The use of financial derivatives by financial institutions to hedge can decrease risk.However,they can also increase risk.Which of the following examples illustrates this?
A) Financial derivatives allow financial institutions to increase their leverage.
B) Some institutions such huge amounts of derivatives that the amounts exceed capital.
C) All of the above are valid examples.
D) None of the above are valid examples.

Question

Quizplus · Accepted Answer

Option A is correct because financial derivatives can be used to amplify the potential returns on an investment, which in turn increases the leverage of the financial institution. This amplification can lead to greater profits if the investments go well, but if they go poorly, the magnification can lead to greater losses than the institution would have suffered without the derivatives. 
Option B is also correct because holding huge amounts of derivatives can create a situation where the institution has significant exposure to the underlying markets, which can lead to increased risk if those markets turn against them. 
Thus both options A and B increase risk, and therefore, option C is the best answer.

The Use of Financial Derivatives by Financial Institutions to Hedge