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Questions and Answers
What is a potential consequence of the high degree of implicit leverage in some derivative strategies?
What is a potential consequence of the high degree of implicit leverage in some derivative strategies?
- Minimized basis risk
- Increased likelihood of financial distress (correct)
- Reduced likelihood of financial distress
- Increased transparency in portfolio management
Why do derivatives add complexity to a portfolio?
Why do derivatives add complexity to a portfolio?
- Because they reduce basis risk
- Because they create an exposure profile that is not well understood by stakeholders (correct)
- Because they eliminate implicit leverage
- Because they provide a hedge against underlying transactions
What is the term for the potential divergence between the expected value of a derivative instrument and an underlying or hedged transaction?
What is the term for the potential divergence between the expected value of a derivative instrument and an underlying or hedged transaction?
- Implicit leverage
- Financial distress
- Portfolio complexity
- Basis risk (correct)
Which of the following is a characteristic of derivatives that can make them difficult to manage?
Which of the following is a characteristic of derivatives that can make them difficult to manage?
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What is a potential consequence of a lack of transparency in derivatives management?
What is a potential consequence of a lack of transparency in derivatives management?
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Study Notes
Risks Associated with Derivatives
- High degree of implicit leverage in some derivative strategies can increase the likelihood of financial distress, making it a significant risk.
- Derivatives can add complexity to a portfolio, making it challenging for stakeholders to understand the exposure profile, leading to a lack of transparency.
- Basis risk arises from the potential divergence between the expected value of a derivative instrument and the underlying or hedged transaction, which can result in unforeseen losses.
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