Basics of Derivatives

A derivative derives its value from an underlying. Underlyings span metals (gold, silver, copper), energy (crude oil, natural gas), agri commodities (wheat, cotton, pulses) and financial assets (shares, bonds, foreign exchange). The four products: (1) Forwards — a customised OTC agreement to buy/sell an underlying at a fixed future date and pre-agreed price; both sides are obliged to honour it. (2) Futures — the same idea, but standardised (lot size, expiry) and traded on a regulated exchange with the clearing corporation as central counterparty, which removes bilateral default risk. Futures are, in effect, exchange-traded forwards. (3) Options — a contract giving the buyer the right, but not the obligation, to buy or sell the underlying at a stated price on or before a stated date; the buyer pays a premium, the seller (writer) receives it and takes on the obligation. (4) Swaps — an agreement to exchange cash flows in the future per a formula; broadly a series of forwards, used to manage interest-rate, currency and commodity risk.

Three participant types drive the market. Hedgers hold or expect exposure to an underlying and use derivatives to reduce risk — a fund manager fearing a market fall can short index futures to protect the portfolio. Speculators/traders take a directional view and prefer derivatives because they offer leverage and lower transaction cost than the cash market. Arbitrageurs exploit price differences between two markets (or between cash and futures), buying cheap and simultaneously selling dear; their activity closes the gap and keeps prices aligned. On structure: exchange-traded derivatives are standardised, centrally cleared, margined and transparently priced; OTC derivatives are tailor-made between counterparties, carry decentralised credit risk, have no central position limits or margining, and little market disclosure. India's exchange-traded derivatives began in June 2000 after the L. C. Gupta Committee (1998) recommended treating derivatives as securities and the J. R. Varma Committee worked out the margining and risk-containment framework; the SCRA was amended in 1999 to bring derivatives within "securities".

Because derivatives are leveraged, the risks compound. The exam-relevant set: counterparty risk (default by the other side — largely removed on exchanges by the clearing corporation, but live in OTC), price risk (loss from adverse moves, amplified by leverage), liquidity risk (inability to exit a position at a fair price), legal/regulatory risk (enforceability), and operational risk (fraud, bad documentation, execution error). Every exchange member must give clients a Model Risk Disclosure Document before F&O trading begins, and candidates should know it exists and why. The practitioner takeaway: derivatives are not automatically "risky" or "safe" — the same instrument hedges risk in one hand and multiplies it in another. Suitability (resources, experience, risk tolerance) is the deciding factor, and for a distributor recommending SIFs with derivative mandates, matching that mandate to the investor's profile is the compliance line.

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