NISM Equity Derivatives FAQs PDF

NISM Equity Derivatives FAQs Answers 1. What is a derivative? Answer: A derivative is a financial instrument whose value is derived from the value of an underlying asset. Derivatives can be used for risk management or speculation. 2. Which of the following are common types of derivatives?...

NISM Equity Derivatives FAQs Answers 1. What is a derivative? Answer: A derivative is a financial instrument whose value is derived from the value of an underlying asset. Derivatives can be used for risk management or speculation. 2. Which of the following are common types of derivatives? A. Swaps B. Forwards C. Futures D. Options Answer: Swaps (A) Forwards, futures, options, and swaps are some common types of derivatives. 3. What is the key difference between a forward and a futures contract? Answer: Futures contracts are traded on an organized exchange, while forward contracts are negotiated directly between two parties. Understanding this difference is key to comprehending how derivative markets operate. 4. Options give the holder the obligation to buy or sell the underlying asset. A. True B. False Answer: False (B) Options provide the right but not the obligation to buy or sell the underlying asset. 5. Match the following types of options with their descriptions: 1. Call A. Give the holder the right to sell Options an asset at a specified price. 2. Put B. Give the holder the right to buy Options an asset at a specified price. Answer: Call Options = Give the holder the right to buy an asset at a specified price. Put Options = Give the holder the right to sell an asset at a specified price. 6. Why is forward contracting important? Answer: Forward contracting is very valuable in hedging and speculation. Forward contracting allows individuals to protect themselves from potential losses or profit confidently in a dynamic market. 7. What are futures contracts? Answer: A futures contract is an agreement to buy or sell an asset on a publicly-traded exchange. Futures contracts provide standardized agreements for buying or selling assets, minimizing counterparty risk. 8. What are the major differences between forwards and futures contracts? A. Settlement frequency B. Counterparty risk C. Trading location D. Contract size Answer: Counterparty risk (B) One significant difference between forwards and futures contracts is the level of counterparty risk involved. 9. What are standardized contracts? Answer: Futures contracts are standardized by exchanges. Standardized contracts have predefined terms and conditions authorized by the exchange itself. 10. What are customized contracts? Answer: Forward contracts are customized agreements between two parties. Customized contracts allow for individually tailored terms between the involved parties. 11. What are the major specifications of a futures contract? Answer: Expiry, contract size, initial margin, price quotation, tick value, mark to market, delivery date, and daily settlement. Understanding the specifications of a futures contract is crucial to successful trading and risk management. 12. What are the limitations of forward contracts? Answer: Lack of centralization, illiquidity, and counterparty risk. Forward contracts face challenges such as fragmented trading, low liquidity, and potential default risks. 13. What are the limitations of futures contracts? Answer: High risks due to leverage, limited flexibility, partial hedging, and potential over-trading. While futures contracts offer benefits, they also come with limitations like high risk exposure and reduced flexibility. 14. Which positions can one take in a futures contract? Answer: Long and short positions. Traders can opt for long positions expecting price increases, or short positions anticipating price decreases in futures contracts. 15. What are the payoffs and profits for a long futures holder? Answer: Unlimited profits and losses with potential upside/downside. Long futures holders aim for profits through price rises, but also face unlimited losses if prices decrease. 16. What are the payoffs and profits for a short futures holder? Answer: Unlimited profits and losses with potential downside/upside. Short futures holders aim for profits through price falls, but also face unlimited losses if prices increase. 17. Which stocks are eligible for futures trading? Answer: Selected stocks meeting liquidity and volume criteria. Futures trading involves specific stocks meeting strict criteria to ensure market stability and participant protection. 18. What are the benefits of trading in index futures? Answer: Higher leverage, risk diversification, ease of trading long/short, and liquidity. Trading index futures offers advantages like efficient risk management, leverage opportunities, and reduced investment risks. 19. What are Options Trading Strategies? A. Strategies employed by traders to trade options contracts B. Strategies employed by governments to stabilize the stock market C. Strategies employed by companies to raise capital D. Strategies employed by investors to buy and hold stocks Answer: Strategies employed by traders to trade options contracts (A) Options trading strategies are strategies employed by traders, by combining options with underlying, or options with futures, or by combining more than options of same or different types and/or same or different strikes/maturity. 20. What determines the fair price of a futures contract? Answer: Underlying asset price, cost of carry, and expected dividends. Futures contract pricing is influenced by underlying asset value, carrying costs, and projected dividend payments. 21. On what basis can a trader identify which option trading strategy to be adopted in which scenario? Answer: Based on the views of the trader on the direction of the price of the underlying and the future volatility of the price of the underlying. Option trading strategies can be adopted based on the trader's views on the direction of the price of the underlying asset and their view on the future volatility of the price of the underlying asset. 