A) What are derivatives?
B) How can derivatives be used to reduce risk?
C) Can derivatives be used to increase risk? Explain.
Risk is probability of loss. Risk management involves a process of risk identification, measurement and evaluation and finding a way of reducing or increasing the risk level to manageable level.
Answer and Explanation:
a.)Derivatives are financial instruments in form of legal contracts that derive their value from the value of the underlying asset of which they are based on. Examples of derivatives are ; forwards, futures,swaps and options.
b.) Derivatives are very instrumental in managing the risk , using derivatives an investor can be able to reduce risk by locking in a price using forwards and futures for a future transaction thereby reducing the uncertainty. The investors can also use options and swap to reduce risk depending on the type of transaction or the exposure. All the derivative contracts help reduce the probability of loss involved in a transaction.
c.)Derivatives can be used to increase the risk in a portfolio by increasing the beta in case of equity and duration in case of a bond by use of futures. Buying bond futures increases the exposure in bonds and buying equity futures increases exposure in equity.
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from Finance 305: Risk ManagementChapter 1 / Lesson 4