NISM Series - VIII Equity Derivatives Cert. - Full-Length Test

Professional clearing member clears the trades of his associate trading member and institutional clients.

The prices of futures are derived from the underlying cash market prices. So an efficient cash market is required for an efficient futures market.

The option premium is a combination of intrinsic value and time value and other factors.

The Intrinsic value is difference between Spot and Exercise Price (Strike Price).

Exercise price remains constant whereas the Spot price fluctuates.

So the option premium will fluctuate as per the movement in Spot price.

Cost components of futures transaction include margins, transaction costs (commissions), taxes etc.

So higher the margins more expensive the trading.

Clearing members have to maintain higher book networth than trading members.

Closing a position means either buying or selling a contract, which essentially results in reduction of client’s open position (long or short). A client is said to be closed a position if he sells a contract that he had bought before or he buys a contract that he had sold earlier.

Loss incurred on derivatives transactions which are carried out in a recognized stock exchange can be carried forward for a period of 8 assessment years.

A short position in a CALL option can be closed out by taking a long position in the same CALL option with the same exercise date and exercise price.

Clearing Members are permitted to settle their own trades as well as the trades of the other non-clearing members known as Trading Members who have agreed to settle the trades through them.

In Options (Both Call and Put), the premium is paid by the buyer of options and not the seller of options. The seller receives the premium.

High interest rates will result in an increase in the value of a call option and a decrease in the value of a put option.

SEBI has powers for Registering and regulating the working of stock brokers, sub–brokers, etc. A trading member on both the segments i.e. Cash and Derivative segments has to register with SEBI and stock exchanges.

An open interest is the total number of contracts outstanding (yet to be settled) for an underlying asset.

In a short position, if the price increases, there is a loss. So, the mark to market margin will be debited.

The absolute amount of minimum capital adequacy requirement for derivative brokers/dealers has to be much higher than for cash market.

Further, if a broker/dealer is involved both in cash and futures segments, or in several exchanges, the capital adequacy requirement should be satisfied for each exchange/segment separately.

If the price of a stock is very volatile, the risk of losses increases. So the Stock Exchanges collect higher initial margins in such cases.

Clearing Member Eligibility Norms : Net-worth of at least Rs.300 lakhs. The Net-worth requirement for a Clearing Member who clears and settles only deals executed by him is Rs. 100 lakhs.

As per SEBI reules – Brokers should keep margins collected from clients in a separate bank account. They should maintain separate client bank account for segregation of client money.

Main objectives of Trade Guarantee Fund (TGF):

– To guarantee settlement of bonafide transactions of the members of the exchange.

– To inculcate confidence in the minds of market participants.

– To protect the interest of the investors in securities. All active members of the Exchange are required to make initial contribution towards Trade Guarantee Fund of the Exchange.

Higher initial margin collection from trading members reduces the chances of their defaults thus improving the solvency & financial capability of the clearing corporation.

The owner of American option can exercise his right at any time on or before the expiry date/day of the contract. The owner of European option can exercise his right only on the expiry date/day of the contract.

A key characteristic of a futures contract that designates when the contract expires and when the underlying asset must be delivered. The exchange on the futures contract is traded will also establish a delivery location and a date within the delivery month when the delivery can take place.

Not all futures contracts require physical delivery of a commodity, and many are settled in cash. Delivery Month is also referred to as “contract month.”

A portfolio consists of many stocks and not all stocks are available for trading in the futures/derivatives market. Also many stock futures have low volumes. Therefore institutions use index based derivatives for hedging. Although it may not give a perfect hedge but with proper choice of index futures, a good hedge can be created.

Trading cum Clearing Member: This is a Clearing Member (CM) who is also a Trading Member (TM) of the exchange. Such CMs may clear and settle their own proprietary trades, their clients’ trades as well as trades of other trading members.

A default by a member in the derivatives segment will be treated as default in all segments of that exchange and as default on all exchanges where he is a member.

Only in-the-money options have intrinsic value whereas at-the-money and out-of-the-money options have zero intrinsic value.

The intrinsic value of an option can never be negative. Time value also can never be negative.

A good index is a trade-off between diversification and liquidity. A well-diversified index reflects the behaviour of the overall market/ economy. While diversification helps in reducing risk, beyond a point it may not help in the context.

Going from 10 stocks to 20 stocks gives a sharp reduction in risk. However, going from 50 stocks to 100 stocks gives very little reduction in risk. Going beyond 100 stocks gives almost zero reduction in risk. Hence, there is little to gain by diversifying beyond a point.

