30 Questions
What is the purpose of a stock market index?
To act as an underlying for financial application of derivatives
How are stocks weighted in a market capitalization weighted index?
Based on their market capitalization
What is free float market capitalization index?
An index that weighs stocks based on their free float market capitalization
In a price-weighted index, which stocks have a greater influence on the index?
Stocks with higher prices
What is an equal-weighted index?
An index that gives equal weights to all stocks
What does a fund manager need to do to maintain equal weights in an equal-weighted index?
Sell stocks that have increased in price and buy stocks that have fallen in price
What does the seller of an option receive?
The premium with an obligation to sell or buy the underlying asset
What is the primary purpose of swaps in the derivatives market?
To manage risk associated with volatile interest rates, currency exchange rates and commodity prices
What is a key feature of OTC derivatives markets?
Decentralized management of counter-party risk and no formal centralized limits on individual positions
What type of market participants are trying to make a profit by taking on risk?
Traders (also called speculators)
What is the relationship between swaps and forward contracts?
Swaps are a series of forward contracts
What is the primary difference between OTC derivatives markets and exchange-traded derivatives markets?
OTC markets have contracts that are tailored to fit the specific requirements of dealing counterparties
How is the open position of a trading member calculated?
By adding up proprietary open position and clients' open positions
What is the basis for calculating proprietary positions of trading members?
Net basis
How are clients' open positions calculated?
By summing together net positions of each individual client
What is the initial deposit required by both parties in a futures contract?
Initial margin
What is the purpose of calculating open positions of trading members and clearing members?
To determine the open positions and obligations
Who identifies orders as proprietary or client while entering orders on the trading system?
Trading members
What is the primary purpose of a clearing house/clearing corporation in an exchange-traded derivatives market?
To guarantee contract performance and settlement of transactions
What is one of the significance of the derivatives market?
To improve price discovery and transfer risks to willing participants
What is the purpose of the Model Risk Disclosure Document?
To provide information on trading risks and fees to clients
What type of contracts are traded on an exchange-traded derivatives market?
Standardized contracts traded on organized exchanges
Who are the two types of market participants that interact in the derivatives market?
Hedgers and speculators
What is the benefit of shifting speculative trades from unorganized to organized markets?
Improved surveillance and stability in the financial system
How are crystallised losses at a contract level for a client adjusted?
Against crystallised profits from another contract for the same client
What is the purpose of Delivery Margins?
To settle through delivery of derivative contracts
How are client level potential in-the-money long option positions computed?
On a daily basis
What is the basis for identifying in-the-money options?
The closing price of the security in the underlying Capital Market segment
When are Delivery Margins levied?
Four days prior to expiry of derivative contract
What triggers an update in the margins rate?
Every change in margin rate in the Capital Market segment
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
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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