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Theme 1
Understand what derivatives are, why they exist, who uses them and how risk transfers.
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Equity Derivatives
Hedger = wants to REDUCE risk | Speculator = wants to TAKE risk | Arbitrageur = wants ZERO risk (risk-free profit)
Currency Derivatives
Cross rates, bid/ask, real INR returns, currency regimes
Interest Rate Derivatives
Yield, duration, PVBP, repo, T-bills, G-Secs and yield-curve risk
Detailed notes
Equity Derivatives
Hedger = wants to REDUCE risk | Speculator = wants to TAKE risk | Arbitrageur = wants ZERO risk (risk-free profit)
NISM Series VIII — Equity Derivatives | 10% weightage | ~10 exam questions
This is the foundation chapter — the "why does this market even exist" chapter. Before you trade a single futures contract or buy a single option, you need to understand what derivatives are, who uses them, and why. The exam tests this chapter with straightforward definitional questions. No calculations. No traps involving formulas. Just clear concepts. Get these right and you've secured easy marks.
What is a Derivative? — A financial contract whose value is *derived* from an underlying asset. The underlying can be a stock, index, currency, commodity, or interest rate. The derivative itself has no independent value — it exists only in relation to something else.
Types of Derivatives:
OTC vs Exchange Traded:
Three types of market participants — this is heavily tested:
| Participant | What they do | Risk appetite | |-------------|-------------|--------------| | Hedger | Reduces existing risk using derivatives | Low — wants to avoid risk | | Speculator | Takes calculated risk for profit | High — wants to take risk | | Arbitrageur | Exploits price differences across markets | Zero — risk-free profit |
Risk transfer mechanism — The fundamental purpose of derivatives. Hedgers want to *offload* risk. Speculators want to *absorb* risk. Derivatives are the bridge between them. Without speculators, hedgers couldn't hedge — there'd be no one to take the other side.
Systematic vs Unsystematic Risk:
Counterparty Risk (Default Risk, Credit Risk) — all three terms mean the same thing. The risk that the other party to a contract fails to honour their obligation. Exchange-traded derivatives eliminate this through the clearing corporation.
Infosys is reporting quarterly results next week. A fund manager holds 10,000 shares of Infosys and is worried results might disappoint and the stock could fall 8-10%.
She doesn't want to sell the shares (tax implications, long-term conviction). Instead she hedges — sells Infosys futures at the current price. If the stock falls, the futures position profits, offsetting the loss on her physical holdings.
A speculator on the other side of that trade WANTS to take the risk — he thinks results will be good and buys the futures expecting to profit from a price rise.
The derivatives market made both transactions possible simultaneously. That's risk transfer in action.
Trap 1: "Speculators stabilise the market" → WRONG Speculators ADD LIQUIDITY, they don't stabilise. The question often gives you "stabilise" as an option to trip you up. The correct answer is always "add liquidity to the futures market."
Trap 2: "Systematic risk can be eliminated through diversification" → FALSE Only unsystematic risk can be diversified away. Systematic risk affects the entire market — you can't escape it by holding more stocks. This is why derivatives exist as a hedge tool.
Trap 3: "Counterparty risk exists in exchange-traded derivatives" → FALSE The clearing corporation eliminates counterparty risk in exchange-traded contracts by acting as the central counterparty. It's only OTC contracts that carry counterparty risk.
Trap 4: "Preference shares are derivative instruments" → FALSE Preference shares are equity instruments. Derivatives are futures, forwards, options, and swaps — contracts whose value derives from an underlying.
Trap 5: "Derivatives market transfers risk from speculators to hedgers" → WRONG ORDER It's the other way around — from hedgers TO speculators. Hedgers offload the risk, speculators absorb it.
10% of the exam = ~10 questions. All easy to medium difficulty. No numericals in this chapter. Questions are mostly definitional — "who is a hedger", "what is systematic risk", "what does a derivatives market do." Read this chapter once carefully and you should score full marks.
Currency Derivatives
Cross rates, bid/ask, real INR returns, currency regimes
NISM Series I — Currency Derivatives | ~9% weightage | ~56 questions
Before you trade a single USDINR futures contract, you need to understand what currency markets are, how exchange rates are quoted, and why currencies move. This chapter is the foundation for everything else. It's also the chapter with the most calculation-based questions — cross rates, real returns on overseas investments, and gold standard math appear in almost every exam set. Get comfortable with currency arithmetic here and you'll find CH3 and CH5 much easier.
What is an exchange rate? The price of one currency expressed in terms of another. USDINR = 84 means 1 USD costs Rs 84.
Base currency vs Quotation currency:
Bid vs Ask (from the bank's perspective):
Currency systems:
Gold Standard — historical system where currency values were tied to gold.
Exchange rate = Gold price in Currency A / Gold price in Currency B
Example: If 1 oz gold = Rs 54,000 and 1 oz gold = USD 675
Then 1 USD = 54,000 / 675 = Rs 80Bretton Woods System — post-WW2 system where USD was pegged to gold at $35/oz, and all other currencies were pegged to USD. Collapsed in 1971 when the US abandoned the gold peg.
