What are derivatives?

Derivatives, such as options or futures, are financial contracts which derive their value
off a spot price time-series, which is called “the underlying".

For examples, wheat farmers may wish to contract to sell their harvest at a future date to
eliminate the risk of a change in prices by that date. Such a transaction would take place
through a forward or futures market. This market is the “derivative market", and the
prices on this market would be driven by the spot market price of wheat which is the
“underlying".

The terms “contracts" or “products" are often applied to denote the specific traded
instrument.The world over, derivatives are a key part of the financial system. The most
important contract types are futures and options, and the most important underlying
markets are equity, treasury bills, commodities, foreign exchange and real estate.

What is a forward contract?

In a forward contract, two parties agree to do a trade at some future date, at a stated
price and quantity. No money changes hands at the time the deal is signed. Why is
forward contracting useful? Forward contracting is very valuable in hedging and
speculation.The classic hedging application would be that of a wheat farmer forward-
selling his harvest at a known price in order to eliminate price risk. Conversely, a bread
factory may want to buy bread forward in order to assist production planning without the
risk of price fluctuations. If a speculator has information or analysis which forecasts an
upturn in a price, then she can go long on the forward market instead of the cash
market. The speculator would go long on the forward, wait for the price to rise, and then
take a reversing transaction. The use of forward markets here supplies leverage to the
speculator.

What are the problems of forward markets?

Forward markets worldwide are afflicted by several problems: (a) lack of

centralisation of trading, (b) illiquidity, and (c) counterparty risk. In the first two of
these, the basic problem is that of too much flexibility and generality.

The forward market is like the real estate market in that any two consenting adults can
form contracts against each other. This often makes them design terms of the deal
which are very convenient in that specific situation for the specific parties, but makes the
contracts non-tradeable if non-participants are involved. Also the “phone market" here is
unlike the centralisation of price discovery that is obtained on an exchange.
Counterparty risk in forward markets is a simple idea: when one of the two sides of the
transaction chooses to declare bankruptcy, the other suffers. Forward markets have one
basic property: the larger the time period over which the forward contract is open, the
larger are the potential price movements, and hence the larger is the counter- party risk.
Even when forward markets trade standardized contracts, and hence avoid the problem
of illiquidity, the counterparty risk remains a very real problem.

What is a futures contract?

Futures markets were designed to solve all the three problems listed above of forward
markets. Futures markets are exactly like forward markets in terms of basic economics.
However, contracts are standardised and trading is centralised, so that futures markets
are highly liquid. There is no counterparty risk (thanks to the institution of a
clearinghouse which becomes counterparty to both sides of each transaction and
guarantees the trade). In futures markets, unlike in forward markets, increasing the time
to expiration does not increase the counter party risk.

What is the difference between Forward and futures contract?

What are various types of derivatives traded at NSE ?

There are two types of derivatives products traded on NSE namely Futures and Options
Futures: A futures contract is an agreement between two parties to buy or sell an asset
at a certain time in the future at a certain price. All the futures contracts are settled in
cash. Options: An Option is a contract which gives the right, but not an obligation, to buy
or sell the underlying at a stated date and at a stated price. While a buyer of an option
pays the premium and buys the right to exercise his option, the writer of an option is the
one who receives the option premium and therefore obliged to sell/buy the asset if the
buyer exercises it on him.

Options are of two types - Calls and Puts options :

"Calls" give the buyer the right but not the obligation to buy a given quantity of the
underlying asset, at a given price on or before a given future date.

"Puts" give the buyer the right, but not the obligation to sell a given quantity of underlying
asset at a given price on or before a given future date. All the options contracts are
settled in cash. Further, the Options are classified based on type of exercise. At present
the Exercise style can be European or American. American Option - American options
are options contracts that can be exercised at any time upto the expiration date.

Options on individual securities available at NSE are American type of options.

European Options - European options are options that can be exercised only on the
expiration date. All index options traded at NSE are European Options.

