INTRODUCTION & HISTORY

OF DERIVATIVES
• To update the students with the current in-
formation of derivative market.
• Introduction of Derivatives and its products
• Participants of Derivative Market
• Eligibility criteria to be selected in stock deriv-
atives
• Clearing and settlement procedure in deriva-
tive market.
1
 Current Status of Indian Derivative Market
• India’s tryst with derivatives began in 2000 when both the NSE and the
BSE commenced trading in equity derivatives.
• In June 2000, index futures became the first type of derivatives instru-
ments to be launched in the Indian markets, followed by index options in
June 2001, options in individual stocks in July 2001, and futures in single
stock derivatives in November 2001.
• In FY18, total turnover of derivatives in NSE reached Rs1,649trn main-
taining a continuous upward trend. Notably, it increased by 75% in FY18
over previous financial year.
• Total turnover in currency derivatives segment at NSE increased by 4% to
Rs50.3tn in FY18 compare to Rs48.6tn in FY17.The currency derivatives
trading in India started in August 2008 at NSE (USD-INR, GBPINR, EURO-
INR and JPY-INR).
• Later in October 2010, currency options trading was allowed on USD-
INR.
• Total turnover of IRF at NSE increased by 4% to Rs3.2tn in FY18 from
Rs3.1tn in FY17. In BSE, total turnover increased tremendously by 75%
from Rs1,280bn in 2016-17 to Rs2,239bn in 2017-18.

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 Currency Futures Currency Options Total

Year Notional
No. of contracts Turnover  No. of con- Turnover  No. of con- Turnover* 
( cr.) tracts tracts ( cr.)
( cr.)

2018-2019 44,97,64,465 32,17,765.12 35,11,20,594 24,67,224.87 80,08,85,059 56,84,989.99

2017-2018 39,04,33,137 25,95,685.67 37,45,30,592 24,32,816.50 76,49,63,729 50,28,502.17

2016-2017 36,26,15,931 24,89,778.94 34,98,35,508 23,67,296.92 71,24,51,439 48,57,075.85

2015-2016 40,97,59,364 27,49,332.96 26,38,23,800 17,52,552.62 67,35,83,164 45,01,885.58

2014-2015 35,55,88,963 22,47,992.34 12,50,75,731 7,75,915.32 48,06,64,694 30,23,907.67

2013-2014 47,83,01,579 29,40,885.92 18,18,90,951 10,71,627.54 66,01,92,530 40,12,513.45

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Largest derivatives exchanges worldwide in 2017, by
number of contracts traded (in millions)

4
 Table 23: Trends in Equity Derivatives Segment of NSE 2017
Index Futures Stock Futures Total
No. of
Year/Month Trading No. of Con- Turnover (` No. of Con- Turnover (` No. of Con- Turnover (`
Days tracts crore) tracts crore) tracts crore)

16,50,23,65
2010-11 254 43,56,755 18,60,41,459 54,95,757 103,42,12,062 2,92,48,221
3
14,61,88,74
2011-12 249 35,77,998 15,83,44,617 40,74,671 120,50,45,464 3,13,49,732
0
2012-13 249 9,61,00,385 25,27,131 14,77,11,691 42,23,872 113,14,67,418 3,15,33,004
10,52,70,52 1,28,44,24,32
2013-14 251 30,85,297 17,04,14,186 49,49,282 3,82,11,408
9 1
12,93,14,31
2014-15 243 41,09,472 23,76,04,741 82,91,766 183,70,41,131 5,56,06,453
8
14,05,38,76
2015-16 247 45,57,124 23,42,43,967 78,28,606 209,86,10,395 6,48,25,834
8
2016-17 248 6,65,35,071 43,35,941 17,38,60,130 1,11,29,587 139,97,46,129 9,43,70,302

