Question

discuss the advantages of financial derivatives to effectively manage investment related risks and the big losses caused by financial derivatives.

Answer 1

Advantages of Financial Derivatives:

The advantages of financial derivatives to effectively manage investments and cover big losses is as follows :

• Hedging risk exposure
• Underlying asset price determination
• Market efficiency
• Access to unavailable assets or markets

1. Hedging risk exposure

Since the value of the derivatives is linked to the value of the underlying asset, the contracts are primarily used for hedging risks. For example, an investor may purchase a derivative contract whose value moves in the opposite direction to the value of an asset the investor owns. In this way, profits in the derivative contract may offset losses in the underlying asset.

2. Underlying asset price determination

Derivates are frequently used to determine the price of the underlying asset. For example, the spot prices of the futures can serve as an approximation of a commodity price.

3. Market efficiency

It is considered that derivatives increase the efficiency of financial markets. By using derivative contracts, one can replicate the payoff of the assets. Therefore, the prices of the underlying asset and the associated derivative tend to be in equilibrium to avoid arbitrage opportunities.

4. Access to unavailable assets or markets

Derivatives can help organizations get access to otherwise unavailable assets or markets. By employing interest rate swaps, a company may obtain a more favorable interest rate relative to interest rates available from direct borrowing.