Derivatives are financial instruments that are associated with the value of the underlying security that it serves. For example, an equity derivative is linked to the value of the equity share it represents. The security of a derivative mutual fund could be anything such as an index, an equity share, a bond, a currency, or any other security. Generally, there are four kinds of derivatives forwards, futures, options and swaps. Derivatives are versatile and complicated instruments that have multiple uses. However, they can also be highly risky. 

The Securities and Exchange Board of India authorises mutual funds to use derivatives for hedging purposes. The mutual fund can protect its investments using derivatives. Also, Derivatives can be used for arbitrage policies by mutual funds. Some mutual funds invest in stocks but also include options to reduce the risk and volatility of their portfolios. Investment in derivative mutual fund generally lowers the overall return but they can prevent drastic losses in a market crash.

SEBI has issued a circular in recommendations with Mutual Fund Advisory Committee according to which Mutual Fund schemes are allowed to engage in transactions in equity derivatives following the specified exposure limits. SEBI has also decided to authorise mutual funds to write call options. Mutual Fund Schemes may write call options as per the call policy of NIFTY 50 and BSE SENSEX. The key points discussed in the circular are discussed below.

• The nominal rate of the call options must not surpass 15% of the total market value of equity shares.
• The total quantity of shares holding the call options written must not go beyond 30% of the unencumbered shares of a company.
• The policy has 7 trading days to rebalance the portfolio in case of any breach of provisions.
• The Mutual Fund policy must not write a call option without holding the equity shares.
• The gross exposure related to the security premium paid and received must not exceed 20% of the net assets of the policy.
• The combined gross exposure of the call option will not be considered as exposures.
• The call option will be noted to market every day and the respective gains or losses occurred into the daily Net Asset Value of the respective policy.

Generally, call options are referred to an agreement that gives a customer the right to acquire an asset at a specified price within a particular period. Earlier, mutual fund schemes were authorised to undertake transactions in equity derivatives but cannot write options or purchase instruments with embedded written options.