Book 4_Derav_READING 70_DERIVATIVE BENEFITS, RISKS, AND ISSUER AND INVESTOR USES

Question 1

Advantages of derivatives

Answer 1

• the ability to change or transfer risk;
• information discovery about the expected prices or volatility of underlying assets or interest rates;
• operational advantages such as ease of short sales, low transaction costs, and greater leverage and liquidity;
• and improved market efficiency.

Question 2

Risks of derivatives

Answer 2

• implicit leverage,
• basis risk from inexact hedges: when the underlying of a derivative differs from a position being hedged with the derivative
• liquidity risk from required cash flows,
• counterparty credit risk,
• and systemic risk for financial markets.

Question 3

Derivatives uses by issuers

Answer 3

Managing risks associated with:
- changes in asset and liability values
- earnings volatility from changes in various underlying securities or interest rates.

Question 4

Derivatives uses by investors

Answer 4

hedging, modifying, or increasing their exposure to the risk of an underlying asset or interest rate.