NISM Series XXI-B Short Notes – Part 3: Derivatives, Mutual Funds & Role of Portfolio Managers
This is Part 3 of our 10-part NISM XXI-B (Portfolio Managers Certification) short notes series on PassNISM.in. This part covers Chapters 5, 6 (Mutual Funds), and 7 (Role of Portfolio Managers) — important topics for the NISM Series XXI-B exam.
👉 Also Read: Part 2: Equity & Fixed Income | Free Mock Test
Chapter 5: Derivatives What is a Derivative?
A derivative is a financial contract whose value is derived from an underlying asset. The underlying can be metals, energy, agricultural commodities, stocks, indices, currencies, or interest rates.
Types of Derivative Products 1. Forward Contract
A private agreement between two parties to buy or sell an asset at a specified price on a future date. Key features:
- Negotiated directly between two parties (Over the Counter)
- Not traded on exchange
- Two major risks: Liquidity Risk (hard to exit) and Counterparty Risk (other party may default)
2. Futures Contract
Developed to overcome forward contract limitations. A futures contract is:
- Traded on a recognized exchange
- Standardized in terms of size, expiry date, and settlement
- Settlement guaranteed by a clearing corporation
- Requires initial and maintenance margin deposits
3. Options Contract
A contract that gives the buyer the right but not the obligation to buy (call option) or sell (put option) an underlying asset at a stated price (strike price) on or before a specified date, for a premium.
- Option Buyer (Holder): Has the right; pays premium; limited risk (premium paid)
- Option Writer (Seller): Has the obligation; receives premium; unlimited risk potential
- Call Option: Right to buy the underlying
- Put Option: Right to sell the underlying
4. Swaps
A contract where two parties agree to exchange specified cash flows on future dates. Most common types:
- Interest Rate Swap – Exchange of fixed rate payments for floating rate payments
- Currency Swap – Exchange of principal and interest in different currencies
Derivative Market Structure
- OTC Derivatives: Customized contracts settled between parties on mutually agreed terms. Higher flexibility but higher counterparty risk.
- Exchange-Traded Derivatives: Standardized contracts cleared through a clearing house. Lower counterparty risk due to clearing corporation acting as central counterparty.
Three Purposes of Derivatives
| Purpose | Explanation |
|---|---|
| Hedging | An investor with an open underlying position uses derivatives to protect against adverse price movements. |
| Speculation | Taking a position in derivatives based on a view of future prices, without holding the underlying. Lower capital requirement. |
| Arbitrage | Exploiting price differences of the same asset in two different markets to earn risk-free profit. |
Commodity & Currency Derivatives
Commodity Derivatives help market participants (farmers, traders, processors) hedge against price volatility through commodity futures and options. They also perform price discovery for commodities.
Currency Derivatives – In currency markets, every trade involves a currency pair (buying one currency by selling another). Currency risk can be managed via forwards, futures, swaps, and options on currency pairs.
Key Concepts in Derivatives
- Zero Sum Game: In a futures contract, one party's gain is exactly equal to the other party's loss (assuming zero transaction costs and taxes).
- Cash Settlement: Derivative positions settled by exchanging price differentials — no physical delivery of the underlying.
- Law of One Price: Identical assets cannot trade at different prices in two markets simultaneously without arbitrage opportunities arising.
- Margin: Funds/securities deposited as collateral by clearing members before executing trades, to ensure financial commitments can be met within a specified time.
Chapter 6: Mutual Funds What is a Mutual Fund?
A mutual fund is an investment vehicle (structured as a trust) that pools money from multiple investors and invests it in various securities — equities, bonds, money market instruments — in line with stated objectives. Investors get access to professional fund management through an Asset Management Company (AMC).
Benefits of Investing Through Mutual Funds
- Affordable Portfolio Diversification – Small investors can access diversified portfolios
- Economies of Scale – Lower transaction costs due to pooled buying power
- Transparency – Regular disclosures of portfolio, NAV, and performance
- Tax Benefits – Certain mutual fund investments offer tax advantages
- Convenient Options – SIP, SWP, STP allow flexible investment management
- Regulatory Comfort – SEBI-regulated with strong investor protection
Key Functions in an AMC
- Compliance Function: Ensures legal compliances; Compliance Officer signs the due-diligence certificate for new scheme documents.
- Fund Management: The most critical function — invests investors' money per the stated scheme objective.
- Operations & Customer Service: The RTA (Registrar & Transfer Agent) maintains investor records, processes purchases/redemptions/switches, and generates account statements.
- Sales & Marketing: Handles branding, advertising, events, and distribution through various channels.
Types of Mutual Fund Products
- Open-Ended vs Close-Ended: Open-ended funds allow ongoing buy/redeem transactions; close-ended funds have fixed maturity and are listed on exchange.
- Active vs Passive Funds: Active funds aim to outperform benchmarks; passive funds (index funds/ETFs) replicate benchmark performance.
- Equity, Fixed Income, Commodity, International Funds – classified by investment universe.
Net Asset Value (NAV)
NAV is the current value of one mutual fund unit. It is calculated as:
NAV = (Current Market Value of Securities + Accrued Income – Expenses & Costs) / Number of Units Outstanding
- Open-ended fund transactions are priced at NAV to ensure fairness for all investors entering, staying, or exiting.
- Close-ended fund unit prices are determined by market demand and supply on the exchange (influenced by NAV, but not the same).
Total Expense Ratio (TER)
All AMC expenses are charged to the scheme through TER. The most important component is the Investment and Advisory Fee charged by the AMC. SEBI caps TER to protect investor returns.
Chapter 7: Role of Portfolio Managers What is Portfolio Management?
Portfolio management involves selecting and managing a basket of assets that minimizes risk while maximizing returns. A portfolio manager designs customized investment solutions for clients based on their goals, risk tolerance, and time horizon.
Types of PMS Providers By Provider Type:
- PMS by Asset Management Companies (AMCs)
- PMS by Brokerage Houses
- Boutique (Independent) PMS Houses
By Product Class:
- Equity-Based PMS
- Fixed Income-Based PMS
- Commodity PMS
- Mutual Fund PMS
- Multi-Asset Based PMS
Three Types of Portfolio Manager Services (Exam Critical)
| Type | Description |
|---|---|
| Discretionary Portfolio Manager | Has full discretion to make investment decisions on behalf of the client without seeking their approval for each transaction. The client gives a mandate; the manager executes. |
| Non-Discretionary Portfolio Manager | Manages the portfolio strictly according to the client's directions. The client retains decision-making control. |
| Advisory Portfolio Manager | Only provides non-binding investment advice and ideas. The final investment decision rests with the investor. |
📌 Key Point: A discretionary portfolio manager exercises or may exercise any degree of discretion as to investments under a portfolio management contract.
Quick Revision Box – Part 3
- Derivatives value is derived from an underlying asset
- Forwards = OTC (counterparty + liquidity risk); Futures = Exchange-traded (standardized)
- Option buyer = right, no obligation; Option writer = obligation
- Mutual funds are structured as trusts regulated by SEBI
- NAV = (Market Value of Assets – Expenses) / Total Units
- Discretionary PMS = manager decides; Non-Discretionary = client directs; Advisory = only advice
- PMS providers can be AMC, brokerage house, or boutique firm
👉 Continue Reading: Part 4: Operational Aspects of PMS & Portfolio Management Process
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