Apr 16-Dec
186 5,21,12,984 33,11,710 12,80,79,951 79,29,425 102,29,34,917 6,67,46,190
16
Apr 17-Dec 11,54,91,63
186 3,99,10,085 32,71,424 15,61,43,708 1,13,47,701 135,86,66,807
17 7

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6
 What is derivatives?
• Derivatives means to derive the value from an underly-
ing assets.
• Underlying assets I.e. commodity & financial assets.
Gold, silver, oil, stocks, bonds & currencies.
• The first “futures” contracts can be traced to the Yo-
doya rice market in Osaka, Japan around 1650. The
farmers were afraid of rice prices falling in the future at
the time of harvesting.
• Start from 1860. Due to manipulation, absence of stan-
dardization, its disappeared from the listing of many
exch by 1968.
• Again start from 1973 with trading options on equities.
7
• In India, derivatives markets have been functioning
since the nineteenth century, with organized trading in
cotton through the establishment of the Cotton Trade
Association in 1875.
• The first contract to be launched on NSE was the Nifty
50 index futures contract. In a span of one and a half
years after the introduction of index futures, index op-
tions, stock options and stock futures were also intro-
duced in the derivatives segment for trading. NSE’s eq-
uity derivatives segment is called the Futures & Options
Segment or F&O Segment. NSE also trades in Currency
and Interest Rate Futures contracts under a separate
segment.
8
• In 1993, the NSE was established as an electronic, na-
tional exchange and it started operations in 1994.
• November 18, 1996-L.C. Gupta Committee set up to
draft a policy framework for introducing derivatives
• May 11, 1998- L.C. Gupta committee submits its report
on the policy framework
• May 25, 2000-SEBI allows exchanges to trade in index
futures
• June 12, 2000 -Trading on Nifty futures commences on
the NSE
• June 4, 2001 Trading for Nifty options commences on
the NSE

9
• July 2, 2001 Trading on Stock options com-
mences on the NSE
• November 9, 2001 Trading on Stock futures
commences on the NSE
• August 29, 2008 Currency derivatives trading
commences on the NSE
• August 31, 2009- Interest rate derivatives trading
commences on the NSE
• 2011- Commenced trading in index futures and
options on global indices, namely the S&P 500
and Dow Jones Industrial Average.
10
• 2012- Commenced trading in index futures and options
contracts on the FTSE ( Financial Times Stock Exchange)
100 index Launched SME-specific EMERGE platform for
the listing and trading of securities of SMEs.
• 2014- Launched NMF-II platform for mutual funds, NBF
II segment for interest rate futures, India VIX index fu-
tures, Commenced trading on NIFTY 50 (then known as
CNX NIFTY) on the Osaka Exchange.
• 2015- Entered into a memorandum of understanding to
enhance the level of cooperation with the London Stock
Exchange Group.- Renamed CNX NIFTY to NIFTY 50.

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• 2016- Launched NIFTY 50 index futures trading on TAIFEX,
Launched platform for sovereign gold bond issuances, Launched
electronic book-building platform for private placement of debt
securities.
• 2017 - Launch of Trading on Soverign Gold Bond (SGB) & Launch
of an international exchange in Gujarat International Finance
Tech City - International Financial Service Centre. NSE IFSC Ex-
change
• 2018 - SE signs Post-Trade Technology and Strategic Partnership
Agreement with Nasdaq, NSE becomes the first Indian stock ex-
change to be part 30 exempted by Commodity Futures Trading
Commission (CFTC), enables access for US clients. NSE launches
e-Gsec Platform for retail, Introduction of Cross Currency Deriv-
atives contracts on EUR-USD, GBP-USD and USD-JPY

12
 Derivative Jargons
• Spot market
• Physical settlement
• Cash settlement
• Spot price- Spot price of an underlying asset is the price
that is quoted for immediate delivery of the asset.
• Forward, future price- Forward price or futures price is
the price that is agreed upon at the date of the contract
for the delivery of an asset at a specific future date.
These prices are dependent on the spot price, the pre-
vailing interest rate and the expiry date of the contract.

