Basics of Derivatives: Forwards, Futures, Options and Swaps for RBI Grade B Finance

Last updated: 2026-11-13 · MockMentor

"Basics of Derivatives" is a line of the General Topics unit in the RBI Grade B Phase 2 Finance syllabus. It looks technical, but the exam asks for clear concepts and simple calculations rather than complex pricing models, which makes it a scoring topic. Derivatives were asked as a descriptive question in 2024 (types, participants and risks) and have appeared in the objective section in recent years through questions on options payoffs, moneyness, margins and swaps. This chapter explains each type of derivative, how they are used and how India regulates them.

In one line: a derivative is a contract whose value comes from an underlying asset; forwards, futures, options and swaps let firms hedge risks and let traders speculate, and in India SEBI regulates exchange-traded derivatives while RBI regulates over-the-counter interest rate, currency and credit derivatives.

Basic concepts

• Derivative: a financial contract whose value depends on (is derived from) the value of an underlying asset, such as a share, an index, a currency, a commodity or an interest rate. The Securities Contracts (Regulation) Act, 1956 defines derivatives to include contracts deriving value from the prices of underlying securities.
• Underlying asset: the asset whose price determines the value of the derivative.
• Hedging: reducing risk by taking an opposite position in a derivative.
• Speculation: taking a position to profit from expected price changes, accepting risk.
• Arbitrage: making a riskless profit from price differences of the same asset in two markets.
• Leverage: the ability to take a large position with a small amount of money, which magnifies both gains and losses.
• Notional value: the face value of the underlying on which payments are based.

Why in News?

1. SEBI's measures to curb speculation in equity index derivatives, applied from November 2024, raised the minimum contract size to ₹15 lakh, limited each exchange to one weekly index expiry, required upfront collection of option premium and removed calendar spread benefits on expiry day.
2. SEBI's studies found that about 91% to 93% of individual traders lost money in equity futures and options in recent years, with aggregate losses running into lakhs of crores of rupees.
3. RBI has expanded the market for interest rate and foreign exchange derivatives, including rupee derivatives for non-residents and credit default swaps, under revised directions.
4. Derivatives on Indian indices traded in GIFT City, such as GIFT Nifty, have grown since they moved from Singapore in 2023.

Features of derivatives

1. Value depends on an underlying asset.
2. A contract between two parties, with a future settlement date.
3. Little or no initial investment compared with buying the asset.
4. Can be settled by delivery of the asset or in cash.
5. Can be traded on exchanges (standardised) or over the counter (customised).
6. Zero-sum between the two parties, before costs: one side's gain is the other's loss.

Participants

Speculators and arbitrageurs give the market liquidity and help keep prices efficient, which in turn helps hedgers.

Exchange-traded and over-the-counter derivatives

Forward contracts

A forward is an agreement to buy or sell an asset on a future date at a price agreed today.

• Customised and traded OTC, usually between a bank and a customer.
• No money changes hands at the start (except possibly collateral).
• Settled on the agreed date, by delivery or cash difference.
• Carries counterparty risk, since either side can default.

Example: an Indian importer must pay US$ 1 million in three months. Fearing that the rupee will weaken, it books a three-month forward with its bank at ₹88.50 per dollar. Whatever the spot rate is in three months, the importer pays ₹8.85 crore. If the rupee falls to ₹90, it saves ₹15 lakh; if it rises to ₹87, it misses a gain of ₹15 lakh. The forward removes uncertainty, which is the purpose of hedging.

Futures contracts

A future is a standardised forward traded on an exchange.

Margins and mark to market

• Initial margin: the deposit required to open a position, set by the exchange using a risk model (SPAN), plus an exposure margin.
• Mark to market (MTM): at the end of each day, the position is valued at that day's settlement price, and the gain or loss is credited or debited.
• Maintenance margin: the minimum balance; if the margin account falls below it, the trader must top it up (a margin call).

Example: a trader buys one lot of a stock future with a lot of 1,000 shares at ₹500. The next day the settlement price is ₹490. The trader's account is debited ₹10 × 1,000 = ₹10,000. If the price rises to ₹505 the day after, the account is credited ₹15,000.

Pricing of futures: cost of carry

Futures price = Spot price × (1 + r)^t, where r is the interest rate and t the time to expiry (minus any income, such as dividends, from the asset).

Example: spot price ₹1,000, interest rate 8% a year, three months to expiry. Futures price ≈ 1,000 × (1.08)^0.25 ≈ ₹1,019.4.

