The Derivative Contract: Which Terms Actually Define It

A derivative contract is defined by its terms and not by the label on it. Whether one side may choose is exercise. When the promise ends is expiry. What the payments are multiplied by is the notional. How many units one contract covers is its contract size. Who owes the other side is the counterparty. Alter any single one of those and a different agreement exists.

The shapes are familiar already: a promise to deal at a set price on a set date, a promise that recognises gain and loss every day, a choice bought for money, an exchange of one stream of payments for another. Less familiar is what separates two contracts wearing the same name. The separation lives in five headings, and every one of them is a term somebody wrote down before either side signed anything.

The five headings come one at a time, worked on two invented contracts. Between them the two contracts fill every heading, and one number behaves completely differently on each. None of it is a specification. Where a real value would sit, the name of the authority that sets it stands in place of the value, and the value is left empty.

What actually makes one derivative contract different from another?

Two sheets of paper can carry the same one word title and oblige entirely different things. The word is a summary that somebody chose. The terms are what was actually agreed, and only the terms are enforceable. The gap between the summary and the agreement is not a technicality, and it is where almost every avoidable misunderstanding in this subject starts.

Here is the everyday version, and it is closer than it looks. Two households on the same street each say they have fixed the price of next year's cooking fuel. The first has signed something that binds both sides: come what may, the fuel arrives at the agreed price and the money is handed over. The second has signed something that lets the supplier decline on the day if the price has moved the wrong way. Both households will say the same sentence at a wedding. Only one of them has actually fixed anything. The label was identical and the obligation was not. Reading a name is not reading a contract, and the whole of the difference sits there.

The second route is to read the terms. Five headings carry the weight, and this guide gives each one its own part. ExerciseThe act of using a choice a contract gives. Only some contracts carry a choice at all. says whether anybody has a decision to make and, if so, who. ExpiryThe date after which nothing further is owed by anybody under the contract. says when the promise ends. NotionalThe amount the payments under a contract are multiplied by. It never changes hands. says what the payments are multiplied by. Contract SizeHow many units of the referenced thing one contract covers. It is the multiplier between a price per unit and an amount per contract. says how many units of the referenced thing one contract covers. CounterpartyThe party on the other side, who owes what the contract says is owed. says who is on the other side and who therefore has to pay.

Read the terms before the obligation, and the obligation before the payoff. A payoff drawing is downstream of all three. The drawing shows what a contract delivers at each price. Useful as that is, the drawing stays completely silent about who could have walked away, when the whole thing stopped, what the amounts were multiplied by and who was standing on the other side. Four questions the picture cannot answer, and all four are settled in the terms.

There is a second habit worth forming now. Changing any single term produces a different agreement rather than a variation of the same one. Move the expiry out by a month and everything the contract can be worth is now measured to a different date. Take away the exercise term and one side has lost a choice it was relying on. Halve the contract size and the same quoted price now stands behind half as much of the referenced thing. None of those is a detail, and none of them shows up in the name.

Exercise: who may choose, and by when?

Exercise is the act of using a choice a contract gives. The whole of the term sits in that one sentence, and the useful word in it is choice. Most contracts do not give one. Both sides of a forward are bound and neither has anything to decide, so a forward carries no exercise term at all; an option carries one, and it sits with exactly one side.

Take the forward first. Two parties agree today to deal at a stated price on a stated date. On that date the deal happens. Nobody is asked. Going ahead was the agreement, so there is no moment where either side considers whether to do it. A side that would rather not is in the same position as anybody who has promised something and then changed their mind. A future carries the same absence of choice, with the daily recognition of gain and loss sitting on top of it.

Now the option, and the asymmetry is the point. One side holds the choice. The holder may use the choice or decline to use it, and either way owes nothing further beyond what was already paid for the choice at the start. The other side granted the choice and cannot decline: if the holder uses it, the granting side performs. One side may choose and the other may not, and that is not a balance of convenience but the structural fact that separates an option from everything else in this guide.

The household version is easy. A deposit paid on a hall for a wedding date can work either way, and which way it works is written on the receipt nobody reads. If the receipt binds both sides, the hall is booked and the money is owed whatever happens. If the receipt lets the family walk away and forfeit the deposit, the family has bought a choice, the hall has sold one, and the hall cannot hand the date to somebody else while that choice is alive. Same deposit, same hall, entirely different arrangement.