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• Strike price- The price at which the buyer of an option
can buy the stock (in the case of a call option) or sell
the stock (in the case of a put option) on or before the
expiry date of option contracts is called strike price. It
is the price at which the stock will be bought or sold
when the option is exercised. Strike price is used in the
case of options only; it is not used for futures or for-
wards.
• Expiration date-In the case of Futures, Forwards and
Index Options, Expiration Date is the only date on
which settlement takes place. In case of stock options,
on the other hand, Expiration date (or simply expiry), is
the last date on which the option can be exercised.
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• American option
• European option
• Contract and contract size
• Contract value-Contract value is notional value of the
transaction in case one contract is bought or sold. It is
the contract size multiplied but the price of the fu-
tures.
• Margin
• Open Interest
• Short and long position
• Index future, index option, Stock future and stock op-
tion
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 Open Interest
• Open Interest is the total number of outstanding contracts that are
held by market participants at the end of the day.
• It can also be defined as the total number of futures contracts or
option contracts that have not yet been exercised (squared off),
expired, or fulfilled by delivery.
• Open interest applies primarily to the futures market. Open inter-
est, or the total number of open contracts on a security, is often
used to confirm trends and trend reversals for futures and options
contracts.
• Open interest measures the flow of money into the futures market.
For each seller of a futures contract there must be a buyer of that
contract. Thus a seller and a buyer combine to create only one con-
tract.
 OI - A confirming indicator
Open
Price Interpretation
Interest

Rising Rising Market is Strong

Rising Falling Market is Weakening

Falling Rising Market is Weak

Falling Falling Market is Strengthening

 Nifty Contract Specification
• A futures contract is a forward contract, which is traded on an
Exchange. NSE commenced trading in index futures on June 12,
2000.
• NSE defines the characteristics of the futures contract such as
the underlying index, market lot, and the maturity date of the
contract. The futures contracts are available for trading from in-
troduction to the expiry date.
• Contract Specifications
• Market type : N
• Instrument Type : FUTIDX
• Underlying : NIFTY
• Underlying Instrument - NIFTY 50.
• Lot Size - 75
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• Trading cycle - Nifty 50 futures contracts have a maximum of 3-
month trading cycle - the near month (one), the next month (two)
and the far month (three). A new contract is introduced on the
trading day following the expiry of the near month contract. The
new contract will be introduced for a three month duration. This
way, at any point in time, there will be 3 contracts available for
trading in the market i.e., one near month, one mid month and
one far month duration respectively
• Expiry day - Nifty 50 futures contracts expire on the last Thursday
of the expiry month. If the last Thursday is a trading holiday, the
contracts expire on the previous trading day.
• Contract size - The value of the futures contracts on Nifty 50 may
not be less than Rs. 5 lakhs at the time of introduction. The per-
mitted lot size for futures contracts & options contracts shall be
the same for a given underlying or such lot size as may be stipu-
lated by the Exchange from time to time.
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• Price steps - The price step in respect of Nifty 50 futures con-
tracts is Re.0.05.
• Base Prices - Base price of Nifty 50 futures contracts on the
first day of trading would be theoretical futures price.. The
base price of the contracts on subsequent trading days would
be the daily settlement price of the futures contracts.
• Price bands - There are no day minimum/maximum price
ranges applicable for Nifty 50 futures contracts. However, in
order to prevent erroneous order entry by trading members,
operating ranges are kept at +/- 10 %. In respect of orders
which have come under price freeze, members would be re-
quired to confirm to the Exchange that there is no inadvertent
error in the order entry and that the order is genuine. On such
confirmation the Exchange may approve such order.

