic Functions of Derivatives
- Hedging and Risk Management: Enabling businesses, portfolio managers, and investors to insulate their physical portfolios from adverse price movements (e.g., shorting index futures to hedge a diversified equity portfolio during macroeconomic turmoil).
- Efficient Price Discovery: Because derivatives trade with lower transaction friction and higher leverage, market information is absorbed first in the derivatives market, transmitting forward-looking pricing signals to the spot market.
- Transaction Cost Efficiency: Rebalancing a portfolio’s market beta using Nifty 50 futures incurs a fraction of the brokerage, stamp duty, and market impact cost associated with physically buying or selling 50 individual underlying stocks.
Classification of Derivative Contracts
- Forwards: Bilateral, unstandardized, private Over-The-Counter (OTC) contracts with high counterparty default risk.
- Futures: Standardized, exchange-traded contracts novated by a central clearing corporation with daily mark-to-market margins and zero counterparty default risk.
- Options: Asymmetric contracts granting the buyer the right (without obligation) to buy (Call) or sell (Put) an underlying asset at an agreed strike price.
- Swaps: Bilateral contracts exchanging cash flows (e.g., fixed-for-floating Interest Rate Swaps / MIBOR OIS).
Mechanics of Exchange-Traded Derivatives
1. Futures Contract Mechanics
- Long Position: Obligation to purchase the underlying asset at the agreed futures price. Profits when the price rises; suffers losses when the price falls.
- Short Position: Obligation to sell the underlying asset. Profits when the price falls; loses when the price rises.
- Margining Mechanism: Exchange clearing corporations enforce Initial Margin (SPAN margin) and Exposure Margin, with daily cash Mark-to-Market (MTM) settlement debiting/crediting trading accounts daily.
2. Options Payoff Architecture and Moneyness
An option buyer pays a non-refundable Premium to the option seller (writer) in exchange for economic protection:
Option Types and Payoff Profiles:
┌───────────────────────────────────────┬──────────────────────────────────────────┐
│ CALL OPTION (Right to BUY) │ PUT OPTION (Right to SELL) │
├───────────────────────────────────────┼──────────────────────────────────────────┤
│ Buyer Payoff = Max(0, S_T - X) - Premium│ Buyer Payoff = Max(0, X - S_T) - Premium│
│ • Profits from upward price movements │ • Profits from downward market declines │
│ • Maximum Loss = Premium Paid │ • Maximum Loss = Premium Paid │
│ • Maximum Gain = Theoretically Infinite│ • Maximum Gain = Strike Price - Premium │
└───────────────────────────────────────┴──────────────────────────────────────────┘
The Concept of Moneyness
Moneyness describes the intrinsic value relationship between the Spot Market Price ($S$) and the Strike Price ($X$):
| Moneyness State | Call Option ($S$ vs $X$) | Put Option ($S$ vs $X$) | Intrinsic Value |
|---|---|---|---|
| In-The-Money (ITM) | Spot Price > Strike Price ($S > X$) | Spot Price < Strike Price ($S < X$) | Positive Intrinsic Value ($> 0$). |
| At-The-Money (ATM) | Spot Price $\approx$ Strike Price ($S \approx X$) | Spot Price $\approx$ Strike Price ($S \approx X$) | Zero Intrinsic Value; pure time value. |
| Out-of-The-Money (OTM) | Spot Price < Strike Price ($S < X$) | Spot Price > Strike Price ($S > X$) | Zero Intrinsic Value; pure time value. |
SEBI Mandates Governing Derivatives in PMS Portfolios
Unlike Category III AIFs or speculative hedge funds, the deployment of derivatives within Portfolio Management Services is tightly governed under Regulation 24 of the SEBI (Portfolio Managers) Regulations, 2020:
SEBI PMS Derivative Mandates:
┌─────────────────────────────────────────────────────────────────────────────────┐
│ 1. Explicit Client Authorization: Derivative trading is permitted ONLY if │
│ explicitly authorized by the client in the PMS Client Agreement. │
├─────────────────────────────────────────────────────────────────────────────────┤
│ 2. Permitted Purpose: Portfolio managers can deploy exchange-traded derivatives │
│ strictly for HEDGING and PORTFOLIO REBALANCING purposes. │
├─────────────────────────────────────────────────────────────────────────────────┤
│ 3. Strict Leverage Ban: The total exposure of the client portfolio in │
│ derivatives cannot exceed the total capital value of the portfolio. │
│ STRUCTURAL LEVERAGE IS ABSOLUTELY PROHIBITED. │
├─────────────────────────────────────────────────────────────────────────────────┤
│ 4. No Uncovered Option Writing: Naked option writing (unhedged short calls or │
│ puts) with unlimited loss potential is strictly prohibited for PMS accounts. │
└─────────────────────────────────────────────────────────────────────────────────┘
Practical Derivative Strategies in PMS Portfolios
- Portfolio Beta Hedging: Selling index futures (Nifty 50 futures) against a client’s equity holdings when macroeconomic indicators flash severe recessionary or geopolitical risks, temporarily reducing effective portfolio beta to zero without liquidating physical stocks and triggering capital gains tax.
- Cash Equitization: Buying liquid index futures to achieve immediate equity exposure when a client deposits large cash sums, while the investment team systematically researches individual stock purchase opportunities over subsequent weeks.
- Covered Call Writing: Writing out-of-the-money call options against stocks physically held in the client’s demat account to generate additional recurring cash yield in a sideways market.