Q. What is a derivative?
A. A derivative is a financial contract, between two or more parties, which is derived from the future value of an underlying asset.

Q. What are the types of derivatives available?
A. There are four main types of derivatives traded today, which are Forward Contracts, Futures Contracts, Option Contracts and Swap transactions.

Q. What is a Forward Contract?
A. A forward contract is a transaction in which the buyer and the seller agree upon the delivery of a specified quality (if commodity) and quantity of underlying asset at a predetermined rate on a specified future date.

Q. What is a Futures Contract?
A. A futures contract is a firm contractual agreement between a buyer and seller for a specified asset on a fixed date in the future. The contract price will vary according to the market place but it is fixed when the trade is made. The contract also has a standard specification so both parties know exactly what is being traded.

Q. What is an Option Contract?
A. An Option Contract confers the right, but not the obligation, to buy (Call) or sell (Put) a specific underlying instrument or asset at a specific price - the strike or exercise price - up until or on a specific future date - the expiry date.

Q. What is a Swap transaction?
A. A Swap transaction is the simultaneous buying and selling of a similar underlying asset or obligation of equivalent capital amount where the exchange of financial arrangement with more favourable conditions than they would otherwise expect.

Q. Importance of Derivatives?
A. Derivatives are very important financial instruments for risk management as they allow risks to be separated and more precisely controlled. Derivatives are used to shift elements of risk and therefore can act as a form of insurance.

Q. Participants in the Derivatives Market?
A. A party who is exposed to an unwanted risk to pass this risk on to another party willing to accept it can use derivatives. In this case he will be called a Hedger. A speculator takes an opposite position to a hedger and exposes him/herself in the hope of profiting from price changes to his or her advantage. There are also arbitrageurs who trade derivatives with a view to exploit any price differences within different derivatives markets or between the derivative instruments and cash or physical prices in the underlying assets.

Q. How are Derivatives traded?
A. Traders are the market players who buy and sell derivatives contracts on behalf of their clients or on their own account in the financial and commodity markets. There are three basic ways in which trading can take place: Over The Counter (OTC); On an exchange floor using open outcry; and Using an electronic, automated matching system. Usually brokers act intermediaries between traders and clients. Brokers do not usually trade on their own account but earn commissions on the deals that they arrange.

Q. How are Forward Contracts traded?
A. Forward contracts are traded between the two parties involved and not on an exchange. A Forward contract involves a credit risk to both counterparties. Forward contracts are not normally negotiable and when the contract is made it has no value. No payment is involved, as the contract is simply an agreement to buy or sell at a future date. Therefore the contract is neither an asset nor a liability.

Q. How are forward prices determined?
A. The forward price for a contract is determined by taking the spot or cash price at the time of the transaction and adding to it a 'cost of carry'. Depending on the asset or commodity, the cost of carry takes into account payments and receipts for matters such as storage, insurance, transport costs, interest payments, dividend receipts, etc. Forward price = Spot or cash price + cost of carry.

Q. What are the major advantage and disadvantage of a forward contract?
A. The major advantage of a forward contract is that it fixes prices for a future date. The major disadvantage of a forward contract is that if spot prices move one way or the other at the settlement date, then there is no way out of the agreement for the counterparties. Both sides are subject to the potential of gains or losses which are binding.

Q. What are the types of underlying assets exist?
A. There are basic types of assets for which futures contracts exist. These are Commodity futures contracts and Financial futures contracts. Although both contracts are similar in principle, the methods of quoting prices, delivery and settlement terms vary according to the contract being traded. Commodity futures comprise grains, oil seeds, energy, metals, coffee, sugar, cocoa, etc. Financial futures comprise Interest rates, Bond prices, Currency exchange rates, stock indices.

Q. What is Basis?
A. The difference between the futures and spot prices at any time is called the basis.

Q. What is Expiry date?
The Expiry date is the date and time after which an option may no longer be exercised.

Q. What is Strike or Exercise price?
The fixed agreed price at which the underlying instrument may be bought (called in) or sold (put out), on exercise of an option, is known as the strike or exercise price.

Q. What is Initial Margin ?
A. Initial Margins are collected upfront which means that the Trading Members will buy and/or sell derivatives contracts on behalf of the clients only on the receipt of margin of minimum such percentage as the relevant authority may decide from time to time, on the price of the derivatives contracts proposed to be purchased, unless the client already has an equivalent credit with the Trading Member.

At the time of calculating the initial margin, the outstanding position of a client is segregated into two - Spread Position and Non Spread Position.

Spread is a form of Speculative trading that involves the simultaneous purchase and sale of related contract. At present we have only Calender spread, which is defined as having equal offsetting positions in 2 different expiry month contracts on the same underlying. For instance, long 200 index futures in July contract and short 200 index futures in August contract. Long Spread means long in the far month contract and Short spread means short in the far month contract. In the example quoted above it is short spread as it has short position in August contract and long position in July contract.

Since there is not much risk involved in spread positions, the initial margin on such positions are quite low.

Q. Non-Payment of Margin ?
A. In case of non-payment of daily settlement by the clients within the next trading day, the Trading Member shall be at liberty to close out transactions by selling or buying the derivatives contracts, as the case may be, unless the constituent already has an equivalent credit with the Trading Member. The loss incurred in this regard, if any, shall be met from the margin money of the client.

Q. Margin Requirements ?
A. Every Trading Member is required to deposit margins with the Exchange/Clearing Corporation/Clearing Member on the outstanding position.

There are two types of margin levied on Derivatives Contracts. One is Initial Margin using the concept of Value at Risk and shall cover one-day loss that can be encountered on the position on 99% of the days and the other is Mark-to-Market Margin. Initial Margin is collected upfront and Mark-to-Market Margin on T+1 basis.

Q. Mark to Market Margin ?
A. Mark-to Market Margins are settled daily which means that any profit arising on the outstanding position at the futures closing price shall be paid out on T+1 day. Similarly any loss arising on the open position at the futures closing price will have to be paid to Exchange on T+1 day.

It is therefore mandatory for the Trading Members to collect from its clients the Margin Deposit, which the member has to provide under these Trading Regulations in respect of the business done by the Members for such clients.

Q. What is Settlement ?
A. At any point of time there will be available near three-month contracts. For instance, In June, June Contract, July Contract and August Contract shall be available for trading.

While entering the contract one has to specify the expiry month of the contract, which will clearly indicate the contract life cycle. The last Thursday of the Expiry month shall be the day of Final Settlement of the current month contract. After the Final Settlement that contract shall get invalidated and a new contract gets introduced automatically.

Daily Settlement takes place at the end of the trading session. The outstanding positions are marked to market at the Daily Settlement Price to calculate the Mark to Market Value and the Profit or Loss, which is nothing but the difference between the Net Traded Value and Mark to Market Value for each contract. The net profit or loss of all the contracts are credited or debited, as the case may be on the T+1 day. Daily Settlement Price is the futures closing price, which is calculated by taking the half an hour, weighted closing futures price. The outstanding positions are brought forward to the next working day at Daily Settlement Price.

The Final Settlement takes place on the last trading day of the contract. Every last Thursday of the Contract Month is the last trading day of that contract. For final settlement the outstanding positions are closed out at the Final Settlement Price, which is the closing spot index and the closing futures index. The net difference is credited or debited, as the case may be, on the T+1 day. With this the whole settlement of that contract takes place.