The term "Derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the underlying asset. The underlying asset can be Securities, Commodities, Bullion, Currency, Livestock or anything else. In other words, Derivative means a forward, future, option or any other hybrid contract of pre-determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities.

With Securities Laws (Second Amendment) Act, 1999, Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act, as :
  • A security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security.
  • A contract which derives its value from the prices, or index of prices, of underlying securities.
Futures Contract means a legally binding agreement to buy or sell the underlying security on a future date. Future contracts are the organized/standardized contracts in terms of quantity, quality (in case of commodities), delivery time and place for settlement on any date in future. The contract expires on a pre-specified date which is called the expiry date of the contract. On expiry, futures can be settled by delivery of the underlying asset or cash. Cash settlement enables the settlement of obligations arising out of the future/option contract in cash.
Option Contract is a type of Derivatives Contract which gives the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined price within or at end of a specified period. The buyer/holder of the option purchases the right from the seller/writer for a consideration which is called the premium. The seller/writer of an option is obligated to settle the option as per the terms of the contract when the buyer/holder exercises his right. The underlying asset could include securities, an index of prices of securities etc.

Under Securities Contracts (Regulations) Act, 1956 options on securities has been defined as "option in securities" means a contract for the purchase or sale of a right to buy or sell, or a right to buy and sell, securities in future, and includes a teji, a mandi, a teji mandi, a galli, a put, a call or a put and call in securities.

An Option to buy is called Call option and option to sell is called Put option. Further, if an option that is exercisable on or before the expiry date is called American option and one that is exercisable only on expiry date, is called European option. The price at which the option is to be exercised is called Strike price or Exercise price.

Therefore, in the case of American options the buyer has the right to exercise the option at any time on or before the expiry date. This request for exercise is submitted to the Exchange, which randomly assigns the exercise request to the sellers of the options, who are obligated to settle the terms of the contract within a specified time frame.

As in the case of futures contracts, option contracts can be also be settled by delivery of the underlying asset or cash. However, unlike futures cash settlement in option contract entails paying/receiving the difference between the strikes price/exercise price and the price of the underlying asset either at the time of expiry of the contract or at the time of exercise / assignment of the option contract.

Futures contract based on an index i.e. the underlying asset is the index, are known as Index Futures Contracts. For example, futures contract on NIFTY Index and BSE-30 Index. These contracts derive their value from the value of the underlying index.

Similarly, the options contracts, which are based on some index, are known as Index options contract. However, unlike Index Futures, the buyer of Index Option Contracts has only the right but not the obligation to buy / sell the underlying index on expiry. Index Option Contracts are generally European Style options i.e. they can be exercised / assigned only on the expiry date.

An index, in turn derives its value from the prices of securities that constitute the index and is created to represent the sentiments of the market as a whole or of a particular sector of the economy. Indices that represent the whole market are broad based indices and those that represent a particular sector are sectoral indices. In the beginning futures and options were permitted only on S&P Nifty and BSE Sensex. Subsequently, sectoral indices were also permitted for derivatives trading subject to fulfilling the eligibility criteria. Derivative contracts may be permitted on an index if 80% of the index constituents are individually eligible for derivatives trading. However, no single ineligible stock in the index shall have a weightage of more than 5% in the index. The index is required to fulfill the eligibility criteria even after derivatives trading on the index have begun. If the index does not fulfill the criteria for 3 consecutive months, then derivative contracts on such index would be discontinued.

By its very nature, index cannot be delivered on maturity of the Index futures or Index option contracts therefore, these contracts are essentially cash settled on Expiry.

Derivative trading in India takes can place either on a separate and independent Derivative Exchange or on a separate segment of an existing Stock Exchange. Derivative Exchange/Segment function as a Self-Regulatory Organization (SRO) and SEBI acts as the oversight regulator. The clearing & settlement of all trades on the Derivative Exchange/Segment would have to be through a Clearing Corporation/House, which is independent in governance and membership from the Derivative Exchange/Segment.

With the amendment in the definition of ''securities'' under SC(R)A (to include derivative contracts in the definition of securities), derivatives trading takes place under the provisions of the Securities Contracts (Regulation) Act, 1956 and the Securities and Exchange Board of India Act, 1992.

Dr. L.C Gupta Committee constituted by SEBI had laid down the regulatory framework for derivative trading in India. SEBI has also framed suggestive bye-law for Derivative Exchanges/Segments and their Clearing Corporation/House which lays down the provisions for trading and settlement of derivative contracts. The Rules, Bye-laws & Regulations of the Derivative Segment of the Exchanges and their Clearing Corporation/House have to be framed in line with the suggestive Bye-laws. SEBI has also laid the eligibility conditions for Derivative Exchange/Segment and its Clearing Corporation/House. The eligibility conditions have been framed to ensure that Derivative Exchange/Segment & Clearing Corporation/House provide a transparent trading environment, safety & integrity and provide facilities for redressal of investor grievances. Some of the important eligibility conditions are -

