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What are Derivatives? Video Lecture | Mathematics for Grade 11

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1. What are derivatives?
Ans. Derivatives are financial contracts whose value is derived from an underlying asset, such as stocks, bonds, commodities, or currencies. They are used to speculate on future price movements, hedge against potential losses, or gain exposure to various financial markets.
2. How are derivatives traded?
Ans. Derivatives can be traded through various exchanges or over-the-counter (OTC) markets. Exchanges provide a centralized platform where standardized derivative contracts are bought and sold, while OTC markets facilitate customized derivative contracts between two parties directly.
3. What are the main types of derivatives?
Ans. The main types of derivatives include futures contracts, options contracts, swaps, and forwards. Futures contracts obligate the buyer to purchase an asset or the seller to sell an asset at a predetermined price and date. Options contracts provide the buyer the right, but not the obligation, to buy (call option) or sell (put option) an asset at a predetermined price within a specified time period. Swaps involve the exchange of cash flows or liabilities between two parties. Forwards are similar to futures contracts but are traded OTC and have more flexibility in terms of customization.
4. What are the risks associated with derivatives trading?
Ans. Derivatives trading involves various risks, including market risk, credit risk, liquidity risk, and operational risk. Market risk arises from potential losses due to adverse price movements in the underlying asset. Credit risk refers to the possibility of default by one of the parties involved in the derivative contract. Liquidity risk pertains to the difficulty of buying or selling derivatives at desired prices due to insufficient market participants. Operational risk involves the risk of errors or failures in the processes and systems used for derivative trading.
5. How are derivatives used in risk management?
Ans. Derivatives are commonly used in risk management to hedge against potential losses. For example, a company that relies on a certain commodity for its production may enter into a futures contract to lock in a favorable price and protect itself from price fluctuations. Similarly, investors can use derivatives to diversify their portfolios, reduce risk exposure, or speculate on market movements. However, it is important to note that derivatives can also amplify losses if used improperly or without adequate understanding of their complexities.
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