The margin requirement is the same for both individual investors and institutional investors.

The derivatives exchange/segment has a separate governing council and no common members are allowed between the Cash segment Governing Board and the Derivatives segment Governing Council of the exchange.

An options strategy in which an investor writes (sells) call options on the open market without owning the underlying security. This strategy is sometimes referred to as an “uncovered call” or a “short call.”

Cash dividends issued by stocks have a big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. Put options gets more expensive due to the fact that stock price always drop by the dividend amount after the ex-dividend date.

The difference between American and European options is relating to the time of exercising the contract. Profit potential in both of them is same.

In case of Clearing Member default, margins paid by the Clearing Member on his own account alone would be used to settle his dues.

Terms of the future contracts are standardized wrt. quantity, time period etc. Only price is decided by the demand supply and other market situations.

A forward contract, on the other hand, is not standardized.

Other things being equal, options tend to lose time value each day throughout their life. This is due to the fact that the uncertainty element in the price decreases.

Thus shorter the time to maturity, lower will be the time value.

The essential idea of entering into a forward is to fix the price and thereby avoid the price risk. By entering into forwards, one is assured of the price at which one can buy/sell an underlying asset.

Thus Forward contracts are basically meant for hedging / managing the risks.

The seller/ writer of the option is required to pay initial margin for entering into the option contract and its should be debited to an appropriate account, say, “Equity Index/Stock Option Margin Account.”

In the balance sheet, such an account should be shown separately under the head “Current Assets.”

A buyer of a Call is bullish and believes that the price will rise. He pays a premium which is his maximum loss but the profits can be unlimited.

The buyer of an option has a right but not the obligation in the contract. Also his risks are limited to the extent of premium paid.

The writer/seller of an option is one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer of option exercises his right. His risks are unlimited.

Thus Option contracts are not symmetrical as the buyers and sellers have different obligations and risk factors.

On the other hand obligations and returns in Futures are symmetrical for both buyer and sellers.

Systematic risks are risks which are associated with movement of entire market due to economic / political and other factors. These cannot be controlled by diversifying one’s portfolio, as the entire portfolio will fall in case of negative news.

The Systematic risks can be controlled by hedging in the F&O section.

Unsystematic risk ie. Company / Industry specific risk can be reduced to a certain extent by diversifying the portfolio.

To make a profit of Rs 5000, he has to earn Rs 100 per share ( 5000 / 50 (lot size) = 100 )

Since he has gone short, he will make a profit when the price falls and he buys at the reduced price.

He has sold at Rs 1800, so when he buys back at Rs 1700 he make Rs 100 profit per share.

Rs 100 X 50 (lot size) = Rs 5000 profit.

Margin from Mr. X

Rs 6300 X 11 contracts X 50 (lot size) X 6% = 207900

Margin from Mr. Y

Rs 6450 X 13 contracts X 50 (lot size) X 6% = 251550

Total Margin = 207900 + 251550 = 459450.

The trader should sell the shares of those specific companies in futures and buy index futures. By this he will profit when the stock prices of those specific companies fall and index rises – if his view proves correct.

A trader in the future’s market pays a relatively small margin for market exposure in relation to the contract value. This is known as leverage.

Forwards are bilateral over-the-counter (OTC) transactions where the terms of the contract, such as price, quantity, quality, time and place are negotiated between two parties to the contract. There is a risk of an economic loss from the failure of counterparty to fulfil its contractual obligation.

Futures markets were innovated to overcome the limitations of forwards. A futures contract is an agreement made through an organized exchange. The clearing corporation associated with the exchange guarantees settlement of these trades.

Exchanges provide assistance if the complaints fall within the purview of the Exchange and are related to trades that are executed on the Exchange Platform. Excess Brokerage charged by Trading Member / Sub-broker comes under this assistance.

Mr. Ravi has bought a Call Option assuming that the price will rise.

The price has fallen and he is in a loss. So he will choose not to exercise his option.

His loss is restricted to the premium he has paid.

When a trader sells a Call option he is bearish / neutral on that scrip. But in case the price rises, he makes losses and theoretically price can rise to any levels – so his losses can be unlimited.

In this eg, he has sold Rs 200 call at Rs 12. In case the price rises, the call price will also rise and theoretically it can rise to any level, leading to ‘unlimited losses.’

STT is levied on transactions involving equity, derivatives and equity oriented mutual funds. It is levied on purchase and sale of equity shares. STT is applicable only on all sell transactions for both futures and option contracts.

