Derivatives in PMS
A PMS may use exchange-traded derivatives on agreed terms, but never beyond the client's funds placed.
A portfolio manager may use derivatives for clients, but on a short leash. SEBI permits derivatives, including for hedging and portfolio rebalancing, only through recognised stock exchanges, only on terms written into the client agreement, and only up to the funds the client has placed with the PM. The principle behind every rule is the same sentence in the Master Circular: the PM should, in essence, invest and not borrow on behalf of its clients.
For a distributor this matters when a strategy advertises hedging or option overlays: the client must understand what the agreement allows before signing it.
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Chapter 5 basics in one line each
- Forward
- A private agreement to buy or sell an asset at a fixed price on a future date; traded over the counter, whereas the Master Circular permits PMS derivatives through recognised stock exchanges.
- Future
- A standardised, exchange-traded forward, marked to market daily with margins.
- Option
- The right, not the obligation, to buy (call) or sell (put) at a strike price; the buyer pays a premium.
- Swap
- An exchange of cash flows, such as fixed for floating interest; mostly over the counter.
What the client agreement must spell out (Master Circular 3.2.2)
- checkQuantum of derivatives exposure, in absolute terms and as a percentage of the other securities in the portfolio.
- checkTypes of derivative instruments and the purpose of using them.
- checkType of derivative position and the exposure on it.
- checkHow derivative contracts are valued and liquidated if the portfolio is liquidated.
- checkThat the PM needs the client's prior permission to change the manner or terms of derivative use.
The limits
- check_circleTotal derivatives exposure of a client may not exceed that client's portfolio funds placed with the PM (Master Circular 3.2.3).
- check_circleNo leveraging the client's portfolio for derivatives (Reg 24(7)), and no borrowing funds or securities for the client (Reg 23(8)).
- check_circleNo speculative transactions, meaning trades settled otherwise than by delivery, except derivatives transactions (Reg 24(11)).
- check_circleDerivatives only on the agreed terms; a breach of those terms is the PM's responsibility (Master Circular 3.2.4), and the Disclosure Document must carry the related disclosures (3.2.5).
Free account, this exam preselected.
Worked example: how much headroom is left
- 1
The account
A client has placed ₹90 lakh with the PM. The agreement permits index futures and options for hedging.
- 2
Existing positions
The PM holds ₹40 lakh of exposure through index futures sold to hedge the equity book.
- 3
The ceiling
Total exposure may not exceed ₹90 lakh, so a further ₹50 lakh at most, and only if the agreement's own stated limit is not lower.
Commodity derivatives (Master Circular 3.3)
- check_circleAllowed for clients on exchange-traded commodity derivatives, after appointing a SEBI-registered custodian.
- check_circleNeeds an agreement, or an addendum for existing clients, plus Disclosure Document coverage of risks, margins, position limits and the PM's experience.
- check_circleIf a contract ends in physical delivery, the PM must dispose of the goods within the agreed time; the Regulations let a PM deal in goods received this way.
- check_circleExposure is reported to clients and in the monthly report to SEBI under "Commodity Derivatives".
Two 2026 developments
SEBI's informal guidance letters of May 18, 2026 (non-discretionary PMS) and August 17, 2026 (discretionary PMS) said a client may pledge holdings in their own demat account for a loan they arrange themselves, at their own discretion; that is not borrowing by the PM, and the pledged shares stay in the PM's AUM until the pledge is invoked. Separately, the SEBI Board on September 24, 2026 approved new PM Regulations that would allow exchange-traded derivatives up to 1.25 times client AUM. That is not in force until notified; today's ceiling is the funds placed.
How XXI-A tests this
Expect arithmetic on the exposure ceiling (portfolio funds minus exposure already taken), true or false on whether a PM may trade derivatives off-exchange (no), and the source of authority (the client agreement). The trap is reading "hedging and rebalancing" as the only permitted purposes; the Master Circular says derivatives are permitted including for those purposes, subject to the agreed terms. Another trap treats a client's own pledge as prohibited borrowing.
FAQs
Can PMS invest in futures and options?expand_more
Yes, through recognised stock exchanges, on terms written into the client agreement, with total exposure no more than the client's funds placed with the PM.
Can a portfolio manager use leverage in PMS?expand_more
No. The Regulations bar leveraging the client's portfolio for derivatives and borrowing funds or securities on the client's behalf.
Can PMS trade commodity derivatives?expand_more
Yes, exchange-traded ones, after appointing a SEBI-registered custodian and with the client's agreement and full disclosure.
What is the derivatives limit in PMS?expand_more
A client's total derivatives exposure may not exceed the funds placed with the PM. A proposal to raise this to 1.25 times AUM was approved by SEBI's Board in September 2026 but is not yet in force.