Q1 What are derivatives? Who are the users of derivatives? What is the purpose of use? Enumerate the difference between Cash and Derivative Market.
Answer:
A Derivative is an agreement between buyer and seller for an underlying asset which is to be bought/sold on certain future date. Derivative does not have any value of its own but its value, in turn, depends on the value of the other physical assets which are called underlying assets.
Users of derivative market and purpose of use
1. Hedgers: Use derivatives to reduce risk of unfavorable price movement in the market to provide offsetting compensation against the underlying asset (kind of insurance).
2. Speculators: These are traders who use derivatives in the expectation of making a profit through market fluctuations.
3. Arbitrageurs: Arbitrageurs simply sell the asset in the overpriced market and simultaneously buy it in the cheaper market in order to gain from the different price of underlying in two different markets.
Difference between cash and derivative market
1. In cash market tangible assets are traded whereas in derivative market contracts based on tangible or intangibles assets like index or rates are traded.
2. In cash market, we can purchase even one share whereas in futures and options minimum lots are fixed.
3. Cash market is more risky than futures and options segment.
4. Cash assets may be meant for consumption or investment. Derivative contracts are for
hedging, arbitrage or speculation.
5. Buying securities in cash market involves putting up all the money upfront where as buying futures simply involves putting up the margin money.
6. With the purchase of shares of the company in cash market the shareholder becomes part owner of the company. While in future sit does not happen.
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Q2 What is the difference between Forward Contract and Futures Contract?
Answer:
Q3 Write short note on Embedded Derivatives.
Answer:
An embedded derivative is a derivative instrument that is embedded in another contract- the host contract. The host contract might be an equity or debt instrument, a lease, an insurance contract or a sale or purchase contract.
Suppose entity XYZ enters into a contract to issue a bond, and the payment of interest and principal of the bond is indexed with the price of gold. Here, the payment will increase or decrease according to the movement in the price of gold; and the debt instrument is host contract with an embedded derivative.
Q4 What do you know about the Swaptions and their uses?
Answer:
Interest rate swaption is an option on an interest rate swap where by holder gets the right but not the obligation to enter into an interest rate swap at the specific fixed rate on an agreed future date.
Uses of swaptions
(a) Swaptions can be used as an effective tool to swap into or out of fixed rate or floating rate interest obligations, according to a treasurer’s expectation on interest rates. Swaptions can also be used for protection if a particular view on the future direction of interest rates turned out to be incorrect.
(b) Swaptions can be applied in a variety of ways for both active traders as well as for corporate treasurers. Swap traders can use them for speculation purposes or to hedge a portion of their swap books. It is a valuable tool when a borrower has decided to do a swap but is not sure of the timing.
(c) Swaptions are useful for borrowers targeting an acceptable borrowing rate. By paying an upfront premium, a holder of a payers swaption can guarantee to pay a maximum fixed rate on a swap, thereby hedging his floating rate borrowings.
(d) Swaptions have become useful tools for hedging embedded option which is common in the natural course of many businesses.
Q5 ) Write short note on Caps, Floors and Collars[CFC].
Answer
Caps:
· A cap provides a guarantee that the coupon rate each period will not be higher than agreed limit. It will be capped at certain ceiling.
· It’s a derivative instrument where the buyer of the cap receives payment at the end of each period where the rate of interest exceeds the agreed strike price.
Floors:
· A floor provides a guarantee that the coupon rate each period will not be lower than agreed limit. It will be floored at certain ceiling.
· It’s a derivative instrument where the buyer of the floor receives payment at the end of each period where the rate of interest goes below the agreed strike price.
Collars:
· Collar provides a guarantee that the coupon rate each period will not fall below lower limit and will not go beyond upper limit. It will be capped at upper limit and floored at lower limit.
· It’s a combination of caps and floors.
· It’s a derivative instrument where the buyer of the collar receives payment at the end of each period where the rate of interest goes below the lower limit or goes beyond the upper limit.
Q6) What are the features of futures contract?
Answer:
✓ These are traded on organized exchanges.
✓ Standardized contract terms like the underlying assets, the time of maturity and the manner of maturity etc.
✓ Associated with clearinghouse to ensure smooth functioning of the market.
✓ Margin requirements and daily settlement to act as further safeguard i.e. marked to market.
✓ Existence of regulatory authority.
✓ Every day the transactions are marked to market till they are re-wound or matured.
Q7 What is insider trading practice?
