Reading 50: derivative benefits, risks, and issuer and investor uses

Question 1

Which of the following most accurately describes a risk of derivative instruments?
Derivatives make it easier for market participants to take short positions.
The underlying of a derivative might not fully match a position being hedged.
Volatility in underlying asset prices is implied by the prices of options on those assets.

Answer 1

Basis risk arises when the underlying of a derivative differs from a position being hedged. Ease of taking short positions with derivatives compared to their underlying assets, and the information about implied volatility that is revealed by option prices, are two of the advantages of derivative instruments. (LOS 50.a)

Question 2

Uses of derivatives by investors most likely include:
hedging against price risk for inventory held.
modifying the risk exposure of a securities portfolio.
stabilizing the balance sheet value of a foreign subsidiary.

Answer 2

Modifying the risk exposure of a securities portfolio is an example of derivatives use by investors. Hedging against price risk for inventory and stabilizing the balance sheet value of a foreign subsidiary are examples of derivatives use by issuers. (LOS 50.b)