What are “exotic" derivatives?

Options and futures are the mainstream workhorses of derivatives markets worldwide.
However, more complex contracts, often called exotics, are used in more custom
situations. For example, a computer hardware company may want a contract that pays
them when the rupee has depreciated or when computer memory chip prices have risen.
Such contracts are “custom-built" for a client by a large financial house in what is known
as the “over the counter" derivatives market. These contracts are not exchange-traded.
This area is also called the “OTC Derivatives Industry". An essential feature of
derivatives exchanges is contract standardisation. All kinds of wheat are not tradeable
through a futures market, only certain defined grades are. This is a constraint for a
farmer who grows a somewhat different grade of wheat. The OTC derivatives industry is
an intermediary which sells the farmer insurance which is customised to his needs; the
intermediary would in turn use exchange-traded derivatives to strip off as much of his
risk as possible.

Why are derivatives useful?

The key motivation for such instruments is that they are useful in reallocating risk either
across time or among individuals with different risk-bearing preferences. One kind of
passing-on of risk is mutual insurance between two parties who face the opposite kind of
risk. For example, in the context of currency fluctuations, exporters face losses if the
rupee appreciates and importers face losses if the rupee depreciates. By forward
contracting in the dollar-rupee forward market, they supply insurance to each other and
reduce risk. This sort of thing also takes place in speculative position taking, the person
who thinks the price will go up is long a futures and the person who thinks the price will
go down is short the futures. Another style of functioning works by a risk-averse person
buying insurance, and a risk-tolerant person selling insurance. An example of this may
be found on the options market : an investor who tries to protect himself against a drop
in the index buys put options on the index, and a risk-taker sells him these options.
Obviously, people would be very suspicious about entering into such trades without the
institution of the clearinghouse which is a legal counterparty to both sides of the trade.
In these ways, derivatives supply a method for people to do hedging and reduce their
risks. As compared with an economy lacking these facilities, it is a considerable gain.
The ultimate importance of a derivatives market hence hinges upon the extent to which it
helps investors to reduce the risks that they face. Some of the largest derivatives
markets in the world are on treasury bills (to help control interest rate risk), the market
index (to help control risk that is associated with fluctuations in the stock market) and on
exchange rates (to cope with currency risk).

What are various instruments available for trading in Futures and Options?

Index Futures Index Options Stock Futures Stock Options Currency Futures and
Interest Rate Futures

When were Index Futures and Index options made available for trading at NSE?

Index Futures were made available for trading at NSE on June 12, 2000 and Index
Options were made available for trading at NSE on June 4, 2001. S&P CNX Nifty
Futures was the first index on which index futures and options was introduced.

When were Stock Futures and stock options made available for trading at NSE?

Stock Futures were made available for trading at NSE on July 2, 2001 and stock options
were made available for trading at NSE on November 9, 2001.

When was currency futures made available for trading at NSE ?

 Currency futures on the USD-INR pair exchange rate was made available for trading on
August 29, 2008. When was interest rate futures made available for trading at NSE?
Interest Rate futures were made available for trading on August 31, 2009.

Are there different trading segments at NSE which offer futures and options instruments
with different types of underlying?

Yes, two different trading segments at NSE offer different kind of instruments in futures
and options. The futures and options with the underlying as index and stock are traded
on the Futures and Options segment while the futures and options with the underlying as
exchange rate of currencies or the coupon of a notional bond (in case of interest rate
derivatives) are traded on the Currency derivatives segment.

Why Should I trade in derivatives?

