NISM-Series-VIII: Equity Derivatives · Understanding Index

Index Funds, ETFs and Derivatives: Index Applications

Updated 11 October 2026 · Fact-checked

An index is a benchmark that other products copy. Index funds and ETFs hold the index stocks to mirror its return. Index futures and options use the index as the underlying and settle in cash. Tracking error is the gap between the fund's return and the index return, usually measured as a standard deviation.

Understand Index Applications: Index Funds, ETFs and Derivatives

An index is a number that shows how a basket of securities is moving. It is not something you can buy directly. To use it, the market builds products that follow it.

An index fund is a mutual fund that holds the index stocks in nearly the same weights as the index. It is passively managed. The fund manager does not pick stocks. The aim is to give you the index return, less costs. You buy and sell units with the fund house at the NAV.

An ETF (exchange traded fund) also follows an index, but its units are listed and traded on a stock exchange at market prices during the day. You need a demat account and a broker to trade it. Large investors can create or redeem units with the fund house in big blocks, which keeps the market price close to the NAV.

Index derivatives are different. In index futures and options, the index is the underlying. You cannot deliver an index, so these contracts are cash settled. The contract value is the index level multiplied by the lot size. They let you hedge or take a view on the whole market without buying every stock.

Tracking error measures how closely a fund follows its index. No fund matches perfectly because of expenses, cash held for redemptions, delays in rebalancing, dividends timing and trading costs. A lower tracking error means better tracking.

Key formulas to remember

Tracking difference: Tracking difference = Fund return − Index return; A simple gap over a period. It is usually negative for an index fund because of costs.
Tracking error: Tracking error = Standard deviation of (Fund return − Index return) over the periods; The usual definition in the workbook. It shows how much the gap varies. Lower is better.
Index futures contract value: Contract value = Index level × Lot size; Use the lot size set by the exchange for that index.
Settlement of index derivatives: Index derivatives are cash settled; No delivery of the underlying stocks takes place.

How to solve Index Applications: Index Funds, ETFs and Derivatives questions

Most questions on this topic test which product does what, or ask you to compute a simple gap or contract value. Use this order.

1Read what the question asks: a product feature, a comparison, tracking error, or a contract value.
2Identify the product. Mutual fund units at NAV means index fund. Exchange-traded units at market price means ETF. Cash-settled contract on the index means index derivative.
3For tracking questions, recall that tracking error is the deviation of the fund from the index, and its causes are costs, cash holding and rebalancing lag.
4For a numerical gap, subtract the index return from the fund return. Keep the sign.
5For contract value, multiply the index level by the lot size.
6Check the options against the trap words: physical delivery, active management, guaranteed return.
7Choose the option that fits the exact definition and not just a similar idea.

Quickest way: Product-matching shortcut

When to use it: Use this for definition and comparison questions when time is short.

Passive and bought from the fund house at NAV: index fund.
Passive and traded on the exchange all day: ETF.
Index as underlying and settled in cash: futures or options.
Asked about differences from the index: tracking error, caused by costs and cash.
Cross out any option that says index derivatives are delivered in shares.

Common mistakes in Index Applications: Index Funds, ETFs and Derivatives

Saying an ETF is bought at NAV from the fund house like a normal fund.
Both are mutual fund products, so they get mixed up.
Fix: Remember that ETF units trade on the exchange at market price. Index fund units deal at NAV with the fund house.
Thinking index funds are actively managed.
The word fund suggests a manager choosing stocks.
Fix: Index funds and ETFs are passive. They copy the index, so no stock picking is involved.
Believing index futures end in delivery of stocks.
Stock futures in some cases involve delivery, so students carry it over.
Fix: An index cannot be delivered. Index derivatives are cash settled.
Defining tracking error as the fund's return.
The word error is read loosely.
Fix: Tracking error is about the deviation from the index, not the fund's own return.
Assuming a good index fund has a positive tracking gap every time.
Students expect the fund to match or beat the index.
Fix: Costs usually pull the fund slightly below the index. Lower tracking error means closer tracking, not outperformance.
Dropping the sign when finding the return difference.
Rushing the subtraction.
Fix: Always compute fund return minus index return and keep the negative sign.

Worked examples

Example 1

An index fund returned 11.6% in a year while its benchmark index returned 12.0%. What is the tracking difference?

Show the solution

Tracking difference = Fund return − Index return.
= 11.6% − 12.0%.
= −0.4%.

Answer: The tracking difference is −0.4%. The fund lagged the index by 0.4 percentage points, mainly due to costs and similar frictions.

Example 2

An index stands at 22,000 and the lot size of its futures contract is 50. What is the contract value, and how is the contract settled at expiry?

Show the solution

Contract value = Index level × Lot size.
= 22,000 × 50.
= ₹11,00,000.
The underlying is an index, which cannot be delivered, so the contract is cash settled.

Answer: The contract value is ₹11,00,000 and the contract is settled in cash.

Exam tips

Expect direct questions on the difference between an index fund and an ETF. Learn the NAV versus market price point first.
Know the causes of tracking error: expenses, cash holding, rebalancing delay and trading costs.
Remember that index derivatives are cash settled. Any option saying physical delivery of the index is a trap.
With 25% negative marking, skip a question only if you cannot narrow the options to two.

Practice questions from Understanding Index

Index Applications: Index Funds, ETFs and Derivatives in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

CFA Level IIIIndex-Based Vehicles: ETFs, Futures, Swaps, Mutual Funds

Index Applications: Index Funds, ETFs and Derivatives: frequently asked questions

What is tracking error in an index fund?

It is how far the fund's returns deviate from its index. It is commonly measured as the standard deviation of the return difference. A lower value means the fund follows the index more closely.

How do ETFs track an index?

An ETF holds the index stocks in nearly the same weights as the index. When the index changes, the fund adjusts its holdings. Creation and redemption of units by large participants keep the market price near the NAV.

What is the difference between an index fund and an ETF?

Both are passive and follow an index. You buy index fund units from the fund house at NAV. You trade ETF units on the exchange at market price, using a demat account and a broker.

Why are index futures and options cash settled?

The index is only a number and cannot be delivered. So the contract is settled by paying the difference in cash.