Set out what derivatives offer users and the risks they carry
The idea
Derivatives allow risk to be transferred to whoever is best placed to bear it, at far lower transaction cost than trading the underlying, and they let exposure be taken where the cash market is impractical. They also aid price discovery, since the derivative market often trades when the underlying does not. The risks follow from the same features: the implicit leverage means small margin supports large exposure, basis risk means an imperfect hedge can move against the position it was meant to protect, and opacity in bilateral markets hides the build-up of exposure.
A practice question
Which is a recognised benefit of derivative markets?
- They eliminate market risk from the financial systemWhy not: Risk is transferred between participants, not destroyed. Someone always ends up holding it.
- They guarantee positive returns to hedgersWhy not: A hedge fixes an outcome; it does not promise a good one, and it often costs money when the feared event does not occur.
- They can transfer risk more cheaply than trading the underlying - correct
The main economic purpose of derivatives is to move risk from people who do not want it to people who are willing to hold it, and to do it cheaply. Trading a futures contract is often cheaper and faster than buying or selling the real asset. Derivatives do not make risk disappear. Someone always ends up holding it. They also do not guarantee profit: a hedge fixes an outcome, and it can cost money if the feared event never happens.
A harder one
A hedge is placed on a related but not identical underlying. What risk remains?
- Basis risk, because the two prices need not move together - correct
- Counterparty risk, since the hedge counterparty may failWhy not: Present in any bilateral contract and quite separate from whether the hedge tracks the exposure.
- Residual price risk disappears once the notional amounts matchWhy not: Matching notional does nothing if the two prices move apart, which is precisely the residual risk.
A hedge is a trade meant to cancel out an existing risk. Basis = Spot price of the exposure - Price of the hedging instrument. If the hedge instrument is related to your exposure but not identical, the two prices will not move exactly together. The gap between them is basis risk. For example, hedging a portfolio of mid-cap shares with large-cap index futures works only as far as the two move together, so the hedge can fail just when it is needed.
The hardest tier
Why are the benefits and the risks of derivatives described as following from the same features?
- Because both are driven by the same regulatory capital rulesWhy not: Regulation is a response to the features rather than the reason they cut both ways.
- Because the leverage that makes them efficient also magnifies losses - correct
- Because both come from the use of exchange-traded contractsWhy not: Over-the-counter contracts have the same leverage, so the link is not about the trading venue or the clearing house.
Derivatives give a large exposure for a small upfront cost. That is why they are efficient, and it is also why losses are magnified. Return on margin = Change in underlying / Margin percentage. For example, a 5% adverse move costs a fully paid-for holder 5%, but a position using 10% margin loses 5 / 10 = half of its margin. You cannot have the efficiency without the leverage.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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