What are derivatives? Definition and regulations for mutual funds

A derivative is a financial contract that derives its value from an underlying asset, such as a stock a bond, a commodity etc.

Derivatives are used as investment tools by seasoned traders and investors to hedge risks or speculate on price changes. However, derivatives can also amplify risks if not used prudently, as they are based on expectations of future price movements.

This is why the Securities and Exchange Board of India (SEBI) has set strict guidelines and limits on how mutual funds in India can use derivatives.

Let us take a closer look at what exactly derivatives are and how mutual funds employ them as part of their investment strategies. This article will help you better understand this complex subject and make informed decisions when investing in mutual funds that use derivatives.

Table of contents

1. Understanding derivatives in mutual funds
2. What is a derivative?
3. Types of derivatives explained
4. How do derivatives work in the share market?
5. Uses and benefits of derivatives
6. Regulations and rules governing derivatives in India
7. Risks associated with derivatives
8. Mutual funds and derivatives

Understanding derivatives in mutual funds

Derivatives are financial contracts whose value depends on an underlying asset such as equities, bonds, currencies, or commodities. They enable parties to buy or sell these assets at predetermined prices on future dates. Mutual funds employ derivatives like futures and options primarily to hedge risks in their portfolios or to potentially capitalise on expected price movements. Debt funds may also use derivatives to manage interest rate and forex risks or enhance potential returns. These instruments may help improve portfolio efficiency but also require careful handling due to their complexity and associated risks.

Also Read: Forward contracts vs futures contracts - Learn about the key differences

What is a derivative?

A derivative is a contract between two parties that derives its value from an underlying asset — such as equities, bonds, currencies, or commodities. It grants the right or obligation to buy or sell the asset at a specified price by a certain date or over a defined period. Examples include futures, options, swaps, and forwards. Derivatives usually do not require payment of the full underlying value upfront and are settled based on changes in the price or cash flows of the underlying asset. They may allow investors to speculate on price movements or hedge against risks in their investment portfolios.

Types of derivatives explained

There are four main types of basic derivatives contracts used in financial markets.

1. Futures contract - This is an agreement to buy or sell a particular asset at a specified price on a future date. Both parties are obligated to fulfill the contract on expiry. Futures are commonly used to speculate on equity indices, commodities, and currencies based on predictions of where their market prices will head.
2. Forwards contract – Similar to futures, but they are customised private agreements traded over the counter. Forwards are contracts to buy or sell an asset at a specified price on a future date. But there is no daily settlement like in futures.
3. Options contract – These give the buyer the right but not the obligation to buy or sell the underlying asset at a specific price on or before the expiration date. The seller is obligated to fulfill their side of the agreed contract if the buyer exercises the option. Calls give the right to buy while puts give the right to sell.
4. Swaps – These involve exchanging a series of cash flows with another party based on an underlying asset. Swaps help users hedge against risks or speculate based on their view of the underlying's price movement. Interest rate swaps and currency swaps are common forms of derivative swap contracts.

How do derivatives work in the share market?

Derivatives in the share market allow investors and fund managers to hedge against adverse price movements or speculate on future changes without owning the underlying shares directly. For instance, futures contracts obligate buying or selling stocks at a preset price on a future date, while options give the right, but not the obligation, to do so. These instruments may help manage risk exposure or, in some cases, contribute to return outcomes within defined risk limits, providing flexibility to adapt strategies according to market conditions.

Uses and benefits of derivatives

There are two broad uses of derivatives – hedging and speculation.

1. Hedging – Derivatives allow mutual funds to limit losses in their existing portfolios by reducing certain risks. For example, if a fund manager expects stock prices to fall, they can buy index put options to protect against the downside. Or if they worry about rising interest rates, they can enter rate swaps that pay fixed and receive floating rates. Hedging does not eliminate risks but helps limit their impact.
2. Speculation – Derivatives also enable mutual funds to take directional bets where they expect prices of the underlying security or index to rise or fall. For instance, buying call options when they expect share prices to rise or selling futures when they anticipate a fall in commodity prices or the broader index. Speculation carries risks if the price view turns out wrong.

