Page 205 - CAPE Financial Services Syllabus Macmillan_Neat

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02269020/CAPE/KMS 2016 SPEC

FINANCIAL SERVICES STUDIES

UNIT 2 - PAPER 02

KEY AND MARK SCHEME

(b) Risk associated with trading derivatives

- Market Risk:- Market risk refers to the general risk in any
investment. Investors make decisions and take positions bases
on assumptions, technical analysis or other factors that lead
them to certain conclusions about how an investment is likely
to perform. An important part of investment analysis is
determining the probability of an investment being profitable
and assessing the risk? Reward ratio of potential losses
against potential gains.

- Counterparty Risk:- or counterparty credit risk, arises if one
of the parties involved in a derivative trade, such as a buyer,
seller or dealer, defaults on the contract. This risk is higher
in over-the-counter markets, which are much less regulated
than ordinary trading exchanges. Traders can manage
counterparty risk by only using dealers they know and consider
trustworthy.

- Liquidity risk:- this applies to investors who plan to close
a derivative trade prior to maturity. Such investors need to
consider if it is difficult to close out the trade or if
existing bid-ask spreads are so large as to represent a
significant cost.

- Interconnection Risk:- this refers to how the interconnection
between various derivative instruments and dealers might
affect an investor’s particular derivative trade. Some
analysts express concern over the possibility that problems
with just one party in the derivative market, such as a major
bank that acts as a dealer, might lead to a chain reaction or
snowball effect that threatens the stability of financial
markets overall.

1 mark for each for identifying the risk; 1 mark for
explanation up to a maximum of 8 marks