Derivatives play a key role in managing financial risk from "summary" of The Economics of Money, Banking and Financial Markets, eBook, Global Edition by Frederic S. Mishkin
Derivatives are financial instruments whose value is derived from the value of some underlying asset or variable, such as a commodity price, interest rate, or stock price. These instruments have become increasingly popular in recent years due to their ability to help firms and individuals manage financial risk. One of the key ways in which derivatives are used to manage risk is through hedging. Hedging involves using derivatives to offset the risk of adverse price movements in an underlying asset. For example, a company that is concerned about rising interest rates may use interest rate swaps to lock in a fixed rate of interest on its debt, thereby protecting itself from potential increases in borrowing costs. Another way in which derivatives are used to manage risk is through speculation. Speculators use derivatives to bet on the direction of price movements in the underlying asset, with the goal of making a profit. While speculation carries a higher level of risk than hedging, it can also provide opportunities for investors to earn substantial returns. In addition to hedging and speculation, derivatives are also used for arbitrage. Arbitrage involves taking advantage of price differentials between related assets in different markets. By using derivatives to exploit these price differences, investors can earn risk-free profits.- Derivatives play a crucial role in managing financial risk by providing individuals and firms with a range of tools to protect themselves from adverse price movements in the financial markets. Whether it is through hedging, speculation, or arbitrage, derivatives offer a flexible and powerful mechanism for managing risk in today's complex and fast-paced financial environment.
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