NISM-Series-XXI-A: Portfolio Management Services (PMS) Distributors · Derivatives

Introduction to Derivatives and Market Participants

Updated 11 October 2026 · Fact-checked

A derivative is a financial contract whose value depends on an underlying asset, such as a share, index, bond, currency or commodity. Participants use derivatives to hedge risk, speculate on price moves or earn arbitrage profit. To answer exam questions, identify the underlying and the participant's purpose.

Understand Introduction to Derivatives and Market Participants

A derivative is a contract. It has no value of its own. Its value is derived from something else, called the underlying. If you own shares and a contract's price moves with those shares, the contract is a derivative of the shares.

Underlying assets can be shares, stock indices, bonds or interest rates, currencies, commodities and even other variables like weather in some markets. In India, equity derivatives on single stocks and indices such as the Nifty are the most commonly traded on exchanges.

The main types are forwards, futures, options and swaps. Forwards and swaps are privately agreed contracts, traded over the counter (OTC). Futures and options are standardised and trade on exchanges, where a clearing corporation stands behind the trades.

Derivatives serve three purposes. Hedging means reducing an existing risk. Speculation means taking a risk in the hope of profit. Arbitrage means earning a risk-free profit from a price gap between two markets or between the spot and derivative price.

For a PMS distributor, the point is simple. A portfolio manager may use derivatives to protect a portfolio from a fall, adjust exposure quickly or earn from mispricing, within the limits of the regulations and the client's agreement. You must know who does what and why.

Key formulas to remember

Derivative value: Value of derivative = f(price of underlying); A derivative has no standalone value. It depends on the underlying.
Hedger: Hedger: has an existing exposure → takes an opposite position to reduce risk; Aim is risk reduction, not profit.
Speculator: Speculator: no existing exposure → takes a view on price direction; Accepts risk for possible profit. Provides liquidity.
Arbitrageur: Arbitrageur: buys cheap in one market and sells dear in another at the same time; Aims at risk-free profit and keeps prices aligned across markets.
Spot and derivative link: Futures price ≈ Spot price adjusted for cost of carry; Gaps beyond this attract arbitrage.

How to solve Introduction to Derivatives and Market Participants questions

Use this method for any conceptual or scenario question on derivatives basics.

1Read the question and find the underlying asset.
2Identify the type of contract: forward, future, option or swap, and whether it is OTC or exchange-traded.
3Check whether the person already has an exposure to the underlying.
4If they hold exposure and act to reduce risk, they are a hedger.
5If they have no exposure and take a view on price, they are a speculator.
6If they trade in two markets at once to lock a price gap, they are an arbitrageur.
7Check the options for absolute words like always or guaranteed, and eliminate them.
8Pick the option that matches the purpose of the trade, not the instrument.

Quickest way: Purpose test

When to use it: Use it for any question asking who a participant is or why a trade is done.

Ask: does the person already own or owe the underlying? Yes points to hedger.
Ask: is there a simultaneous trade in two markets for a price gap? Yes points to arbitrageur.
Otherwise, if they only take a price view, they are a speculator.
Remember that the same contract can serve any of the three purposes.

Common mistakes in Introduction to Derivatives and Market Participants

Thinking a derivative is an asset with its own independent value.
Derivatives trade at prices, so they look like ordinary securities.
Fix: Remember the price is derived from the underlying. If the underlying is removed, the contract has no meaning.
Classifying a participant by the instrument used.
Students link futures with speculation and options with hedging.
Fix: Classify by purpose and existing exposure. Any instrument can serve any role.
Saying hedging removes all risk or guarantees profit.
The word hedge sounds like full protection.
Fix: Hedging reduces risk, often at a cost or by giving up some gain. Reject options that say it eliminates all risk.
Calling speculators harmful and unnecessary.
Speculation is seen as gambling.
Fix: Speculators take on risk that hedgers want to shed and add liquidity. Exam answers treat them as useful participants.
Treating arbitrage as risky.
Students mix it up with speculation.
Fix: Arbitrage involves simultaneous offsetting trades to lock a gap, so it is meant to be risk-free.
Mixing up OTC and exchange-traded contracts.
Both are introduced together.
Fix: Forwards and swaps are OTC and customised. Futures and options are standardised and exchange-traded.

Worked examples

Example 1

A PMS client holds a portfolio of large-cap shares and fears a market fall over the next month. The portfolio manager takes a position in index derivatives that gains if the market falls. Which participant role does the manager play, and why?

Show the solution

The underlying is a stock index, which relates to the equity portfolio.
The client already has exposure to the equity market.
The derivative position is opposite to the portfolio exposure: it gains when the market falls.
The purpose is to reduce risk, not to seek extra profit.

Answer: The manager acts as a hedger, because the trade offsets an existing exposure to reduce risk.

Example 2

A share trades at a lower price in one market than the price of its derivative implies, after allowing for cost of carry. A trader buys the share in the cheaper market and sells the derivative at the same time to lock the gap. Is the trader a hedger, speculator or arbitrageur?

Show the solution

The trader has no stated prior exposure to hedge.
The trader buys and sells in two markets at the same time.
The aim is to capture the price gap, which is locked in.
A locked gap through simultaneous trades is risk-free profit seeking.

Answer: The trader is an arbitrageur.

Exam tips

Questions often give a short scenario. Decide the role from purpose and existing exposure, not the instrument.
Watch for absolute words like always, guaranteed, eliminates and no risk. They usually mark a wrong option.
Know the OTC versus exchange-traded split: forwards and swaps are OTC, futures and options are exchange-traded.
PMS negative marking is 10% of the marks for a question, so guess only when you can remove at least one option.

Practice questions from Derivatives

Introduction to Derivatives and Market Participants in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

CSEETDerivatives Market

Introduction to Derivatives and Market Participants: frequently asked questions

What are derivatives in simple terms?

A derivative is a contract whose value depends on an underlying asset such as a share, index, bond, currency or commodity. You trade the contract, not the asset itself. Futures, options, forwards and swaps are the main types.

What is the difference between hedgers, speculators and arbitrageurs?

A hedger has an exposure and trades to reduce risk. A speculator takes on risk to profit from a price view. An arbitrageur trades in two markets at once to earn risk-free profit from a price gap.

How are derivatives used in portfolio management?

A portfolio manager can use them to hedge against market falls, adjust exposure quickly or take advantage of mispricing. Use must stay within the regulations and the client's agreement.

Is the same derivative always used for the same purpose?

No. The same contract can be used to hedge, speculate or arbitrage. The role depends on the trader's exposure and intent.