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 Derivative includes: -

• 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.
However so far delivery against future contracts have not been introduced and the future contract is settled by cash settlement only.

Options 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 anytime 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 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 strike 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. However so far delivery against option contracts have not been introduced and the option contract, on exercise or expiry, is settled by cash settlement only.

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 a derivative trading on the index has 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.Therefore index options are the European options while stock options are American options.

Derivative trading in India takes 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 Organisation (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 byelaw for Derivative Exchanges/Segments and their Clearing Corporation/House, which lay's 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 Byelaws. 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 on-line screen based Trading System.
• The Derivatives Exchange/Segment shall have on-line surveillance capability to monitor positions, prices, and     volumes on a real time basis so as 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.

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 stock in terms of average daily market capitalisation 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.

Lot size refers to number of underlying securities in one contract. The lot size is determined keeping in mind the minimum contract size requirement at the time of introduction of derivative contracts on a particular underlying. For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the minimum contract size is Rs.2 lacs, then the lot size for that particular scripts stands to be 200000/1000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.

The basis for any adjustment for corporate action is such that the value of the position of the market participant on cum and ex-date for corporate action continues to remain the same as far as possible. This will facilitate in retaining the relative status of positions viz. in-the-money, at-the-money and out-of-the-money. Any adjustment for corporate actions is carried out on the last day on which a security is traded on a cum basis in the underlying cash market. Adjustments mean modifications to positions and/or contract specifications as listed below:
• Strike price
• Position
• Market/Lot/ Multiplier
The adjustments are carried out on any or all of the above based on the nature of the corporate action. The adjustments for corporate action are carried out on all open, exercised as well as assigned positions. The corporate actions are broadly classified under stock benefits and cash benefits. The various stock benefits declared by the issuer of capital are:
• Bonus
• Rights
• Merger/ demerger
• Amalgamation
• Splits
• Consolidations
• Hive-off
• Warrants, and
• Secured Premium Notes (SPNs) among others
The cash benefit declared by the issuer of capital is cash dividend.

Two type of margins have been specified -

Initial Margin - Based on 99% VaR and worst case loss over a specified horizon, which depends on the time in which Mark to Market margin is collected.
Mark to Market Margin (MTM) - collected in cash for all Futures contracts and adjusted against the available Liquid Networth for option positions. In the case of Futures Contracts MTM may be considered as Mark to Market Settlement.

Dr. L.C Gupta Committee had recommended that the level of initial margin required on a position should be related to the risk of loss on the position. The concept of value-at-risk should 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 recommendations of the Dr. L.C Gupta Committee have been a guiding principle for SEBI in prescribing the margin computation & collection methodology to the Exchanges. With the introduction of various derivative products in the Indian securities Markets, the margin computation methodology, especially for initial margin, has been modified to address the specific risk characteristics of the product. The margining methodology specified is consistent with the margining system used in developed financial & commodity derivative markets worldwide. The exchanges were given the freedom to either develop their own margin computation system or adapt the systems available internationally to the requirements of SEBI. A portfolio based margining approach which takes an integrated view of the risk involved in the portfolio of each individual client comprising of his positions in all Derivative Contracts i.e. Index Futures, Index Option, Stock Options and Single Stock Futures, has been prescribed. The initial margin requirements are required to be based on the worst case loss of a portfolio of an individual client to cover 99% VaR over a specified time horizon.
The Initial Margin is Higher of (Worst Scenario Loss +Calendar Spread Charges) Or Short Option Minimum Charge
The worst scenario loss are required to be computed for a portfolio of a client and is calculated by valuing the portfolio under 16 scenarios of probable changes in the value and the volatility of the Index/ Individual Stocks. The options and futures positions in a client's portfolio are required to be valued by predicting the price and the volatility of the underlying over a specified horizon so that 99% of times the price and volatility so predicted does not exceed the maximum and minimum price or volatility scenario. In this manner initial margin of 99% VaR is achieved. The specified horizon is dependent on the time of collection of mark to market margin by the exchange. The probable change in the price of the underlying over the specified horizon i.e. 'price scan range', in the case of Index futures and Index option contracts are based on three standard deviation (3s ) where 's ' is the volatility estimate of the Index. The volatility estimate 's ', is computed as per the Exponentially Weighted Moving Average methodology. This methodology has been prescribed by SEBI. In case of option and futures on individual stocks the price scan range is based on three and a half standard deviation (3.5 s) where 's' is the daily volatility estimate of individual stock. If the mean value (taking order book snapshots for past six months) of the impact cost, for an order size of Rs. 0.5 million, exceeds 1%, the price scan range would be scaled up by square root three times to cover the close out risk. This means that stocks with impact cost greater than 1% would now have a price scan range of - Sqrt (3) * 3.5s or approx. 6.06s. For stocks with impact cost of 1% or less, the price scan range would remain at 3.5s.
For Index Futures and Stock futures it is specified that a minimum margin of 5% and 7.5% would be charged. This means if for stock futures the 3.5 s value falls below 7.5% then a minimum of 7.5% should be charged. This could be achieved by adjusting the price scan range.
The probable change in the volatility of the underlying i.e. 'volatility scan range' is fixed at 4% for Index options and is fixed at 10% for options on Individual stocks. The volatility scan range is applicable only for option products.
Calendar spreads are offsetting positions in two contracts in the same underlying across different expiry. In a portfolio based margining approach all calendar-spread positions automatically get a margin offset. However, risk arising due to difference in cost of carry or the 'basis risk' needs to be addressed. It is therefore specified that a calendar spread charge would be added to the worst scenario loss for arriving at the initial margin. For computing calendar spread charge, the system first identifies spread positions and then the spread charge which is 0.5% per month on the far leg of the spread with a minimum of 1% and maximum of 3%. Further, in the last three days of the expiry of the near leg of spread, both the legs of the calendar spread would be treated as separate individual positions. In a portfolio of futures and options, the non-linear nature of options make short option positions most risky. Especially, short deep out of the money options, which are highly susceptible to, changes in prices of the underlying. Therefore a short option minimum charge has been specified. The short option minimum charge is 3% and 7.5 % of the notional value of all short Index option and stock option contracts respectively. The short option minimum charge is the initial margin if the sum of the worst -scenario loss and calendar spread charge is lower than the short option minimum charge. To calculate volatility estimates the exchange are required to uses the methodology specified in the Prof J.R Varma Committee Report on Risk Containment Measures for Index Futures. Further, to calculate the option value the exchanges can use standard option pricing models - Black-Scholes, Binomial, Merton, Adesi-Whaley.
The initial margin is required to be computed on a real time basis and has two components:-
The first is creation of risk arrays taking prices at discreet times taking latest prices and volatility estimates at the discreet times, which have been specified.
The second is the application of the risk arrays on the actual portfolio positions to compute the portfolio values and the initial margin on a real time basis.
The initial margin so computed is deducted from the available Liquid Networth on a real time basis.At the end of the day NSE sends a client wise file to all the brokers and this margin is debited to clients. Next day the broker is supposed to report the collection of margin. If the margin is short, a penalty is levied and the outstanding position is liable to be squared up at the cost of the investor.

