Which one of the following best describes the primary purpose of derivatives markets?

• A. To record and report the historical cost of financial assets
• B. To facilitate the direct purchase and sale of physical commodities
• C. To provide companies with long-term financing through the issuance of shares
• D. To allow investors to hedge risk or speculate on price movements of underlying assets

Answer: (D)

Verified step by step guidance

1. Understand the concept of derivatives markets: Derivatives are financial instruments whose value is derived from an underlying asset, such as stocks, bonds, commodities, or currencies. They are used for hedging risk or speculating on price movements.
2. Clarify the purpose of derivatives markets: The primary purpose is to allow investors to manage risk by hedging against potential losses or to speculate on future price movements of the underlying assets.
3. Eliminate incorrect options: Review each option provided in the question and determine whether it aligns with the primary purpose of derivatives markets. For example, recording historical costs, facilitating direct purchase of commodities, or issuing shares are not the main functions of derivatives markets.
4. Focus on the correct option: The correct answer is the one that directly relates to the purpose of derivatives markets, which is to allow investors to hedge risk or speculate on price movements of underlying assets.
5. Summarize the reasoning: The derivatives market exists to provide tools for risk management and speculation, making it distinct from other financial markets that focus on asset trading or financing.