CH13 · 10 questions
Basics of Derivatives
NISM Series V-D | Chapter 13 | 10 marks out of 150
What this chapter is about
Study the concepts below for Chapter 13 of NISM Series V-D. This chapter carries 10 marks out of 150.
Key concepts
What is a Derivative? - A financial contract whose value is *derived* from an underlying asset. The underlying can be a stock, index, currency, commodity, or interest rate. The derivative itself has no independent value - it exists only in relation to something else.
Types of Derivatives:
- Forwards - private bilateral contracts, customised, traded OTC
- Futures - standardised forwards, exchange-traded, guaranteed by clearing corporation
- Options - right but not obligation, buyer pays premium
- Swaps - exchange of cash flows, mostly OTC (not tested heavily in Series VIII)
OTC vs Exchange Traded:
- OTC (Over the Counter) = directly between two parties, customised, counterparty risk exists, not transparent
- Exchange Traded = standardised, anonymous, guaranteed by clearing corporation, fully transparent
Three types of market participants - this is heavily tested:
| Participant | What they do | Risk appetite |
|---|---|---|
| Hedger | Reduces existing risk using derivatives | Low - wants to avoid risk |
| Speculator | Takes calculated risk for profit | High - wants to take risk |
| Arbitrageur | Exploits price differences across markets | Zero - risk-free profit |
Risk transfer mechanism - The fundamental purpose of derivatives. Hedgers want to *offload* risk. Speculators want to *absorb* risk. Derivatives are the bridge between them. Without speculators, hedgers couldn't hedge - there'd be no one to take the other side.
Systematic vs Unsystematic Risk:
- Systematic Risk = market-wide risk (recession, inflation, geopolitical events). Cannot be diversified away. Affects all stocks.
- Unsystematic Risk = company/sector specific risk (management change, factory strike). Can be reduced through diversification.
Counterparty Risk (Default Risk, Credit Risk) - all three terms mean the same thing. The risk that the other party to a contract fails to honour their obligation. Exchange-traded derivatives eliminate this through the clearing corporation.
Real market example
Infosys is reporting quarterly results next week. A fund manager holds 10,000 shares of Infosys and is worried results might disappoint and the stock could fall 8-10%.
She doesn't want to sell the shares (tax implications, long-term conviction). Instead she hedges - sells Infosys futures at the current price. If the stock falls, the futures position profits, offsetting the loss on her physical holdings.
A speculator on the other side of that trade WANTS to take the risk - he thinks results will be good and buys the futures expecting to profit from a price rise.
The derivatives market made both transactions possible simultaneously. That's risk transfer in action.
Trap Alert
Trap 1: "Speculators stabilise the market" → WRONG Speculators ADD LIQUIDITY, they don't stabilise. The question often gives you "stabilise" as an option to trip you up. The correct answer is always "add liquidity to the futures market."
Trap 2: "Systematic risk can be eliminated through diversification" → FALSE Only unsystematic risk can be diversified away. Systematic risk affects the entire market - you can't escape it by holding more stocks. This is why derivatives exist as a hedge tool.
Trap 3: "Counterparty risk exists in exchange-traded derivatives" → FALSE The clearing corporation eliminates counterparty risk in exchange-traded contracts by acting as the central counterparty. It's only OTC contracts that carry counterparty risk.
Trap 4: "Preference shares are derivative instruments" → FALSE Preference shares are equity instruments. Derivatives are futures, forwards, options, and swaps - contracts whose value derives from an underlying.
Trap 5: "Derivatives market transfers risk from speculators to hedgers" → WRONG ORDER It's the other way around - from hedgers TO speculators. Hedgers offload the risk, speculators absorb it.
Must-remember rules
- Hedger = wants to REDUCE risk | Speculator = wants to TAKE risk | Arbitrageur = wants ZERO risk (risk-free profit)
- Systematic risk = non-diversifiable = market risk
- Unsystematic risk = diversifiable = company-specific risk
- OTC = customised, bilateral, counterparty risk exists
- Exchange traded = standardised, anonymous, no counterparty risk (clearing corp guarantees)
- Arbitrage = simultaneous buy and sell in different markets to exploit price difference
- Derivatives were originally invented as HEDGING tools
- Speculators provide depth and liquidity - without them, hedgers can't hedge
Series V-D exam weight
This chapter carries 10 marks out of 150. Use the Series V-D syllabus and mock tests to plan your revision.
Quick revision - 60 second scan
- Derivative = contract deriving value from an underlying
- Hedger (reduce risk) | Speculator (take risk) | Arbitrageur (zero risk)
- Risk transfers FROM hedgers TO speculators
- Systematic risk = cannot diversify | Unsystematic risk = can diversify
- OTC = counterparty risk | Exchange = no counterparty risk (clearing corp)
- Speculators add LIQUIDITY, not stability
- Counterparty risk = default risk = credit risk (same thing)