Futures trading will be of interest to those who wish to: 1) Invest - take a view on the
market and buy or sell accordingly. 2) Price Risk Transfer- Hedging - Hedging is buying
and selling futures contracts to offset the risks of changing underlying market prices.
Thus it helps in reducing the risk associated with exposures in underlying market by
taking a counter- positions in the futures market. For example, the hedgers who either
have security or plan to have a security is concerned about the movement in the price of
the underlying before they buy or sell the security. Typically he would take a short
position in the Futures markets, as the cash and futures price tend to move in the same
direction as they both react to the same supply/demand factors. 3) Arbitrage - Since the
cash and futures price tend to move in the same direction as they both react to the same
supply/demand factors, the difference between the underlying price and futures price
called as basis. Basis is more stable and predictable than the movement of the prices of
the underlying or the Futures price. Thus arbitrageur would 4) Predict the basis and
accordingly take positions in the cash and future markets. 5) Leverage- Since the
investor is required to pay a small fraction of the value of the total contract as margins,
trading in Futures is a leveraged activity since the investor is able to control the total
value of the contract with a relatively small amount of margin. Thus the Leverage
enables the traders to make a larger profit or loss with a comparatively small amount of
capital. Options trading will be of interest to those who wish to: 1) Participate in the
market without trading or holding a large quantity of stock 2) Protect their portfolio by
paying small premium amount Benefits of trading in Futures and Options 1) Able to
transfer the risk to the person who is willing to accept them 2) Incentive to make profits
with minimal amount of risk capital 3) Lower transaction costs 4) Provides liquidity,
enables price discovery in underlying market 5) Derivatives market are lead economic
indicators. 6) Arbitrage between underlying and derivative market. 7) Eliminate security
specific risk. What are the benefits of trading in Index Futures compared to any other
security? An investor can trade the 'entire stock market' by buying index futures instead
of buying individual securities with the efficiency of a mutual fund. The advantages of
trading in Index Futures are: The contracts are highly liquid Index Futures provide
higher leverage than any other stocks It has lower risk than buying and holding stocks It
is just as easy to trade the short side as the long side Only have to study one index
instead of 100's of stocks
Who uses index derivatives to reduce risk?

There are two important types of people who may not want to bear the risk of index
fluctuations: A person who thinks Index fluctuations are peripheral to his activity For
example, a person who works in primary market underwriting, effectively has index
exposure - if the index does badly, then the IPO could fail. But this exposure has nothing
to do with his core competence and interests (which are in the IPO market). Such a
person would routinely measure his index exposure on a day-to-day basis and use index
derivatives to strip off that risk. Similarly, a person who takes positions in individual
stocks implicitly suffers index exposure. A person who is long ITC is effectively long ITC
and long Index. If the index does badly, then his “long ITC" position suffers. A person
like this, who is focussed on ITC and is not interested in taking a view on the Index
would routinely measure the index exposure that is hidden inside his ITC exposure, and
use index derivatives to eliminate this risk A person who thinks Index fluctuations are
painful An investor who buys stocks may like the peace of mind of capping his downside
loss. Put options on the index are the ideal form of insurance here. Regardless of the
composition of a person's portfolio, index put options will protect him from exposure to a
fall in the index. To make this concrete, consider a person who has a portfolio worth 1
million, and suppose Nifty is at 1000. Suppose the person decides that he wants to
never suffer a loss of worse than 10%. Then he can buy himself Nifty puts worth 1
million with the strike price set to 900. If Nifty drops below 900 then his put options
reimburse him for his full loss. In this fashion, “portfolio insurance" through index options
will greatly reduce the fear of equity investment in the country. More generally, anytime
an investor or a fund manager becomes uncomfortable, and does not want to bear index
fluctuations in the coming weeks, he can use index futures or index options to reduce (or
even eliminate) his index exposure. This is far more convenient than distress selling of
the underlying equity in the portfolio. Conversely, anytime investors or fund managers
become optimistic about the index, or feel more comfortable and are willing to bear index
fluctuations, they can increase their equity exposure using index derivatives. This is
simpler and cheaper than buying underlying equity. In these ways, the underlying equity
portfolio can be something that is “slowly traded", and index derivatives are used to
implement day-to-day changes in equity exposure.

How will retail investors benefit from index derivatives?

