Question

1. In your opinion, discuss the usefulness of financial derivatives to effectively manage investment related risks as well as the massive losses caused by financial derivatives. [6 Marks]

*Comprehensive answer please*

Answer 1

Ans.1 Financial Derivatives: Financial Derivatives is an instruments in which a value is depends on other assets like stock, bonds etc.

I will explain the usefulness of financial derivatives to effectively manage investment related risks in the following:

1. Hedging Risk : It is a strategy to protect a position from losses. In hedging, Investers can take a position in future market which is inverse to the one in the physical market. The main objective of hedging is to reducing the risk associated with the changes in prices.

2. Interest Based Rate Risk: It is also one of the Risk. Many organisations issues stock or bonds at fixed or floating interest rate. Due to market instability, prices may be fluctuated. In order to overcome this risk, Interest swaps mechanism is made to reduce the risk exposure.

3. Credit Based Risk : Derivatives also manage the credit based risk. An investers are likely to face risk and uncertainty when  if they owned debt. In order to minimise the risk, credit default swap is made to protect against corporate default.

I will explain the massive losses caused by financial derivatives:

1.Speculative Exposure: Financial Derivatives is commonly used as a tool of speculation. Due to unexpected events and unpredicable future may lead to huge losses.

2. High Risk Exposure : Due to complicated nature and market volatility of financial derivatives. It may lead to high risk exposure.

3. Counter Party Based Risk: Eventually Financial Derivaties are traded over the counter through formal process. Some derivatives may not be upto the benchmark. So that it may lead to possibility of Counter-party based risk.

I hope that this answer is helpful to you.