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Portfolio Analysis and Financial Derivatives
Portfolio diversification:
• “Don’t put all your eggs in one basket” is a
proverb that warns against investing all of your
resources in a single source
...

• grouping of financial assets such as stocks, bonds,
commodities, currencies, cash equivalents and
even non publicly traded securities like real
estate, art etc
...

• risk management strategy of combining a variety
of assets to reduce the overall risk of an
investment portfolio
...

Benefits:
1
...

• losses occurring in one asset gets compensated by
gains in the other assets
• difficult to predict future developments that may
take place in the investment environment
• well-diversified portfolio helps investors to be
prepared for any negative development by

spreading his investment sum across variety of
assets
...
High returns
• induces an investor to select investment assets
that generate good returns
...

• By combining such assets, the investor can
increase the overall returns from his portfolio
...

3
...

• Multiple assets provide returns from multiple
sources which can get accumulated over a period
...

4
...

Challenges
1
...

• Efficient diversification sometimes becomes
difficult due to unavailability of required type of
assets
...

• In Indian debt markets are not as developed as
those in developed countries, Hence the choice of
assets in that category is limited
...

2
...

• Investor may not have access to reliable
information on various aspects of individual assets,
such as their past return performance, industry

performance, risk factors associated with assets
etc
...
High costs
• Sometimes investors may diversify excessively
known as over diversification
• over diversified portfolios result in high costs due
to duplication of similar assets in portfolio, high
transaction cost due to more trading, lack of tax
advantage due to regular capital gains tax, cost of
fetching information about assets and doing
research for investment purpose
...

4
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• Continued negative sentiments in markets also
result in low benefits despite good diversification
...


Portfolio risk:
• Portfolio risk is a chance that the combination of
assets or units, within the investments that you
own, fail to meet financial objectives
...

• Portfolio risks include market risk, interest-rate
risk, inflation risk, and credit risk: Market risk is
the probability that the value of an investment
follows the rise and fall of the stock market
...

• Portfolio managers use standard deviation to
estimate how much a portfolio might move in
relation to the market over time (a higher
standard deviation means a broader range of
returns)
...

• The value of financial derivatives is dependent on
the underlying asset
...

• The value of the underlying asset changes with the
market movements
...

• Example
Advantages:
Lock in Prices
Hedging
Leverage
Disadvantages:
High Risk
Leverage
Counter-Party Risk

What are futures? Explain the mechanism of future
trading:
Meaning:
Futures are a type of derivatives contract where the
buyer and seller enter into an agreement to fix the
quantity and price of the asset
...

Upon entering the contract, the buyer and seller are
obligated to fulfil their duty regardless of the asset’s
current market price
...

However, the main purpose is to fix the price of the
asset against volatility
...
When you trade using Futures
Contracts, the process is known as Futures Trading
...
In addition, the
clearinghouse plays the role of a counterparty to the
parties of the contract, which reduces the credit risk in
the future
...

Since these contracts are standard, the futures
contracts listed on the stock exchange cannot be
changed or modified in any possible way,
Suppose an oil producer wants to sell oil but fears that
the oil prices may fall in the future
...
With the aid of
future contracts, the oil producer can lock in the price
at which the oil will sell thereby delivering the oil to
the buyer, once the future contract expires
...
Since this
company prepares well by planning and prefers to have
oil coming in each month, they may also employ the
use of a future contract
...
They know that they
will be taking up the delivery of that oil once their
contract expires
...
Primarily the two
types of participants involved in futures trading are the
Hedgers and Speculators
...
Hedgers try to
avoid risk, to protect themselves against price
fluctuations
...
You can select
a broker and start learning about the trading platform
...
Following are a few strategies you
can use:
Long call
The buyer buys trade at the earlier decided price on a
future date
...
The buyer
usually practices this when the value of the stock has
gone higher than the predetermined price
...

Bull put spread

When a party sells and buys two contracts and the
predetermined price of one of the contracts is higher
than the other
...
The strike price of the contract bought
should be higher than the strike price of the contract
sold
...

In simpler words, it is an agreement formed between
both parties to sell their asset on an agreed future
date
...
Since it is a customized
contract, the size of the agreement entirely depends
on the term of the contract
...
The settlement of the forward
contract gets done on the maturity date, and hence
they are reserved by the expiry period
...


This particular underlying instrument could be a stock,
currency, an index, a commodity, or some other
security
...

All options in the stock market have a specific expiry
date by which the holder can exercise the contract
...

Features of an option contract
Derivatives: Option contracts are derivatives, as their
values are derived from the performance of the
underlying asset in the market
...

If the bearer does not exercise the option on or before
a certain date, it will become useless
...

Speculation: Options are used for speculation, with
strategies
...

Hedging: Options are used for hedging by investors to
reduce risk on other open positions by taking an
opposite position in the market
...
This

means that the option buyer isn’t under the obligation
to pay for or buy the underlying asset if they don’t
want to but can hold the contract and wait for the
preferred price movement
...

Contract Size: All options contract come with a
contract size (lot size) which refers to the volume of
the underlying asset linked to the contract
...

Traders consider call options in stock market if their
analysis shows that the underlying asset price will
increase further
...

Either you can exercise the option and buy the
underlying security at the predetermined price or sell
the option if the stock price exceeds the break-even
price
...

Put options

A put option grants the bearer the right to sell the
underlying financial asset at a pre-fixed price before
the contract expires
...

Put options are used to hedge portfolios during
plunging markets
...

Distinguish between:
BASIS FOR
FORWARD
COMPARISON CONTRACT

FUTURES CONTRACT

Meaning

Forward Contract is A contract in which the
an agreement
parties agree to
between parties to exchange the asset for
buy and sell the
cash at a fixed price
underlying asset at and at a future
a specified date and specified date, is
agreed rate in
known as future
future
...


What is it?

It is a tailor made
contract
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BASIS FOR
FORWARD
COMPARISON CONTRACT

FUTURES CONTRACT

Traded on

Over the counter, Organized stock
i
...
there is no
exchange
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Settlement

On maturity date
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Risk

High

Low

Default

As they are private No such probability
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Size of
contract

Depends on the
contract terms
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Maturity

As per the terms of Predetermined date
contract

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