The answer to this fits under “People who find Index fluctuations painful". Every retail
investor in the economy who is in pain owing to a downturn in the market index is
potentially a happy user of index derivatives. If a contract is just a relationship
between long and short, how do we ensure “contract performance"? The key
innovation of derivatives markets is the notion of the clearinghouse that guarantees the
trade. Here, when A buys from B, (at a legal level) the clearinghouse buys from B and
sells to A. This way, if either A or B fail on their obligations, the clearinghouse fills in the
gap and ensures that payments go through without a hitch. The clearinghouse, in turn,
cannot create such a guarantee out of thin air. It uses a system of initial margin and daily
mark-to-market margins, coupled with sophisticated risk containment, to ensure that it is
not bankrupted in the process of supplying this guarantee.
What is the role of arbitrage in the derivatives area?

All pricing of derivatives is done by arbitrage, and by arbitrage alone. In other words,
basic economics dictates a relationship between the price of the spot and the price of a
futures. If this relationship is violated, then an arbitrage opportunity is available, and
when people exploit this opportunity, the price reverts back to its economic value. In
this sense, arbitrage is basic to pricing of derivatives. Without arbitrage, there would be
no market efficiency in the derivatives market: prices would stray away from fair value all
the time. Indeed, a basic fact about derivatives is that the market efficiency of the
derivatives market is inversely proportional to the transactions costs faced by
arbitrageurs in that market. When arbitrage is fluent and effective, market efficiency is
obtained, which improves the attractiveness of the derivatives from the viewpoint of
users such as hedgers or speculators. What happens if there are only a few
arbitrageurs ready to function in the early days of the market? In most countries, there
are bigger arbitrage opportunities in the early days of the futures market. As larger
resources and greater skills get brought into the arbitrage business, these opportunities
tend to vanish. India is better placed in terms of skills in arbitrage, as compared with
many other countries, thanks to years of experience with “line operators" who are used
to doing arbitrage between exchanges. These kinds of traders would be easily able to
redirect their skills into this new market. These “line operators" are fluent with a host of
real-world difficulties, such as different expiration dates on different exchanges, bad
paper, etc. Their skills are well-suited to index arbitrage.

What is the role of liquidity in enabling good derivatives markets?

The role of liquidity (which is defined as low transactions costs) is in making arbitrage
cheap and convenient. If transactions costs are low, then the smallest mispricing on the
derivatives market will be removed by arbitrageurs, which will make the derivatives
market more efficient.

What should a market index be?

A market index is a large, well-diversified portfolio which is an approximation to returns

obtained in owning \the overall economy". Portfolio diversification is a powerful means of
stripping out firm- and industry-effects, so that the returns on the well-diversified portfolio
reflect only economy-wide effects, and are relatively insensitive to the specific
companies or industries in the index portfolio. Market index returns time-series are
central to modern financial economics, and have enormous value for a variety of real-
world applications. A good market index should be highly liquid to support products in
the real world, it should have a high hedging effectiveness against a huge variety of real-
world portfolios, and it should be hard to manipulate.

What is special about Nifty for use in index derivatives?

The methodology created for the NSE-50 index explicitly isolates a set of securities for
which the market impact cost is minimised when buying or selling the entire index
portfolio. This makes Nifty well-suited to applications such as index funds, index
derivatives, etc. Nifty has a explicit methodology for regular maintenance of the index
set. It is successful at expressing the market risk inherent in a wide variety of portfolios
in the country.

How does this low impact cost matter?

As is the case in all areas of finance, in the context of index derivatives, there is a direct
mapping between transactions costs and market efficiency. Index futures and options
based on Nifty will benefit from a high degree of market efficiency because arbitrageurs
will face low transactions costs when they eliminate mispricings. This high degree of
market efficiency on the index derivatives market will make it more attractive to pure
users of the derivatives, such as hedgers, speculators and investors. High liquidity also
immediately implies that the index is hard to manipulate, which helps engender public
confidence.

