NISM Series VIII – Equity Derivatives: Basics of Derivatives & Indian Market
If you are preparing for the NISM Series VIII Equity Derivatives Certification Examination, this short note is your starting point. Here you will understand what derivatives are, how they evolved globally, and how India built its own derivatives market. This is Part 1 of our 7-part study series for NISM Series 8.
Quick Answer (Featured Snippet): A derivative is a financial contract whose value depends on an underlying asset such as stocks, indices, commodities, currencies, or interest rates. In India, equity derivatives are regulated by SEBI and traded on BSE and NSE.
What is a Derivative?
A derivative is a contract or product whose value comes from the value of another asset called the underlying asset. The underlying asset can be metals, energy resources, agricultural commodities, or financial instruments like shares or indices.
In simple terms, you are not buying the asset itself. You are entering a contract that tracks the price of that asset.
Global History of Derivative Markets
Understanding the history helps in exam questions related to the NISM Series 8 syllabus.
| Year / Period | Event |
|---|---|
| 12th Century | Sellers in Europe signed contracts promising future delivery of goods |
| 13th Century | English Cistercian Monasteries sold wool up to 20 years in advance to foreign merchants |
| Late 17th Century | A rice futures market was developed in Japan at Dojima, near Osaka |
| 1848 | Chicago Board of Trade (CBOT) started facilitating forward contract trading |
| 1865 | CBOT listed the first exchange-traded derivative contract (futures contract) in the USA |
| 1919 | Chicago Mercantile Exchange (CME) was reorganized for futures trading |
| 1972 | CME introduced the International Monetary Market allowing currency futures trading |
| 1973 | Chicago Board Options Exchange became the first marketplace for listed options trading |
| 1975–77 | CBOT introduced Treasury Bill futures and T-Bond futures contracts |
| 1982 | CME introduced Eurodollar futures; Kansas City Board of Trade launched first stock index futures |
Factors That Drove Global Growth of Derivative Markets
- High volatility in financial markets created demand for risk management tools
- Integration of global financial markets increased cross-border exposures
- Advanced communication technology reduced transaction costs
- Better understanding among market participants about risk management
- Continuous product innovation in the derivatives space
Indian Derivatives Market – A Timeline
This section is frequently tested in the NISM equity derivatives certification exam.
| Year | Development |
|---|---|
| 1996 | SEBI formed the Dr. L.C. Gupta Committee to develop a regulatory framework for derivatives trading in India |
| 1998 | SEBI set up the Prof. J.R. Verma Committee to recommend risk containment measures for derivatives markets |
| 1999 | The Securities Contracts Regulation Act (SCRA) was amended to include derivatives within the definition of 'securities' |
| 2000 | SEBI permitted BSE and NSE to launch equity derivative segments — the start of exchange-traded derivatives in India |
Types of Derivative Products in India
1. Forwards
A forward contract is a direct agreement between two parties to buy or sell an asset on a specific future date at a price decided today. Both parties are obligated to honour the transaction regardless of the prevailing market price on the delivery date. Forwards are customised, over-the-counter (OTC) contracts.
2. Futures
Futures are standardised forward contracts traded on a recognised stock exchange. Instead of negotiating directly, parties trade through a regulated exchange platform. Think of futures as exchange-traded forward contracts.
3. Options
An options contract gives the buyer the right, but not the obligation, to buy or sell the underlying asset at a pre-decided price on or before a specific date. The buyer pays a premium for this right. The seller receives the premium but carries the obligation to fulfil the contract if the buyer exercises the option.
4. Swaps
A swap is an agreement between two parties to exchange cash flows in the future based on a pre-set formula. Swaps are widely used to manage exposure to volatile interest rates, currency exchange rates, and commodity prices.
Who Participates in Derivative Markets?
Featured Snippet: The three main types of market participants in derivatives are Hedgers, Speculators/Traders, and Arbitrageurs.
Hedgers
Hedgers already hold positions in the underlying asset and use derivatives to reduce or offset their risk. Their primary goal is to protect against potential losses.
Speculators / Traders
Speculators take positions in derivative contracts based on their view of future price movements. They aim to profit from market movements without necessarily holding the underlying asset.
Arbitrageurs
Arbitrageurs exploit price differences for the same asset across different markets or instruments to earn risk-free profits. Their activity helps bring prices back in line across markets.
OTC vs Exchange-Traded Derivatives
The Over-the-Counter (OTC) market is not a physical place. It is a network of broker-dealers who negotiate and match contracts privately. OTC contracts are less regulated because transactions occur in private.
In contrast, exchange-traded derivatives like those on NSE or BSE are standardised, transparent, and regulated by SEBI, with the clearing corporation acting as a counterparty to every trade.
Why Are Derivatives Significant?
- They improve price discovery in financial markets
- They help in the efficient transfer of risk from those who cannot afford it to those willing to bear it
- They shift speculative trading from unorganised markets to organised, regulated exchanges
Key Risks in Derivative Trading
Because derivatives are leveraged instruments, they carry multiple types of risk:
- Counterparty Risk: The risk that the other party may default on the contract
- Price Risk: Loss from adverse price movements in the underlying asset
- Liquidity Risk: Inability to exit from a position when needed
- Legal / Regulatory Risk: Uncertainty around the enforceability of contracts
- Operational Risk: Errors arising from fraud, improper documentation, or incorrect execution
Quick Revision – Key Facts to Remember
- CBOT listed the first exchange-traded futures contract in 1865
- The first stock index futures were launched by Kansas City Board of Trade in 1982
- India's equity derivative segment started in 2000 after SEBI approval
- The Dr. L.C. Gupta Committee was set up by SEBI in 1996
- Derivatives in India were brought under 'securities' via SCRA amendment in 1999
Internal Links
- NISM Series VIII Study Material
- NISM Series 8 Free Mock Test
- NISM Series 8 Syllabus – Complete Guide
- How to Register for NISM Certification Exam
This is Part 1 of the NISM Series VIII Short Notes series on PassNISM.in. Continue to Part 2 – Understanding Index & Types of Stock Market Indices.