What Is a Derivative?

A derivative is a financial security with a value that is reliant upon or derived

from, an underlying asset or group of assets—a benchmark. The derivative itself
is a contract between two or more parties, and the derivative derives its price
from fluctuations in the underlying asset.

Futures
Futures contracts—also known simply as futures—are an agreement between
two parties for the purchase and delivery of an asset at an agreed upon price at a
future date. Futures trade on an exchange, and the contracts are standardized.
Traders will use a futures contract to hedge their risk or speculate on the price of
an underlying asset. The parties involved in the futures transaction are obligated
to fulfill a commitment to buy or sell the underlying asset.

Forwards
Forward contracts—known simply as forwards—are similar to futures, but do not
trade on an exchange, only over-the-counter. When a forward contract is
created, the buyer and seller may have customized the terms, size and
settlement process for the derivative. As OTC products, forward contracts carry a
greater degree of counterparty risk for both buyers and sellers.

Counterparty risks are a kind of credit risk in that the buyer or seller may not be
able to live up to the obligations outlined in the contract. If one party of the
contract becomes insolvent, the other party may have no recourse and could
lose the value of its position. Once created, the parties in a forward contract can
offset their position with other counterparties, which can increase the potential for
counterparty risks as more traders become involved in the same contract.

Swaps
Swaps are another common type of derivative, often used to exchange one kind
of cash flow with another. For example, a trader might use an interest rate
swap to switch from a variable interest rate loan to a fixed interest rate loan, or
vice versa.

An interest rate swap is a type of a derivative contract through which two counterparties agree
to exchange one stream of future interest payments for another, based on a specified principal
amount. In most cases, interest rate swaps include the exchange of a fixed interest rate for a
floating rate.
Currency Swap
A currency swap is a transaction in which two parties exchange an equivalent amount of
money with each other but in different currencies. The parties are essentially loaning each
other money and will repay the amounts at a specified date and exchange rate.

Call and Put option

A Call Option gives the buyer the right, but not the obligation to buy the underlying security at
the exercise price, at or within a specified time. A Put Option gives the buyer the right, but not
the obligation to sell the underlying security at the exercise price, at or within a specified time.
Straddle
A straddle is a trading strategy that involves options. To use a straddle, a trader buys/sells a
Call option and a Put option simultaneously for the same underlying asset at a certain point of
time provided both options have the same expiry date and same strike price.
Strangle
The short strangle strategy requires the investor to simultaneously sell both a [call] and a [put]
option on the same underlying security. The strike price for the call and put contracts must be,
respectively, above and below the current price of the underlying.

Bull & Bear Spreads

In options trading, an option spread is created by the simultaneous purchase and sale of
options of the same class on the same underlying security but with different strike
prices and/or expiration dates.
Any spread that is constructed using calls can be refered to as a call spread. Similarly, put
spreads are spreads created using put options.
If an option spread is designed to profit from a rise in the price of the underlying security, it
is a bull spread. Conversely, a bear spread is a spread where favorable outcome is attained
when the price of the underlying security goes down

Put-call parity

put–call parity defines a relationship between the price of a European call option and European put
option, both with the identical strike price and expiry,

Put–call parity can be stated in a number of equivalent ways, most tersely as:
C-P = D(F-K)
where C is the (current) value of a call, P is the (current) value of a put, "D" is the discount
factor, "F" is the forward price of the asset, and "K" is the strike price. Note that the spot price is
given by D*F=S (spot price is present value, forward price is future value, discount factor relates
these).

Option Greek:
Greeks, including Delta, Gamma, Theta, Vega and Rho, measure the different factors that
affect the price of an option contract.

Bermuda options

There are two main types or styles of options, American and European options.
American options are exercisable at any time between the purchase date and the
date of expiration. European options, however, are exercised only at the date of
expiration. Bermuda options are a restricted form of the American option that
allows for early exercise but only at set dates.

