What is a primary purpose of derivatives in financial markets?

A primary purpose of derivatives in financial markets is to provide a form of insurance against major losses. Derivatives are financial instruments whose value is derived from an underlying asset, index, or rate. They can be used for hedging purposes, allowing companies and investors to protect themselves against adverse price movements in the underlying asset. For instance, if a farmer anticipates a lower price for their crop at harvest time, they can use derivatives such as futures contracts to lock in a selling price in advance, mitigating the risk of loss due to price declines.

While derivatives can also be used for speculative purposes, their fundamental role in risk management is what distinguishes them in a financial context. By using derivatives effectively, market participants can safeguard their investment portfolios and maintain stability in their financial outcomes, especially during periods of high volatility.

The other options do not accurately reflect the primary purpose of derivatives. Increasing overall market volatility is not a goal of derivatives; rather, they aim to manage and potentially reduce volatility for positions held in the market. Eliminating all types of financial risk is not feasible; derivatives can mitigate some risks but cannot eliminate all risks, as some market uncertainties remain unpredictable. Finally, derivatives do not serve to replace traditional investments; instead, they often complement investment strategies by providing