Risks

Lesson

While derivatives can be used for various purposes, such as hedging or speculation, they also carry inherent risks that investors should know.

Practice Question #1

Which of the following is NOT a risk associated with derivative securities?

A) Counterparty risk

B) Market risk

C) Liquidity risk

D) Inflation risk

Select an option above to see an explanation here.

A) Counterparty risk is the risk that the other party in a derivative contract will not fulfill their obligations. B) Market risk is the risk that the value of a derivative will change due to fluctuations in the underlying asset's price. C) Liquidity risk is the risk that a derivative cannot be easily bought or sold at a fair price. D) Inflation risk is not directly associated with derivative securities, as it refers to the risk that the purchasing power of money will decrease over time due to rising prices.

Terms

Counterparty risk:: The risk that the other party in a derivative contract will not fulfill their obligations.
Market risk:: The risk that the value of a derivative will change due to fluctuations in the underlying asset's price.
Margin:: The amount of collateral required to enter into a derivative contract.
Liquidity risk:: The risk that a derivative cannot be easily bought or sold at a fair price.
Credit risk:: The risk that the issuer of a derivative will default on their obligations.

Practice Question #2

What is the primary purpose of using derivatives for hedging?

A) To profit from anticipated price movements in the underlying asset

B) To offset potential losses in an investment portfolio

C) To increase the leverage of an investment

D) To speculate on the future value of an asset

Select an option above to see an explanation here.

A) Profiting from anticipated price movements is a speculative use of derivatives, not hedging. B) Hedging involves using derivatives to offset potential losses in an investment portfolio. C) Increasing leverage is not the primary purpose of hedging with derivatives. D) Speculating on the future value of an asset is a speculative use of derivatives, not hedging.

Historical Example

In the late 1990s, a large hedge fund called Long-Term Capital Management (LTCM) used highly leveraged derivatives to make speculative bets on interest rates. When the market moved against them, the fund suffered massive losses and nearly collapsed, requiring a bailout from major financial institutions to prevent a broader market crisis.

Practice Question #3

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

A) Futures

B) Options

C) Swaps

D) Forwards

Select an option above to see an explanation here.

A) Futures obligate the holder to buy or sell an underlying asset at a specified price on a specified date. B) Options give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price. C) Swaps involve the exchange of cash flows or other financial instruments between two parties. D) Forwards obligate the holder to buy or sell an underlying asset at a specified price on a specified date, customized for the parties involved.

Real-World Example

An investor who owns a large amount of stock in a particular company may use a put option, a derivative, to protect against potential losses if the stock's price declines. By purchasing the put option, the investor can sell the stock at a specified price, limiting potential losses if its value drops.