Answer:
The insider is any person who accesses the price sensitive information of a company before it is published to the general public. Insider includes corporate officers, directors, and owners of firm etc. who have substantial interest in the company. Even persons who have access to non public information due to their relationship with the company are an insider.
Insider trading practice is the act of buying or selling or dealing in securities by as a person having unpublished inside information with the intention of making abnormal profit’s and avoiding losses. This inside information includes dividend declaration, issue or buy back of securities, amalgamation, mergers, takeover or major expansion plans.
Insider trading practices are lawfully prohibited. The regulatory bodies in general are imposing different fines and penalties for those who indulge in such practices. SEBI has framed various regulations implemented the same to prevent the insider trading practices.
Q8 Write short notes on the “Marking to Market”.
Answer:
✓ Futures contracts follow a practice known as mark-to-market.
✓ At the end of each trading day, the exchange sets a settlement price based on the day’s closing price range for each contract.
✓ Each trading account is credited or debited based on that day’s profits or losses and checked to ensure that the trading account maintains the appropriate margin for all open positions.
✓ While the margin accounts of each party get adjusted at the end of each day, on the same time the old futures contract gets replaced with the new one at the new price.
✓ Thus each future contract is rolled over to the next day at new price.
Q9 Explain the term Intrinsic Value and Time Value of the option.
Answer:
Intrinsic value of an option and time value of an option are primary determinants of an option’s price. Intrinsic value is the value that any given option would have if it is to be exercised immediately. This is defined as the difference between the options strike price and the stock’s actual current price.
An option’s intrinsic value can never be negative.
1. Say you bought a call option with strike price of ₹500 for ₹20 and two months later its market price is ₹515
Here the intrinsic value of the option is
= Spot (Market)Price – Strike Price = 515-500 = 15
2. Say you bought a put option with strike price of ₹500 for ₹20 and two months later its market price is ₹490
Here the intrinsic value of the option is
= Strike price – Spot Price = 500-490 = 10
Time value (extrinsic value) is the difference between options premium and its intrinsic value.
Considering the same example of call option we can compute the time value of the option Time Value = Options Premium– Intrinsic Value
= 20-15
= 5
Q10 Write short notes on Interest Swaps
Answer:
✓ A swap is a contractual agreement between two parties to exchange or ‘swap’ future payment streams based on differences in the returns to different securities or changes in the price of some underlying item.
✓ In an Interest rate swap, the parties to the agreement, termed as swap counterparties, agree to exchange payments indexed to two different interest swaps.
✓ Financial intermediaries, such as banks, pension funds, and insurance companies as well as non financial firms use interest rate swaps to effectively change the maturity of outstanding
debt or that of an interest bearing asset.
✓ Currency swaps grew out of parallel loan agreements in which firms exchange loans denominated in different currencies.
Q11 What is the significance of underlying in relation to derivative instrument?
Answer:
The underlying may be a share, commodity or any other asset which has a marketable value which is subject to market risks. The importance of underlying in derivative instruments is as follows:
✓ All derivative instruments are dependent on an underlying to have value.
✓ The change in value in a derivative contract is broadly equal to the change in value in the underlying.
✓ In the absence of a valuable underlying asset the derivative instrument will have no value.
✓ On maturity, the position of profit/loss is determined by the price of underlying instruments.
If the price of the underlying is higher than the contract price the buyer makes a profit. If the
price is lower, the buyer suffersaloss.
Q12 What is the difference between options and futures
Answer:
Q13 Explain Initial Margin& Maintenance Margin.
Answer:
Initial Margin
Before a futures position can be opened, there must be enough available balance in the futures trader's margin account to meet the initial margin requirement. Upon opening the futures position, an amount equal to the initial margin requirement will be deducted from the trader's margin account and transferred to the exchange's clearing firm. This money is held by the exchange clearinghouse as long as the futures position remains open.
Maintenance Margin
The maintenance margin is the minimum amount a futures trader is required to maintain in his margin account in order to hold a futures position. The maintenance margin level is usually slightly below the initial margin.
If the balance in the futures trader's margin account falls below the maintenance margin level, he or she will receive a margin call to top up his margin account so as to meet the initial margin requirement.
Example:
Let's assume we have a speculator who has ₹10000 in his trading account. He decides to buy August Crude Oil at ₹40 per barrel. Each Crude Oil futures contract represents 1000 barrels and requires an initial margin of ₹9000 and has a maintenance margin level set at ₹6500.