The Contract size (Lot size) is specified by the exchange. (minimum value of Rs. 5,00,000).

Futures contracts have two types of settlements: (A) the mark-to-market (MTM) settlement which happens on a continuous basis at the end of each day, and (B) the final settlement which happens on the last trading day of the futures contract.

Mark to Market (MTM) is a process by which margins are adjusted on the basis of daily price changes in the markets for underlying assets.

(Options contracts have two types of settlements: Daily premium settlement and Final settlement)

In case of American options, buyers can exercise their option any time before the maturity of contract.

In case of European options, owner of such option can exercise his right only on the expiry date/day of the contract.

Only the specified quantity as per the lot size of the option contract.

12 months maturity means full one year of interest cost.

So 12% of 425 = 425 x 12 / 100 = 51

425 + 51 = 476 is closest to the one-year forward price

In a cash settlement method, the parties to a transaction settle by receiving or paying the gains or losses related to a contract in cash (i.e., money transfer)

On the National Stock Exchange (NSE):

• Index futures contracts expire on the last Thursday of the contract month.

• Once the March contract expires (last Thursday of March), the April series begins immediately on the next trading day.

• The next trading day is usually Friday, which becomes the opening day of the April series.

 Therefore, the April series opens on the last Friday of March.

An operational risk is defined as a risk incurred by an organisation’s internal activities. So losses due to fraud, inadequate documentation, inadequate disaster management, and improper execution are all operational risks.

Liquid Networth is defined as Liquid Assets minus Initial Margin. In above case he has deposited Rs 75 lakhs as liquid assets. Rs 50 lakhs is the requirement, so the balance of Rs 25 lakhs will be used as the initial margin.

Rho is the change in option price given a one percentage point change in the risk-free interest rate.

A calendar spread becomes a naked/open position, when the near month contract expires or either of the legs of the spread is closed.

Derivatives market helps in transfer of various risks from those who are exposed to risk but have low risk appetite to participants with high risk appetite. For example, hedgers want to give away the risk where as traders are willing to take risk.

A Call option gives the buyer the right, but not the obligation to buy the underlying at the strike price. A put option gives the buyer of the option the right, but not the obligation, to sell the underlying at the strike price.

BID ASK price means Buyer and Seller price – eg Rs 100 – 101 So Ask price is the price at which the trader is prepared to sell the share.

The open position of all the clients of a trading member are grossed up to arrive at the total exposure of the trading member.

In India, futures and options (F&O) trading is allowed only on a limited number of stocks that meet specific eligibility criteria set by SEBI (Securities and Exchange Board of India) and the stock exchanges.

Criteria for selection include:

• Market capitalization: The stock must have a sufficient market size.
• Liquidity: High trading volume and turnover.
• Price fluctuation: Limited volatility to avoid manipulation.
• Public shareholding: Adequate free float for retail participation.

The list of eligible stocks is reviewed periodically, and stocks can be added or removed based on their compliance with the criteria.

Mr. A sold a PUT option, that means he has a bullish or neutral view on PQR stock.

However, PQR stock has fallen by Rs 50 ( 400 – 350 ).

Which means he has lost Rs 50.

Since he has sold a PUT, he will receive the premium which is Rs 32.

So his net loss will be Rs 50 (Loss) – Rs 32 (Premium Recd) = Rs 18

Total Loss = Rs 18 x 500 (lot size) = Rs. 9000

Rs 50 X 0.2 = Rs 10.

Each tick movement will result in profit or loss of Rs 10 for the index buyer or seller, respectively.

High interest rates means high cost of capital and this will result in an increase in the value of a call option and a decrease in the value of a put option.

In a forward contract, there are two parties:

1. The buyer (long position) → Agrees to buy the asset at a specified future date and price.
2. The seller (short position) → Agrees to sell the asset at the same specified future date and price.

Since the seller is obligated to deliver the asset, they assume a short position in the contract. Thus, the correct answer is “a short position.”

A call option gives the buyer the right, but not the obligation, to buy the underlying asset at the exercise (strike) price.

1. If the market price is less than the strike price, the call option is out of the money (OTM).
2. Since the buyer can purchase the asset cheaper in the open market, they will not exercise the option.
3. As a result, the option expires worthless, and the buyer loses only the premium paid.

Thus, the correct answer is “Expire worthless.”

As per Prof. J. R. Verma Committee recommendations the securities placed with the Clearing Corporation shall be marked to market on a periodical basis (weekly).