  • Derivative trading to take place through an online screen based Trading System.
  • The Derivatives Exchange/Segment shall have online surveillance capability to monitor positions, prices, and volumes on a real time basis to deter market manipulation.
  • The Derivatives Exchange/ Segment should have arrangements for dissemination of information about trades, quantities and quotes on a real time basis through atleast two information vending networks, which are easily accessible to investors across the country.
  • The Derivatives Exchange/Segment should have arbitration and investor grievances redressal mechanism operative from all the four areas / regions of the country.
  • The Derivatives Exchange/Segment should have satisfactory system of monitoring investor complaints and preventing irregularities in trading.
  • The Derivative Segment of the Exchange would have a separate Investor Protection Fund.
  • The Clearing Corporation/House shall perform full novation, i.e. the Clearing Corporation/House shall interpose itself between both legs of every trade, becoming the legal counterparty to both or alternatively should provide an unconditional guarantee for settlement of all trades.
  • The Clearing Corporation/House shall have the capacity to monitor the overall position of Members across both derivatives market and the underlying securities market for those Members who are participating in both.
  • The level of initial margin on Index Futures Contracts shall be related to the risk of loss on the position. The concept of value-at-risk shall be used in calculating required level of initial margins. The initial margins should be large enough to cover the one-day loss that can be encountered on the position on 99% of the days.
  • The Clearing Corporation/House shall establish facilities for electronic funds transfer (EFT) for swift movement of margin payments.
  • In the event of a Member defaulting in meeting its liabilities, the Clearing Corporation/House shall transfer client positions and assets to another solvent Member or close-out all open positions.
  • The Clearing Corporation/House should have capabilities to segregate initial margins deposited by Clearing Members for trades on their own account and on account of his client. The Clearing Corporation/House shall hold the clients’ margin money in trust for the client purposes only and should not allow its diversion for any other purpose.
  • The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades executed on Derivative Exchange / Segment.
  • Presently, SEBI has permitted Derivative Trading on the Derivative Segment of BSE and the F&O Segment of NSE.
The various types of membership in the derivatives market are as follows:

  • Trading Member (TM) : A TM is a member of the derivatives exchange and can trade on his own behalf and on behalf of his clients.

  • Clearing Member (CM) : These members are permitted to settle their own trades as well as the trades of the other non-clearing members known as Trading Members who have agreed to settle the trades through them.

  • Self-clearing Member (SCM) : A SCM are those clearing members who can clear and settle their own trades only.

  • Balance Sheet Networth Requirements : SEBI has prescribed a networth requirement of Rs. 3 crores for clearing members. The clearing members are required to furnish an auditor's certificate for the networth every 6 months to the exchange. The networth requirement is Rs. 1 crore for a self-clearing member. SEBI has not specified any networth requirement for a trading member.

  • Liquid Networth Requirements : Every clearing member (both clearing members and self-clearing members) has to maintain at least Rs. 50 lakhs as Liquid Networth with the Exchange/Clearing Corporation.

  • Certification requirements : The Members are required to pass the certification programme approved by SEBI. Further, every trading member is required to appoint at least two approved users who have passed the certification programme. Only the approved users are permitted to operate the derivatives trading terminal.

The derivatives member is required to adhere to the code of conduct specified under the SEBI Broker Sub-Broker regulations. The following conditions stipulations have been laid by SEBI on the regulation of sales practices:

  • Sales Personnel : The derivatives exchange recognizes the persons recommended by the Trading Member and only such persons are authorized to act as sales personnel of the TM. These persons who represent the TM are known as Authorized Persons.

  • Know-your-client : The member is required to get the Know-your-client form filled by every client.

  • Risk disclosure document : The derivatives member must educate his client on the risks of derivatives by providing a copy of the Risk disclosure document to the client.

  • Member-client agreement: The Member is also required to enter into the Member-client agreement with all his clients.

Derivative products have been introduced in a phased manner starting with Index Futures Contracts in June 2000. Index Options and Stock Options were introduced in June 2001 and July 2001 followed by Stock Futures in November 2001. Sectoral Indices were permitted for derivatives trading in December 2002. Interest Rate Futures on a notional bond and T-bill priced off ZCYC have been introduced in June 2003 and Exchange Traded Interest Rate Futures on a notional bond priced off a basket of Government Securities were permitted for trading in January 2004.

A stock on which Stock Option and single Stock Future contracts are proposed to be introduced is required to fulfill the following broad eligibility criteria -

  • The stock shall be chosen from amongst the top 500 stocks in terms of average daily market capitalization and average daily traded value in the previous six month on a rolling basis.

  • The stock’s median quarter-sigma order size over the last six months shall be not less than Rs.1 Lakh. A stock’s quarter-sigma order size is the mean order size (in value terms) required to cause a change in the stock price equal to one-quarter of a standard deviation.

  • The market wide position limit in the stock shall not be less than Rs.50 crores. A stock can be included for derivatives trading as soon as it becomes eligible. However, if the stock does not fulfill the eligibility criteria for 3 consecutive months after being admitted to derivatives trading, then derivative contracts on such a stock would be discontinued.

The Standing Committee on Finance, a Parliamentary Committee, at the time of recommending amendment to Securities Contract (Regulation) Act, 1956 had recommended that the minimum contract size of derivative contracts traded in the Indian Markets should be pegged not below Rs. 2 Lakhs. Based on this recommendation SEBI has specified that the value of a derivative contract should not be less than Rs. 2 Lakh at the time of introducing the contract in the market. In February 2004, the Exchanges were advised to re-align the contracts sizes of existing derivative contracts to Rs. 2 Lakhs. Subsequently, the Exchanges were authorized to align the contracts sizes as and when required in line with the methodology prescribed by SEBI.