Derivatives Introduction - CMA/CA Final SFM Video Lectures

Question 1

How are financial markets broadly classified?

Answer 1

Financial markets are broadly classified into three main categories: money market, capital market, and forex market.

Question 2

What is the distinction between money market and capital market?

Answer 2

Money market deals with short-term securities (less than 12 months), while capital market deals with long-term securities (more than 12 months).

Question 3

What are the two main components of the capital market?

Answer 3

The capital market has two main components: bond market (debt market) and share market (stock market or stock exchange).

Question 4

What are the primary market and secondary market in the context of stock markets?

Answer 4

The primary market is where companies issue shares to the public (IPO or SPO), while the secondary market is where these shares are traded among investors.

Question 5

What are the components of the derivative market?

Answer 5

The derivative market has two main components: futures and options.

Question 6

What is a derivative, and why is it called so?

Answer 6

A derivative is a contract between two parties expected to be settled in the future, deriving its value from the underlying asset. It’s called a derivative because it doesn’t have intrinsic value; its value is derived from the underlying asset.

Question 7

What is the function of financial derivatives?

Answer 7

Financial derivatives help manage financial risk arising from changes in prices, interest rates, and currency rates by providing a commitment to prices for a future date.

Question 8

How does a forward exchange contract protect against currency rate fluctuations?

Answer 8

A forward exchange contract allows you to fix a currency exchange rate today for a transaction in the future, protecting you from adverse currency rate movements.

Question 9

What does a derivative contract allow you to do?

Answer 9

A derivative contract allows you to buy or sell something at a future date at a price agreed upon today.

Question 10

What are some examples of underlying assets in the derivative market?

Answer 10

Underlying assets in the derivative market can include commodities, precious metals, foreign exchange rates, interest rates, and market indices.

Question 11

Why do financial derivatives not require a substantial initial investment?

Answer 11

Financial derivatives do not require a substantial initial investment because they derive their value from the underlying asset’s price movements, allowing investors to enter with little or no upfront capital.

Question 12

What is a forward exchange contract, and how does it work in the context of currency risk?

Answer 12

A forward exchange contract is an agreement to exchange currencies at a predetermined rate in the future, protecting against adverse currency rate movements. It allows parties to fix the exchange rate today for a future currency transaction.

Question 13

How does a forward exchange contract benefit an importer in international trade?

Answer 13

A forward exchange contract benefits an importer by ensuring a fixed exchange rate for future currency payments, reducing the risk of unfavorable currency rate fluctuations.

Question 14

Why would an investor enter into a derivative contract like a forward exchange contract?

Answer 14

An investor would enter into a derivative contract like a forward exchange contract to hedge against the risk of adverse price movements in the underlying asset, ensuring price certainty for future transactions.

Question 15

What are the four key components of the definition of a derivative?

Answer 15

The four key components of the definition of a derivative are: a contract between two parties, expected settlement in the future, value derived from an underlying asset, and little or no initial investment required.

Question 16

How does the value of a derivative change over time?

Answer 16

The value of a derivative changes over time based on the fluctuations in the price of the underlying asset. It can increase or decrease in value.

Question 17

What is the significance of derivatives in managing financial risk?

Answer 17

Derivatives play a crucial role in managing financial risk by providing tools to protect against adverse price movements, interest rate changes, and currency rate fluctuations.

Question 18

What is the primary purpose of entering into a derivative contract?

Answer 18

The primary purpose of entering into a derivative contract is to mitigate risk and uncertainty associated with future price movements or financial conditions.

Question 19

What is the primary difference between bullish and bearish sentiments in the stock market?

Answer 19

Bullish sentiments indicate an expectation of rising prices, while bearish sentiments suggest an expectation of falling prices.

Question 20

In a forward contract, what is the primary characteristic regarding the price of the security?

Answer 20

The price in a forward contract is agreed upon today for buying or selling securities at a specified future date.

Question 21

What distinguishes futures contracts from forward contracts?

Answer 21

Futures contracts are traded on derivative markets and guarantee performance and settlement, whereas forward contracts are typically private agreements with higher default risk.

Question 22

How does an intermediary in the derivative market help prevent defaults in futures contracts?

Answer 22

The intermediary holds deposits from both parties, deducts or adds to these deposits based on the contract’s outcome, ensuring that settlements occur without the need for legal action.

