NISM Certifications · NISM-Series-VIII: Equity Derivatives

Basics of Derivatives: formula sheet

Full chapter guide

Key formulas

Core definition: Derivative value = f(price of underlying); The derivative has no independent value. It depends on the underlying.
Legal status: Derivative ∈ 'securities' under SCRA, 1956; Derivatives are securities in law, so they are regulated by SEBI and traded on recognised exchanges.
Types of underlying: Share | Index | Commodity | Currency | Interest rate | Other derivative; Equity derivatives use shares or indices as the underlying.
Uses of derivatives: Hedging | Speculation | Arbitrage; These are the three standard purposes. Match each to the participant type.
Leverage: Exposure = contract value; Outlay = margin or premium (much smaller); Small outlay controls a large value. This magnifies both profit and loss.
Forward and futures obligation: Both buyer and seller are obligated to perform at expiry; Neither side has a choice. Payoff can be a gain or loss for both.
Option buyer: Right without obligation; pays premium; maximum loss = premium; Applies to both call buyers and put buyers.
Option seller (writer): Obligation if exercised; receives premium; maximum gain = premium; Loss can be very large for a call writer and large for a put writer.
Call vs put: Call = right to buy; Put = right to sell; Both are at the strike price, on or by expiry depending on option style.
Standardised vs customised: Futures, options on exchange = standardised; forwards, swaps = mostly OTC and customised; Exchange-traded contracts are guaranteed by the clearing corporation.
Swap: Exchange of cash flows on a notional amount; The notional principal is usually not exchanged in an interest rate swap.
Standardisation: Exchange-traded = standard terms; OTC = customised terms; Exchange fixes lot size, expiry and strikes. OTC parties negotiate every term.
Counterparty risk: Exchange-traded: clearing corporation guarantee; OTC: bilateral credit risk; Margins and daily mark-to-market reduce default risk on exchanges. OTC usually has no such guarantee.
Liquidity and exit: Exchange-traded: easy exit by reverse trade; OTC: exit needs the counterparty's consent; Standard contracts are easier to trade and square off.
Transparency: Exchange-traded: public prices and volumes; OTC: private deals; Price discovery is better on an exchange.
Typical examples: Futures and options = exchange-traded; forwards and swaps = OTC; Forwards are the standard OTC example in this syllabus.
Hedger: Existing exposure in spot + opposite position in derivative → lower price risk; Motive is risk reduction. Not profit-seeking from direction.
Speculator: No underlying exposure + directional view → derivative position; Takes risk, uses leverage, provides liquidity.
Arbitrageur: Buy in cheaper market + sell in dearer market at the same time → locked-in profit; Aims at risk-free profit from mispricing. Keeps markets aligned.
Cash and carry (basic idea): Futures price above fair value → buy spot, sell futures; Reverse cash and carry is the opposite: sell spot, buy futures when futures are too cheap.
Three economic functions: Price discovery + Risk transfer + Market efficiency/liquidity; Most MCQs test which of these a statement describes. Risk is transferred, not eliminated.
Hedger vs speculator: Hedger = reduces risk; Speculator = takes risk for profit; Arbitrageur = earns from price gaps; Risk moves from hedgers to those willing to bear it.
Order of Indian launches: Index futures (June 2000) → Index options (2001) → Stock options (2001) → Stock futures (2001); Index futures were the first exchange-traded derivative in India. Check the sequence in your NISM workbook before the exam.
Regulatory step: SCRA amendment 1999 → SEBI committee report → trading from June 2000; Legal clarity came before trading began.

Quick revision

A derivative derives its value from an underlying asset or reference rate such as a share, index, currency or commodity.
The four basic contract types are forwards, futures, options and swaps.
A forward is a customised OTC contract; a futures contract is standardised and traded on an exchange.
Exchange-traded derivatives are standardised and have a clearing corporation guaranteeing performance.
OTC derivatives are customised and carry counterparty default risk.
An option gives the buyer a right, not an obligation; the seller has the obligation if the buyer exercises.
A hedger reduces existing risk; a speculator takes risk for profit; an arbitrageur exploits price gaps between markets.
Derivatives help in price discovery and risk transfer.
Leverage lets a small margin control a larger exposure, which magnifies both gains and losses.
Check every Indian date and instrument against the workbook before the exam.
On negative marking: a wrong answer loses 25% of the marks for that question, so skip when truly unsure.

Common mistakes

Treating the underlying as the derivative, for example calling a share a derivative. Fix: Remember: the share is the underlying. The futures or option on the share is the derivative.
Saying derivatives reduce risk for everyone. Fix: Derivatives can reduce risk (hedgers) or add risk (speculators). Leverage magnifies losses too.
Saying the option buyer is obligated to buy or sell. Fix: Remember: the buyer holds the right and pays the premium. Only the seller carries the obligation.
Treating futures and forwards as identical. Fix: List the differences: futures are exchange-traded, standardised, marked to market and guaranteed by the clearing corporation. Forwards are OTC, customised and carry counterparty risk.
Saying exchange-traded derivatives have no risk. Fix: Remember it removes the risk of the other trader defaulting. Market risk from price movements remains.
Thinking OTC derivatives are illegal. Fix: OTC contracts are legitimate private contracts. They simply lack standardisation and the exchange's guarantee.
Deciding the participant from the instrument, such as 'options users are speculators'. Fix: Judge by motive and existing exposure. Any of the three can use any derivative.
Saying a hedger earns profit from the hedge. Fix: Look at the whole position. The derivative gain or loss offsets the spot move. The aim is stability.
Saying derivatives eliminate risk. Fix: Remember that risk is transferred to those willing to bear it. The total risk in the system does not vanish.
Confusing price discovery with price fixing. Fix: Price discovery means the market reveals a price from many participants' views. No one sets it.

Exam tips

Expect direct definition questions. Learn the one-line definition word for word in your own words.
Watch for options with absolute words like 'always' or 'never'. They are often traps.
Know the three uses (hedging, speculation, arbitrage) and who does each.
Remember SCRA treats derivatives as securities. This is a common one-mark question.
NISM Series VIII has negative marking of 25% of the marks of a question, so skip options you cannot reason out.
Expect direct questions that give a description and ask you to name the contract. Match the single strongest clue first.
Watch for statements that swap the buyer and seller roles in options. Check who pays the premium and who has the obligation.
Questions on differences between forwards and futures usually test standardisation, exchange trading, margin and counterparty risk.