A reader who knows only whether a contract carries an exercise term already knows which of the two obligation structures they are looking at. Reading one row is a genuinely fast test. The price, the size, the dates and the identity of the parties are all beside the point. One row of the term sheet, read on its own, shows whether there is a decision anywhere in the contract and whose it is.

How exercise is actually effected on any particular contract, and the last moment at which the choice may be made, sit outside these five headings. Both are mechanics, set by the Securities and Exchange Board of India (SEBI) at sebi.gov.in, and they differ between contracts and they move. A value written out for either one would be wrong rather than merely old on the day it changed, so the row stays empty and the name of the authority goes in it.

Expiry: when does the promise end, and what is left afterwards?

Every derivative contract has a date after which nothing further is owed by anybody under it. Expiry is that date, and the surprising part is not the date but what sits on the far side of it. After expiry the contract is not a bad contract or a worthless one. It is not a contract. There is nothing to hold, nothing to sell, nothing to settle and nobody to chase. The paper describes something that has finished happening.

Compare that with the things a reader is more used to. A holding in a business carries on being a holding. A loan carries on being a loan until it is repaid. A derivative contract does neither: it has a stated end, and reaching that end is not a failure of the contract but the completion of it. The word expiry is used rather than maturity or termination for exactly that reason. Nothing has gone wrong. The promise has simply run out of time to be a promise.

The consequence lands immediately and it is worth stating as its own claim. Everything a contract can ever be worth has to happen before that date. Anybody holding a choice therefore cares about how much time is left and not only about where the price sits today. A choice with eleven months to run and a choice with four days to run can sit at exactly the same price of the referenced thing and be worth entirely different amounts. One of them still has room for something to happen and the other very nearly does not.

The everyday version: a return window on something bought from a shop. On the last day of the window the right to return is real and usable. On the day after, there is no weakened right to return. There is no right at all, and the strength of the buyer's argument on the pavement outside has nothing to do with it.

Expiry also settles something that would otherwise be a trap, and this is where the invented forward starts doing real work. Its price is arithmetic, so it can be built up rather than accepted as a figure. The invented reference asset has a spot price of Rs 2,000.00/-, its financing costs 6.50 per cent a year, and it pays nothing at all while it is held. A payout during the holding period would subtract from the carry, and this record contains no payout to subtract. Rs 2,000.00/- times 1.065 is Rs 2,130.00/-, a carry of Rs 130.00/-. The Rs 2,130.00/- is what carrying the asset for a year costs, and it is not a forecast that the price will rise by 6.50 per cent. Nobody expressed a view. Somebody added up an interest bill.

Now the trap, and it is a trap about the moment rather than about the arithmetic. Suppose the spot price falls from Rs 2,000.00/- to Rs 1,920.00/-, a fall of Rs 80.00/-, with a full year still to run. Two quite different quantities move, and an account that names only one of them teaches something false.

The first quantity is the price of a contract struck today, for delivery a year from today. The price is arithmetic on the new spot: Rs 1,920.00/- times 1.065 is Rs 2,044.80/-. Against the Rs 2,130.00/- computed a moment ago, that is a gap of Rs 85.20/-. The carry applies to the new spot as well, so the gap is 1.065 times the spot move of Rs 80.00/-.

The second quantity, the worth of a contract already struck at Rs 2,130.00/-, is a completely different thing. The contract already struck settles in a year, so its change has a year still to be discounted. Discounting the Rs 85.20/- for that year at 6.50 per cent a year gives Rs 80.00/-, to the paisa. The worth of a contract already struck moves exactly one for one with the spot. The price of a new contract moves 1.065 times it. Neither sentence can be said honestly without naming which quantity and which moment is meant.

At expiry there is no year left to discount, so the two quantities become the same number and both are Rs 80.00/-. The same fact reads from the other end: a unit held and a unit sold forward cancel rupee for rupee at the final date and nowhere before it. Expiry is what makes the equality true, and a flat net line drawn without the date named quietly asserts an equality that holds on exactly one day.

The expiry calendar itself, and the last day on which a contract may be dealt in, are set by SEBI at sebi.gov.in. The calendar and the last day move, and they differ between contracts, so the authority is named in place of a value.

Notional: what is it, and does any of it change hands?

The notional is the amount the payments under a contract are multiplied by. The definition is that short, and here is the sentence that has to arrive in the same breath as the figure every single time, without exception: the notional never changes hands. Not at the start, not at the end, not in part. The notional is a number written into the agreement so that two rates have something to be applied to, and it stays exactly where it is while the arrangement runs and after it finishes.

