Liquidity Risk

Liquidity refers to the ability of the market participants to buy or sell the desired quantity of an underlying asset. As forwards are tailor-made contracts i.e. the terms of the contract are according to the specific requirements of the parties, other market participants may not be interested in these contracts.

Counterparty Risk

Counterparty risk is the risk of economic loss arising from the failure of a counterparty.

It helps in improving price discovery based on actual valuations and expectations.

It enables the transfer of various risks from those who are exposed to risk but have a low risk appetite to participants with a high-risk appetite. For example, hedgers want to give away the risk whereas traders are willing to take risk.

It enables the shift of speculative trades from the unorganized market to the organized market. Risk management mechanism and surveillance of activities of various participants in the organized space provide stability to the financial system.

Question 1

___________________ wants to make money at all the time regardless of any fluctuations happening in the market.

1. Straddle
2. Hedger
3. Speculator
4. All of the above

Question 2

What does hedging do?

1. It maximises business profits
2. It minimises business losses
3. It produces a clearer outcome
4. Hedging can be used only in currency markets and not in equity markets

Securities Contracts (Regulation) Act, 1956 (SCRA)

Governs stock trading and aims to prevent market manipulation.

SEBI Act, 1992

Establishes the Securities and Exchange Board of India (SEBI) to regulate and protect investors.

Question 1

What does novation mean in the context of trade clearing?

1. The clearing corporation becomes the legal counterparty to both sides of every trade.
2. Modification of an order before it is executed on the exchange.
3. Cancellation of unsettled trades at the end of the day.
4. A penalty charged by the exchange for default.

Question 2

What is multilateral netting as performed by the clearing corporation?

1. Consolidating all trades of all clearing members to determine net delivery and payment obligations for each member, rather than settling trade-by-trade.
2. Offsetting buy and sell orders before trade execution on the exchange.
3. Pairing each buyer with a single specific seller for delivery (bilateral netting only).
4. Netting off a broker’s losses in one security against profits in another security for margin benefit.

SPAN Margin

SPAN (Standard Portfolio Analysis of Risk)
Think of it as a risk calculator used worldwide.
It looks at your entire portfolio and figures out: “If the market moves badly tomorrow, how much can you lose?”
Based on this, it decides how much margin (deposit) you must keep.

Exposure Margin

This adds an extra buffer-against sudden, wild swings. For stock futures and option selling, it’s approximately 3.5% of the contract value.
For index derivatives, it's around 2-3%.

Day 1: Entry

Buy Nifty futures at ₹17,800. Contract value = ₹17,800 × 75 = ₹13.35 lakh.

Margin blocked (say 12%) = ₹1.6 lakh.

Closing price = ₹18,000.

Gain = (18,000 – 17,800) × 75 = ₹15,000.

Profit added → Margin balance rises to ₹1.75 lakh.

Day 2

Reference = 18,000. Closing = ₹17,900.

Loss = (17,900 –18,000) ×75 = -₹7,500.

Loss deducted → Margin balance falls to ₹1.675 lakh.

Day 3

Reference = 17,900. Closing = ₹18,100.

Gain = (18,100 – 17,900) × 75 = ₹15,000.

Profit added → Margin balance becomes ₹1.825 lakh.

F = Futures Price

S = Spot Price

This is the basic version, used when costs/income are expressed in rupee terms or using simple interest.

Question 1

Which of the following statements best distinguishes a forward contract from a futures contract?

1. Forwards are standardized contracts traded on exchanges, while futures are private agreements traded over-the-counter.
2. Forwards settle gains/losses only at maturity, whereas futures are marked-to-market daily with margins.
3. Forwards carry minimal credit risk due to clearinghouse guarantees, whereas futures have high counterparty default risk.
4. Forwards require an initial margin deposit, while futures typically require no upfront payment.

Question 2

Suppose the spot price of a stock index is ₹10,000. The risk-free interest rate is 6% per annum. Assume no dividends on the index and no other holding costs or benefits. What is the fair futures price for a contract expiring in 6 months (0.5 year), based on the cost-of-carry model? (Use simple interest for approximation.)

1. ₹10,000
2. ₹10,300
3. ₹10,600
4. ₹10,700

Question 3

Mr. Sharma shorts 1 lot of XYZ futures at ₹200 per unit. Each lot represents 100 units. Later, he closes (squares off) his position at ₹180 per unit. What is Mr. Sharma’s profit or loss on this futures trade (ignoring transaction costs)?

