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NISM Certifications · NISM-Series-VIII: Equity Derivatives · Understanding Index

Which statement best describes why an index with higher diversification is preferred as an underlying for index derivatives?

A well-diversified index is preferred because it is less prone to manipulation, as no single stock dominates its movement. Diversification reduces company-specific risk but does not eliminate systematic risk, and it does not guarantee higher returns.

  1. AIt has lower impact cost for each constituent only
  2. BIt is less susceptible to manipulation because no single stock dominates its movementCorrect
  3. CIt always gives higher returns than individual stocks
  4. DIt removes systematic risk completely

Explanation

A well-diversified, liquid index is hard for any single participant to manipulate, since no single stock dominates its movement. Diversification reduces unsystematic risk but cannot remove systematic market risk. It does not guarantee higher returns.

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