1.

Learning Outcomes
After studying this module, you shall be able to

Know what is Derivative and the purpose of its existence.

Learn the various types of Derivatives and its features and benefits.
Know the methodology used in pricing of futures contract.
Learn the clearing and settlement procedure of futures contract at National stock
exchange.
Analyze the various applications used in Futures contract.

2. Introduction
The word Derivative is derived from mathematics which refers to a variable that has been derived
from another variable. In simple sense, Derivative has no independent value of its own; its value
is obtained from the value of an underlying asset. For example curd is a derivative of milk or
similarly, measure of temperature is derived from the measurement of Fahrenheit. In financial
world, a derivative is a financial product which derives its value from another asset.
For ex. Sensex is a derivative of 30 shares at Bombay Stock Exchange and NIFTY is a derivative
of 50 shares at NSE.

Derivatives have come to existence from the need to manage the risk arising from movements in
markets beyond our control. Derivatives are used to shift risk and therefore acts as a form of
insurance.For some risks, management can obtain protection from an insurance company (fire,
loss of profit, loss of stock, marine insurance).However, for some other risks like adverse
exchange rate movements, risk associated with rise/decline in the price of commodity or stocks,
the Instruments that can be used to provide such protection are called derivative instruments.
Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative
purposes.

In India, derivatives came in to existence when Prof Dr. L.C Gupta Committee in 1998 came out
strongly in favor of Introduction of financial derivatives in order to provide the facility/ for the
purpose r /of hedging in the most cost-efficient way against market risk. L C Gupta report which
was submitted to SEBI advisory committee which was finally accepted by Government of India
and derivative trading was allowed in the Indian market.

A derivative is a financial instrument or a financial contract, whose value is derived from one or
more underlying assets. Underlying asset of a Derivatives can be tangible assets like wheat,
cotton or any other commodity and intangible like interest rates, weather or index etc. or financial
instruments like equity or Bond.
securities after it has been decided
to be introduced for risk hedging.

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 2.1 Stock to be included in the derivatives market has to satisfy certain
eligibility criteria

Among the top 500 stocks are chosen for derivatives contract
quarter-sigma order size over the last six months shall be not
less than 1 Lakh.
The market wide position limit in the stock shall not be less than 50 crores.

Only eligible stock (as per above mentioned criteria) can be permitted for derivative
trading. Derivative trading needs to be discontinued in case stock does not fulfil the
criteria for 3 consecutive months

Derivative contracts are permitted by SEBI.

SEBI has introduced different Derivative contracts as follows:
Index future contracts are permitted in June 2000 Index Options and Stock Options were
introduced in June 2001 and July 2001 followed by Stock Futures in November 2001.
Sectoral indices were permitted for derivatives trading in December 2002. SEBI
permitted mini derivative (F&O) contract on Index (Sensex and Nifty) in Dec 2007.
Longer tenure Index options contracts and Volatility Index in 2008. In Aug 2008, Bond
Index was introduced.
Source:SEBI Website

2.2 Features of Derivatives

1. Derivatives are the part of secondary market and no funds can be raised through derivatives.
2. The transactions in the Derivative are settled by taking offsetting position in the same
derivatives.
3. No limit on the number of units transacted because there is no physical asset involved.
4. Derivative market is quite liquid in nature.
5. These are tailor made instruments and its use depends upon investors requirement.

2.3. Two Purpose of Derivatives

2.3.1 Price Discovery of the underlying asset

Prices in an organized derivative market reflect the perception of market participants about the
future and lead the prices of underlying to the perceived future level. Price of derivative coincides
with price of underlying at the expiration date. Thus, it helps in price discovery.

2.3.2 Tool for Risk management

Derivative instruments helps in transfer risks through hedging from the hedger to the speculator.

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 Derivatives can be

1. Over the counter (OTC)

2. Exchange Traded (ETC)

1. Over the counter (OTC)

Privately negotiated securities are called over the counter contracts and are regulated by statutory
provisions. It carries higher risk of default by any of the parties.

