Question

a. Define “financial derivatives” in 1 or 2 sentences.

b. What are the three main use cases for “financial derivatives”?

c. In the world of buying/selling financial derivatives, what is the so-called “settlement-risk” and how can you avoid it when trading with unconditional forward transactions? (1-2 sentences)

Answer 1

a)A derivative is a financial contract that derives its value from an underlying asset. The buyer agrees to purchase the asset on a specific date at a specific price. Derivatives are often used for commodities, such as oil, gasoline, or gold

b)Financial derivatives are mainly used for:-

Hedging, Speculating, Arbitraging

A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment

Speculation is the purchase of an asset with the hope that it will become more valuable in the near future.

Arbitrage is the purchase and sale of an asset in order to profit from a difference in the asset's price between markets. It is a trade that profits by exploiting the price differences of identical or similar financial instruments on different markets

c) Settlement risk is the risk that a counterparty fails to deliver a security or its value in cash as per agreement when the security was traded after the other counterparty or counterparties have already delivered security or cash value as per the trade agreement.

The settlement risk can be avoided by:-

1. Delivery versus payment.
2. Settlement through clearing houses.
3. Settling foreign exchange via a special-purpose entity, such as the CLS Group