LM 3: Derivative Benefits, Risk, & Issuer & Investor Uses

Question 1

What are 4 benefits of derivative markets? RIOM

Answer 1

1. risk allocation, transfer, & management (reduce exposure without selling stock)
2. information discovery (where spot prices are going, interest rate hikes, etc)
3. operational advantages (low transaction costs, low cash requirements, etc)
4. market efficiency

Question 2

What are 6 risks of using derivatives, describe them? ILBLCS

Answer 2

1. increased leverage
2. lack of transparency (very complex and not well understood by investors)
3. basis risk (when instrument is similar but not the exact instrument to hedge)
4. liquidity risk
5. counterparty credit risk
6. systemic risk & destablization

Question 3

How must derivatives be recording for accounting purposes?

Answer 3

generally required to show derivatives at their fair value

Question 4

Describe the 3 hedging strategies used by issuers? CFN

Answer 4

1. cash flow hedge (protect one from changes in value related to future cash flows)
2. fair value hedge (offset fluctuation in fair value of an asset or liability for accounting purposes)
3. net investment hedge: offset currency risk (using foreign currency or derivative instrument to offset exchange rate exposure of equity in its foreign operations.)

Question 5

Where are derivatives that qualify for hedge accounting recorded?

Answer 5

other comprehensive income, which effects equity.

Question 6

How does derivatives markets impact markets of underlying assets, list 2?

Answer 6

• makes them more efficient
• increases their liquidity