Financial Derivatives

FINANCIAL DERIVATIVES
Module 1
Introduction
to Stock
Market
Stock Markets in India
q There are 2 major stock exchanges in India:
q BSE – Bombay Stock Exchange

q NSE – National Stock Exchange
q There are 2 types of share markets:
Primary Share Market Secondary Share Market

• This is the market where companies or businesses • The actual trading of companies share occurs in the
register themselves. secondary market.
• Companies enter the primary share market to raise • After a company’s shares are listed on a stock
funds by offering their stocks. exchange, investors can engage in trading i.e, sale or
• When a company registers itself on a primary share purchase of stock, on prices that are governed by
market and offers to sell its shares for the first time, it is market movements.
known as Initial Public Offering (IPO). • You can trade in shares in the secondary share market
• Here you must understand that the shares are a only through a broker.
physical representation of a small value of the
company and owning shares means that you are a part
owner of the company.
This presentation should not be used by anyone other than AR Finance Room & is only intended for delivering the Financial Derivatives Program at Chitlkara University
Types of Stock Market Indices
q There are different types of stock market indices based on the kind of stocks taken into account to create
the index.
q Benchmark indices such as BSE Sensex and NSE Nifty

q Broader indices such as Nifty 50 and BSE 100
q Indices created based on market capitalization of companies, such as BSE Midcap and BSE Smallcap
q S&P BSE SENSEX
q Sensex is a blend of the two words - sensitive index. This stock market index was introduced in 1986, making it India’s oldest share
market index. The BSE Sensex consists of the top 30 largest and most frequently traded stocks listed in the Bombay Stock Exchange
(BSE). Since Standard and Poor’s (S&P), an international credit rating agency, licensed its technical expertise to BSE to construct the
index, it is always referred to along with the S&P tag in its name.
q CNX NIFTY (NIFTY 50)
q Also known as the NSE Nifty, this index was first created in 1996. This share market index consists of the top 50 of the largest and
most frequently traded stocks within the NSE. The NIFTY is owned and maintained by India Index Services & Products Limited (IISL),
which is a joint-venture organization between an Indian credit rating agency CRISIL and the National Stock Exchange. In fact, the
CNX portion in the CNX NIFTY stands for CRISIL and NSE
q Stock Index
q An index is a number which measures the change in a set of values over a period of time. A stock index represents the change in
value of a set of stocks which constitute the index. 16 More specifically, a stock index number is the current relative value of a
weighted average of the prices of a pre-defined group of equities. A stock market index is created by selecting a group of stocks that
are representative of the entire market or a specified sector or segment of the market. It is calculated with reference to a base period
and a base index value. The beginning value or base of the index is usually set to a number such as 100 or 1000.
q The main index of the NSE is the Nifty 50. The Nifty 50 is a well diversified 50 stock index accounting for 13 sectors of the economy.
It is used for a variety of purposes such as benchmarking fund portfolios, index based derivatives and index funds. The base value of
the Nifty, which is the benchmark broad-based index of the National Stock Exchange, was set to 1000 on the start date of November
3, 1995. Thereafter, changes in the values of the group of equities used to create the index will be reflected on this base number in
weighted average percentage terms
q Stock Index Contd…
q Broad-based market indices are meant to capture the overall behavior of equity markets. Stock market indices are useful for a variety
of reasons. Some uses of them are:
q As a barometer for market behaviour
q As a benchmark for portfolio performance
q As an underlying in derivative instruments like Index futures, Index options
q In passive fund management by index funds/ ETFs
q Sectoral indices capture the behavior of a particular sector, just as market indices capture behavior of the overall market. For eg: The
Bank Nifty / Nifty Bank Index, which is a banking sector index of the NSE, which contains the 12 most liquid and large capitalised
stocks from the banking sector which trade on the National Stock Exchange (NSE). It provides investors and market intermediaries a
benchmark that captures the capital market performance of Indian banking sector
Index Construction
q Index Construction
q A good index is a trade-off between diversification and liquidity. A well diversified index is more representative of the market/economy.
There are however, diminishing returns to diversification. Going from 10 stocks to 20 stocks gives a sharp reduction in risk. 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 more serious problem lies in the stocks which are included into an index when
it is broadened. If the stock is illiquid, the observed prices yield contaminated information and actually worsen an index.
Index Construction
q Index Construction
q A good index is a trade-off between diversification and liquidity. A well diversified index is more representative of the market/economy.
There are however, diminishing returns to diversification. Going from 10 stocks to 20 stocks gives a sharp reduction in risk. 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 more serious problem lies in the stocks which are included into an index when
it is broadened. If the stock is illiquid, the observed prices yield contaminated information and actually worsen an index.
q The computational methodology followed for construction of stock market indices are:
q Free Float Market Capitalization Weighted Index,
q Market Capitalization Weighted index and the
q Price Weighted Index
Index Construction
Free Float Market Cap Weighted Index Market Cap Weighted Index
• The free float factor (Investible Weight Factor), for each • In this type of index calculation, each stock in the index
company in the index is determined based on the affects the index value in proportion to the market value
public shareholding of the companies as disclosed in of all shares outstanding. In this the index would be
the shareholding pattern submitted to the stock calculated as per the formulae below:
exchange by these companies.
• Index = Current Mkt Cap x Base Value
• Free Float Market Cap = Issue size x Price x Investible Base Mkt Cap
weight factor
• Index = Free Float Current Mkt Cap x Base Value