• Basis: spot price minus futures price. It narrows to zero at expiry.
• Contango: futures price above spot, the normal case because of the cost of carry.
• Backwardation: futures price below spot, as when there is a shortage of the asset.

Forwards and futures compared

Options

An option gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a fixed price (the strike price) on or before a set date. The seller (writer) has the obligation to fulfil the contract if the buyer exercises it. For this right, the buyer pays a price called the premium.

Types

Positions and payoffs

Example of a call: an investor buys a call on a stock with a strike of ₹200 for a premium of ₹10.

Break-even for a call = strike + premium; for a put = strike − premium.

Moneyness

Value of an option

Premium = Intrinsic value + Time value

• Intrinsic value: the amount by which an option is in the money; for a call, spot − strike (if positive), otherwise zero.
• Time value: the extra amount buyers pay because the option may gain value before expiry. It falls as expiry approaches (time decay) and is zero at expiry.

Example: a call with a strike of ₹100 on a share trading at ₹110 has a premium of ₹14. Its intrinsic value is ₹10 and time value ₹4.

Factors affecting option prices

The Black-Scholes model (1973) gives a formula for the price of European options using these factors. The "Greeks" measure sensitivity: delta (to the price of the underlying), gamma (to changes in delta), theta (to time), vega (to volatility) and rho (to interest rates).

Put-call parity

For European options on the same underlying, strike and expiry: Call premium + Present value of strike = Put premium + Spot price. If this does not hold, arbitrage is possible.

Common strategies

• Protective put: holding a share and buying a put, which works like insurance.
• Covered call: holding a share and selling a call to earn premium.
• Straddle: buying a call and a put at the same strike, to profit from a large move in either direction.
• Strangle: like a straddle, but with different strikes, cheaper and needing a bigger move.
• Spreads: buying and selling options of different strikes to limit both risk and reward.

Swaps

A swap is an agreement between two parties to exchange cash flows over a period.

Example of an interest rate swap: Company A has a floating rate loan and fears rates will rise. Company B has a fixed rate loan and expects rates to fall. They agree on a swap: A pays B a fixed 7% on ₹100 crore, and B pays A the floating rate. A's interest cost is now effectively fixed, and B's floating.

Central banks also use swaps. The RBI has used foreign exchange swaps with banks to manage rupee liquidity, and has bilateral currency swap arrangements with other central banks, such as with Japan and the SAARC countries.

Uses and benefits of derivatives

1. Hedging price, interest rate and currency risk.
2. Price discovery: futures prices reflect expectations about future spot prices.
3. Transfer of risk to those willing to bear it.
4. Lower transaction costs than trading the underlying.
5. Better market efficiency and liquidity through arbitrage.
6. Help in managing portfolios, such as by changing exposure quickly.

Risks of derivatives

Warren Buffett called derivatives "financial weapons of mass destruction" in 2002, warning about their complexity and hidden risks. The 2008 crisis, in which credit default swaps and complex mortgage derivatives played a role, proved his concern. After 2008, the G20 required standardised OTC derivatives to be centrally cleared and reported.

The derivatives market in India

Evolution

Regulation

• SEBI regulates derivatives traded on stock and commodity exchanges.
• RBI regulates OTC interest rate derivatives, foreign exchange derivatives and credit derivatives, under the RBI Act and FEMA, through directions on market participants, products and reporting. Trades must be reported to the trade repository run by CCIL.
• Users must have an underlying exposure for some OTC currency derivatives, to keep them for hedging.

Concerns about retail participation

Indian equity options are among the most traded in the world by number of contracts, driven mainly by individual traders buying short-dated index options. Most lose money. SEBI responded with larger contract sizes, fewer weekly expiries, upfront premium collection, intraday monitoring of position limits and investor warnings. The debate continues on whether further limits are needed.

Possible exam and interview questions

1. What are derivatives? Explain the types of derivatives and the role of each type of market participant. (620 words)
2. Distinguish between forwards and futures. How do margins and mark to market reduce risk in futures? (420 words)
3. An investor buys a put option with a strike of ₹500 at a premium of ₹20. Calculate the net profit if the share price at expiry is ₹450 and if it is ₹520.
4. What is an interest rate swap? How can a company use it to hedge against rising interest rates?
5. Interview: Is the boom in options trading in India healthy for the market?

Related reading: risk management and Basel norms, equity market, and foreign exchange market.

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