A cross rate is an exchange rate between two currencies derived via a third currency (usually USD).
Formula:
EURINR = EURUSD × USDINR
Cross rate bid = lower currency bid × lower USD bid
Cross rate offer = higher currency offer × higher USD offerExample: EURUSD = 1.1650/1.1655, USDINR = 85.35/85.40
EURINR bid = 1.1650 × 85.35 = 99.43 EURINR offer = 1.1655 × 85.40 = 99.54
GBPINR calculation: GBPUSD = 1.34/1.3425, USDINR = 86.5/86.52 GBPINR bid = 1.34 × 86.5 = 115.91 GBPINR offer = 1.3425 × 86.52 = 116.15
This type appears in every exam. The formula never changes.
Steps: 1. Convert INR → foreign currency at entry rate (divide) 2. Apply investment return in foreign currency terms 3. Convert back at exit rate (multiply) 4. Calculate % return in INR terms
Example: Indian investor puts Rs 3,90,000 in US stocks when USDINR = 65.
Key insight: Even if the investment grows in USD, if INR appreciates (USDINR falls), your INR returns get compressed. If INR depreciates (USDINR rises), your INR returns get boosted.
| Indicator | Higher Reading | Currency Impact | |-----------|---------------|----------------| | GDP growth | Better than expected | Currency appreciates | | CPI (inflation) | Higher than expected | Initially appreciates (rate hike expectations), then depreciates | | Nonfarm payrolls (US) | Higher = more jobs | USD appreciates | | Interest rates | Higher | Currency appreciates (capital inflows) | | Capital inflows (FPI) | More money coming in | Currency appreciates |
The simple rule: Things that attract foreign money into a country strengthen its currency. Things that push money out weaken it.
January 2024: RBI keeps rates steady while US Fed signals rate cuts. The interest rate differential between India and US narrows. This makes Indian assets slightly less attractive to foreign investors. Result: some capital outflow, mild INR depreciation, USDINR moves from 82 to 84.
Separately, strong US retail sales data comes out. This signals a robust US economy. Investors expect the Fed to delay rate cuts. USD strengthens globally — USDINR moves up further to 84.50.
Trap 1: "Bid price is always lower than ask price" — TRUE but don't confuse direction For USDINR, if quote is 83.10/83.12:
Trap 2: "Cross rate uses bid×offer and offer×bid" — WRONG EURINR bid = EURUSD bid × USDINR bid (both bids) EURINR offer = EURUSD offer × USDINR offer (both offers)
Trap 3: "A managed float currency has no central bank intervention" — FALSE Managed float = market + OCCASIONAL intervention. That's the whole point.
Trap 4: "Vehicle currency increases number of exchange rates to deal with" — FALSE Vehicle currency (USD) REDUCES the number of exchange rates needed in a multilateral system. Instead of quoting every currency pair directly, you quote everything vs USD.
~9% = ~56 questions. Cross rate numericals appear in every single exam set — expect 3-4 per exam. Real returns calculation appears 1-2 times per exam. Currency movement analysis (appreciating/depreciating) appears 4-5 times per exam. Master the arithmetic and you'll score full marks on this chapter.
Interest Rate Derivatives
Yield, duration, PVBP, repo, T-bills, G-Secs and yield-curve risk
NISM Series IV — Interest Rate Derivatives | ~25% weightage | ~100 questions
The largest chapter in the entire Series IV workbook at 68 pages. This is not a derivatives chapter — it is a fixed income fundamentals chapter. Before you can understand interest rate futures, you need to understand bonds: how they are priced, what yield means, how duration measures risk, what repo is, and how the yield curve works. Roughly 25% of all exam questions come from here. Master the bond math and the yield curve concepts, and you've secured the foundation of the exam.
Money market (maturity < 1 year): Treasury Bills, Call Money, Certificates of Deposit, Commercial Paper, Repo/Reverse Repo
Bond market (maturity ≥ 1 year): Government bonds (G-Secs), State Development Loans, Corporate bonds
Together = Debt market = Fixed Income Securities market
Standard money market tenors: Overnight (ON), 1W, 2W, 1M to 1Y Most liquid: ON, 1M, 3M
Standard bond market tenors: 2Y, 5Y, 7Y, 10Y, 15Y, 20Y, 25Y, 30Y Most liquid: 2Y and 10Y
Coupon bond: Pays periodic coupons (interest) + principal at maturity. Most common. Has reinvestment risk.
Zero coupon bond: No periodic payments. Issued at discount, redeemed at face value. No reinvestment risk. True return can be calculated in advance. Duration = Maturity.
Annuity: Equal periodic payments of coupon + part of principal. Example: EMI loans. Most consumer/housing loans are structured as annuities.
Consol (Perpetual bond): Pays coupon forever, principal never repaid. Example: UK government consols at 3%.