1. ₹2,000 profit
2. ₹2,000 loss
3. ₹20 profit
4. ₹20 loss

Question 4

If a trader’s futures position incurs losses such that the funds in the margin account fall below the required maintenance margin level, what typically happens?

1. The trader will receive a margin call to deposit additional funds to restore the margin to the initial level.
2. The position is automatically terminated by the exchange with no further action.
3. The trader can continue to hold the position until expiry without adding funds.
4. The losses are ignored as long as the trader has paid initial margin once.

These options have a stock index as the underlying asset. For example, Options on Nifty, Sensex, etc.

These options have individual stocks as the underlying asset. For example, Option on ONGC, NTPC, etc.

The owner (buyer/holder) of an American Option can exercise his right at any time on or before the expiry date/day of the contract.

The owner (buyer/holder) of a European Option can exercise his right only on the expiry date/day of the contract. In India, all Index and Stock Options are European Style Options.

It is the price which the option buyer pays to the option seller.

It is the price at which the underlying asset is trading in the spot market. In our examples, it is the value of underlying index (Nifty 50) which was 18315.10 at that point of time.

Strike price is the price per share for which the underlying security may be purchased by the call option holder (or sold by the put option holder). In our examples, strike price for both call and put options is 18400.

In-the-money (ITM) Option

This option would give the option holder a positive cash flow, if it were exercised immediately. A call option is said to be ITM, when spot price is higher than strike price. A put option is said to be ITM when spot price is lower than strike price. In our examples, the put option is in-the-money.

At-the-money (ATM) Option

At-the-money option would lead to zero cash flow if it were exercised immediately. Therefore, for both call and put ATM options, strike price is equal to spot price. In reality, because the strike prices are at fixed intervals of say, Rs.5, Rs.10 or Rs.50, while the spot price moves in much smaller increments, the two prices may rarely be equal. Hence an ATM option can be defined as an option with a strike price which is closest to the spot price.

For example, if the index is at 18415 and three options on the index with strike prices of 18350, 18400 and 18450 are available for trading, the option with the strike price of 18400 is an ATM option.

Out-of-the-money (OTM) Option

An out-of-the-money option is one with a strike price worse than the spot price for the holder of option. In other words, this option would give the holder a negative cash flow if it were exercised immediately.

An out-of-the-money option is one with a strike price worse than the spot price for the holder of option. In other words, this option would give the holder a negative cash flow if it were exercised immediately. A call option is said to be OTM, when spot price is lower than strike price. A put option is said to be OTM when spot price is higher than strike price. In our examples, the call option is out-of-the-money.

Call Option – Right to Buy

A Call option gives the buyer the right (not obligation) to buy an asset at a fixed price (called Strike Price) before/at expiry.

The seller (writer) of the call is obligated to sell if the buyer chooses to exercise.

The buyer pays a Premium to the seller.

Premium is like a booking fee.

Payoff for Buyer of Call Option

Call Buyer (Right to Buy at ₹1,500. Premium ₹50)

• Loss is limited to premium (₹50) → flat line below zero.
• Profit starts after ₹1,550 (Strike + Premium = Breakeven Price) and grows unlimited as stock price rises.

Put Option – Right to Sell

A Put Option gives the buyer the right (not obligation) to sell an asset at strike price before/at expiry.

The seller (writer) of the put must buy if the buyer exercises.

Buyer pays premium, risk is limited, and the seller receives the premium.

Buying a Put Option Profitability depends on the Concept of Selling High at price and Buying at a Low price.

Payoff Diagram: Buyer of Put Option

Put Buyer (Right to Sell at ₹1,700, Premium ₹40)

• Loss is limited to premium (₹40) → flat line below zero.
• Profit starts after ₹1,660 (Strike Premium = Break even) and increases as stock price falls.

Question 1

If you sell a put option with strike of Rs. 245 at a premium of Rs.40, how much is the maximum gain that you may have on expiry of this position?

1. 285
2. 40
3. 0
4. 205

Question 2

Spot Price = Rs. 100. Call Option Strike Price = Rs. 98. Premium = Rs. 4. An investor buys the Option contract. On Expiry of the Option the Spot price is Rs. 108. Net profit for the Buyer of the Option is _____________.

1. Rs. 6
2. Rs. 5
3. Rs. 2
4. Rs. 4

Question 1

If in case of Put Buy, Spot Price < Strike Price then it means a person is in __________ situation.

1. At the money
2. In the money
3. Out the money

Question 2

In-The-Money option is ____________.

1. An option with a negative intrinsic value
2. An option which cannot be profitably exercised by the holder immediately
3. An option with a positive intrinsic value
4. An option with zero-time value