Answer-first summary for fast verification
Answer: Exchanges offer multiple protection tools that help against counterparty credit risk, but those tools do not protect against economic risk.
## Explanation **D is correct** because exchanges offer protection tools against counterparty credit risk, but these tools do not protect against economic risk (fundamental market risk). This is demonstrated by subsequent financial bubbles like the dotcom bubble, sub-prime mortgage bubble, and even recent Gamestop stock manipulations, where exchange protections existed but couldn't prevent economic bubbles. **A is incorrect** because it misidentifies who would be required to pay - buyers (not sellers) would have been required to pay the full value of forward contracts at expiry. **B is incorrect** because netting mechanisms wouldn't have helped significantly in this case. Most investors were concentrated on selling tulips and were not allowed to short sell, which could have actually helped stabilize markets by allowing traders to profit from declining prices. **C is incorrect** because early exchanges already existed during tulip mania; they just didn't offer adequate protection to members. Credit risk elimination wouldn't help when fundamental demand disappears - the core problem was not non-payments but having no buyers for the product when the bubble burst. **Learning Objective:** Describe how exchanges can be used to alleviate counterparty risk. **Reference:** Global Association of Risk Professionals. Financial Markets and Products. New York, NY: Pearson. Chapter 5. Exchanges and OTC Markets.
Author: LeetQuiz .
Ultimate access to all questions.
No comments yet.
Dutch tulip mania is considered one of the first major financial bubbles. It occurred in 1636-37 when introduction of tulips imported from Turkey generated extremely high demand which led to an astronomical jump in prices. Tulips were first traded as forward contracts, but the government passed laws allowing certain contracts to be transformed to options contracts. Short selling was strictly prohibited. After the price of tulips rose so high that a single bulb exceeded the cost of an average home, the price collapsed, and many investors went bankrupt. Which of the features of exchange markets listed below would have helped to prevent or mitigate the tulip mania?
A
If Dutch exchanges had allowed only forward contracts, tulip sellers would have been contractually required to pay the full value of the contracts at expiry, which would have minimized speculative trades.
B
By allowing the netting of multiple trades in the portfolio, exchanges help offset the risk from long and short trades, which can decrease potential losses in the portfolio.
C
The main role of an exchange is to enforce payments by counterparties on both sides of the trades, which would have eliminated credit risk for tulip traders.
D
Exchanges offer multiple protection tools that help against counterparty credit risk, but those tools do not protect against economic risk.