Depository: Public Debt Office (PDO) of RBI
Account types:
RBI-regulated entities must hold G-Secs compulsorily in electronic form (SGL or Gilt Account).
Auction types: Yield-based (new securities) and Price-based (re-issuance)
Eligible to open CSGL: SCBs, PDs, NSDL, CDSL, SHIL (Stock Holding Corp), NABARD, CCIL
Coupon rate: Annual coupon / Face value. NOT a true return measure — ignores price premium/discount and capital gain/loss at redemption.
Current Yield = Annual Coupon / Current Market Price × 100
Yield to Maturity (YTM):
True return: Only zero coupon bond gives a truly calculable return in advance (no reinvestment).
Price risk (Market risk): Bond price changes IMMEDIATELY when interest rates change.
Reinvestment risk: Effect is SLOW over time — it affects how coupons get reinvested.
Credit risk: Risk of default by issuer. Sovereign bonds = risk-free. Corporate bonds have credit risk.
Credit spread: Yield difference between corporate bond and equivalent sovereign bond. Measures credit risk premium.
Macaulay Duration:
Modified Duration (MD) = Macaulay Duration / (1 + YTM)
Key formula:
Change in bond price ≈ -MD × Change in YTM × Bond PriceExample: Bond price = Rs 100, MD = 5.80, YTM falls 0.01% (1 basis point)
Change = 100 × 5.80 × 0.0001 = Rs 0.58 → New price = 100.58Price Value of Basis Point (PVBP): Absolute rupee change in bond price for 1 basis point change in YTM.
PVBP = MD × Bond Price × 0.0001Both MD and PVBP measure price risk — same concept in different units (% vs Rs).
Term structure = snapshot of interest rates for different maturities at ONE point in time. Shift = how the term structure changes over time.
Four shapes: 1. Normal (Positive/Upward sloping): Long-term rates > Short-term rates. Longer term → higher rate. Most common. Indicates economic growth expected. 2. Inverted (Negative/Downward sloping): Long-term rates < Short-term rates. Rate rises first then falls. High demand for short-term money (working capital), low demand for long-term capital expenditure. May indicate recession. 3. Flat: Long-term rate = Short-term rate. Same rate for all maturities. 4. Humped: Rate rises for medium term, then falls. High for medium term, falls on either side.
Three types of shifts: 1. Parallel shift: All rates move by the same amount in the same direction. No yield curve spread risk. 2. Steepening: Long-term minus short-term difference WIDENS (from positive to more positive, OR from negative to less negative). Anti-clockwise rotation. 3. Flattening: Long-term minus short-term difference NARROWS (from positive to less positive, OR from negative to more negative). Clockwise rotation.
Yield curve spread risk: Arises when shift is NON-PARALLEL (steepening or flattening). NOT when shift is parallel.
What drives rates:
Applies to coupon bonds (not zero coupon).
When a bond is traded between coupon dates:
Dirty price (Full price) = Clean price + Accrued interest
Day count conventions:
Repo = Repurchase Agreement
Simple rule: Repo = Borrowing money against collateral (security)
Callable bond: Issuer has the right to prepay (redeem) before maturity. Used when rates fall — issuer can refinance at lower rates.
Puttable bond: Investor has the right to sell back (redeem) to issuer before maturity. Used when rates rise — investor can exit and reinvest at higher rates.
Trap 1: "Current yield is same as YTM" — FALSE Current yield ignores capital gain/loss at redemption. YTM accounts for it (approximately).
Trap 2: "Zero coupon bond has no price risk" — FALSE Zero coupon bonds have NO reinvestment risk but DO have price risk (price still changes with interest rates). In fact, duration = maturity, so they have MORE price risk than equivalent coupon bonds.
Trap 3: "Inverted yield curve means long-term rate > short-term rate" — FALSE Inverted = long-term LOWER than short-term. Normal = long-term HIGHER.
Trap 4: "Parallel shift creates yield curve spread risk" — FALSE Only non-parallel shifts (steepening/flattening) create yield curve spread risk.
Trap 5: "High credit rating = high interest rate" — FALSE High credit rating (AAA) = LOW interest rate (low risk premium). BBB = HIGH interest rate.
Trap 6: "SGL account is for all investors" — FALSE SGL = only SCBs, PDs, select FIs. Regular investors use CSGL (through SCB/PD) or Gilt Account.
Trap 7: "An investor can have multiple Gilt Accounts" — FALSE Maximum ONE Gilt Account per investor.
~25% of all questions. Term structure questions (normal/inverted/flat/humped, parallel/steepening/flattening) appear in almost every exam — 3-5 per exam. Modified duration calculations appear 2-3 times. Current yield calculations 1-2 times. SGL/CSGL/Gilt account rules 2-3 times. T-bill auction details 1-2 times. This is the chapter to invest the most study time in.
Next: revise cards and rules across the same chapters.
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2. Underlying Market