Answer Key of the course Financial Markets and Institutions (PGDMBKFS-First year)

1. Which type of derivative instrument(s) would be appropriate in each of the

following situations? Explain why and how a particular instrument would
be
used
to
reduce
the
potential
risk.
(5*4=20 marks)
(a) The firm should use interest rate derivatives to hedge against interest
rate risk. Since firm is holding a bond of worth 10 million, it can either
sell bond futures or can buy put option on bond. Under this, firm would
be able to sell the bond at a pre determined price at some future point
of time.
(b) The firm should use commodity derivatives. Firm can enter into a
forward contract to sell soyabean at a fixed price after three months.
Firm can also either sell soyabeans futures or can buy put option on
soyabean for a maturity of 3 months.
(c) The firm should use currency derivatives to hedge against exchange
rate risk. It can buy US dollar forward/future or can also buy a call
option on US dollar. Under this, the firm would be able to buy US dollar
at a fixed price to make payments and the changes in exchange rate
would not alter its future liability in terms of Indian rupees.
(d) Mr. X should use stock derivatives. He can sell stock futures or can buy
a put option to sell the shares of Godrej at a pre determined price.
(e) The portfolio manager can use index derivatives in this case. He can
sell index futures or can buy a put index option on sensex.
2. The inter-bank bid and ask rate in foreign exchange market is 67-67.20
Indian rupee per US dollar. Consider each of the following situations and
comment:
(2*3=6 marks)
(a) One can buy 1 USD from Axis bank at the rate of Rupees 67.20. So to
buy 100 USD, one requires 6720 rupees.
(b) One can sell 1 USD to Axis bank at the rate of 67 rupees. So one would
receive 3350 rupees by selling 50 USD to the bank.

3. Explain whether the following type of events may involve Fundamental

Volatility/Transitory
Volatility
in
prices
or
both
and
why?
(4*2=8 marks)
(a) It involves Fundamental volatility as Enrons price decline was due to
its poor financial statements which had permanent impact over prices
(b) It involves transitory volatility as prices move around the
announcement date due to high trading by uninformed traders and get
reverse to their fundamental level after certain period of time.
(c) It involves Transitory volatility as it is for short term and the prices
become stable after two days
(d) It essentially involves fundamental volatility as prices react to the
published information of the firm and the changes are permanent in
nature.

4. In each of the following situations, which order is considered as the best

buy/sell order in the market at a given point of time and gets priority for
execution?
(2.5*2=5 marks)
(a) The best buy order is the one with the highest price. This is because
the system views all buy orders available from the point of view of a
seller in the market. The second order (100 shares @ rupees 40.10) is
the best buy order and gets priority for execution as it offers higher
price to the sellers.
(b) The best sell order is the one with the lowest price. This is because the
system views all sell orders from the point of view of the buyers. The
second order (500 shares @ rupees 50) is the best sell order and gets
priority for execution as it offers lower price to the buyers.
5. Explain the following types of orders used by traders in the markets :
( 6*2= 12 marks)
(a) Market order: An order to buy or sell securities at the best price
obtainable at the time of entering the order.
(b) Limit order: An order that allows the price to be specified while
entering the order into the system.
(c) Stop loss order: The one that allows the Trading Member to place an
order which gets activated only when the market price of the relevant
security reaches or crosses a threshold price. Until then the order does
not enter the market.
(d) Day order: A Day order, as the name suggests, is an order which is
valid for the day on which it is entered. If the order is not matched
during the day, the order gets cancelled automatically at the end of the
trading day.
(e) Minimum Fill order: Minimum Fill (MF) orders allow the Trading
Member to specify the minimum quantity by which an order should be
filled.
(f) An Immediate or cancel order: An Immediate or Cancel (IOC) order
allows a Trading Member to buy or sell a security as soon as the order
is released into the market, failing which the order will be removed
from the market.

6. Explain whether the following type of markets are order-driven or quotedriven and why?
(2*2= 4 marks)
(a) Foreign Exchange market is a quote/dealer driven market in which
Authorized dealers decide about the quotes to be given to the
customers and make the market.
(b) Indian stock market is orderd riven market in which there are no
dealers. Trading is entirely based on the orders and prices are
determined by the demand and supply.

7. In the light of the below statement, explain how circuit breakers help in
reducing extreme volatility and affect market crashes.
(5 marks)
Circuit breakers are trading rules that limit trading activity during the high
volatility or crash perod in the market. Trading halt is one of the types of
circuit breakers used by a regulatory authority. Trading halts stop trading
when prices have moved. Trading may remain halted until the order
imbalance is resolved or until some time passes. In India, the Exchanges
have implemented index-based market-wide circuit breakers with effect
from July 02, 2001 based on SEBI Circular. The index-based market-wide
circuit breaker system applies at 3 stages of the index movement, either
way viz. at 10%, 15% and 20%. These circuit breakers when triggered
bring about a coordinated trading halt in all equity and equity derivative
markets nationwide. Trading halt helps only if crashes are due to transitory
volatility and this gives informed traders an opportunity and some time to
react. This could help reducing high volatility due to impatient traders and
makes prices stable.