The notional is largest on a swap, and the misreading does the most damage there, so work it on the invented swap. Two invented parties, Chitrakoot Cements Limited and Saranga Capital Limited, are under one agreement with a notional of Rs 1,000 crore. Chitrakoot Cements pays a fixed 7.20 per cent a year, the rate written into the agreement. Saranga Capital pays a floating benchmark reading 6.00 per cent a year for the first period. Each side receives what the other pays.

The arithmetic runs as follows. Over one full first period the fixed leg is 7.20 per cent a year of Rs 1,000 crore, or Rs 72.00 crore gross. The floating leg is 6.00 per cent a year of Rs 1,000 crore, or Rs 60.00 crore gross. The two difference to a net of Rs 12.00 crore, and Chitrakoot Cements pays that Rs 12.00 crore to Saranga Capital because the fixed rate is the higher of the two for this period.

The same figure can be reached in one step, and both routes are worth seeing because the second is the one that makes the term click. The gap between the two rates is 1.20 percentage pointsThe plain gap between two rates, which is not the same as a percentage of one rate. Always stated with the base it is applied to., and 1.20 percentage points of Rs 1,000 crore is Rs 12.00 crore. The division back confirms it: Rs 12.00 crore over Rs 1,000 crore is 0.012, or 1.2 per cent, written 1.20 per cent where two decimal places are kept throughout. The share of the notional that moves is the gap itself, restated.

The notional is a multiplier, not an amount at risk, and reporting one without that sentence tells a reader the arrangement is more than eighty-three times larger than the cash it actually produces. Precision about that multiple is the habit: Rs 1,000 crore divided by Rs 12.00 crore is 250 divided by 3, or 83.33 rounded to two places. The 83.33 is a rounding and not an equality, and a tidy 83 would suggest the division came out clean when it did not.

A reader who has followed the arithmetic will reasonably ask for the worth of the arrangement today, and the answer is an absence to be named rather than filled. Valuing a swap needs a reading of the floating benchmark for every future period, and this record holds one reading, for the first period, and nothing after it. So the first period net is computable and printed, the value of the arrangement is not computable, and inventing a curve to fill the hole would be inventing at exactly the point where it matters most.

Drag it to the bottom and the argument finishes itself. At a gap of nil the cash bar is gone entirely, nothing at all changes hands, and the notional bar is exactly where it was, pixel for pixel, having been redrawn every single frame. A quantity that can be held at Rs 1,000 crore while the cash goes to nothing was never an amount at risk. The notional was always a multiplier waiting for something to multiply.

Contract Size: how many units does one contract cover?

A price is quoted for one unit. A contract almost never covers one unit. The contract size is the number that sits between those two facts, and it is the reason a quoted price and the value of one contract are two different numbers that a careless reader will treat as one.

Work it on the invented reference asset. Its spot price is Rs 2,000.00/-, its financing costs 6.50 per cent a year and it pays nothing while it is held. Take a contract size of 50 units, a figure INVENTED FOR TEACHING and not a specification of anything. One contract then covers 50 units. Multiply and watch it happen: 50 units at Rs 2,000.00/- each is Rs 1,00,000/-. The Rs 1,00,000/- is the exposureThe amount of the referenced thing a position actually stands against, as opposed to the amount the payments are multiplied by. of one contract, meaning the amount of the referenced thing this position actually stands against.

The amount posted follows from the exposure and not from the quoted price. Deciding that is the second job of the contract size. At a margin of 8.0 per cent, INVENTED FOR TEACHING, the amount posted against Rs 1,00,000/- of exposure is Rs 8,000.00/-. Get to it either way and the two routes agree: 8.0 per cent of Rs 2,000.00/- is Rs 160.00/- a unit, and 50 units at Rs 160.00/- each is Rs 8,000.00/-; or 8.0 per cent of Rs 1,00,000/- is Rs 8,000.00/- directly. Real margin requirements are set by clearing corporations under the framework SEBI maintains at sebi.gov.in, they vary by contract and by day, and they move, so the 8.0 per cent here exists only so that the arithmetic can be shown at all.