OTC contracts are

Forward contracts
Swaps like Interest rate swap, Credit default swap
Options like Stock options warrants, currency options, credit default options

OTC have following features:

1. Non-standardized contracts and no formal rules or mechanism for risk sharing.

2. Management of counter party is decentralized. It carries higher risk of default by any of
the parties.
3. Prices are less transparent due to non-standardization.
4. No restriction on time as they are private contracts.
5. Most of the contracts result in physical delivery at expiry.

2. Exchange traded contracts

They are standardized contracts traded as per rules and regulations of the exchange.

Exchange traded contracts are:

Futures-stock, Bond, Currency

Options-Stock, Index, Currency, Bond

Features

1. All ETC are standardized with respect to quantity, price and time.
2. Exchange authorities have strict surveillance over these contracts.
3. All the contracts are guaranteed against the counter party default.
4. Positions can only be squared off at any point of time.
5. Only few contracts may live up to expiry and result in Physical delivery.

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 3. Participants and Classification of Derivatives market

3.1 Participants of Derivatives Market:

1. Hedgers
2. Speculators
3. Arbitrageurs

3.1.1 Hedgers
One of the main purposes for which derivative trading has been initiated is to hedge or provide
protection to the parties to a contract. Hedgers have risk exposure which they offset by a
derivative and seek to protect themselves against price movements in an asset in which they have
interest. For example, an American buying shares of an Indian company on an Indian exchange
would be exposed to exchange-rate risk while holding that stock. In order to reduce this risk, the
investor could purchase currency futures of dollars to lock in a specified exchange rate for the
future stock sale and currency conversion back into dollars.

3.1.2 Speculators

Speculators are the participants who are ready to take risk in expectation of return. They take
position in the market either expecting that the prices will go up or expecting that the prices will
go down. They may go long (buy) or short (sell) based on their expectations. However, they have
naked positions and therefore, they are inviting risk for earning a return. The speculators create
volumes of trading in the derivative market and hedgers & arbitrageurs get counter party for other
traders. The speculators create volumes of trading in the derivative market and hedgers &
arbitrageurs get counterparty for their trades.

3.1.3 Arbitrageurs

The arbitraging refers to locking in a risk less profit by simultaneously entering into two
transactions in two different markets separated geographically or timing. The profit opportunities
may occur due to price differences in two different markets but could not last for long due to
arbitraging.
Arbitrageurs may deal in to cash and derivatives market or only derivatives market for different
periods of time earning arbitrage profits. Their actions shall narrow down the differential in
prices. For example, arbitrageurs may buy in the spot market and sell in the futures market.

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 3.2 Classification of Derivatives

Classification of Derivatives

Financial Commodity

Basic Complex

Forwards Swaps
Futures Exotic
Options
Warrants & convertibles

The distinction between financial and commodity derivatives is the difference in the underlying
asset. In commodity derivatives, the underlying instrument is a commodity like wheat, cotton,
sugar, pepper, turmeric, natural gas, gold, silver and so on. In a financial derivative, underlying
assets are stock, T bills, bonds, foreign exchange, stock indices etc.

4. Introduction to Forward Contracts and Future Contracts

4.1 Forward Contracts

Forward Contract is an agreement made today between a buyer and a seller wherein the seller is
under obligation to deliver a specified asset of specified quality and quantity to the buyer on a
future date and place is specified at a price agreed upon today.
The buyer in return has to pay the seller a pre-negotiated price in exchange for the delivery.
Forwards are not marketable; once a firm enters into a forward contract there is no convenient
way to trade out of it except that of reversing the trade between the same parties.
For example: Wheat farmer selling his harvest at a known price at a future date in order to
eliminate price risk.

