NISM Series VIII · Unit 1 of 10 · about 8% of the paper
Basics of derivatives: NISM Series VIII notes and practice questions
A derivative gets its value from something else: a share, an index, a currency or a commodity. This unit teaches the language, the purposes of derivatives and the differences between types.
What to know in Unit 1
- Forwards versus futures.
- Hedgers, speculators and arbitrageurs.
- Exchange-traded versus over-the-counter.
Key terms, examples and exam traps
Derivative
A derivative is a financial contract whose value depends on, or is derived from, an underlying asset or reference rate such as a share, index, currency or commodity.
Example. A contract's value moves with the price of a stock index.
Exam trap. This statement is false: A derivative is a share issued by a company.
Underlying
The underlying is the asset or index on which a derivative contract is based.
Example. A futures contract is based on the Nifty 50, which is its reference.
Exam trap. This statement is false: The underlying is the premium paid on an option.
Forward contract
A forward contract is a private agreement to buy or sell an asset at a fixed price on a future date. It is customised and traded over the counter, with counterparty risk.
Example. Two parties agree privately to exchange an asset at a fixed price in three months.
Exam trap. This statement is false: A forward contract is standardised and traded on exchanges.
Futures contract
A futures contract is a standardised agreement traded on an exchange to buy or sell an underlying at a fixed price on a future date, with the clearing corporation guaranteeing performance.
Example. An exchange-traded contract in which both parties must settle at expiry.
Exam trap. This statement is false: A futures contract carries no obligation for either party.
Hedger
A hedger uses derivatives to reduce an existing price risk rather than to profit from price moves.
Example. A fund manager takes an opposite position to protect a stock portfolio from a fall.
Exam trap. This statement is false: A hedger aims to maximise profit from price moves.
Speculator
A speculator takes positions in derivatives to profit from expected price changes and accepts the risk.
Example. A trader buys index futures expecting a sharp rise.
Exam trap. This statement is false: A speculator has no exposure to the price risk.
Arbitrageur
An arbitrageur exploits price differences between related markets to earn a low-risk profit.
Example. A trader buys in the cash market and sells in the futures market to lock in a price gap.
Exam trap. This statement is false: An arbitrageur needs to predict the market's direction.
Exchange-traded derivative
Exchange-traded derivatives have standardised terms, are cleared by a clearing corporation and carry lower counterparty risk.
Example. A contract with a fixed lot size, expiry and daily settlement.
Exam trap. This statement is false: Exchange-traded derivatives are customised for each buyer.
Over-the-counter derivative
OTC derivatives are privately negotiated and tailor-made but carry higher counterparty and liquidity risk.
Example. Two institutions agree bespoke terms without an exchange.
Exam trap. This statement is false: OTC derivatives are guaranteed by a clearing corporation.
Swap
A swap is an agreement to exchange cash flows over a period, such as fixed for floating interest payments.
Example. Two parties agree to exchange a fixed rate payment for a floating one.
Exam trap. This statement is false: A swap is an exchange-traded futures contract.
Leverage
Leverage in derivatives means controlling a large exposure with a small margin, magnifying both gains and losses.
Example. A trader controls a ₹10 lakh position with ₹1.5 lakh margin.
Exam trap. This statement is false: Leverage reduces the risk of losses.
Price discovery
Derivatives markets help in price discovery by reflecting market expectations about future prices of the underlying.
Example. Futures prices show where the market expects the index to be next month.
Exam trap. This statement is false: Derivatives play no role in price discovery.
6 practice questions
Read each question and choose your answer before opening the free mock, which shows the correct answer and the reason.
Q1. Which term is described here? A futures contract is a standardised agreement traded on an exchange to buy or sell an underlying at a fixed price on a future date, with the clearing corporation guaranteeing performance.
- Ban period
- Futures versus forwards risk
- Futures contract
- Reverse cash-and-carry
Q2. Which term is described here? Derivatives markets help in price discovery by reflecting market expectations about future prices of the underlying.
- Option writer margin
- Price discovery
- Delta
- Mark-to-market accounting
Q3. Which term is described here? A forward contract is a private agreement to buy or sell an asset at a fixed price on a future date. It is customised and traded over the counter, with counterparty risk.
- Pair trade
- Forward contract
- Bear put spread
- Trading member
Q4. Which statement best describes “Hedger”?
- Open futures positions are marked to market at year end for accounting, and unrealised losses may be recognised.
- Reverse cash-and-carry sells the underlying and buys the future when the future is cheap relative to fair value.
- The premium depends on spot, strike, time to expiry, volatility, interest rates and dividends; higher volatility and longer time raise it.
- A hedger uses derivatives to reduce an existing price risk rather than to profit from price moves.
Q5. Which statement best describes “Speculator”?
- The underlying is the asset or index on which a derivative contract is based.
- In the ban period, traders can only reduce their open positions in the stock; fresh positions are not allowed.
- A speculator takes positions in derivatives to profit from expected price changes and accepts the risk.
- Delta measures the change in an option's price for a ₹1 change in the underlying. Calls have delta between 0 and 1; puts between −1 and 0.
Q6. Which term is described here? A swap is an agreement to exchange cash flows over a period, such as fixed for floating interest payments.
- SEBI Act
- Swap
- Contango
- Single-stock futures
Frequently asked questions
How much of NISM Series VIII comes from Unit 1?
Unit 1 (Basics of derivatives) usually carries about 8% of the questions. The whole exam has 100 questions and the pass mark is 60%.
What should I study in NISM Series VIII Unit 1?
Forwards versus futures. Hedgers, speculators and arbitrageurs. Exchange-traded versus over-the-counter.
Are these NISM Series VIII practice questions free?
Yes. Take the full free mocks to see the correct answer and the reason for every question.
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