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Questions and Answers
What is the purpose of a stock market index?
How are stocks weighted in a market capitalization weighted index?
What is free float market capitalization index?
In a price-weighted index, which stocks have a greater influence on the index?
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What is an equal-weighted index?
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What does a fund manager need to do to maintain equal weights in an equal-weighted index?
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What does the seller of an option receive?
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What is the primary purpose of swaps in the derivatives market?
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What is a key feature of OTC derivatives markets?
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What type of market participants are trying to make a profit by taking on risk?
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What is the relationship between swaps and forward contracts?
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What is the primary difference between OTC derivatives markets and exchange-traded derivatives markets?
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How is the open position of a trading member calculated?
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What is the basis for calculating proprietary positions of trading members?
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How are clients' open positions calculated?
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What is the initial deposit required by both parties in a futures contract?
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What is the purpose of calculating open positions of trading members and clearing members?
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Who identifies orders as proprietary or client while entering orders on the trading system?
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What is the primary purpose of a clearing house/clearing corporation in an exchange-traded derivatives market?
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What is one of the significance of the derivatives market?
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What is the purpose of the Model Risk Disclosure Document?
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What type of contracts are traded on an exchange-traded derivatives market?
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Who are the two types of market participants that interact in the derivatives market?
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What is the benefit of shifting speculative trades from unorganized to organized markets?
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How are crystallised losses at a contract level for a client adjusted?
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What is the purpose of Delivery Margins?
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How are client level potential in-the-money long option positions computed?
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What is the basis for identifying in-the-money options?
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When are Delivery Margins levied?
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What triggers an update in the margins rate?
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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.