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?

Stocks with higher prices Signup and view all the answers

What is an equal-weighted index?

An index that gives equal weights to all stocks Signup and view all the answers

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 Signup and view all the answers

What does the seller of an option receive?

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

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 Signup and view all the answers

What is a key feature of OTC derivatives markets?

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

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

Traders (also called speculators) Signup and view all the answers

What is the relationship between swaps and forward contracts?

Swaps are a series of forward contracts Signup and view all the answers

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 Signup and view all the answers

How is the open position of a trading member calculated?

By adding up proprietary open position and clients' open positions Signup and view all the answers

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

Net basis Signup and view all the answers

How are clients' open positions calculated?

By summing together net positions of each individual client Signup and view all the answers

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

Initial margin Signup and view all the answers

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

To determine the open positions and obligations Signup and view all the answers

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

Trading members Signup and view all the answers

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 Signup and view all the answers

What is one of the significance of the derivatives market?

To improve price discovery and transfer risks to willing participants Signup and view all the answers

What is the purpose of the Model Risk Disclosure Document?

To provide information on trading risks and fees to clients Signup and view all the answers

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

Standardized contracts traded on organized exchanges Signup and view all the answers

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

Hedgers and speculators Signup and view all the answers

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

Improved surveillance and stability in the financial system Signup and view all the answers

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

Against crystallised profits from another contract for the same client Signup and view all the answers

What is the purpose of Delivery Margins?

To settle through delivery of derivative contracts Signup and view all the answers

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

On a daily basis Signup and view all the answers

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

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

When are Delivery Margins levied?

Four days prior to expiry of derivative contract Signup and view all the answers

What triggers an update in the margins rate?

Every change in margin rate in the Capital Market segment 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.