Financial Markets — Practice Q&A
Q: Why does equity generally offer higher potential returns than debt, and what's the underlying reason for this?
A: The core reason is claim priority — in the event a company faces financial distress or liquidation, debt holders are legally entitled to repayment before equity holders receive anything, meaning equity holders bear more risk (their residual claim could be worth little or nothing in severe distress). This higher risk is why equity investors demand the possibility of higher returns as compensation, while debt investors accept generally lower but more predictable returns in exchange for their repayment priority.
Q: Why do bond prices and yields move inversely to each other?
A: A bond pays a fixed coupon (interest amount) set when it's issued. If market interest rates rise after issuance, newly issued bonds offer higher yields, making the existing lower-yielding bond relatively less attractive — so its price must fall for its effective yield (return relative to price) to become competitive with newer bonds. This inverse relationship is why bond prices are sensitive to interest-rate changes, connecting directly to broader monetary policy conditions.
Q: What's the core value proposition of a mutual fund compared to buying individual stocks/bonds directly?
A: Diversification accessible even to investors with relatively small amounts to invest. Building a genuinely diversified portfolio of individual securities directly typically requires more capital than most individual investors can economically deploy across many positions — pooling money into a mutual fund lets the fund's larger aggregate size hold many more individual positions than an individual investor could efficiently replicate alone, spreading risk across a broader portfolio.
Q: What's the key difference between a futures contract and an options contract?
A: A futures contract obligates both parties to complete the transaction (buy/sell the underlying asset at the predetermined price on the specified date) — there's no choice involved once the contract exists. An options contract gives the buyer the right, but not the obligation, to complete the transaction, in exchange for paying a premium upfront to the option seller. This right-versus-obligation distinction is the single most important conceptual difference between the two instrument types.
Q: Can the same derivative instrument be used for both hedging and speculation? How does that work?
A: Yes — the distinction is about the user's purpose and existing risk exposure, not the instrument itself. A futures contract used by someone with an existing underlying position (like a farmer locking in a future crop sale price) is hedging — reducing an existing risk. The same type of futures contract used by someone with no underlying position, betting purely on anticipated price movement, is speculation — taking on new risk exposure in pursuit of profit.
Q: Why does derivatives trading in India typically involve additional eligibility and risk-disclosure requirements beyond standard equity trading?
A: Derivatives typically involve leverage — controlling a large notional position with a much smaller amount of capital committed upfront — which amplifies both potential gains and potential losses relative to the capital actually at risk. This amplified-risk profile raises investor-protection considerations that direct equity or debt investment generally doesn't carry to the same degree, which is why SEBI's regulatory framework imposes additional requirements specifically for derivatives access.