22. List out some major categories in which options trading strategies can be classified. Answer: Bullish Option Strategies, Bearish Option Strategies, Range bound Option Strategies, Volatile Option Strategies Options trading strategies can be broadly classified into categories based on the view on the direction of underlying’s price and/or the view on volatility of underlying’s price. 23. Match the following option strategy categories with their descriptions: 1. Volatile A. Used when expecting the Option underlying assets to decline Strategies 2. Bearish B. Used when expecting high Option volatility in the underlying assets Strategies 3. Bullish C. Used when expecting the Option underlying assets to remain within Strategies a specific range 4. Range bound D. Used when expecting the Option underlying assets to rise Strategies Answer: Bullish Option Strategies = Used when expecting the underlying assets to rise Bearish Option Strategies = Used when expecting the underlying assets to decline Range bound Option Strategies = Used when expecting the underlying assets to remain within a specific range Volatile Option Strategies = Used when expecting high volatility in the underlying assets 24. What does a Put Option give you the right to do? Answer: Sell the underlying at a specified price and within a specified period A Put Option provides the holder the right but not the obligation to sell the underlying asset at a predetermined price within a specified time frame. 25. What does a Call Option give you the right to do? Answer: Buy the underlying at a specified price and within a specified period A Call Option gives the holder the right but not the obligation to buy the underlying asset at a predetermined price within a specified time frame. 26. When are you bullish on the market and would typically sell a Put Option or buy a Call Option? A. When expecting the prices to decrease B. When expecting the prices to remain stable C. When not concerned about market movement D. When expecting the prices to increase Answer: When expecting the prices to increase (D) Selling a Put Option or buying a Call Option is done when one expects prices to increase and wants to profit from the upward movement in prices of the underlying asset. 27. Options trading has gained significant traction due to the advantage of requiring.................................................. capital to invest than directly purchasing stocks. Answer: low 28. Equity Options traded on Indian Stock Exchanges are typically European Style options. A. True B. False Answer: True (A) European Style options are the most common type traded on Indian Stock Exchanges. 29. What is the Black-Scholes Model used for? Answer: Determining the fair price or theoretical value for a call or a put option The Black-Scholes Model is a pricing model utilized to calculate the fair price or theoretical value of call or put options based on various variables. 30. What is basis risk? Answer: Type of systematic risk due to changing basis amounts at different contract times Basis risk arises from the fluctuation in basis amounts between the time of entering the contract and settling it, leading to potential risks. 31. Explain the concept of hedging. Answer: Hedging is a risk management strategy that involves offsetting losses in investments by taking an opposite position in a related asset. Hedging is a technique used to mitigate potential losses by investing in assets that offset the risks present in the primary investments. 32. Match the mathematical option pricing models with their assumptions: 1. A. Assumes share prices and index Binomial values follow a Log-Normal Model Distribution 2. B. Assumes share prices and index Black- values follow a Binomial Scholes Distribution Model Answer: Binomial Model = Assumes share prices and index values follow a Binomial Distribution Black-Scholes Model = Assumes share prices and index values follow a Log-Normal Distribution 33. What is portfolio hedging? Answer: Portfolio hedging refers to techniques used to reduce risk exposure in an investment portfolio due to market risk rather than stock-specific risk. Portfolio hedging is a risk management strategy used to minimize potential losses in an investment portfolio. 34. How can the optimum hedge ratio of a portfolio be calculated? Answer: The optimum hedge ratio of a portfolio is calculated using the formula N = (β * VA) / VF, where VA is the current value of the portfolio and VF is the current value of one futures contract. Calculating the optimum hedge ratio helps investors determine the appropriate amount to hedge in order to manage risk effectively. 35. What is meant by cross hedging? Answer: Cross hedging involves trading in the futures market of an asset that is closely associated with the underlying asset that does not have available futures contracts. Cross hedging allows investors to hedge against specific risks when direct futures contracts are not available for the underlying asset. 36. Describe how an investor can hedge using futures with an illustrative example. Answer: An investor can hedge using futures by taking a position that offsets the risk in their existing position. For example, by shorting index futures to offset potential losses in a long stock position. Hedging with futures can help investors protect their positions from adverse market movements. 37. What are the limitations of hedging? Answer: Hedging cannot completely eliminate price risk, requires incurring transaction costs, needs margin maintenance, and is typically for a short period rather than a long-term solution. Understanding the limitations of hedging is crucial for investors to make informed decisions about risk management. 