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 Factor driving the growth of deriva-
tives.
• Increased volatility in asset prices in financial
market.
• Increased integration of national financial mar-
ket with international market.
• Due to latest technology of communication,
cost decrease.
• Development of more sophisticated risk man-
agement tools.
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 Advantages of Derivatives
• They help in transferring risks from risk adverse
people to risk oriented people.
• They help in the discovery of future as well as
current prices.
• They catalyze entrepreneurial activity.
• They increase the volume traded in markets be-
cause of participation of risk adverse people in
greater numbers.
• They increase savings and investment in the long
run.
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 Upside and Downside Risk
• If you are uncertain about some consequential event,
the set of possible desirable outcomes is sometimes
called your “upside risk”. The set of possible adverse
outcomes is then your “downside risk”. For example, if
you will either win five dollars or lose three dollars
based on a die toss, your upside risk is a gain of five dol-
lars. Your downside risk is a loss of three dollars.
• If you want to take loan and afraid of interest go up, you
fixed out the rate of loan. If later on interest go up, you
will be in profit and it is known as downside risk. But if
interest rate go down, you will be in loss and it is upside
risk.
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 Cash Vs Derivatives Market
1. Cash/Spot market Re- 1. There is no physical de-
quire D-mat, Trading and livery. So, only Trading
Bank account. and Bank account only.
2. Investor can buy/sell 1 2. Investor can buy/sell only
share also. in lot size.
3. For pay in and pay out 3. Daily/Mark to Market
T+2 cycle followed. settlement done.
4. 100% of contract value 4. Only % of contract value
paid by buyers to sellers. is paid by buyer to sellers
5. Buyer of shares are the 5. Buyers of future are not
owners. the owners.
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6. Buyer has voting right.
7. Buyer have benefits of div-
idend, right, bonus or split
shares.
8. Buyer can hold shares as
per requirement.
9. No repetitive cost.
10. Buyer cannot buy Index.
6. Buyer doesn’t have vot -
ing right.
7. No benefits of dividend,
right, bonus or split
shares.
8. Buyer can hold future up
to maturity only. Then
carry forward position.
9. Every expiry attracts
transaction cost.
10. Buyer can buy index fu-
ture.
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 Derivatives products
• Derivatives products :
1. Forward contract
2. Future contract
3. Options – warrants (option with 1 yr maturity) –
LEAPS (option with 3 yr maturity-Long Term Equity
Anticipation Securities)
4. Basket- index option
5. Swaps: Agreement betw. two parties to exchange
cash flows in future. Interest rate swap & Currency
Swap
27
 Derivative Products
• Forward Contracts : A forward contract is an agreement be-
tween two parties – a buyer and a seller to purchase or sell
something at a later date at a price agreed upon today. Forward
contracts, sometimes called forward commitments , are very
common in everyone life. Any type of contractual agreement
that calls for the future purchase of a good or service at a price
agreed upon today and without the right of cancellation is a
forward contract.
• Future Contracts : A futures contract is an agreement between
two parties – a buyer and a seller – to buy or sell something at a
future date. The contact trades on a futures exchange and is sub-
ject to a daily settlement procedure. Future contracts evolved
out of forward contracts and possess many of the same charac-
teristics. 28
• Options Contracts: Options are of two types – calls and puts.
Calls give the buyer the right but not the obligation to buy a
given quantity of the underlying asset, at a given price on or be-
fore a given future date. Puts give the buyer the right, but not
the obligation to sell a given quantity of the underlying asset at
a given price on or before a given date.
• Swaps : Swaps are private agreements between two parties to
exchange cash flows in the future according to a prearranged
formula. They can be regarded as portfolios of forward con-
tracts. The two commonly used swaps are interest rate swaps
and currency swaps.
• Interest rate swaps: These involve swapping only the interest
related cash flows between the parties in the same currency.
• Currency swaps: These entail swapping both principal and in-
terest between the parties, with the cash flows in one direction
being in a different currency than those in the opposite direc-
tion.

