Financial Markets and Instruments

10 Questions

What happens to the risk reduction when you go from 50 stocks to 100 stocks in an index?

Risk reduction is very little

What is the primary goal of a good index in terms of diversification and liquidity?

Find a balance between diversification and liquidity

What is the problem with including illiquid stocks in an index?

It yields contaminated information and worsens the index

What is the primary methodology used to construct stock market indices?

All of the above

What is the 'Free Float Factor' in the context of Free Float Market Capitalization Weighted Index?

The public shareholding of a company

What is the benefit of diversification up to a certain point in an index?

It reduces the risk of the index

What is the purpose of diversification in an index?

To make the index more representative of the market

What happens to the benefit of diversification beyond a certain point in an index?

It gives almost zero reduction in risk

What is the primary issue with broadening an index?

The stocks included may be illiquid

What type of index is constructed based on the market capitalization of the stocks?

Market Capitalization Weighted Index

Study Notes

Arbitrage

If the return from investing in riskless instruments is more than the return from arbitrage trades, it makes sense to arbitrage, known as reverse-cash-and-carry arbitrage.
This arbitrage activity ensures that spot and futures prices stay in line with the cost-of-carry.
Exploiting arbitrage involves trading on the spot market.

Hedging Using Stock Index Futures

Hedging is a risk mitigation mechanism.
A certain exposure in a security can be hedged by an equal and opposite transaction in the futures for the same security.
There are two types of risks: Unsystematic Risk (also known as Company Specific Risk or Diversifiable Risk) and Systematic Risk (also known as Market Risk or Non-diversifiable Risk).

Unsystematic Risk

Unsystematic risk is specific to a company and can be reduced through diversification.
Examples: change in government policy affecting the price of steel and company shares.

Systematic Risk

Systematic risk is associated with the overall market returns and cannot be reduced through diversification.
Examples: cultivating rice and missing out on high profits due to high demand for wheat, or vice versa.

Importance of Derivatives

The past two decades have seen exponential growth in international trade and business due to globalization and liberalization.
The demand for international money and financial instruments has increased significantly, leading to increased financial risk.
Derivatives have been developed to manage this risk and ensure commitments to prices for future dates.

Index Construction

A good index is a trade-off between diversification and liquidity.
Diversification reduces risk, but there are diminishing returns to diversification beyond a certain point.
Including illiquid stocks in an index can worsen the index due to contaminated information.
There are three computational methodologies for constructing stock market indices: Free Float Market Capitalization Weighted Index, Market Capitalization Weighted index, and Price Weighted Index.