At the operational level, how do security contracts compare versus index-based

contracts?

The basic fact is that index-based contracts attract a much more substantial order-flow,
which helps them have tighter spreads (i.e. greater liquidity). At a more basic economic
level, we say that there is less asymmetric information in the index (as opposed to
securities, where insiders typically know more than others), which helps index-based
trading have better liquidity. At settlement, in the case of security-options, there is the
possibility of delivery, and in that case arises the question of depository vs. physical
delivery. Both alternatives are quite feasible. However, in index-based contracts, that
question does not arise since all index-based contracts are cash-settled. The index has
much less volatility than individual securities. That helps index options have lower prices,
and index futures can work with lower margins. The most important difference between
the index and individual securities concerns manipulation. Given that an index is
carefully built with liquidity considerations in mind, it is much harder to manipulate the
index as compared with the difficulty of manipulating individual securities.

How do I start trading in the index and stock derivatives (futures and options) market?

Futures/ Options contracts in both index as well as stocks can be bought and sold
through the trading members of National Stock Exchange. Some of the trading members
also provide the internet facility to trade in the futures and options market. You are
required to open an account with one of the trading members and complete the related
formalities which include signing of member-constituent agreement, constituent
registration form and risk disclosure document. The trading member will allot to you an
unique client identification number. To begin trading, you must deposit cash and/or other
collaterals with your trading member as may be stipulated by him. What is the
Expiration Day for Stocks or Index futures and options? It is the last day on which the
contracts expire. Index / Stock Futures and Options contracts expire on the last
Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts
expire on the previous trading day.
What is the contract cycle for Equity based products in NSE ?

Futures and Options contracts have a maximum of 3-month trading cycle -the near
month (one), the next month (two) and the far month (three). New contracts are
introduced on the trading day following the expiry of the near month contracts. The new
contracts are introduced for a three month duration. This way, at any point in time, there
will be 3 contracts available for trading in the market (for each security) i.e., one near
month, one mid month and one far month duration respectively. For example on January
26,2008 there would be three month contracts i.e. Contracts expiring on January
31,2008, February 28, 2008 and March 27, 2008. On expiration date i.e January 31,
2008, new contracts having maturity of April 24,2008 would be introduced for trading.

What are mini- derivative contract and what are the uses of it?

The minimum contract size for the mini derivative contract on Nifty Index is1 lakh. The
contract of Nifty index with this contract size is known as the mini derivative contract.
The lower minimum contract size enables smaller investors / retail investors to
participate and hedge their portfolio using these contracts.

What is meant by longer dated derivatives products? Why longer dated index options
are required?

Longer dated derivatives products are useful for those investors who want to have a long
term hedge or long term exposure in derivative market. The premiums for longer term
derivatives products are higher than for standard options in the same stock because the
increased expiration date gives the underlying asset more time to make a substantial
move and for the investor to make a healthy profit. Currently, longer dated options on
Nifty with tenure of upto 3 years are available for the investors.

What is meant by a volatility Index and how is it computed?

Volatility Index is a measure of expected stock market volatility, over a specified time
period, conveyed by the prices of stock / index options.

What is the concept of In the money, At the money and Out of the money in respect of
Options?

In- the- money options (ITM) - An in-the-money option is an option that would lead to
positive cash flow to the holder if it were exercised immediately. A Call option is said to
be in-the-money when the current price stands at a level higher than the strike price. If
the Spot price is much higher than the strike price, a Call is said to be deep in-the-
money option. In the case of a Put, the put is in-the-money if the Spot price is below the
strike price. At-the-money-option (ATM) – An at-the money option is an option that
would lead to zero cash flow if it were exercised immediately. An option on the index is
said to be "at-the-money" when the current price equals the strike price. Out-of-the-
money-option (OTM) - An out-of- the-money Option is an option that would lead to
negative cash flow if it were exercised immediately. A Call option is out-of-the-money
when the current price stands at a level which is less than the strike price. If the current
price is much lower than the strike price the call is said to be deep out-of-the money. In
case of a Put, the Put is said to be out-of-money if current price is above the strike price.

