Derivatives (Futures, Options, Swaps)
Intuition
Derivatives are financial contracts whose value is derived from an underlying asset, a stock, an index, a commodity, a currency, or an interest rate. They are used for two broad purposes: hedging (reducing existing risk) and speculation (taking on risk in pursuit of profit).
An exporter who will receive USD in three months uses a currency forward to lock in today's exchange rate, hedging. A trader who believes the Nifty will fall buys put options, speculation. The same instrument serves both purposes depending on who is using it and why.
India has one of the most active derivatives markets globally by contract volume, primarily driven by index options (Nifty and Bank Nifty options). The F&O segment on NSE dwarfs the cash equity segment in notional volume.
Mechanics
Four main types:
1. Futures Agreement to buy/sell an asset at a fixed price on a future date. Both parties are obligated.
- Equity futures: settle in cash (no delivery of shares in most Indian stock futures)
- Lot size: standardised (e.g., Nifty 50 futures = 25 units per lot)
- Margin: initial margin required (typically 10–15% of contract value); marked-to-market daily
- No upfront premium, just margin
2. Options Buyer gets the RIGHT (not obligation) to buy (Call) or sell (Put) at a strike price.
- Call option: right to BUY at strike. Profit if price rises above (strike + premium paid)
- Put option: right to SELL at strike. Profit if price falls below (strike − premium paid)
- Buyer pays premium upfront; max loss = premium paid
- Writer (seller) receives premium; max profit = premium received; potentially unlimited loss
- Indian equity options: European-style (exercise only at expiry) for index; American-style available for stock options
3. Swaps (OTC) Agreement to exchange cash flows. Most common:
- Interest Rate Swap (IRS): Fixed rate exchanged for floating rate (e.g., fixed 7% vs MIBOR). Used by companies to manage interest rate exposure.
- Currency Swap / Cross-Currency Swap: Exchange principal and interest in different currencies
4. Forwards (OTC) Customised futures contract directly between two parties. Common in currency markets (USD/INR forwards).
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