Benefits

Lesson

Derivatives can be used for various purposes, including hedging, speculation, and arbitrage.

Practice Question #1

Which of the following is NOT a benefit of using derivatives?

A) Hedging against price fluctuations

B) Speculating on future price movements

C) Reducing counterparty risk

D) Taking advantage of arbitrage opportunities

Select an option above to see an explanation here.

A) Hedging against price fluctuations is a benefit of using derivatives. B) Speculating on future price movements is a benefit of using derivatives. C) Reducing counterparty risk is not a benefit of using derivatives, as derivatives can introduce counterparty risk. D) Taking advantage of arbitrage opportunities is a benefit of using derivatives.

Terms

Derivative:: A financial instrument whose value is derived from the value of an underlying asset.
Hedging:: The use of derivatives to reduce the risk of adverse price movements in an asset.
Speculation:: The use of derivatives to profit from the expected price movements of an asset.
Arbitrage:: The simultaneous purchase and sale of an asset to profit from price differences.

Practice Question #2

Which type of derivative gives the holder the right, but not the obligation, to buy or sell an asset at a specified price on or before a specified date?

A) Futures

B) Options

C) Swaps

D) Margin

Select an option above to see an explanation here.

A) Futures obligate the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and price. B) Options give the holder the right, but not the obligation, to buy or sell an asset at a specified price on or before a specified date. C) Swaps involve the exchange of cash flows or liabilities between two parties. D) Margin is the amount of collateral required to enter into a derivatives contract.

Historical Example

In the late 1990s, a large hedge fund called Long-Term Capital Management (LTCM) used derivatives to make highly leveraged bets on the convergence of interest rates between countries. When the Russian government defaulted on its debt in 1998, global markets were disrupted, and LTCM's bets went awry. The fund lost billions of dollars and had to be bailed out by a consortium of banks to prevent a more significant financial crisis.

Practice Question #3

What is the primary purpose of using derivatives for hedging?

A) To profit from expected price movements

B) To reduce the risk of adverse price movements

C) To take advantage of arbitrage opportunities

D) To increase leverage in a portfolio

Select an option above to see an explanation here.

A) Profiting from expected price movements is the primary purpose of using derivatives for speculation, not hedging. B) Reducing the risk of adverse price movements is the primary purpose of using derivatives for hedging. C) Taking advantage of arbitrage opportunities is a different use of derivatives. D) Increasing leverage in a portfolio can be a benefit of using derivatives, but it is not the primary purpose of hedging.

Real-World Example

An airline company might use derivatives to hedge its exposure to fluctuations in fuel prices. By entering into a futures contract to buy jet fuel at a fixed price in the future, the airline can lock in its costs and reduce the risk of rising fuel prices negatively impacting its profits.