Market wide position limits on Single Stock Derivative Contracts are as follows
The market wide limit of open position (in terms of the number of underlying stock) on futures and option contracts on a particular underlying stock is lower of-
- 30 times the average number of shares traded daily, during the previous calendar month, in the relevant underlying security in the underlying segment,
Or
- 20% of the number of shares held by non-promoters in the relevant underlying security i.e. free-float holding.
This limit would be applicable on all open positions in all futures and option contracts on a particular underlying stock.

The measures specified by SEBI include:
• Investor's money has to be kept separate at all levels and is permitted to be used only against the liability of    the Investor and is not available to the trading member or clearing member or even any other investor.
• The Trading Member is required to provide every investor with a risk disclosure document which will    disclose the risks associated with the derivatives trading so that investors can take a conscious decision to    trade in derivatives.
• Investor would get the contract note duly time stamped for receipt of the order and execution of the order.    The order will be executed with the identity of the client and without client ID order will not be accepted by    the system. The investor could also demand the trade confirmation slip with his ID in support of the contract    note. This will protect him from the risk of price favour, if any, extended by the Member.
• In the derivative markets all money paid by the Investor towards margins on all open positions is kept in trust    with the Clearing House/Clearing corporation and in the event of default of the Trading or Clearing Member    the amounts paid by the client towards margins are segregated and not utilised towards the default of the    member. However, in the event of a default of a member, losses suffered by the Investor, if any, on settled /    closed out position are compensated from the Investor Protection Fund, as per the rules, bye-laws and    regulations of the derivative segment of the exchanges.
• In the derivative markets all money paid by the Investor towards margins on all open positions is kept in trust    with the Clearing House/Clearing corporation and in the event of default of the Trading or Clearing Member    the amounts paid by the client towards margins are segregated and not utilised towards the default of the    member. However, in the event of a default of a member, losses suffered by the Investor, if any, on settled /    closed out position are compensated from the Investor Protection Fund, as per the rules, bye-laws and    regulations of the derivative segment of the exchanges.
• The Exchanges are required to set up arbitration and investor grievances redressal mechanism operative    from all the four areas / regions of the country.
Remember, Derivatives are tools which can be used for hedging, speculation as well as trading. It is always advisable to take positions in derivatives with caution. Since the trader is required to give only margin, there is a tendency of overtrading which must be avoided. Overtrading may result in failure to pay margin call &/or MTM the outstanding position is liable to be squared up. Before trading it is necessary that the investor should go through the risk disclosure document carefully so that he is aware of the precautions to be taken in derivatives trading