Exam Studf

Question 1

What are the derivatives?

Answer 1

A derivative is a financial contract (instrument) which derives its value from the price of another underlying security or commodity.
•The underlying assets can be:
1.Real commodities, like agricultural commodities, energy, precious metals;
2.Financial assets, like currencies, common stock, and bonds

Question 2

What is a forward contract and why would a forward agreement be used?

Answer 2

A forward contract is a contract in which the counterparties agree to exchange the underlying at a defined date in the future but at a price decided now.

This is to cope with price volatility.

Question 3

What are the main differences between a futures and forward contract? What are the main advantages of a futures contract over a forward contract?

Answer 3

Futures contracts are standardized agreements traded on organized exchanges, with fixed contract specifications such as size, expiration date, and tick size. In contrast, forward contracts are customized agreements negotiated privately between two counterparties, normally arranged by an intermediary known as a broker.

forward contracts remain popular due to their flexibility and tailor-made nature.

Question 4

Hedging

Answer 4

hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset. Hedging is to protect against price movement.

Question 5

Speculation

Answer 5

Speculation involves taking financial risks to achieve higher returns. Investors engage in speculation to profit from price fluctuations in financial instruments, anticipating future market movements. Unlike hedging, speculation isn’t about risk reduction but rather seeking opportunities for financial gain. Traders might, for instance, speculate on stock prices by buying with the expectation of selling at a higher price.

Question 6

Hedging example

Answer 6

•For example, the main risk traditionally faced by farmers is that market price is lower than expected by the time the harvest is brought to market.
•The new commodity markets provided a way of hedging against this by allowing famers to purchase contracts to sell at a ‘normal’ average price that covered cost plus a normal profit margin.