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 Features of Forward Contract

1. Forward contracts are not standardized form of contracts.

2. They are over the counter transactions.(not traded recognized exchanges )
3. Every order is separate and is determined with respect to the contract size, expiration date,
asset type and quality. The date and price of the contract is unique and decided in advance by the
two trading parties.
4. Futures contracts are bilateral agreements and exposed to counter party risk.
5. In forward contract, both the parties takes the opposite position. One party agrees to buy the
asset at specified price at future date; it is said to have taken a long position. Another party takes
opposite i.e short position; agrees to sell the same asset at the same date on the price agreed upon.
A party without obligation offsetting futures contract is said to have an open position.

Benefits of Forward contracts

Forward contract can be used to secure or hedge or lock in the price of purchase of asset on the
future commitment date For Ex. A bread factory may want to buy wheat forward in order to assist
production planning without taking risk of price fluctuations. Price discovery is another use of
forward prices to predict spot price that will prevail in future. Also, no cost is involved as margins
are involved in forward contracts. It is entered in to by two parties generally known to each other.

Limitations of Forward contract

1. Forward contract have counter party risk and in case of default by other party, the
aggrieved party may have to suffer a loss.
2. No party can take benefit of favorable price movements as squaring off is not possible in
forward contracts.
3.
terms.

4.2 Futures Contracts

Any contract which is standardized involving two parties having an agreement to buy or sell an
asset with specific quantity and quality on a price which is agreed today for future delivery.

Standardization of Future contract

1. Underlying asset can be stock, commodity, interest rate, bonds, Govt securities.
2. Settlement can be cash or physical delivery.
3. The amount and units of the underlying asset per contract is specified.
4. Delivery month and the grade in deliverable is specified.
5. Last trading date id specified.

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 Features of Future contract

1. Futures are standardized contracts that are to run in either the final cash settlement or
assets are delivered at later stage. Certain future contracts such as stocks or currency,
settled in cash on the price differentials. For example, the futures of Reliance share can
be traded on NSE and future of gold can be traded on MCX.
2. These contracts trading on organized futures exchanges with a clearing organization that
serves as an intermediary between the parties.
3. Both parties pay margin on Clearing Association and are generally settled by marked to
market every day.
4. Each futures contract has identified a relevant month which is the month of the contract
delivery or permanently settlement. These contracts are recognised with their delivery
month. For example: .Futures of Reliance in January can be future of January, futures of
February or futures of March for 1, 2, 3 months respectively.

Future contract is different from trading an underlying stock in the sense that when you buy a
stock you pay full value of the transaction (i.e. the number of shares multiplied by market price of
each share) but in case of futures, you have to pay margin. There is no time component; you own
the stock for all times to come until you sell. You make a loss or profit only when you sell the
shares you own.

Difference between Forward and Futures contract

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 When you trade futures

Long is equivalent of initiating a futures position by buying a future contract and squaring up by
selling it.

Short is equivalent of initiating the position by first selling a future contract and then squaring up
by buying it back.

You pay only margin which is a fractional portion of the total transaction value, generally about
15% in case of index futures, and up to 50% in the case of individual stock futures.

All the future contracts are dated.

For example, Indian futures and option settlement takes place on last Thursday of every month.
So the current month futures expire on the hursday. If the trader has to carry his
position to the next month, he has to shift his position to the next month future.

Futures are generally traded using technical analysis because product facilitates speculation. You
can go long or short on futures depending upon the short term view of the market and or a stock.

The futures prices for a particular contract are the price at which you agree to buy or sell. It is
determined by supply and demand in the same way as a spot price.

