Derivative basics — CFA L1 Deriv

Four derivative types. Forward: private contract (OTC). Future: standardised, exchange-traded. Option: right but not obligation. Swap: exchange of cash flows over time.

Foundation

Forwards vs Futures: • Forward: private contract; OTC; counterparty risk; not standardized • Future: exchange-traded; daily settled; no counterparty risk; standardized Options: • Call: right to buy at strike • Put: right to sell at strike • Exercise on expiry (European) or anytime (American) Swaps: exchange of cash flows. IRS (interest rate), CCS (currency), equity swaps. Indian derivative markets: • NSE F&O: among largest globally • Stock futures, index futures, options on indices and select stocks • Currency F&O, commodity F&O • Margin requirements: SPAN, exposure, MTM

Deep Dive

OTC vs exchange-traded: • OTC: customised, less liquid, counterparty risk; trillions in interest rate, currency, credit derivatives globally • Exchange-traded: standardized, liquid, central counterparty (clearinghouse) Indian context: • Mostly exchange-traded for retail/medium institutional • OTC interest rate swaps for banks/large corporates • Currency forwards for corporates hedging exports/imports Pricing intuition: • Forward = Spot + cost of holding (interest, dividends adjusted) • Option = intrinsic + time value • Swap = series of forwards Difference between F&O and equity for retail: F&O leveraged, time-decaying, complex risk profile. Different skill set required.

Advanced

Counterparty risk: • OTC: each party at risk of other defaulting • Exchange-traded: clearinghouse takes counterparty role; eliminates direct exposure Derivatives uses: • Hedging: offsetting existing position • Speculation: betting on direction • Arbitrage: exploiting price differences • Income: writing options for premium Most Indian retail F&O is speculation (betting on direction of NIFTY or stocks). Most lose. CFA-grade understanding distinguishes: • Hedging (legitimate, useful) • Speculation (high-risk, often loss-making for retail) • Arbitrage (institutional)

Regulatory references

SEBI F&O Regulations
CFA Institute curriculum
NSE F&O bye-laws

Common mistakes & pitfalls

Treating F&O as gambling.
Not understanding time decay.
Excessive leverage for retail.
Confusing forward and future.

Frequently asked

Should retail use F&O?

Generally no, unless rigorous risk management + understanding. Used for hedging actual positions: legitimate. Used for speculation: usually loss-making. SEBI restrictions tightened post-2022 study.

How are options priced?

Black-Scholes-Merton (continuous-time) or Binomial (discrete). Inputs: spot, strike, time, volatility, interest rate. Output: theoretical price. Market price reflects supply-demand + theory.

Practice questions

Click each question to reveal the answer and explanation.

Q 1

Forward vs future:

(a)Same thing
(b)Forward: OTC, customized, counterparty risk; Future: exchange-traded, standardized, no counterparty risk
(c)Forward: exchange-traded; Future: OTC
(d)No difference

Correct: (b) Forward: OTC, customized, counterparty risk; Future: exchange-traded, standardized, no counterparty risk

Forward: private OTC contract; counterparty risk. Future: exchange-traded; clearinghouse eliminates counterparty risk.

Q 2

Option time decay (theta):

(a)Increases option value
(b)Decays option value as expiry approaches
(c)Constant
(d)Random

Correct: (b) Decays option value as expiry approaches

Theta decay: option value falls as time-to-expiry decreases. Most options decline in value if underlying stays flat. Time is enemy for option holders.

Q 3

NIFTY weekly option expiry:

(a)Monday
(b)Thursday
(c)Saturday
(d)Friday

Correct: (b) Thursday

NIFTY weekly options: Thursday expiry. Massive retail trading volume around expiry. Most options expire worthless.

Q 4

Indian retail F&O loss rate (SEBI study):

(a)10%
(b)~89%
(c)50%
(d)100%

Correct: (b) ~89%

89% of retail F&O traders lost money. Major reason for SEBI 2023 tightening including pre-test, margin requirements.

Q 5

Hedging is:

(a)Speculating on direction
(b)Offsetting an existing position to reduce risk
(c)Buying both call and put
(d)Always profitable

Correct: (b) Offsetting an existing position to reduce risk

Hedging: derivative offsets existing exposure. E.g., farmer hedges harvest with futures. Reduces directional risk.

Educational purposes only. The numbers, returns, and examples used in this lesson are illustrative. Past performance does not guarantee future results. Mutual fund and securities investments are subject to market risks. This lesson is not investment advice; for advice tailored to your circumstances, consult a SEBI-registered Investment Adviser. Read our full disclaimer.