Free Float Base Mkt Cap
Attributes of an Index
1 It should capture the behavior of a large variety of different portfolios in the market
2 The stocks included in the index should be highly liquid
3 It should be professionally maintained
A single stock or a small group of stocks in the index should not move the index significantly. Otherwise,
4 the shifts in other stocks will not be sufficiently captured in the index
Attributes of an Index
In brief the level of diversification of a stock index

should be monitored on a continuous basis. It
should ensure that the index is not vulnerable to
speculation. Stocks with low trading volume or with
very tight bid ask spreads are illiquid and should not
be a part of index. The index should be managed
smoothly without any dramatic changes in its
composition.
Numerical
In US $ Company A Company B
Outstanding Shares 20000 40000
Market Price of Shares 100 90
How To Make a Perfect Portfolio
q To make a perfect portfolio, ones needs to be very logical and clear in their thinking as to what should be the
best portfolio to exist according to them and not according to any outsider.
Step 1 Step 2 Step 3 Step 4

Decide the sector that Diversify your portfolio Keep the money Invest keeping in mind
you would like to target in such a manner that invested in stocks for the future of the
even if one sector is atleast 1 year company
performing bad, the
overall portfolio is still in
profit
How To Place Order in Stock Mkt
q Regular Order
q Cover Order
q AMO
Risk to Reward Ratio
q The risk/reward ratio, sometimes known as the R/R ratio, is a measure that compares the potential profit of
a trade to its potential loss. It is calculated by dividing the difference between the entry point of a trade and
the stop-loss order (the risk) by the difference between the profit target and the entry point (the reward).
q RR Ratio = Entry Point – Stop Loss Point

Profit Target – Entry Point
Numerical
q If a trader buys a stock at an entry point of $25.60, then places a stop loss at $25.50 and a profit target at
$25.85, the risk/reward ratio is?
Some Points to be Remembered
q If the ratio is great than 1.0, the potential risk is

greater than the potential reward on the trade. If the
ratio is less than 1.0, the potential profit is greater
than the potential loss.
q In isolation, it is better to take trades that have

lower risk/reward ratios, as that means the profit
potential outweighs the risk. The risk/reward ratio
doesn't need to be very low to be effective, though.
q Trades with ratios below 1.0 are likely to produce

better results than those with a greater than 1.0
risk/reward ratio.

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q BSE – Bombay Stock Exchange

q There are 2 types of share markets:

Primary Share Market Secondary Share Market

q Benchmark indices such as BSE Sensex and NSE Nifty

q CNX NIFTY (NIFTY 50)

q As a barometer for market behaviour

q As a benchmark for portfolio performance

q As an underlying in derivative instruments like Index futures, Index options

q In passive fund management by index funds/ ETFs

q Free Float Market Capitalization Weighted Index,

q Market Capitalization Weighted index and the

q Price Weighted Index

• Index = Free Float Current Mkt Cap x Base Value

2 The stocks included in the index should be highly liquid

3 It should be professionally maintained

In brief the level of diversification of a stock index

Step 1 Step 2 Step 3 Step 4

q RR Ratio = Entry Point – Stop Loss Point

q If the ratio is great than 1.0, the potential risk is

q In isolation, it is better to take trades that have

q Trades with ratios below 1.0 are likely to produce

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