38. Who are arbitrageurs? Answer: Arbitrageurs are investors who capitalize on mispricing of assets across different markets or locations to make profits. Arbitrageurs play a key role in ensuring market efficiency by exploiting temporary pricing disparities. 39. Explain the concept of a futures price or a forward rate. Answer: A futures price refers to the agreed-upon fixed price at which an underlying asset will be transacted on a future date. Understanding futures prices is essential for participants in futures markets to engage in price speculation and risk management. 40. What is the futures spot parity equation? Answer: The futures spot parity equation is F0 = S0 * erT, where F0 is the futures price today, S0 is the spot price today, r is the risk-free interest rate, and T is the time until delivery date. The futures spot parity equation helps determine the fair value relationship between the spot price and the futures price of an asset. 41. How is arbitrage carried out in financial markets? Answer: Arbitrage involves exploiting pricing inefficiencies by taking offsetting positions across different markets or timeframes to lock in profits with minimal risk. Arbitrage opportunities arise when assets are mispriced, allowing traders to profit from the price differentials. 42. What is cash-and-carry arbitrage? Answer: Cash-and-carry arbitrage involves buying the underlying asset while simultaneously selling the futures contract to exploit price differentials in the markets. Cash-and-carry arbitrage is a popular strategy used by traders to profit from price imbalances between spot and futures prices. 43. What happens if an option expires out of the money? Answer: The buyer loses the premium paid to buy the contract and the seller earns the profit. When a Call Option expires out of the money, the strike price is higher than the current market price; When a Put Option expires out of the money, the strike price is lesser than the current market price. 44. Is there any Margin payable in Options? Answer: When you buy an Options contract, you need to pay a premium amount. When you sell an Options contract, you need to pay a margin requirement. The loss for the buyer is limited to the premium paid. 45. How are the Options contracts settled? Answer: All Options contracts on indices are settled in cash on the expiration date. For single stock contracts, the option contracts are settled via delivery. Settlement depends on whether it is an index option or a single stock option. 46. What is the difference between square off and exercise an Option? Answer: Squaring off is taking the opposite of your existing position; exercising an option is taking delivery of the underlying asset. Squaring off involves closing the position to neutralize it. 47. Do Option buyers have the same rights as stock buyers? Answer: No, option buyers have limited rights compared to stock buyers. Stock buyers have ownership rights and other benefits like dividends and voting rights. 48. What is the contract cycle for Options in India? Answer: Options in India have a maximum 3-month trading cycle with contracts expiring on the last trading Thursday of the month. New option contracts are introduced the next trading day after the expiration of monthly contracts. 49. What are Covered and Naked Calls? Answer: Covered calls have an opposite position in the underlying asset, while naked calls do not. Covered calls are less risky as the stock is already owned to meet any obligations. 50. What is the “Underlying asset” in Options? Answer: The underlying asset is the asset from which an Option's value is derived, such as Stock, Commodity, Index, or Currency. Options derive their value from an existing asset. 51. How does Volatility affect Options? Answer: Volatility estimates potential stock price changes. Historical Volatility looks at past movements, while Implied Volatility forecasts future volatility. Volatility influences whether an option will end in or out of the money. 52. What can be the risks and rewards in various positions in options? Answer: The risk and reward vary based on the type of option and market outlook. Options provide different risks and rewards based on the position taken. 53. What is the Intrinsic Value of an option? Answer: The intrinsic value is the amount by which an option is in- the-money, calculated as the immediate exercise value of the option. Intrinsic value is derived from the asset's market and strike prices. 54. Why can the Intrinsic Value Of Options Contracts Never Be Negative? Answer: Intrinsic value cannot be negative because it is the value when the option is in-the-money and traders will only exercise the option if it is profitable. Options give traders the choice to exercise or let the contract expire to limit losses. 55. Explain Time Value with reference to Options? Answer: Time value is the premium for the possibility of an option becoming profitable before expiration due to favorable price changes. Options lose time value as expiration nears. 56. What are the factors that affect the value of an option (premium)? Answer: Underlying asset price, Exercise price, Interest rates, and Time to expiry are key factors affecting option value. Various factors contribute to the pricing dynamics of options contracts. 57. Who decides on the premium paid on options & how is it calculated? Answer: Options premium is determined by competitive bids and offers in the trading environment after knowing the theoretical price with the help of pricing models. The premium is the sum of intrinsic value and time value. Options premium is influenced by market conditions and the balance between bids and offers. 58. What are Option Greeks? Answer: Option Greeks are measurements of the sensitivity of option prices to factors like the price of the underlying asset, volatility, and time to expiry. Option Greeks help in understanding how an option price might change based on various market factors. 