Clearing of trades on a stock exchange is primarily handled by clearing members. They ensure the proper settlement of trades executed by trading members. Clearing members play a crucial role in maintaining the integrity and efficiency of the trading system by facilitating the clearing and settlement process. Thus, the correct answer is “by the clearing members.”

Delta measures the sensitivity of the option value to a given small change in the price of the underlying asset.

A put option is said to be OTM when spot (market) price is higher than strike price.

A call option is said to be OTM, when spot (market) price is lower than the strike price.

He sold at Rs 354 and bought back at Rs 341 which means he has made a profit.

Rs 354 – Rs 341 = Rs 13

Rs 13 X 900 (Lot size) = Rs 11700 Profit

Profit can be made in a short position when the price falls and the same is bought back.

For eg – You sold a stock at Rs 100 ie. created a short position. When price falls to say Rs 80 and you buy it back, you make a profit of Rs 20.

In case of futures, you have to square up in the same expiry month.

Private equity funds are not connected to any index, nor are they listed on a stock exchange.

Futures contracts have two types of settlements: (A) the mark-to-market (MTM) settlement which happens on a continuous basis at the end of each day, and (B) the final settlement which happens on the last trading day of the futures contract.

Option premium consists of two variables – Intrinsic Value and Time Value. In the above case, the cash market price is 120 and the strike price is Rs 110.

So the Intrinsic value is Rs 10 ( 120 – 110 ). The balance of option premium (24 – 10), i.e., Rs 14, is the time value.

Position limits are the maximum exposure levels which the entire market can go up to and each Clearing Member / Trading member or investor can go up to.

Thus no investor can take an extra ordinary large position and influence the direction of a scrip / market.

The seller of PUT option is either bullish or neutral. He gains the premium received if the underlying increases or remains flat.

A bull call spread is constructed by buying a call option with a low strike price, and selling another call option with a higher strike price.

Traders can trade in derivatives by paying a small margin ( around 25 to 30% of the total contract value), This leverage increases the risk as the trader can take up positions beyond his capacity.

For eg. You bought a futures contarct of 1000 shares at Rs 500. The price drops to Rs 480. Therefore there is a notional loss of Rs. 20 (500 – 480) x 1000 shares = Rs 20,000.

This is a notional loss and not an actual loss. The actual profit / loss will happen only when you square up the contract.

Stock price or Spot price means the current market price of that stock in the cash market.

Explanation: There are five fundamental parameters on which the option price depends upon:

1) Spot price of the underlying asset

2) Strike price of the option

3) Volatility of the underlying asset’s price

4) Time to expiration

5) Interest rates These factors affect the premium/ price of options in several ways.

The writer of an option is one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer of the option exercises his right.

One of the responsibilities of the Clearing Corporation is to decide the daily settlement prices.

A market order is an order to buy or sell a contract at the best bid/offer price currently available in the market. Price is not specified at the time of placing this order.

While opening a client’s account, the broker should know some important details of his clients. Therefore the Client Registration form asks for deatils on the backgroung of the client ( to know if there is a criminal background or is not banned in any other manner, whether in terms of criminal or civil proceedings by any enforcement agency worldwide).

The client should be identified by the intermediary by using reliable sources including documents/information. The intermediary should obtain adequate information to satisfactorily establish the identity of each new client and the purpose of the intended nature of the relationship.

The broker is required to get a Risk Disclosure Document signed by the client, at the time of client registration.

Bid and Ask price means the Buyer and Seller price.

For eg price of a stock as quoted on a stock market is Rs. 100 – 101. So 100 is the Bid price and 101 is the Ask price. The ask will always be higher than the bid price.

Forward contract is an agreement made directly between two parties to buy or sell an asset on a specific date in the future, at the terms decided today. There is no stock exchange, commodity exchange, etc. involved.

A put option is said to be in the money when market price is lower than the strike price.

Contract month is the maturity month of the contract.

For eg – A trader may buy a March month contract in January.

So March will be the contract month.

Initial margin requirements are based on 99% value at risk over a one day time horizon.

Put-call parity is a fundamental principle in options pricing that shows a mathematical relationship between the price of a call, price of a put, the underlying asset, and the strike price, assuming they have the same strike and expiry.
The basic formula is:

C+PV(X)=P+S

Where:

• C = Call premium

• P = Put premium

• PV(X) = Present value of strike price

• S = Spot price of the underlying

This relationship helps identify arbitrage opportunities and ensures fair pricing of options.