Either the ratio or the amount alone misleads, so the ratio it implies has to be held alongside the amount. Rs 1,00,000/- of exposure standing on Rs 8,000.00/- posted is 12.50 times, and a 4.0 per cent adverse move on the exposure is Rs 4,000.00/-, or 50.0 per cent of what was posted. Per unit that is Rs 80.00/- against Rs 160.00/-, the same 50.0 per cent seen at a smaller size. A four per cent move in the referenced thing takes half of what was put down, and that ratio, not the size of the exposure, is what makes these contracts different to hold. Name the base of every one of those ratios in the same sentence as the ratio and none of them can be quietly swapped for another.

Now put the two quantity words side by side. Here is where they have to be told apart. Every rupee of the multiplier on this forward is a rupee of the referenced thing the position stands against, so the notional and the exposure are the same Rs 1,00,000/-. On the swap in the part above the two are nothing like the same. No principal is ever exchanged, so a notional of Rs 1,000 crore stands against no principal at all, and the cash it produces in the first period is Rs 12.00 crore.

The two words are kept apart because they only sometimes agree, and a reader who treats them as one word will be right on some contracts and badly wrong on others. Keeping the two apart is the entire justification for two words where one would feel simpler, and it is why every quantity here is named as one or the other before it is given a size.

Counterparty: who is on the other side, and what if they do not pay?

The counterparty row looks like a formality: a name, an address, a signature block, and readers skip it. The row is not a formality. A promise is worth exactly what the party making it can honour, and a payoff drawing shows what is owed rather than what arrives. Every figure on every payoff drawing in this subject is a statement about an obligation. Turning an obligation into money requires somebody on the other side who performs.

The household version needs no translation at all. Somebody agrees to repay a neighbour next month. The agreement is identical whoever they are. Whether the money turns up is not identical, and everybody knows to think about that in ordinary life, then stops thinking about it the moment the arrangement acquires a diagram.

Two arrangements exist, and both have names. In the first, the two sides face each other directly. Chitrakoot Cements Limited is relying on Saranga Capital Limited for the life of the agreement, and Saranga Capital is relying on Chitrakoot Cements for the same period. Each side has one specific party to think about, and if that party stopped performing, the contract would say what is owed and the reliance would be on that party alone to produce it.

In the second, the contract is clearedAn arrangement where a party steps in between the two sides and becomes the counterparty to each of them separately.. A party stands between the two sides and becomes the counterparty to each of them. The long side no longer faces the short side; it faces the party in the middle. The short side does the same. Clearing is a substitution and not a removal: neither side is relying on the other any longer, and both are now relying on the party standing between them. Something has changed, and what changed is who has to perform rather than whether anybody has to.

Everything in this part is written in the conditional voice, and the reason is worth stating. No party fails anywhere in this record: no default, no shortfall, no instance of anybody not paying. Each arrangement can therefore be described, along with what it would mean for who has to perform, and no invented contract stands as evidence about what either arrangement achieves. Describing what happens when a party actually fails needs an instance to work on, and this record contains none; inventing one would invent the conclusion along with it.

The conditions on which a clearing corporation stands as the counterparty to each side are set by SEBI at sebi.gov.in, and they move. A clearing corporation is identified by its role rather than by a name. An exchange does a different job and is not the same thing.

Which of these terms do the two sides set, and which are set for them?

The five headings are now set out. The next question decides how much freedom anybody has over them, and the answer splits cleanly in two.

Where two parties agree a contract directly between themselves, they set every one of the five terms and can set them to anything they both accept. Any expiry date. Any contract size, including one that is not a round number. Any exercise arrangement or none. Whatever notional the two of them write down. And the counterparty on each side is simply the other party. Nobody else is in the room.

Where a contract is dealt on an exchange, the five terms arrive already fixed. The fixed terms are standardised termsTerms fixed in advance for a whole series of contracts rather than agreed between the two sides who deal one of them., meaning terms written for the whole series rather than negotiated by whoever happens to be dealing. The two sides then agree only two things: the price, and how many contracts.

What standardisation does, stated without praising it, is make any contract in a series identical to any other, so one can be closed by taking the opposite one. Closing out that way is a mechanical consequence of sameness rather than a benefit anybody granted. If one party's contract and another's are word for word the same thing, then holding one of each leaves a holder with nothing, and the position can end without anybody having to find the original other side.

What it costs, stated equally plainly, is that a party whose need does not match the standard terms gets an approximate fit rather than an exact one. If the need finishes in seven weeks and the series finishes in nine, the choice is to take the nine or to go and agree something directly. Neither route is better in general. Ranking them would need to know what the contract was for, and that is a fact about the party holding it rather than a fact about a contract.

