Chapter 24: Derivatives Market
A Derivative is a specialized financial contract whose value is not derived from intrinsic standalone worth, but is instead derived from the value, performance, or price of an underlying asset, reference rate, or index.
Under Section 2(ac) of the Securities Contracts (Regulation) Act, 1956 (SCRA), derivatives are legally recognized securities in India.
Common Underlying Assets
- Equities: Individual stocks (e.g., Reliance Industries, Infosys) or broad equity indices (e.g., NIFTY 50, BSE SENSEX).
- Currencies: Foreign exchange pairs (e.g., USD/INR, EUR/INR).
- Interest Rates: Government bond yields and interbank interest rates.
- Commodities: Agricultural commodities (cotton, wheat) and non-agricultural commodities (crude oil, gold, silver).
Zero-Sum Game Nature
Unlike the primary equity cash market—where corporate growth and earnings expansion create aggregate economic wealth for all shareholders over time—the derivatives market is inherently a zero-sum game (before transaction costs). For every rupee gained by one party on a derivative position, an exact equal rupee is lost by the counterparty.
The derivatives market encompasses four foundational contract structures:
1. Forward Contracts
- Customized bilateral agreements between two private parties to buy or sell an asset at a specified future date at a price agreed upon today.
- Traded Over-the-Counter (OTC) rather than on an exchange; exposed to counterparty default risk and lack of secondary liquidity.
2. Futures Contracts
- Standardized, exchange-traded forward contracts with specified contract sizes, expiration dates, and tick sizes.
- Central Counterparty Novation: Cleared and guaranteed by the clearing corporation, eliminating counterparty credit risk.
- Mark-to-Market (MTM): Profits and losses are settled in cash daily.
3. Options Contracts (Calls and Puts)
An option gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (Strike Price) on or before a specified date (Expiration Date). The buyer pays an upfront, non-refundable fee (Premium) to the option seller (Writer).
- Call Option (CE): Gives the holder the right to buy the underlying asset. Purchased by investors expecting prices to rise.
- Put Option (PE): Gives the holder the right to sell the underlying asset. Purchased by investors expecting prices to decline or hedging downside risk.
| Parameter | Option Buyer (Holder) | Option Seller (Writer) |
|---|---|---|
| Rights vs. Obligations | Holds the right; zero obligation | Carries strict legal obligation |
| Maximum Risk | Limited strictly to the Premium paid | Theoretically unlimited |
| Maximum Reward | Theoretically unlimited (Calls) / Substantial (Puts) | Limited strictly to the Premium collected |
| Margin Requirement | No margin required (pays premium upfront) | Heavy margin requirements (SPAN + Exposure) |
Derivatives fulfill essential economic functions when utilized appropriately:
- Risk Hedging: Allows corporate treasuries, mutual funds, and individual investors to insulate existing cash market portfolios against adverse market movements (e.g., buying NIFTY Puts to protect an equity portfolio against a market downturn).
- Transparent Price Discovery: Because derivatives absorb breaking news and global sentiment rapidly, futures prices often lead spot prices in discovering fair market equilibrium.
Mandatory Physical Settlement in Indian Stock Derivatives
Under SEBI regulations, all open positions in individual stock futures and stock options contracts that expire 'in-the-money' (ITM) on expiry day are subject to compulsory physical delivery. A trader holding an ITM long call or short put must take delivery of actual shares, requiring substantial cash resources and demat delivery.
SEBI Risk Warning for Retail Derivatives Traders
SEBI's landmark research study revealed that over 90% of individual active retail traders in the equity F&O segment incur net financial losses, with the average loss exceeding Rs. 1.25 Lakhs per trader over a three-year period (inclusive of transaction costs and brokerage). Retail investors should avoid derivatives unless they possess professional risk-management capabilities, adequate capital reserves, and a clear hedging objective.