Regulations and rules governing derivatives in India

In India, derivatives markets are regulated by the Securities and Exchange Board of India (SEBI) to promote transparency, fairness, and investor protection. SEBI mandates standardised derivatives contracts to be traded on recognised exchanges such as NSE and BSE, along with margin requirements and disclosure norms to manage counterparty and market risks. Only derivatives based on specified underlying assets are permitted, subject to regulatory approval. SEBI also regulates brokers, clearing corporations, and other market intermediaries involved in derivatives trading to help maintain market integrity.

Risks associated with derivatives

Derivatives typically carry high market risk due to leverage—small price changes in the underlying asset may lead to high potential gains or losses. They may also involve liquidity risk, counterparty risk (particularly in non-exchange-traded contracts), and complexity risk, making them potentially unsuitable for investors without adequate understanding. In certain derivative positions, losses may exceed the initial investment. Hence, understanding the derivative’s nature, the behaviour of the underlying asset, and the importance of robust risk management is critical when dealing with these instruments.

Mutual funds and derivatives

While derivatives offer useful tools for mutual fund managers, they also pose risks if not used properly. To curb excessive speculation in derivatives and prevent systemic risks, SEBI has put in place certain guidelines.

The total exposure related to derivatives for mutual funds cannot exceed a certain amount, and derivatives can only be used for hedging and portfolio balancing purposes. Moreover, mutual funds are required to disclose the details of derivative transactions undertaken as per the formats prescribed by SEBI. These disclosures help improve transparency for investors regarding the fund's derivatives strategies.

Fund managers need to have the necessary skills and experience in derivatives trading. The fund's trustees need to ensure compliance with SEBI guidelines and review the adequacy of risk management measures. Violations can attract penalties.

SEBI has proposed additional measures to tighten derivatives market rules, including the below.

• Recalibrating Market Wide Position Limits (MWPL) for single-stock derivatives.
• Introducing intraday monitoring of MWPL utilisation.
• Implementing pre-open and post-closing sessions for derivatives trading.

Also Read: All you need to know about Alternative Investment Funds

Conclusion

Derivatives are nuanced financial instruments that enhance trading flexibility but also entail risk and require considerable market knowledge. Mutual funds, being professionally managed, give investors access to such trading approaches even if they do not have the required financial expertise. Additionally, there are strict regulations on the use of derivatives trading by mutual funds to mitigate risk and safeguard investor interest.

For individuals investing directly in the stock market, speculation using derivatives can help boost return potential but requires extensive knowledge and monitoring.

As an investor, do your due diligence on the fund house and scheme's investment policy and risk management practices related to derivatives before committing your funds.

FAQs:

What is the derivatives rule for mutual funds?

SEBI restricts traditional mutual funds to using derivatives solely for hedging and portfolio balancing, prohibiting speculative use. Additionally, there are also limits on the total exposure to derivatives.

What is the difference between a stock and a derivative?

A stock represents ownership in the underlying company. A derivative is a contract whose value is derived from an underlying security like a stock. Stocks involve ownership rights whereas derivatives do not.

Are derivatives beneficial?

Used prudently, derivatives can offer benefits like hedging risks in a portfolio, speculating on anticipated price movements, and improving portfolio efficiencies. However, unchecked usage of derivatives often amplifies risks. Hence safeguards are beneficial.

Why do funds use derivatives?

Funds may use derivatives for three broad reasons - hedging existing portfolio risks, speculating on expected price movements to enhance returns, and improving portfolio efficiencies through arbitrage and other derivative strategies. But funds need robust risk management practices for the prudent use of derivatives. In the context of mutual funds, derivative use is only allowed for hedging and portfolio balancing, not for speculation.

What is the difference between futures, options, forwards, and swaps?

Futures and forwards are agreements to buy or sell at a set price and date; futures are standardised and exchange-traded, forwards are private. Options give the right, not obligation, to transact. Swaps are contracts exchanging cash flows based on indices/assets.

How do derivatives help in the share market?

They may provide tools for hedging risk, enhancing potential returns, and gaining market exposure without full capital outlay.

Can retail investors trade derivatives?

Yes, retail investors may trade derivatives on stock exchanges through registered brokers, but are advised to understand inherent risks and margin requirements.

What are the risks involved in trading derivatives?

Risks include market volatility, leverage magnifying losses, liquidity issues, and counterparty default.

How does SEBI regulate derivatives in India?

SEBI sets rules for trading, clearing, margining, surveillance, and investor protection in derivatives markets through exchanges and brokers.