Answer to Question #170336 in Finance for innocent kampumba

Question

(a)  What are derivative instruments?                                                                  (5 marks)

(b)  Explain the types of derivative instruments.                                                 (10 marks)

(c)  What are the advantages and disadvantages of using derivative instruments?                   (10 marks)

Answer 1

(a) Derivatives are financial instruments that derive their value in response to changes in interest rates, financial instrument prices, commodity prices, foreign exchange rates, credit risk and indices.

(b) The most common types of derivatives are forwards, futures, options, and swaps. The most common underlying assets include commodities, stocks, bonds, interest rates, and currencies. 

(c) Advantages:

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

Disadvantages of using derivative instruments:

• High risk,
• Speculative features,
• Counter-party risk.