Question 23

What are the three types of participants in the derivative market?

Answer 23

The three types of participants are hedgers (risk-avoiders), speculators (risk-takers), and arbitrators (risk-neutral profit-makers).

Question 24

In a speculative scenario involving a futures contract, what happens if one party defaults on the contract?

Answer 24

An intermediary in the derivative market ensures the settlement by adjusting the deposit balances of both parties, mitigating the risk of default.

Question 25

How does a futures contract compare to a forward contract?

Answer 25

Futures contracts are traded on derivative markets, involve standardized terms, and are guaranteed by intermediaries, whereas forward contracts are private agreements with customizable terms and higher default risk.

Question 26

What is the fundamental characteristic of a forward contract?

Answer 26

A forward contract involves an agreement to buy or sell a security at a future date, with the price agreed upon today.

Question 27

In a futures contract, what role does the derivative market play?

Answer 27

The derivative market serves as an intermediary, guaranteeing performance and settlement of futures contracts.

Question 28

What are bullish sentiments in the stock market, and how do they relate to futures contracts?

Answer 28

Bullish sentiments reflect an expectation of rising prices, which may lead to individuals entering into futures contracts as buyers to lock in current prices for future purchase.

Question 29

What is the key advantage of using an intermediary in futures contracts?

Answer 29

Intermediaries hold deposits from both parties and facilitate settlements, reducing the risk of defaults.

Question 30

How does a bearish sentiment differ from a bearish trend in the stock market?

Answer 30

A bearish sentiment reflects an expectation of falling prices, while a bearish trend indicates a historical decline in prices.

Question 31

Why are futures contracts considered an upgraded version of forward contracts?

Answer 31

Futures contracts are standardized, traded on derivative markets, and involve intermediaries, making them more reliable and accessible compared to private forward contracts.

Question 32

What is the primary function of derivatives in financial markets?

Answer 32

Derivatives help parties manage financial risk by providing commitments to prices for future dates, allowing hedgers to protect against adverse price movements.

Question 33

How do futures contracts mitigate risk in speculative scenarios?

Answer 33

Futures contracts traded on derivative markets offer standardized terms, guarantee performance, and prevent defaults through intermediaries, reducing the risk of speculative trades.

Question 34

What is a long position in the stock market?

Answer 34

A long position in the stock market involves buying a security with the expectation of selling it at a higher price in the future.

Question 35

What is a short position in the stock market, and how does it differ from a long position?

Answer 35

A short position in the stock market involves selling a security with the intent to buy it back at a lower price later. It differs from a long position where you buy first and sell later.

Question 36

How does short selling work in the stock market?

Answer 36

Short selling involves borrowing a stock you don’t own, selling it at a high price, and then buying it back at a lower price to return to the lender, profiting from the price difference.

Question 37

What is the difference between long and short positions in futures contracts?

Answer 37

In futures contracts, a long position means agreeing to buy at the contracted price, while a short position means agreeing to sell at the contracted price, without the need for actual buying and selling of assets.

Question 38

How can you sell shares at a guaranteed price using a futures contract when you currently own shares priced differently?

Answer 38

By taking a short position in a futures contract with a price of 452 when you currently own shares priced at 440, you agree to sell the shares at 452 in the future, ensuring a guaranteed selling price.

Question 39

What is the primary difference between forward contracts and futures contracts?

Answer 39

The primary difference is that forward contracts are customized, private agreements, while futures contracts are standardized and traded on regulated exchanges.

Question 40

What role does the ClearingHouse play in futures contracts?

Answer 40

The ClearingHouse guarantees the performance of futures contracts, ensuring that the parties involved fulfill their obligations.

Question 41

Why do futures contracts require margin deposits?

Answer 41

Futures contracts require margin deposits to cover potential losses and ensure the financial commitment of the parties. Margin amounts change with daily price fluctuations.

Question 42

What is the purpose of an intermediary in futures contracts?

Answer 42

An intermediary, often the derivative market, facilitates futures contracts, guarantees performance, and manages deposits, reducing the risk of defaults between the parties.

Question 43

What are bullish and bearish sentiments in the context of the stock market?

Answer 43

Bullish sentiment indicates an expectation of rising prices, while bearish sentiment indicates an expectation of falling prices in the future.

Question 44

What is the key difference between bullish and bearish sentiments and bullish and bearish trends in the stock market?