The early exercise feature of Bermuda options allows for an investor to use the
option and convert it to shares on specific dates before expiry. The dates—
contained in the contract's terms—are known upfront during the purchasing of
the option.

Rainbow option
 A rainbow option is an options contract linked to the performances of two or more
underlying assets. They can speculate on the best performer in the group or minimum
performances of all the underlying assets at one time. Each underlying may be called a
color so the sum of all of these factors makes up a rainbow.

Asian option

An Asian option is an option type where the payoff depends on the average price of
the underlying asset over a certain period of time as opposed to standard options
(American and European) where the payoff depends on the price of the underlying
asset at a specific point in time (maturity).

Hedging or Hedge ratio

A hedge ratio is the ratio of exposure to a hedging instrument to the value of

the hedged asset. A ratio of 1 or 100% means that the position is fully hedged and a ratio of 0
means it is not hedged at all.

Mutual Funds and Hedge Funds:

Mutual funds:

 Don't take share from the profit

 Are available to the general public

 Charge a management fee (normally 1–2%)

 Can't make high-risk investments

Hedge funds:

 Take ~20% performance fee from the profit

 Are available only to high-net-worth and sophisticated investors

 Charge management fee (normally 2%) plus performance fee (normally 10–30%)

 Can make high-risk investments

 Tend to perform better than mutual funds

Type of Risk

Reinvestment risk

Reinvestment risk refers to the possibility that an investor will be unable to reinvest cash flows
(e.g., coupon payments) at a rate comparable to their current rate of return.

Interest Rate risk

The risk of value depreciation of bonds and other fixed-income investments is

known as interest rate risk.
Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a financial
risk that exists when a financial transaction is denominated in a currency other than the domestic
currency of the company. The exchange risk arises when there is a risk of an unfavourable change
in exchange rate between the domestic currency and the denominated currency before the date
when the transaction is completed. [1][2]

Default risk is the risk that a lender takes on in the chance that a borrower will be unable to
make the required payments on their debt obligation. Lenders and investors are exposed
to default risk in virtually all forms of credit extensions.
Political risk is a type of risk faced by investors, corporations, and governments that political
decisions, events, or conditions will significantly affect the profitability of a business actor or the
expected value of a given economic action.

VAR- Value at risk

A VAR statistic has three components: a time period, a confidence level and a
loss amount (or loss percentage). Keep these three parts in mind as we give
some examples of variations of the question that VAR answers:

 What is the most I can—with a 95% or 99% level of confidence—expect to

lose in dollars over the next month?
 What is the maximum percentage I can—with 95% or 99% confidence—
expect to lose over the next year?

You can see how the "VAR question" has three elements: a relatively high level
of confidence (typically either 95% or 99%), a time period (a day, a month or a
year) and an estimate of investment loss (expressed either in dollar or
percentage terms).

Value at Risk (VAR) calculates the maximum loss expected (or worst case
scenario) on an investment, over a given time period and given a specified
degree of confidence
Leading indicators look forwards, through the windshield, at the road ahead. Lagging
indicators look backwards, through the rear window, at the road you've already travelled. A
financial indicator like revenue, for example, is a lagging indicator, in that it tells you about
what has already happened.
Popular leading indicators include average weekly hours worked in manufacturing, new orders
for capital goods by manufacturers, and applications for unemployment insurance.
Lagging indicators include things like employment rates and consumer confidence.

Sharpe ratio is the measure of risk-adjusted return of a financial portfolio. A portfolio with a
higher Sharpe ratio is considered superior relative to its peers

What Is the Treynor Ratio?

The Treynor ratio, also known as the reward-to-volatility ratio, is a performance
metric for determining how much excess return was generated for each unit of
risk taken on by a portfolio.
What is Beta of an asset?
Beta of an asset is a way of measuring systematic risk of an asset. It shows how price
of a security responds to changes in market price. It indicates the extent of movement of
the returns of the stock with respect to the movement of market returns. Assets that are
riskier than average will have Betas that exceed 1 and assets that are safer than
average will have Betas lower than 1. The riskless asset will have a value of Beta=0. in
The Beta of the market portfolio or the average of Betas across al assets the market is
1.

