Option & Derivatives: Basic Interview Questions

Sometimes the Interviewer will check the basic knowledge of Options & Derivatives and will then proceed with challenging Interview Questions

Let’s deep dive into the interview questions:

1.     What is an exchange?

An exchange, refers to a marketplace or platform where various financial instruments, such as stocks, bonds, commodities, derivatives, and currencies, are traded. It provides a centralized venue where buyers and sellers can come together to execute transactions.

Exchanges play a vital role in facilitating the smooth functioning of financial markets by providing a transparent and regulated environment for trading. They establish the rules, regulations, and procedures that govern the trading activities, ensuring fair and orderly markets.

2.     What is over the counter market?

The over-the-counter (OTC) market refers to a decentralized marketplace where financial instruments, such as stocks, bonds, derivatives, and currencies, are traded directly between two parties without the involvement of a centralized exchange. In contrast to exchange-traded markets, OTC markets are typically less formal and operate through a network of dealers and brokers.

3.     What is a derivative?

In finance, a derivative is a financial instrument whose value is derived from an underlying asset or set of assets. The underlying asset can be a commodity, stock, bond, currency, or an index. Derivatives are used as a way to manage and mitigate financial risk or to speculate on future price movements.

Derivatives play a crucial role in financial markets, allowing investors, traders, and institutions to manage risk, hedge against price movements, speculate on future prices, and enhance investment strategies. However, it's important to note that derivatives can also involve higher levels of risk and complexity compared to traditional investments.

4.     What are different types of Derivatives traded in the market?

Derivatives in finance can be classified into four main types:

a)     Forwards: Forwards are contracts but are customized agreements between two parties rather than standardized contracts traded on OTC. They specify the price and delivery date for the underlying asset. Forwards are commonly used in over-the-counter (OTC) transactions, allowing parties to tailor the terms of the agreement to their specific needs.

b)     Futures Contracts: Futures contracts are agreements to buy or sell an asset at a predetermined price and date in the future. They are standardized contracts traded on exchanges and are commonly used to hedge against price fluctuations. For example, a farmer might enter into a futures contract to sell their crop at a fixed price in order to protect against a drop in prices.

c)     Options: Options give the holder the right, but not the obligation, to buy (call option) or sell (put option) an asset at a predetermined price within a specified period. Options provide flexibility and can be used for hedging, speculation, or generating income. Traders can use options to protect their portfolio against downside risk or to leverage their investment.

d)     Swaps: Swaps are agreements between two parties to exchange cash flows based on predetermined terms. The most common type of swap is an interest rate swap, where two parties agree to exchange fixed and floating interest rate payments over a specified period. Swaps are used to manage interest rate risk, currency risk, or to modify the cash flow characteristics of assets or liabilities.

5.     What are different underlying assets in an Option & Derivative Contract?

Options are derivative contracts that provide the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (strike price) within a specified time period. The underlying asset can vary depending on the type of option contract. Here are some common types of underlying assets in options:

1. Stocks: Stock options are among the most widely traded options. They have stocks of individual companies as their underlying assets. For example, options on shares of Apple Inc. would have the Apple stock as their underlying asset.

2. Stock Indices: Options can be based on stock market indices, such as the S&P 500, Dow Jones Industrial Average, or NASDAQ-100. These options allow investors to gain exposure to a broad market index rather than individual stocks.

3. Exchange-Traded Funds (ETFs): Options can also be based on ETFs, which are investment funds that trade on stock exchanges. ETF options provide investors with the ability to gain exposure to a diversified portfolio of assets represented by the underlying ETF.

4. Currencies: Options on currencies, commonly known as foreign exchange options or forex options, have currency pairs as their underlying assets. For instance, an option could be based on the exchange rate between the U.S. dollar and the Euro (USD/EUR).

5. Commodities: Options on commodities allow investors to trade on the price movements of various physical goods or raw materials. Examples of underlying commodities include gold, silver, crude oil, natural gas, agricultural products, and more.

6. Interest Rates: Options can be based on interest rates, specifically interest rate futures contracts. These options allow market participants to hedge or speculate on changes in interest rates, such as those based on government bonds or short-term interest rate benchmarks.

7. Bonds: Some options have bonds as their underlying assets. These options are less common compared to other types of options, but they exist and can be used for hedging or investment purposes.

Thank you for reading all the interview questions. :o)

I hope you shine in the Interview Process.