Answer 44

Sentiments refer to expectations about future price movements, while trends describe historical price movements in the past.

Question 45

How does arbitrage differ from speculation in the financial markets?

Answer 45

Arbitrage involves making a profit without taking any risk, while speculation involves taking calculated risks to make a profit based on market expectations.

Question 46

What does a long position in a futures contract indicate?

Answer 46

A long position in a futures contract indicates a position of buying at the contracted price.

Question 47

What is short selling in the context of the stock market?

Answer 47

Short selling in the stock market involves selling a stock that is not owned with the expectation of buying it back later at a lower price.

Question 48

How can you sell shares at a price of 452 in the future when the spot market price is 430?

Answer 48

To sell shares at a price of 452 in the future when the spot market price is 430, you should enter into a futures contract with a short position at 452 and deposit margin. You will realize a gain from the futures contract to compensate for the difference.

Question 49

What happens if the share price rises to 470 in the spot market after taking a short position at 452 in a futures contract?

Answer 49

If the share price rises to 470 in the spot market after taking a short position at 452 in a futures contract, you will incur a loss in the futures contract. However, you will still be able to sell the shares in the spot market at 470, and the loss from the futures contract will be reduced from your overall realization.

Question 50

What is the key difference between a long position and a short position in futures contracts?

Answer 50

The key difference is that a long position in a futures contract means agreeing to buy at the contracted price, while a short position means agreeing to sell at the contracted price.

Question 51

How does short selling work in the context of stock trading?

Answer 51

Short selling in stock trading involves borrowing a stock you don’t own, selling it at the current high price, and later buying it back at a lower price to return to the lender, thereby profiting from the price difference.

Question 52

What is the advantage of using a futures contract to sell shares at a specific price in the future?

Answer 52

The advantage is that using a futures contract allows you to sell shares at a specific contracted price in the future, regardless of the spot market price at that time, providing price certainty.

Question 53

How is a gain from a futures contract calculated when selling shares in the spot market at a lower price than the contracted futures price?

Answer 53

To calculate the gain, subtract the spot market selling price from the contracted futures price and multiply the result by the number of shares in the contract.

Question 54

What happens if the spot market price is lower than the contracted futures price when using a futures contract to sell shares?

Answer 54

In this scenario, you will make a gain in the futures contract equal to the difference between the contracted futures price and the lower spot market price.

Question 55

What occurs if the spot market price is higher than the contracted futures price when using a futures contract to sell shares?

Answer 55

When the spot market price is higher than the contracted futures price, you will incur a loss in the futures contract equal to the difference between the contracted futures price and the higher spot market price.

Question 56

How does the gain or loss in a futures contract impact the overall realization when selling shares using a futures contract?

Answer 56

The gain or loss from the futures contract is added to or deducted from the overall realization when selling shares, affecting the final realized amount.

Question 57

What is the significance of using futures contracts to hedge against price movements?

Answer 57

Using futures contracts for hedging allows individuals or businesses to lock in a specific future selling price, protecting them from adverse price movements in the spot market.

Question 58

What is a long position in a futures contract, and when is it typically taken?

Answer 58

A long position in a futures contract involves agreeing to buy the underlying asset at the contracted price. It is typically taken when the trader expects the asset’s price to rise in the future.

Question 59

What is a short position in a futures contract, and when is it typically taken?

Answer 59

A short position in a futures contract involves agreeing to sell the underlying asset at the contracted price. It is typically taken when the trader expects the asset’s price to fall in the future.

Question 60

How is short selling related to short positions in the futures market?

Answer 60

Short selling is a strategy associated with short positions in the futures market. It involves selling an asset one does not own with the expectation of buying it back at a lower price in the future to make a profit.

Question 61

Explain how short selling works and why it is used by traders.

Answer 61

Short selling involves borrowing an asset, selling it at a high price, and then buying it back at a lower price to return it to the lender. Traders use short selling to profit from falling asset prices.

Question 62

How do long and short positions in futures contracts differ from long and short positions in the spot market?

Answer 62

In futures contracts, a long position means agreeing to buy at the contracted price, while a short position means agreeing to sell at the contracted price. In the spot market, a long position involves buying and holding an asset with the expectation of selling at a higher price, while a short position involves selling an asset with the expectation of buying it back at a lower price.