Both arrangements are named and no more than named. The exchange traded contract in its own right, and what standardisation buys and costs when it is examined properly, is covered separately and worked in full where it belongs.

What do two whole contracts look like with every term filled in?

Here are both invented contracts read down as term sheets, side by side. The two were chosen for one reason: between them they fill every one of the five headings, and the notional and the exposure agree exactly on the first and diverge sharply on the second.

Read the forward's price line once more before moving on, because it is the pillar this whole subject stands on and it is easy to let slip. Rs 2,000.00/- carried for one year at 6.50 per cent a year is Rs 2,130.00/-, a carry of Rs 130.00/-. Rs 2,130.00/- is what it costs to hold the thing until the date, and it is not an expectation about where the price goes. Anybody offering to sell forward for less than Rs 2,130.00/- is offering money away. The number therefore sits where it does, and nobody's opinion enters it.

How does somebody actually use these five rows on an ordinary day?

The five rows are not an examination checklist. The five rows are what a working reader runs through in about ninety seconds when a contract, a disclosure or a summary line lands in front of them, and the ninety seconds is the point: it is fast because it is fixed, and it is fixed because guessing which question to ask next is where the time actually goes.

A lender looking at a borrower who has entered into contracts wants the counterparty row and the expiry row before anything else. The counterparty row says who has to perform for the borrower's arrangement to produce what the borrower says it will produce. The expiry row says when the arrangement stops doing that. If the loan runs longer than the contract does, the difference matters enormously. A borrower whose contract finishes eight months before the loan does has a gap, and the gap is visible in one row.

An analyst handed a sheet of totals does the division first and asks questions second. A total of notionals is not a size, and the analyst's first move is to find the cash the arrangements actually produced and divide it into the notional to see the multiple. On the invented swap that division is Rs 12.00 crore into Rs 1,000 crore, or 1.2 per cent, and the analyst now knows the notional total was describing something eighty three times the cash. On a set of forwards the same division might return something close to one, and the analyst now knows the totals there mean roughly what they look like. Same arithmetic, two very different conclusions, and neither was available from the label.

Somebody inside an invented manufacturer with contracts open reads a different pair of rows. The contract size row tells them how many contracts stand behind the amount of the referenced thing they actually deal in. A whole number problem sits underneath: 50 units to a contract means the amounts available are 50, 100, 150 and so on, and a need that sits at 130 units gets two contracts or three, never two and three fifths. The exercise row tells them whether anybody has a decision to make before the date arrives. A decision means the position needs watching, and no decision means it needs only recording.

The habit under all of that is a labelling habit, and it costs nothing to build. Say whether a figure is a price, a premium, a payoff or a profit. Say whether a quantity is a notional or an exposure. Say the period of every rate out loud. Then 7.20 per cent a year is never quietly compared with something measured over a quarter. Name the base of every ratio in the same sentence as the ratio. Then 50.0 per cent of what was posted is never mistaken for 50.0 per cent of the exposure. Four small disciplines, and between them they catch most of what goes wrong in this subject before it has a chance to compound.

Should anybody enter into one?

Every term on a previously unseen contract can now be read. Whether to sign one is the honest question to ask next, so here is the honest answer. Reading the terms cannot settle it, and the refusal is structural rather than cautious.

A short list would have to be known first, and every item on it is a fact about the party rather than about the contract. First, what the contract would be held against. A contract held against something a reader already has is a completely different proposition from the same contract held on its own. Then what the reader could afford to lose across the whole range of prices, not at the price they have in mind. How likely each of those prices is. Whether the reader could produce cash on a morning when the position had moved against them. The amount posted is not the end of the matter. And whether the reader may enter into such a contract at all. SEBI sets that at sebi.gov.in, and for an interest rate contract the Reserve Bank of India sets it at rbi.org.in.

The middle three need a probability and a distribution, and neither has been stated, so an answer offered anyway would be an invention at exactly the point where a reader is least able to check it. A payoff is a description of an obligation. The payoff says what happens at each price and is completely silent about which price arrives.

Being able to read every term in a contract is not a reason to sign one. The five rows give what has been agreed. The five rows do not say whether agreeing it was sensible for the party signing. Sensible is a question about the party rather than about the contract.

Which of these values does an authority set?

Chitrakoot Cements Limited, Saranga Capital Limited, the reference asset and every price, rate, notional, exposure, contract size and margin here are invented.
Educational material. Not advice on any investment, tax, budget or market position.