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, live stock 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 entails paying/receiving the difference between the price at which the contract was entered and the price of the underlying asset at the time of expiry of the contract.

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 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 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.

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.

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.

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.

Lot size refers to number of underlying securities in one contract. Additionally, for stock specific derivative contracts SEBI has specified that the lot size of the underlying individual security should be in multiples of 100 and fractions, if any, should be rounded of to the next higher multiple of 100. This requirement of SEBI coupled with the requirement of minimum contract size forms the basis of arriving at the lot size of a contract.

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 scrips stands to be 200000/1000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.

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 Net Worth for option positions. In the case of Futures Contracts MTM may be considered as Mark to Market Settlement.

Initial Margin
Short Option Minimum Charge (Worst Scenario Loss +Calendar Spread Charges)
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 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 form the available Liquid Net Worth on a real time basis.

Mark to Market Margin
Options – The value of the option are calculated as the theoretical value of the option times the number of option contracts (positive for long options and negative for short options). This Net Option Value is added to the Liquid Net Worth of the Clearing member. Thus MTM gains and losses on options are adjusted against the available liquid net worth. The net option value is computed using the closing price of the option and are applied the next day.

Futures – The system computes the closing price of each series, which is used for computing mark to market settlement for cumulative net position. This margin is collected on T+1 in cash. Therefore, the exchange charges a higher initial margin by multiplying the price scan range of 3 & 3.5 with square root of 2, so that the initial margin is adequate to cover 99% VaR over a two days horizon.

MARGIN COLLECTION

Initial Margin- is adjusted from the available Liquid Networth of the Clearing Member on an online real time basis.

Marked to Market Margins-
Futures contracts: The open positions (gross against clients and net of proprietary / self trading) in the futures contracts for each member is marked to market to the daily settlement price of the Futures contracts at the end of each trading day. The daily settlement price at the end of each day is the weighted average price of the last half an hour of the futures contract. The profits / losses arising from the difference between the trading price and the settlement price are collected / given to all the clearing members.

Option Contracts: The marked to market for Option contracts is computed and collected as part of the SPAN Margin in the form of Net Option Value. The SPAN Margin is collected on an online real time basis based on the data feeds given to the system at discrete time intervals.

Client Margins
Clearing Members and Trading Members are required to collect initial margins from all their clients. The collection of margins at client level in the derivative markets is essential as derivatives are leveraged products and non-collection of margins at the client level would provided zero cost leverage. In the derivative markets all money paid by the client towards margins 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.
Therefore, Clearing members are required to report on a daily basis details in respect of such margin amounts due and collected from their Trading members / clients clearing and settling through them. Trading members are also required to report on a daily basis details of the amount due and collected from their clients. The reporting of the collection of the margins by the clients is done electronically through the system at the end of each trading day. The reporting of collection of client level margins plays a crucial role not only in ensuring that members collect margin from clients but it also provides the clearing corporation with a record of the quantum of funds it has to keep in trust for the clients.