Looking for the answer to the question below related to Financial Management ?
An example of a derivative security is ______.
Options:
| A. a common share of General Motors B. a call option on Mobil stock C. a commodity futures contract D. B and C |
The Correct Answer Is:
- D. B and C
The correct answer is D. B and C. Both a call option on Mobil stock (option B) and a commodity futures contract (option C) are examples of derivative securities. Let’s explain why these options are correct and why the other options (A. a common share of General Motors) are not:
Why Option B (a call option on Mobil stock) is Correct:
A call option is a financial derivative that gives the holder the right, but not the obligation, to buy a specific quantity of an underlying asset (in this case, Mobil stock) at a predetermined price (strike price) within a specified period (expiration date).
Call options are used for various purposes, including speculation, hedging, and income generation through option premiums. They derive their value from the underlying stock’s price movement. Therefore, a call option on Mobil stock is a derivative because its value is derived from the underlying Mobil stock.
Why Option C (a commodity futures contract) is Correct:
A commodity futures contract is another example of a derivative security. It is a standardized agreement to buy or sell a specific quantity of a commodity (e.g., gold, oil, wheat) at a predetermined price on a future date. Futures contracts are used by market participants, including producers and consumers of commodities, to hedge against price fluctuations.
These contracts derive their value from the expected future price of the underlying commodity. Therefore, a commodity futures contract is considered a derivative because its value is derived from the price of the underlying commodity.
Why Option A (a common share of General Motors) is Not Correct:
Option A, “a common share of General Motors,” is not an example of a derivative security. A common share represents equity ownership in a company and is considered an underlying asset rather than a derivative.
The value of a common share is primarily determined by the performance and financial health of the issuing company, as well as market supply and demand factors. It is a direct ownership stake in the company and does not derive its value from another financial instrument, which is a characteristic of derivatives.
In contrast to derivatives like options and futures contracts, common shares entitle shareholders to participate in the company’s profits through dividends and to vote on corporate matters, such as board elections and major decisions.
Why Option D (B and C) is Correct:
Option D, “B and C,” is correct because both a call option on Mobil stock and a commodity futures contract are examples of derivative securities. They are financial instruments whose values depend on the price movements of underlying assets (Mobil stock and commodities, respectively).
Derivatives are widely used in financial markets for risk management, speculation, and investment purposes, and they play a crucial role in hedging against price fluctuations and managing exposure to various financial risks.
In summary, derivative securities are financial instruments whose values are derived from the price movements of underlying assets. Options and futures contracts are common examples of derivatives, as they derive their values from the underlying stock or commodity.
In contrast, common shares, such as those of General Motors, are not derivatives; they represent direct ownership in a company and are not based on the value of another financial instrument.
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