What is the meant by lot size of contract in the equity derivatives market?

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 1000 each and the minimum contract size is 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.

Is there any Margin payable?

Yes. Margins are computed and collected on-line, real time on a portfolio basis at the
client level. Members are required to collect the margin upfront from the client & report
the same to the Exchange.

How are the contracts settled in case of Index / Stock Futures and Options?

All the Index / Equity futures and options contracts are settled in cash on a daily basis
and at the expiry or exercise of the respective contracts as the case may be.
Clients/Trading Members are not required to hold any stock of the underlying for dealing
in the Futures / Options market. All out of the money and at the money option contracts
of the near month maturity expire worthless on the expiration date.

What are the risks associated with trading in Derivatives?

Investors must understand that investment in derivatives has an element of risk and is
generally not an appropriate avenue for someone with limited resources/ limited
investment and / or trading experience and low risk tolerance. An investor should
therefore carefully consider whether such trading is suitable for him or her in the light of
his or her financial condition. An investor must accept that there can be no guarantee of
profits or no exception from losses while executing orders for purchase and / or sale of
derivative contracts, Investors who trade in derivatives at the Exchange are advised to
carefully read the Model Risk Disclosure Document and the details contained therein.
This document is given by the broker to his clients and must be read, the implications
understood and signed by the investor. The document clearly states the risks associated
with trading in derivatives and advises investors to bear utmost caution before entering
into the markets.

What is meant by currency futures?

Currency futures can be described as contracts between the sellers and buyers whose
values are derived from the underlying Exchange Rate. Currency derivatives are mostly
designed for hedging purposes, although they are also used as instruments for
speculation.
Currency futures trading is allowed in which currency pairs?

Currency future trading is allowed in the US dollar – Indian Rupee (USD – INR); Great
Britain Pound – Indian Rupee (GBP – INR), Euro – Indian Rupee (EURO-INR) and
Japanese Yen – Indian Rupee (JPY-INR).

Who can trade in the Currency Futures Market?

Except FIIs and NRIs, every individual/corporate/institution/bank etc. is allowed to trade

in the Currency Futures market.

What is the permitted lot size in case of Currency futures?

Permitted lot size for USDINR future contracts is 1000 US dollars. Members place
orders in terms of number of lots. Therefore, if a member wants to take a position for
10000 USD, then the number of contracts required is 10000/1000 = 10 contracts.

How do I start trading Currency futures at NSE?

Currency futures can be bought and sold through the trading members of NSE. To open
an account with a NSE trading member, you will be required to complete the formalities
which include signing of member constituent agreement, constituent registration form
and a risk disclosure document. The trading member will allot you a unique client
identification number. To begin trading, you will be required to deposit cash or collateral
with your trading member as may be stipulated by them.

What is the Settlement price for currency futures ?

The settlement price is the Reserve Bank of India Reference Rate on the last trading
day. How is Settlement mechanism done in Currency futures? The currency futures
contracts are settled in cash in Indian Rupee.

What is the final settlement day in case of currency futures ?

Final settlement day is the last working day (subject to holiday calendars) of the month.
The last working day is taken to be the same as that for Inter-bank Settlements in
Mumbai. The rules for Inter-bank Settlements, including those for ‘known holidays’ and
‘subsequently declared holiday’ are those laid down by FEDAI (Foreign Exchange
Dealers Association of India). In keeping with the modalities of the OTC markets, the
value date / final settlement date for the each contract is the last working day of each
month and the reference rate fixed by RBI two days prior to the final settlement date is
used for final settlement. The last trading day of the contract is therefore 2 days prior to
the final settlement date. On the last trading day, since the settlement price gets fixed
around 12:00 noon, the near month contract ceases trading at that time (exceptions: sun
outage days, etc.) and the new far month contract is introduced.

