5 Questions
What is the main concern related to liquidity risk in derivative instruments?
The timing difference between the cash flow of a derivative and the underlying transaction.
What is the primary source of counterparty credit risk in derivative instruments?
The difference in the current price versus the expected future settlement price.
What is the term used to describe the potential for derivative markets to contribute to market stress and instability?
Destabilization and systemic risk
What is the common consequence of a counterparty defaulting on their obligations in a derivative transaction?
The transaction is settled at a lower price than expected.
What is the primary consequence of excessive risk-taking and use of leverage in derivative markets?
Increased market volatility and potential for market stress.
Study Notes
Risks Associated with Derivative Instruments
- Liquidity Risk: Arises from potential mismatch between cash flow timings of a derivative instrument and the underlying or hedged transaction.
- Counterparty Credit Risk: Occurs due to differences between current and expected future settlement prices, resulting in counterparty credit exposure.
- Destabilization and Systemic Risk: Excessive risk taking and leverage in derivative markets can contribute to market stress, as seen in the 2008 financial crisis.
This quiz covers the risks associated with derivative instruments, including liquidity risk, counterparty credit risk, and systemic risk. Learn how to identify and manage these risks in financial markets.
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