Pricing of futures contract

Price of futures is the total of current spot price and cost of carry. Cost of carry is the interest cost
of a similar position in cash market and carried to maturity of the futures contract less any
dividend expected till the expiry of the contract. Simply, it includes storage cost, insurance cost,
transport cost and finance cost i.e. any interest forgone on funds used for purchase of the
commodity. Spot price is the current price of the commodity. Price depends generally on the
demand and supply of the underlying asset.
price would be on delivery date. On delivery day or on expiry of the contract, future price equals
spot price but prior to this the future price could be above or below spot price. This difference is
known as basis. (Basis= Future price- Spot price) . On expiry, basis is equal to zero. If the future

is negative or underlying asset is in short supply in the cash market and there is an expectation of
the increased supply in future. For ex. Agricultural products.

Futures Price = Current spot price + cost of carry

Or

F = S * e rt

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 where:
F = theoretical futures price
S = value of the underlying index
r = rate of interest
t = time to expiration

Example:

Futures Price of 1 month contract = 4000 + 4000*0.12*30/365 = 4000 + 40 = 4040

The mechanism of pricing of futures can be explained as follows:

Suppose, in cash market, underlying asset is selling at Rs 100/-. Expected return from the asset is
3% per quarter. Risk free lending/borrowing rate is 2% per quarter.

Price of futures will be 100+100(.02-.03) = 99

required to pay interest of 2.

In case the future contracts are available at 92/-, the investor should buy one future contract for
92 and sell one unit of asset for rs 100 and invest money @8% p.a for 3 months. After 3
months, he will receive the proceeds of 102/- (100+2).He will spend 92/- to purchase an asset.
Besides, he will not receive the yield of 3 from the asset. So his cost is 95. His gain would be
7 (102-95).

If the future contract is 107, he should sell the futures contract at rs 107 and should borrow

110 (107+3) and payment would be 102 (100+2). He would be able to make a profit of 8.

5. Clearing and settlement procedure in Future and options at National

stock exchange
Clearing and Settlement Procedure in Futures and Options at National Stock Exchange

National Securities Clearing Corporation Limited ( NSCCL ) the clearing agency for all deals on
the derivatives segment performed.
NSCCL acts as the legal counterparty for all NSE F & O segment and guarantees settlement.
A Clearing Member (CM ) of NSCCL has the task of clearing and settlement of all deals by
Trading Members (TM ) on NSE.

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 Foremost, the CM performs the following functions:

Clearing - Computing obligations that all his TM to settle positioning.

Settlement - Performing actual settlement. Only fund settlement is currently in the index and
stock futures and options allowed. The settlement of futures in stock through delivery is proposed
to be executed sooner or Indian stock exchanges.
Risk management - setting position limits on the basis of in advance deposits / margins for each
TM and monitoring of positions on a continuous basis.

Types of Clearing Members

Trading Members Clearing Member: A Clearing Member who is also a Trading member.

Professional -Clearing Member: Professional clearing member is a clearing member who is not
trading member.

Self- Clearing Member ( SCM): A Clearing Member who is also a TM . Such CMs can clear
and regulate only their own private transactions and their customers, but cannot clear and settle
trades in other TMs.

Clearing Member Eligibility Norms

Clearing Member eligibility standards

Net worth of at least Rs.300 lakhs.

Deposit of 50 lakhs to NSCCL is the part of the deposit of the CM.

Additional incremental deposits of 0.10 lakhs to NSCCL for each additional TM in case
the CM agrees to clear and deals on other TMs behalf.

The position in the futures contracts for each user is mark-to-market to the daily
settlement price at the end of each trading day of the futures contracts.

Mark to market reduces the default risk of the parties as profits/ losses are computed as
the difference between the previous day's settlement price and current day's settlement
price. There daily is premium settlement takes place daily at NSE which is in cash.

CMs are responsible to collect and resolve for the premium amounts from the TMs and
their clients clearing and settlement through them.

The pay-in and pay-out of the premium settlement is on T + 1 day (T = trading day). The
premium payable and premium receivable amount are debited or credited to CMs
clearing bank account.

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 Final Exercise settlement is effected for option positions at in-the-money strike prices
existing at the close of trading hours, on the expiration day of an option contract. Long
positions at in-the money strike prices are automatically assigned to short positions in
option contracts with the same series, on a random basis.