What do you understand by Stock market indices? Name the

major stock market indices.
Stock market indices are used to measure the general movement of the stock market. It
is used as a proxy for overall market movement. The major stock market indices are:

- Bombay Stock Exchange Sensitive Index (BSE) popularly known as Sensex. It reflects
the movements of 30 sensitive shares from specified and non specified groups.

- S and P CNX nifty, known as Nifty Index. It reflects the movements of 50 scrips
selected on the basis of market capitalization and liquidity.

What are the different types of Equity Market?

Equity market consists of primary market and secondary market.

Primary equity market – is also called new issues market as securities are issued to
public for the very first time. In this market the new issues are made in following four
ways:

- Public issue
- Rights issue
- Private placements
- Preferential allotment

Secondary equity market – also known as Stock exchanges which are an important
part of capital market. It is an organized market place where securities are traded.
These securities are issued by government, semi-government bodies, public sector
undertakings, joint stock companies etc.

What do you understand by Money Market? Give an example.

Money market is the market where short term instruments of credit with a maturity
period of one year or less than that are traded. Such instruments are known as near
money. The borrowers of money market are traders, government, speculators and
lenders in this market are commercial banks, central bank, financial institutions and
insurance companies etc.

What are the main phases of Portfolio management?

Portfolio management is the management of various financial assets that make a

portfolio. There are following seven phases in portfolio management:

- Specification of Investment Objectives and Constraints

- Choice of Asset Mix
- Formulation of Portfolio Strategy
- Selection of Securities
- Portfolio Execution
- Portfolio Revision
- Portfolio Evaluation

Explain Fundamental analysis and Technical analysis.

Security analysis includes two types of analysis namely, fundamental analysis and
technical analysis.

Fundamental analysis takes into account three types of analysis:

- Economy analysis
- Industry analysis
- Company analysis

Technical analysis helps in forecasting the future price of share on basis of historical
movements of price.

What are the assumptions on which CAPM is based? What are

the essential elements of CAPM?
CAPM (Capital Asset Pricing Model) is a risk and return model. It predicts the
relationship between risk of an asset and its expected result. This model assumes that:

- Investors are risk averse.

- Investors are known with all the market fluctuations and information.
- There are no restrictions and transaction costs on investment.
- Information available in the market will be digested by the capital markets.
- Investors have identical time horizons.
- Investors have homogeneous expectations about risk and return of securities.

The essential elements of CAPM are:

- Risk free rate

- Market Risk Premium
- Beta of the security
Rf+ B(rm-rf)

Dividend Discount model:

What Is the Dividend Discount Model?

The dividend discount model (DDM) is a quantitative method used for predicting
the price of a company's stock based on the theory that its present-day price is
worth the sum of all of its future dividend payments when discounted back to
their present value. It attempts to calculate the fair value of a stock irrespective of
the prevailing market conditions and takes into consideration the dividend payout
factors and the market expected returns. If the value obtained from the DDM is
higher than the current trading price of shares, then the stock is undervalued and
qualifies for a buy, and vice versa

Examples of the DDM

Assume Company X paid a dividend of $1.80 per share this year. The company
expects dividends to grow in perpetuity at 5 percent per year, and the company's
cost of equity capital is 7%. The $1.80 dividend is the dividend for this year and
needs to be adjusted by the growth rate to find D 1, the estimated dividend for
next year. This calculation is: D 1 = D 0 x (1 + g) = $1.80 x (1 + 5%) = $1.89. Next,
using the GGM, Company X's price per share is found to be D(1) / (r - g) = $1.89
/ ( 7% - 5%) = $94.50.