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 The difference between Forward Contracts and
Futures Contracts
Sr.
Basis Futures Forwards
No
Traded on organized ex-
1 Nature Over the Counter
change
Contract
2 Standardized Customized
Terms
3 Liquidity More liquid Less liquid
Margin Pay- Requires margin pay-
4 Not required
ments ments
5 Settlement Follows daily settlement At the end of the period.

Contract can be reversed

Can be reversed with any only with the same counter-
6 Squaring off
member of the Exchange. party with whom it was en-
tered into.
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 Participants In derivatives market
1. Hedgers: Hedgers use futures, forwards & options
to reduce the risk that they face from the potential
future movement of prices in the fin mkt.
2. Speculator: Speculators have bet on prices’ move-
ment. They just take an advantages of the price
movement. They can long or short at forward or
option contract.
3. Arbitrageurs: They grab the risk less profit by enter-
ing in to two market simultaneously.

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 Difference between exchange traded v/s
OTC market
• Derivatives that are traded on an exchange called exchange
traded derivatives. Whereas, privately negotiated deriva-
tives contracts are called OTC contracts.
• In OTC, the mgt of counter party risk is decentralized and
located within individual institutions.
• In OTC, there are no formal centralized limits on individual
positions, leverage or margining.
• In OTC, there are no formal rules for risk & burden sharing.
• In OTC, there are no formal rules or mechanisms for ensur-
ing mkt stability & integrity and not even for participants.
• OTC contracts are generally not regulated by regulatory au-
thority or exchange.

