Derivatives and risk management
Derivatives questions test whether you understand what a derivative actually does - transfer risk at a price - and whether you can tell a hedge from speculation and explain both to a retail client without overselling.
The instruments
Forwards and futures lock in a price for future delivery; futures are standardised, exchange-traded and cleared, forwards are bespoke and carry counterparty exposure. Options give the buyer a right, not an obligation, in exchange for a premium: a call profits as the underlying rises, a put as it falls. Swaps exchange cash-flow streams, most commonly fixed for floating interest.
Mechanics and risk
Futures positions are marked to market daily and require initial and variation margin, so a position can generate cash calls even if the underlying thesis is eventually right. Leverage magnifies both gains and losses. Exchange clearing through a central counterparty reduces, but does not eliminate, credit risk; it concentrates it in margin and default-fund arrangements.
Suitability
Derivatives are generally unsuitable for retail clients seeking growth, and are appropriate mainly where there is an identifiable exposure to offset - a farmer hedging input costs, an exporter hedging foreign currency receivables.
Worked example
An exporter will receive USD 500,000 in 90 days. Spot NZD/USD is 0.6000; the 90-day forward is 0.5970. Locking in converts the receipt to NZD 837,521. If the kiwi strengthens to 0.6200, an unhedged exporter receives only NZD 806,452 - the forward is worth about NZD 31,000. If the kiwi weakens, the hedge costs the same amount in forgone upside. The point is certainty, not profit.
Traps
Describing a hedge by its profit and loss rather than its risk effect. Forgetting margin calls on futures. Confusing the option premium with the strike. Ignoring that a forward removes both favourable and unfavourable moves.