59. Who are the likely players in the Options Market? Answer: Developmental Institutions, Mutual Funds, Domestic and Foreign Institutional Investors, Brokers, and Retail Investors. Various types of investors and institutions participate in the Options Market. 60. What are the risks for an Options buyer? Answer: The risk for an Options buyer is limited to the premium paid. Options buyers can only lose the premium they paid for the option. 61. What are the risks for an Options writer? Answer: The risk for an Options writer is unlimited while their gains are limited to the premiums earned. Options writers face potentially unlimited losses if the market moves against their position. 62. What are Stock Index Options? Answer: Stock Index Options have a stock index as the underlying asset, representing a group of stocks. Stock Index Options provide exposure to a broad market represented by an index. 63. What are the uses of Index Options? Answer: Index Options enable investors to gain broad market exposure with reduced transaction costs. Index Options are used for diversification and cost-effective market exposure. 64. Who would use index options? Answer: Index Options are attractive to a wide range of users, from conservative investors to aggressive traders. Various types of investors and traders find Index Options useful for different purposes. 65. What are Options on individual stocks? Answer: Options on individual stocks are contracts where the underlying asset is a specific equity stock. These options are based on the performance of an individual company's stock. 66. What is Over the Counter Options? Answer: Over the Counter (OTC) options are customized contracts traded directly between parties. OTC options offer flexibility in terms of contract terms and are not traded on formal exchanges. 67. What are the components of the option value? Answer: The option value consists of Intrinsic Value and Time Value. Intrinsic Value is the amount the option is worth if exercised, while Time Value is the extra value based on factors like volatility and time. 68. What is time decay? Answer: Time decay is the reduction in the value of an option as it approaches expiry, with the time value component diminishing to zero. Options lose value over time due to time decay, benefiting sellers more than buyers. 69. What do you mean by squaring up the options? Answer: Squaring up options involves closing a position by taking an equal but opposite position in the same option or allowing it to expire. Traders square up their options positions to exit their trades or eliminate obligations. 70. What is open interest and volume in options? Answer: Open interest refers to the total number of outstanding contracts, while volume is the number of contracts traded in a day. Open interest and volume help traders gauge market activity and liquidity in options. 71. What are options trading hours in India? Answer: Options on NSE and BSE can be traded from 9:15 am to 3:30 pm on trading days, excluding holidays. Options trading hours in India coincide with the regular market trading hours. 72. What is the option expiry time and date for equity options in Indian? Answer: 1-month Option contracts expire on the last Thursday of the month, typically at 3:30 pm. Equity options in India follow a standard expiry schedule at the end of the month. 73. What is the difference between selling a call option and buying a put option? Answer: Selling a call option involves receiving a premium and capping potential profits, while buying a put option involves paying a premium and having unlimited profit potential. Traders use these strategies based on their market outlook and risk tolerance. 74. What is the difference between selling a put option and buying a call option? Answer: Selling a put option involves receiving a premium and facing potential loss, while buying a call option involves paying a premium and having limited risk. Traders use these strategies based on their market expectations and risk management. 75. What is a contract cycle? Answer: A contract cycle refers to the process of buying contracts maturing in a nearby month and selling the deferred month contracts in commodities and financial derivatives markets. Understanding the concept of contract cycles is essential for traders to profit from price differences between different contract months. 76. What is a bull spread in futures? Answer: A bull spread in futures involves buying contracts in the nearby month and selling contracts in the deferred month to profit from the spread between the prices. Bull spreads are used by traders to speculate on the price difference between near and distant contract months. 77. What is a bear spread in futures? Answer: A bear spread in futures refers to selling contracts in the nearby month and buying contracts in the distant month to take advantage of savings in the cost of carry. Traders utilize bear spreads to capitalize on decreasing prices in the futures market. 78. What is 'Contango'? Answer: Contango is a situation where futures contract prices are higher than the spot price and the futures contracts maturing earlier. Understanding contango is important for traders to analyze the relationship between futures and spot prices. 79. What is 'Backwardation'? Answer: Backwardation is a situation where futures contract prices are lower than the spot price and the futures contracts maturing earlier. Traders monitor backwardation to assess potential market trends and opportunities. 80. What is Basis? Answer: Basis is calculated as the cash price minus the futures price, indicating whether the futures are trading at a premium (Contango) or discount (Backwardation). Understanding basis helps traders evaluate the relationship between cash and futures prices. 