- CFA Exams
- 2024 Level II
- Topic 7. Derivatives
- Learning Module 50. Derivative Benefits, Risks, and Issuer and Investor Uses
- Subject 1. Derivative Benefits and Risks
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Subject 1. Derivative Benefits and Risks PDF Download
Some of the main benefits that financial derivatives bring to the market are:
Derivative instruments can involve risks such as a high degree of implicit leverage and less transparency in some cases than cash instruments, as well as basis, liquidity, and counterparty credit risks. The complexity of derivatives means that sometimes the parties that use them don't understand them well. As a result, they are often used improperly, leading to potentially large losses. This can explain why unknowledgeable investors tend to consider derivatives excessively dangerous. Excessive risk taking in the past by market participants through the use of derivatives has contributed to market destabilization and system risk.
Derivatives are also mistakenly characterized as a form of legalized gambling. This view tends to overlook the benefits of derivatives (e.g., risk management). In fact, derivatives make financial market work better, not worse.
User Contributed Comments 6
|johntan1979||In his 2002 letter to Berkshire Hathaway shareholders, Warren Buffett dubbed derivative securities as "financial weapons of mass destruction."
We all know very well what happened not so much later.....
|To-be-CFA||Benefits of Derivatives:
- Provide price information.
- Allow risk to be managed and shifted among market participants.
- Reduce transaction costs.
- Promote market efficiency.
|irapp92||@johntan1979.. From my understanding, buffet still holds the belief that derivatives are the largest existential threat to the modern global economy, mostly due to their complexity and opaqueness on BB bank books. He seems to imply 2008 was merely a glimpse into the depth and scope of the derivatives market + the risks inherent. Great infographic put out by money.visualcapitalist.com titled "All of the Worlds Money and Markets in One Visualization"... Definitely worth checking out if you're feeling a bit apocalyptic.|
|jmorris||Like most things, the issue isn't derivatives, but the humans who trade them. For businesses that are exposed to short-term price fluctuation in commodities or currencies, derivatives are extremely beneficial. However, when traders artificially push prices in one direction or the other, resulting in wild swings in prices, things get dangerous. How you stop humans from being humans is a tough problem to solve though, especially considering all these things were artificially created by us in the first place.|
|yassine||@johntan1979 - Is a sharp knife a dangerous weapon or useful tool? It all depends how you use it.|
|sshetty2||Where do you draw the line between an unknowledgable investor and a knowledgeable one? And, better yet, who is actually drawing that line. Hmm, better to just use derivatives to even out a portfolio, lol.|
I am using your study notes and I know of at least 5 other friends of mine who used it and passed the exam last Dec. Keep up your great work!
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