European exercise style is opted at NSE for index options contracts and options
contracts.

Exercise settlement is cash settled by debiting/ crediting of the clearing accounts of the
relevant Clearing Members with the respective Clearing Bank.

Final settlement loss/ profit amount for option contracts on Index is debited/ credited to
the relevant CMs clearing bank account on T+1 day (T = expiry day).

Final settlement loss/ profit amount for option contracts on Individual Securities is
debited/ credited to the relevant CMs clearing bank account on T+1 day (T = expiry day).

Open positions, in option contracts, cease to exist after their expiration day.

The pay-in / pay-out of funds for a CM on a day are the net amount across settlements
and all TMs/ clients, in F&O Segment.
Source: www.nseindia.com

Types of Futures contract

1. Stock Index Futures

2. Commodity Futures
3. Currency Futures
4. Interest rate Futures

1. Stock Index Futures

A stock index future contract is a contract to buy or sell the face value of the underlying stock
index where the face value is defined as being the value of index multiplied by the specified
monetary amount. For ex In India, future contracts can be traded with NIFTY or SENSEX or
some other indices as the underlying assets.

In order to track the market, an investor should buy all the constituents of the market index in
the same proportion in which these are present in the market index. With the availability of
index futures, investors can simply buy or sell index futures and can track the market.
However, it is a difficult proposition.

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 2. Commodity Futures

Future contracts on various commodities like agricultural product like grains, food commodity,
textiles or metallurgical futures contract like gold, silver, platinum and copper have been in
existence for nearly three centuries. Buying commodity futures saves on storage cost, insurance
and wastage costs but at the same time one has to forgo the convenience of having inventory
ready. They are traded separately on commodity exchanges like NCDEX or MCX.

3. Currency Futures

Currency forwards and futures are very useful for those who are involved in the international
trade. Due to fluctuations in the exchange rate, it is important for traders to avail
opportunities in the futures market to hedge exchange rate risk. Currency futures are
standardized contract wherein underlying asset is currency. These contracts are traded on a
recognized stock exchange to deal in one currency against another on a specified future date,
at a price specified on the date of contract.

In India, currency futures started in 2008 and are being traded at NSE and MCX-SX.

Guidelines by Reserve bank of India regarding currency futures

1. Only person Resident in India are permitted to sell/buy currency futures to hedge an exposure
to foreign exchange rate risk.
2. Currency futures permitted in US dollar-Indian Rupee and may be approved in other
currencies from time to time.
3. The size of each contract shall be US$ 1000.
4. The contract shall be quoted and settled in Indian rupee.
5. The maturity of each contract shall not exceed 12 months.
6. e on the last trading day.

4. Interest Rate Futures

A futures contract whose underlying asset is the interest rate is called interest rate futures. As we
know, there is always inverse relationship between interest rates and bond prices. A slight change
in interest rate is reflected in the bond prices. Interest rate futures helps the investors to hedge
against the bond-price fluctuations.

For ex: an investor is holding government securities expect that the interest rates would rise.
Consequently, the market price of securities would decline. In order to protect himself, he can sell
futures and in case if he expects the interest rate to decline, he would buy the futures.

In April 2003, SEBI announced a scheme for the introduction of exchange traded interest rate
derivatives contracts in India. NSE launched in June 2003, which did not take off and again re
launched in 2009 after the guidelines of RBI for the trading of interest rate futures in India.
IRF is a standardized interest rate derivative product to buy or sell notional security or an index of
interest rates at a specified future date at a specified price. In order to hedge against interest rate

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 risk any person resident in India can buy or sell interest rate futures. Foreign institutional
investors are also allowed subject to certain conditions.