81. What is Cash settlement? Answer: Cash settlement is a process of fulfilling a futures contract by paying the monetary difference rather than physically delivering the underlying asset. Cash settlement provides flexibility in futures trading by settling contracts financially. 82. What is Offset? Answer: Offset refers to liquidating a futures contract by entering into an opposite position (purchase or sale) of an identical contract. Offsetting allows traders to close out their positions in the futures market. 83. What is settlement price? Answer: The settlement price is the price at which all outstanding trades in a market are settled, resulting in the payment of profits or losses. Settlement price is a key reference point for valuing futures contracts at the end of a trading session. 84. What is convergence? Answer: Convergence refers to the continuous decline in the difference between the spot and futures contract prices, aiming to reach zero at the contract's maturity. Convergence is a critical concept for futures traders as it signals the alignment of spot and futures prices. 85. Do futures price converge to the spot prices closer to the date of expiry? Why? Answer: Yes, as futures approach expiry, prices naturally converge due to factors such as cost of carry and market demand, leading to equilibrium between spot and futures prices. Understanding the convergence of futures and spot prices is crucial for timing trades effectively. 86. What are Call Options? Answer: A call option gives the holder the right to buy a specified quantity of the underlying asset at the strike price on the expiration date. Call options provide investors with the opportunity to benefit from price increases in the underlying asset. 87. What are Put Options? Answer: A put option gives the holder the right to sell a specified quantity of the underlying asset at the strike price on or before the expiry date. Put options offer investors a way to profit from potential declines in the underlying asset's price. 88. What is option premium? Answer: Option premium is the price paid by the option buyer to acquire the right to buy or sell the underlying asset. Option premium plays a crucial role in determining the profitability of options contracts. 89. What is strike price? Answer: The strike price is the predetermined price at which the underlying asset can be bought or sold if the option buyer exercises their right. Understanding the strike price is essential for calculating potential profits and losses in options trading. 90. What is an expiration date? Answer: The expiration date is the date on which the option contract expires, and the option is either exercised or becomes worthless. Expiration dates are significant in options trading as they define the timeline for decision-making. 91. What is the exercise date? Answer: The exercise date is when the option is actually exercised, determining the specific time when the contract terms are fulfilled. For investors, understanding the exercise date is crucial for executing options contracts at the right time. 92. What is Open Interest? Answer: Open Interest is the total number of outstanding futures and options contracts in the market at a specific time, indicating the level of active participation. Open Interest provides insights into market sentiment and potential price movements based on contract positions. 93. How open interest is different from the traded volumes? Answer: Open Interest reflects the total number of outstanding contracts, while traded volumes represent the quantity of contracts traded during a specific period. Distinguishing between open interest and traded volumes helps traders understand market liquidity and participant activity levels. 94. What do you mean by an option holder or buyer? Answer: An option holder or buyer purchases an option contract, gaining the right to buy (in the case of a call) or sell (in the case of a put) the underlying asset at a defined price within a specified timeframe. Option holders benefit from price movements in the underlying asset while limiting their risk to the premium paid for the option. 95. What do you mean by option writer or seller? Answer: An option writer or seller is the individual who sells an option contract, obligating themselves to buy (in the case of a put) or sell (in the case of a call) the underlying asset if the option buyer decides to exercise their right. Option writers generate income from the premiums received for writing options but face potentially unlimited losses. 96. What is an American Option? Answer: An American Option is an option contract that can be exercised, bought, or sold at any time until its expiry date. American options offer flexibility to traders as they can be exercised at any point during the contract period. 97. What is a European Option? Answer: A European Option is an option contract that can only be exercised on its expiration date, unlike American options which allow exercise at any time until expiry. European options have a distinct exercise timeline compared to American options, impacting trading strategies. 98. How are options different from futures? Answer: Options provide buyers with the right but not the obligation to buy or sell an underlying asset at a specified price, while futures contracts require both parties to fulfill the contract terms. Differentiating between options and futures helps traders choose the most suitable derivative instruments for their trading goals. 99. Explain 'In the Money', 'At the Money', & 'Out of the Money' Options? Answer: An option is 'at-the-money' when the strike price equals the underlying asset price; 'in-the-money' when the strike price is below the asset price (for calls) or above (for puts); and 'out-of-the-money' when the strike price is higher than the asset price (for calls) or lower (for puts). Understanding these terms helps traders assess the current state and potential profitability of options contracts.