Since his account is ₹10000, which is more than the initial margin requirement, he can therefore open up one August Crude Oil futures position.
One day later, the price of August Crude Oil drops to ₹38 a barrel. Our speculator has suffered an open position loss of ₹2000 (₹2 x 1000 barrels)and thus his account balance drops to ₹8000.
Although his balance is now lower than the initial margin requirement, he did not get the margin call as it is still above the maintenance level of₹6500.
Unfortunately, on the very next day, the price of August Crude Oil crashed further to ₹35, leading to an additional
₹3000 loss on his open Crude Oil position. With only ₹5000 left in his trading account, which is below the maintenance level of ₹6500, he received a call from his broker asking him to top up his trading account back to the initial level of ₹9000 in order to maintain his open Crude Oil position.
This means that if the speculator wishes to stay in the position, he will need to deposit an additional ₹4000 into his trading account.
Otherwise, if he decides to quit the position, the remaining ₹5000 in his account will be available to use for trading once again.
Q14 Write Short Notes on Put Call Parity Theory
Answer:
This theory was developed to explain the relationship between the prices of the options and their underlying stock.
Put-call parity is the relationship that must exist between the prices of European put and call options that both have the same underlier, strike price and expiration date.(Put-call parity does not apply to American options because they can be exercised prior to expiry.)
According to Put Call parity theory “The total of current price of the underlying stock and the price of the put option is exactly equal to the total of the price of the call option and present value of the exercise price of the underlying stock.”
We can represent the above theory in following formula
S + P = C + PV of Exercise price of the stock
Where,
S = Current price of the underlying asset P= Price (Premium) of the put option
C= Price (Premium) of the call option
Q15 Write Short Notes FRA’s
Answer:
Forward Rate Agreement(future)is an agreement between two parties to fix the future interest rate. Interest rate is based on agreed notional principal for a specified period.
On the agreed date if the market rate differs from the agreed FRA rate. A difference amount is paid by either of the party as settlement. The principal amount is not exchanged here and no party is obliged to borrow or lend money.
Users
▪ Those who wish to hedge against future interest rate risk by fixing the future interest rate today itself.
▪ Those who want to make profit based on their expectation on the future development of interest rate.
▪ Those who try to take advantage of different prices of FRAs and other financial instruments.
Characteristics
▪ It is an off balance sheet agreement as there is no exchange of principal amount.
▪ There is no need to pay initial margins or variation margins
▪ The existing FRA agreement can be closed any time by entering into new and opposite FRA at a new price.
▪ FRAs are customized to meet the specific requirements of the customer.
▪ FRAs offers highest liquidity and hence termed as money market instrument
Q16 What is the difference between Cash and Derivative Market
Answer:
Q17 Write Short Notes on Options
Answer:
Options:
An option is a claim without any liability. It is a claim contingent upon the occurrence of certain conditions and, therefore, option is a contingent claim. More specifically, an option is contract that gives the holder a right, without any obligation, to buy or sell an asset at an agreed price on or before a specified period of time. The option to buy an asset is known as a call option and the option to sell an asset is called put option. The price at which option can be exercised is called as exercise price or strike price. Based on exercising the option it can be classified into two categories:
(i) European Option: When an option is allowed to be exercised only on the maturity date.
(ii) American Option: When an option is exercised any time before its maturity date. When an option holder exercises his right to buy or sell it may have three possibilities.
(a) An option is said to be in the money when it is advantageous to exercise it.
(b) When exercise is not advantageous it is called out of the money.
(c) When option holder does not gain or lose it is called at the money.
The holder of an option has to pay a price for obtaining call/put option. This price is known as option premium. This price has to be paid whether the option is exercised or not.
Q18 How are stock futures settled?
Answer:
✓ All the futures and Options contracts are settled in cash on a daily basis and at the expiry or exercise of the respective contracts as the case may be.
✓ Clients/Trading members are not required to hold any stock of the underlying for dealing in the futures/options market.
✓ All out of the money and at the money options contracts of the near month maturity
expire worthless on the expiration date.
Q19 What are the reasons for stock index futures becoming more popular financial derivatives over stock futures segment in India?
Answer:
Stock index futures is most popular financial derivatives over stock futures due to following reasons:
✓ It adds flexibility to one’s investment portfolio. Institutional investors and other large equity holders prefer the most this instrument in terms of portfolio hedging purpose. The stock systems do not provide this flexibility and hedging.
