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Financial Derivatives Quiz
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Financial Derivatives Quiz

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Questions and Answers

What is the purpose of a stock market index?

  • To invest in the stock market directly
  • To act as an underlying for financial application of derivatives (correct)
  • To provide investment advice
  • To predict the stock prices
  • How are stocks weighted in a market capitalization weighted index?

  • Based on their free float market capitalization
  • Based on their market capitalization (correct)
  • Based on their stock prices
  • Based on their total revenue
  • What is free float market capitalization index?

  • An index that weighs stocks based on their stock price
  • An index that weighs stocks based on their free float market capitalization (correct)
  • An index that weighs stocks based on their total market capitalization
  • An index that weighs stocks based on their revenue
  • In a price-weighted index, which stocks have a greater influence on the index?

    <p>Stocks with higher prices</p> Signup and view all the answers

    What is an equal-weighted index?

    <p>An index that gives equal weights to all stocks</p> Signup and view all the answers

    What does a fund manager need to do to maintain equal weights in an equal-weighted index?

    <p>Sell stocks that have increased in price and buy stocks that have fallen in price</p> Signup and view all the answers

    What does the seller of an option receive?

    <p>The premium with an obligation to sell or buy the underlying asset</p> Signup and view all the answers

    What is the primary purpose of swaps in the derivatives market?

    <p>To manage risk associated with volatile interest rates, currency exchange rates and commodity prices</p> Signup and view all the answers

    What is a key feature of OTC derivatives markets?

    <p>Decentralized management of counter-party risk and no formal centralized limits on individual positions</p> Signup and view all the answers

    What type of market participants are trying to make a profit by taking on risk?

    <p>Traders (also called speculators)</p> Signup and view all the answers

    What is the relationship between swaps and forward contracts?

    <p>Swaps are a series of forward contracts</p> Signup and view all the answers

    What is the primary difference between OTC derivatives markets and exchange-traded derivatives markets?

    <p>OTC markets have contracts that are tailored to fit the specific requirements of dealing counterparties</p> Signup and view all the answers

    How is the open position of a trading member calculated?

    <p>By adding up proprietary open position and clients' open positions</p> Signup and view all the answers

    What is the basis for calculating proprietary positions of trading members?

    <p>Net basis</p> Signup and view all the answers

    How are clients' open positions calculated?

    <p>By summing together net positions of each individual client</p> Signup and view all the answers

    What is the initial deposit required by both parties in a futures contract?

    <p>Initial margin</p> Signup and view all the answers

    What is the purpose of calculating open positions of trading members and clearing members?

    <p>To determine the open positions and obligations</p> Signup and view all the answers

    Who identifies orders as proprietary or client while entering orders on the trading system?

    <p>Trading members</p> Signup and view all the answers

    What is the primary purpose of a clearing house/clearing corporation in an exchange-traded derivatives market?

    <p>To guarantee contract performance and settlement of transactions</p> Signup and view all the answers

    What is one of the significance of the derivatives market?

    <p>To improve price discovery and transfer risks to willing participants</p> Signup and view all the answers

    What is the purpose of the Model Risk Disclosure Document?

    <p>To provide information on trading risks and fees to clients</p> Signup and view all the answers

    What type of contracts are traded on an exchange-traded derivatives market?

    <p>Standardized contracts traded on organized exchanges</p> Signup and view all the answers

    Who are the two types of market participants that interact in the derivatives market?

    <p>Hedgers and speculators</p> Signup and view all the answers

    What is the benefit of shifting speculative trades from unorganized to organized markets?

    <p>Improved surveillance and stability in the financial system</p> Signup and view all the answers

    How are crystallised losses at a contract level for a client adjusted?

    <p>Against crystallised profits from another contract for the same client</p> Signup and view all the answers

    What is the purpose of Delivery Margins?

    <p>To settle through delivery of derivative contracts</p> Signup and view all the answers

    How are client level potential in-the-money long option positions computed?

    <p>On a daily basis</p> Signup and view all the answers

    What is the basis for identifying in-the-money options?

    <p>The closing price of the security in the underlying Capital Market segment</p> Signup and view all the answers

    When are Delivery Margins levied?

    <p>Four days prior to expiry of derivative contract</p> Signup and view all the answers

    What triggers an update in the margins rate?

    <p>Every change in margin rate in the Capital Market segment</p> Signup and view all the answers

    Study Notes

    Stock Market Indices

    • A stock market index is used as an underlying for financial applications of derivatives
    • Types of stock market indices:
      • Market capitalization weighted index
      • Free-Float Market Capitalization Index
      • Price-Weighted Index
      • Equal Weighted Index

    Market Capitalization Weighted Index

    • Each stock is given weight according to its market capitalization
    • Higher the market capitalization of a constituent, higher is its weight in the index

    Free-Float Market Capitalization Index

    • Computes the index based on weights of each security based on free float market capitalization
    • Sensex and Nifty have moved to free float basis over time

    Price-Weighted Index

    • A stock index in which each stock influences the index in proportion to its price
    • Stocks with a higher price will be given more weight and have a greater influence over the performance of the index

    Equal Weighted Index

    • All stocks included in the index have the same weightage
    • The number of shares of each stock is adjusted to maintain the same equal weights

    Derivatives

    • Buyer of an option pays the premium and buys the right, seller receives the premium with obligation to sell/buy the underlying asset
    • Swaps: an agreement to exchange cash flows in the future according to a prearranged formula
    • Swaps help manage risk associated with volatile interest rates, currency exchange rates, and commodity prices

    Types of Derivatives Markets

    • OTC Derivatives Market:
      • Contracts are tailor-made to fit specific requirements
      • No centralized limits on individual positions, leverage, or margining
      • No formal rules for risk management
    • Exchange Traded Derivatives Market:
      • Contracts are standardized
      • Traded on organized exchanges with prices determined by anonymous auction platform
      • Clearing house/clearing corporation guarantees contract performance

    Settlement Mechanism

    • Initial margin is deposited by both parties to the contract
    • Transactions are private with little or no disclosure to the entire market

    Significance of Derivatives Market

    • Helps in improving price discovery based on actual valuations and expectations
    • Helps in transferring risks from those who are exposed to risk but have low risk appetite to participants with high risk appetite
    • Helps shift speculative trades from unorganized market to organized market
    • Provides stability to the financial system

    Market Participants

    • Hedgers: want to give away risk
    • Traders: willing to take risk
    • Arbitrageurs: take advantage of price differences between two markets

    Risk Management

    • Market participants advised to read the Model Risk Disclosure Document
    • Document issued by members of Exchanges and contains important information on trading in Equities and F&O Segments of exchanges

    Margins

    • Delivery margins: levied on lower of potential deliverable positions or in-the-money long option positions
    • Exposure margins: VAR and Extreme Loss percentage applied on client level settlement obligations

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    Description

    Test your knowledge of financial derivatives, including options and swaps. Learn about the roles of buyers and sellers in option agreements and the characteristics of swaps.

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