Pay off positions inFutures

1. Going Long-Buy Futures

2. Going Short- Sell futures
3. Long hedging
4. Short hedging

1. Going Long-Buy Futures

When an investor enters in to a contract by agreeing to buy at pre-determined price then he is

anticipating increase in the futures price and wants to make profit out of it. There is bullish
outlook and buyer can make unlimited profit if the asset price rises.

For ex: Suppose the price of wheat today is Rs 5,000 per ton while the future price of wheat
which is to be delivered in three months is Rs5,500/- . The processor of grain chooses to buy
futures at Rs 5,500 expecting that the price of wheat will increase. Suppose after three months,
the price of the wheat increases to Rs7,000/- . The processor can now make profit and can sell
futures which would be trading at Rs7500/- reflecting the physical market conditions.

2. Going Short- Sell futures

When an investor enters in to a contract by agreeing to sell at pre-determined price then he is

anticipating fall in the futures price and want to make profit out of it. By sell now at high price,
the contract can be re purchased at a lower price, thus making profit. The seller is expecting the
price to fall and can have unlimited profit in that situation. There is unlimited risk involved in
case the price rise

3 Long hedging

A company that knows that it is due to buy an asset in the future can hedge by taking a long
futures position. This is known as long hedge. A long hedge is most appropriate when a company
wants to lock in a price now of an asset which it is planning to purchase in future.

For Ex. Suppose that the tyre manufacturing company estimates that it requires 1000 quintal
rubber by June 15. The spot price of rubber is rs5350/- per quintal and June futures price is 5210
per quintal. The company can hedge its position by taking a long position in 10 June futures
contract and closing its position on June 15. The strategy has the effect of locking in the price of
the rubber that is required at close to 5210.

Suppose the price of rubber on June 15 is 5260/-per quintal. The company gains from futures
contract 1000 (5260-5210)=50,000/-. It pays rs5260000 for rubber. The total costs to the
company is 5260000-50000=5210000 i.e. 5210 per quintal.

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 Suppose the price of rubber on June 15 is 5050/-per quintal. The company loses from futures
contract 1000 (5210-5050)=1,60,000/-. It pays 5050000 for rubber. The total cost to the
company is 5050000+160000=5210000 i.e. 5210 per quintal.

4 Short Hedging-Long spot and short futures

A short hedge is one that involves a short position in futures contract. A short hedge is
appropriate when a hedger already owns an asset and expects to sell it at some future time. It can
also be used that when hedger does not own asset but knows that asset will be owned at some
time in future. Hedger has bearish outlook: prices are expected to fall. In case of price increase,
loss on the spot position is offset by gain on futures position. In case of price increase, gain on the
spot position is offset by loss on futures position.

6. Summary
Let us recapitulate

1. Dr. L.C Gupta Committee came out strongly in favor of Introduction of financial
derivatives in order to provide the facility for hedging in the most cost-efficient way
against market risk.
2. A Derivative is any security whose price is determined by the value of another asset.
3. One of the main reason of existence of derivatives is to hedge or provide protection to the
parties to contract.
4. Derivatives can be classified in to Financial and Commodity Contract. The basic
difference between them is underlying asset. Financial contracts are further divided in to
basic and complex. Basics are futures, forwards, Options, Warrant & Convertibles.
Complex contracts are Swaps and Exotics.
5. Forward contracts are non-standardized form of contracts whereas Futures are
standardized contracts.
6. The theoretical price of a future contract is sum of the current spot price and cost of carry.
However, the actual price of futures contract very much depends upon the demand and
supply of the underlying stock.
7. Process of clearing and settlement at stock exchanges are clearly defined. National
Securities Clearing Corporation Limited (NSCCL) is the clearing and settlement agency
for all deals executed on the Derivatives (Futures & Options) segment at NSE.
8. Mark to market reduces the default risk of the parties as profits/ losses are computed as
the difference between the previous day's settlement price and current day's settlement
price.
9. Various future contracts like commodity futures, interest rate futures, stock index futures
are available to hedge the risk against the price fluctuations.

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