X-A chapters / Module 3: Investment Products

Chapter 10. Understanding Derivatives

Forwards, futures, options and swaps: pricing, margining and settlement, uses for hedging, speculation and arbitrage, and SEBI's 2024 index-derivative measures.

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Total watch time 57 min · Hindi audio

Key topics

Derivative basics, margins and open interest
Forwards vs. futures, options and swaps
Option payoffs; intrinsic and time value
Futures pricing, basis and arbitrage
Commodity and currency derivatives
SEBI index-derivative measures (2024)

Chapter test

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Formulas in this chapter (7)

Full formula sheet →

Futures price: cost of carry

Ch 10

F = S + Cost of carry · Basis = Spot − Futures · At expiry F = S (basis = 0)

Example →: Spot ₹3,984, 27-day futures ₹4,032 → annualised return (48 ÷ 3,984) × (365 ÷ 27) = 16.29%. If it beats the funding cost, cash-and-carry arbitrage exists.
Trap →: 'At expiry futures stay above spot because of interest' is wrong; the carry shrinks to zero and futures converge to spot.

Long call payoff (buyer)

Ch 10.3

Payoff = Max(Spot − Strike, 0) − Premium

Example →: Strike ₹100, premium ₹5: spot ₹112 → +₹7; spot ₹95 → −₹5 (maximum loss = premium).
Trap →: Forgetting to subtract the premium overstates profit. The buyer's maximum loss is the premium.

Short call payoff (writer)

Ch 10.3

Payoff = Premium − Max(Spot − Strike, 0)

Example →: Strike ₹100, premium ₹5, spot ₹120 → 5 − 20 = −₹15. Maximum loss is unlimited.
Trap →: 'The call writer's maximum loss is the premium' describes the buyer. The writer's loss is unlimited.

Long put payoff (buyer)

Ch 10.3

Payoff = Max(Strike − Spot, 0) − Premium

Example →: Strike ₹200, premium ₹8, spot ₹180 → 20 − 8 = +₹12. Maximum gain = strike − premium.
Trap →: A long put's gain is not unlimited; it's capped because the price can't fall below zero.

Short put payoff (writer)

Ch 10.3

Payoff = Premium − Max(Strike − Spot, 0)

Example →: Strike ₹200, premium ₹8: spot ₹180 → 8 − 20 = −₹12; spot ₹210 → keeps the ₹8 premium.
Trap →: The put writer profits when the price stays above the strike, because the buyer won't exercise.

Intrinsic and time value

Ch 10.3

Call IV = Max(Spot − Strike, 0) · Put IV = Max(Strike − Spot, 0) · Time value = Premium − IV

Example →: Spot ₹110, strike ₹100 → call IV ₹10 (in the money); put IV 0 (out of the money).
Trap →: Intrinsic value can't be negative; it's floored at zero.

Initial margin

Ch 10.2

Initial margin = SPAN margin + Extreme loss margin (ELM) · Premium margin (option buyers) = Premium × Quantity

Example →: Higher volatility → higher SPAN margin → bigger margin requirement.
Trap →: Premium margin is collected from option buyers, not sellers.