32
 Trading Process in Derivatives Market
• Step 1: Trader will place order to buy/sell
through broker.
• Step 2: The broker will match the order placed
by trader.
• Step 3: if the order is executed, the broker will
then have to get this order cleared by CM. Once
the order is cleared by CM, they take responsi-
bility of fulfilling the obligations of the contract
at maturity.
• Step 4: As a CM is responsible for the fulfillment of
the contract at maturity, the CM will have to post a
margin that is usually based on the volatility of the
underlying the asset price.
• Step 5: The above requirement of margin will shifted
to broker.
• Step 6: The broker will maintain margin account. It
will be updated daily on the basis of the settlement
price of that day, known as the Mart to Market.
• Step 7: Traders need to follow the instruction of bro-
ker to keep MTM as per changes in the price of un-
derlying asset.
• Step 8: At maturity, the contract will be settled. If
there is a profit/loss, the amount will be credited/
debited in to trader’s account.
 Clearing and Settlement
• National Securities Clearing Corporation limited –
NSCCL is the clearing and settlement agency for
all deals executed on the Derivatives segment.
• NSCCL acts as legal counter party to all deals on
NSE’s F&O segment and guarantees settlement.
• A Clearing Member (CM) of NSCCL has the re-
sponsibility of clearing and settlement of all deals
executed by Trading Members(TM) on NSE, who
clear and settle such deals through them.
 Clearing Members
• A Clearing Member (CM) of NSCCL has the responsibility
of clearing and settlement of all deals executed by Trad-
ing Members(TM) on NSE, who clear and settle such
deals through them. Primarily, the CM performs the fol-
lowing functions:
• Clearing: Computing obligations of all his TM's i.e. de-
termining positions to settle.
• Settlement: Performing actual settlement. Only funds
settlement is allowed at present in Index as well as
Stock futures and options contracts
• Risk Management: Setting position limits based on up-
front deposits / margins for each TM and monitoring
positions on a continuous basis.
 Types of Clearing Members
• Trading Member Clearing Member (TM-CM) : A
Clearing Member who is also a TM. Such CMs may
clear and settle their own proprietary trades, their
clients’ trades as well as trades of other TM’s.
• Professional Clearing Member (PCM) : A CM who is
not a TM. Typically banks or custodians could be-
come a PCM and clear and settle for TM’s.
• Self Clearing Member (SCM): A Clearing Member
who is also a TM. Such CMs may clear and settle
only their own proprietary trades and their clients’
trades but cannot clear and settle trades of other
TM’s.
 CM Eligibility Norms
• Net worth of at least Rs.300 lakhs. The net worth
requirement for a CM who clears and settles only 
deals executed by him is Rs. 100 lakhs.
• Deposit of Rs. 50 lakhs to NSCCL which forms the 
Base Minimum Capital (BMC) of the CM.
• Additional incremental deposits of Rs.10 lakhs to
NSCCL for each additional TM in case the CM un-
dertakes to clear and settle deals for other TMs.
 Eligibility Criteria for selection of Securities
• New securities being introduced in the F&O segment are based
on the eligibility criteria which take into consideration average
daily market capitalization, average daily traded value, the mar-
ket wide position limit in the security, the quarter sigma values,
the Average daily deliverable value and as approved by SEBI.
• The average daily market capitalisation and the average daily
traded value would be computed on the 16th of each month, on
a rolling basis, to arrive at the list of top 500 securities.
• Similarly, the quarter sigma order size, considering the order
book snapshots of securities in the previous six months and av-
erage daily deliverable value of a stock, on a rolling basis in the
previous six months, would be calculated on the 16th of each
month.
40
• Further, the market wide position limit (number of shares) shall be val-
ued taking the closing prices of stocks in the underlying cash market on
the date of expiry of contract for the previous month.
• Futures & Options contracts may be introduced on new securities which
meet the below mentioned eligibility criteria, subject to approval by
SEBI.
1. The stock shall be chosen from amongst the top 500 stocks in terms of
average daily market capitalisation and average daily traded value in the
previous six months on a rolling basis.
2. The stock's median quarter-sigma order size over the last six months
shall be not less than Rs. 25 lakhs. For this purpose, a stock's quarter-
sigma order size shall mean the order size (in value terms) required to
cause a change in the stock price equal to one-quarter of a standard de-
viation.
3. The market wide position limit in the stock shall not be less than Rs.500
crores. The market wide position limit (number of shares) shall be val-
ued taking the closing prices of stocks in the underlying cash market on
the date of expiry of contract in the month. 41
4. The Average daily delivery value in cash market shall not be less
than Rs.10 crores in the previous six months on a rolling basis.
5. All the existing F&O stocks which meets the eligibility criteria shall
continue to be cash settled (Till further notification from SEBI),
however such F&O stocks, if fail to satisfy any of the eligibility cri-
teria for a continuous period of three months, shall move from
cash settlement to physical settlement for a period of one year.
6. After moving to physical settlement, the continued eligibility crite-
ria is that market wide position limit in the stock shall not be less
than Rs. 200 crores and stock's median quarter-sigma order size
over the last six months shall not be less than Rs. 5 lakhs.
7. If an existing security fails to meet aforesaid continued eligibility
criteria for three months consecutively, then no fresh month con-
tract shall be issued on that security.

42
 Eligibility Criteria for selection of Indices
• The futures & options contracts on an index can be in-
troduced only if the stocks contributing to 80% weigh-
tage of the index are individually eligible for derivative
trading. However, no single ineligible stocks in the index
shall have a weightage of more than 5% in the index.
The above criteria is applied every month, if the index
fails to meet the eligibility criteria for three months con-
secutively, then no fresh month contract shall be issued
on that index.

43
 Framework for continued eligibility of In-
dex derivatives
• The product success framework shall be applicable to all index deriva-
tives at the underlying level. The framework shall not be applicable to
flagship index of the exchange. The flagship index for National Stock Ex-
change of India for the purpose of product success framework is Nifty
50 Index
• The criteria for evaluation of the index derivatives are as follows:
• 15% of trading members active in all index derivatives or 20 trading
members whichever is lower should have traded in any derivative con-
tract on the index being reviewed in each of the month during the re-
view period,
• Trading on a minimum of 75% of the trading days during the review pe-
riod,
• Average daily turnover of at least INR 10 crore during the review period,
and
• Average daily open interest of INR 4 crore during the review period 44