What is meant by Interest Rate Futures?

An interest rate futures contract is "an agreement to buy or sell a debt instrument at a
specified future date at a price that is fixed today." What is the underlying for Interest
Rate Futures? Currently, exchange traded Interest rate futures are based on the
notional coupon bearing GOI security. While the name ‘interest rate futures’ suggests
that the underlying is interest rate, it is actually bonds that form the underlying
instruments. An important point to note is that the underlying bond in India is a “notional”
government bond which may not exist in reality. The underlying for bond futures in India
is a notional 10 year government bond with a coupon payment of 7% p.a. In India, the
RBI and the SEBI have defined the characteristics of this bond: maturity period of 10
years and coupon rate of 7% p.a.

Why a Notional Bond is being used as Underlying?

Currently, the underlying for bond futures in India is a notional 10 year government bond
with a coupon payment of 7% p.a. Such a bond may not actually exist. So, let us
understand why such a notional underlying has been selected. If futures were to be
introduced on each of the government bonds, then there would be a large number of
interest rate futures contracts trading on each bond and as a result, the liquidity would
be poor for many of these futures. So a single bond futures has been identified which
pays 7% p.a. as coupon rate and has maturity of 10 years. All bonds have been
assigned a multiplier called ‘conversion factor’ which brings that bond on par with the
theoretical bond available for trading. If the bond future were to be based on an actual
bond issue, it could potentially raise the activity in the futures market to such a large
extent as to cause severe shortages of this actual bond for delivery at expiry. To avoid
this danger of shortages to meet the delivery requirement, the Exchange allows a
specific set of bonds--rather than a single bond--with different coupons and expiry dates
to be used for satisfying the obligations of short position holders in a contract. Thus,
while the purpose of a notional underlying bond is to ensure liquidity, the purpose of
having a basket of bonds is to ensure that there delivery is not affected by short supply,
which would have arisen in case of a single bond.

Why has the bond with a 7% coupon rate been chosen?

The coupon rate of 7 % has been chosen for the hypothetical bond because the yields
on government bonds are generally close to 7 % and hence there would not be much
difference in yield between the delivered bond and the hypothetical underlying.

How is the settlement done in case of Interest Rate futures?

The interest rate futures have to be physically settled unlike the equity derivatives which
are cash settled in India. Physical settlement entails actual delivery of a bond by the
seller to the buyer. But because the underlying notional bond may not exist, the seller is
allowed to deliver any bond from a basket of deliverable bonds identified by the
authorities.

What are the uses of Interest Rate futures?

It is not just the financial sector, but also the corporate and household sectors that are
exposed to interest rate risk. Banks, insurance companies, primary dealers and
provident funds bear significant interest rate risk on account of the mismatch in the
tenure of their assets (such as loans and Govt. securities) and liabilities. These entities
therefore need a credible institutional hedging mechanism. Interest rate risk is becoming
increasingly important for the household sector as well, since the interest rate exposure
of several households are rising on account of increase in their savings and investments
as well as loans (such as housing loans, vehicle loans etc.). Moreover, interest rate
products are the primary instruments available to hedge inflation risk, which is typically
the single most important macroeconomic risk faced by the household sector. It is
therefore important that the financial system provides different agents of the economy a
greater access to interest rate risk management tools such as exchange-traded interest
rate derivatives. Who can participate in the Interest Rate Futures market Banks and
Primary Dealers Mutual Funds and Insurance Companies Corporate houses and
Financial Institutions FIIs and NRIs Member Brokers and Retail Investors

How to participate in Interest Rate Futures trading at NSE ?

Interest rate futures can be bought and sold through the trading members of the National
Stock Exchange. To open an account with a NSE trading member you will be required to
complete the formalities which include signing of member constituent agreement,
constituent registration form and a risk disclosure document. The trading member will
allot you a unique client identification number. To begin trading you will be required to
deposit cash or collateral with your trading member as may be stipulated by them.