✓ It creates the possibility of speculative gains using leverage. Because a relatively small
amount of margin money controls a large amount of capital represented in a stock index contract, a small change in the index level might produce a profitable return on one’s investment if one is right about the direction of the market. Speculative gains in stock futures are limited but liabilities are greater.
✓ Stock index futures are the most cost efficient hedging device whereas hedging through
individual stock futures is costlier.
✓ Stock index futures cannot be easily manipulated whereas individual stock price can be
exploited more easily.
✓ Since, stock index futures consists of many securities, so being an average stock, is much less volatile than individual stock price. Further, it implies much lower capital adequacy and margin requirements in comparison of individual stock futures. Risk diversification is possible under stock index future than in stock futures.
✓ One can sell contracts as readily as one buys them and the amount of margin required is the same.
✓ In case of individual stocks the outstanding positions are settled normally against physical delivery of shares. In case of stock index futures they are settled in cash all over the world on the premise that index value is safely accepted as the settlement price.
✓ It is also seen that regulatory complexity is much less in the case of stock index futures in comparison to stock futures. It provides hedging or insurance protection for a stock portfolio in a falling market.
Q20 What are the assumptions under Black-Scholes Model
Answer:
1. European Options are considered,
2. No transaction costs,
3. Short term interest rates are known and are constant,
4. Stocks do not pay dividend,
5. Stock price movement is similar to a random walk,
6. Stock returns are normally distributed over a period of time, and
7. The variance of the return is constant over the life of an Option.
Q21 Explain various types of Swaps
Answer:
1. Plain Vanilla Interest Rate Swap
✓ The most common and simplest swap is a "plain vanilla" interest rate swap.
✓ In this swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period of time.
✓ Concurrently, Party B agrees to make payments based on a floating interest rate to Party A on that same notional principal on the same specified dates for the same specified time period.
✓ In a plain vanilla swap, the two cash flows are paid in the same currency.
✓ The specified payment dates are called settlement dates, and the time between are called settlement periods.
✓ Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties.
✓ For example, on Dec. 31, 2006, Company A and Company B enter into a five-year swap with the following terms:
· Company A pays Company B an amount equal to 6% per annum on a notional principal of ₹20 million.
· Company B pays Company A an amount equal to one-year labour+ 1% per annum on a notional principal of ₹20 million.
2. Basis Rate Swap
✓ A basis swap is a floating-floating interest rate swap. A simple example is a swap of 1- month Libor for 6-month Libor.
✓ Basis rate swap is a type of swap in which two parties swap variable interest rates based on different money markets. This is usually done to limit interest-rate risk that a company faces as a result of having differing lending and borrowing rates.
✓ For example, a company lends money to individuals at a variable rate that is tied to the London Interbank Offer (LIBOR) rate but they borrow money based on the Treasury Bill rate. This difference between the borrowing and lending rates (the spread) leads to interest-rate risk. By entering into a basis rate swap, where they exchange the T-Bill rate for the LIBOR rate, they eliminate this interest-rate risk.
3. Asset Rate Swap
✓ Similar in structure to a plain vanilla swap, the key difference is the underlying of the swap contract. Rather than regular fixed and floating loan interest rates being swapped, fixed and floating investments are being exchanged.
✓ In a plain vanilla swap, a fixed labor is swapped for a floating labor. In an asset swap, a fixed investment such as a bond with guaranteed coupon payments is being swapped for a floating investment such as an index.
4. Amortizing Rate Swap
✓ An exchange of cash flows, one of which pays a fixed rate of interest and one of which pays a floating rate of interest, and both of which are based on a notional principal amount that decreases.
✓ In an amortizing swap, the notional principal decreases periodically because it is tied to an underlying financial instrument with a declining(amortizing) principal balance, such as a mortgage.
✓ The notional principal in an amortizing swap may decline at the same rate as the underlying or at a different rate which is based on the market interest rate of a benchmark like mortgage interest rates or the London Interbank Offered Rate.
✓ The opposite of an amortizing swap is an accreting principal swap - its notional principal increases over the life of the swap. In most swaps, the amount of notional principal remains the same over the life of the swap.
Corporate actions.
https://www.youtube.com/watch?v=V8wKtp4aeQQ&t=2195s
Private Equity-03 https://youtu.be/Wip9pwV7fZU
Derivatives https://youtu.be/iV2p9a-TUFU
Cash Recon https://youtu.be/F6H-wgwuDa8
Cash Dividend https://youtu.be/F6H-wgwuDa8
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