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Explanation:
Warren Buffett specifically pointed out a critical risk of derivatives as their potential to induce significant liquidity problems. Particularly, (rating) downgrade triggers in derivative contracts can demand higher collateralization at critical moments, leading to unexpected, substantial cash demands on a company. This requirement can strain a company's financial resources, potentially triggering further downgrades and intensifying financial distress, creating a downward spiral in the firm's financial health.
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Q.6153 In the wake of the Global Financial Crisis (GFC), a risk manager is evaluating the complex landscape of derivatives, mindful of Warren Buffett's characterization of these instruments as "financial weapons of mass destruction." The manager is focused on dissecting the subtle, yet potentially severe, risks that derivatives could introduce to a firm's financial stability. Which of the following statements most precisely articulates one of the significant risks tied to derivatives, as underscored by Warren Buffett?
A
Derivatives can inadvertently lead to interest rate mismatches, potentially exposing firms to significant interest rate volatility risks.
B
Derivatives, with their inherent counterparty risk, necessitate a substantial initial investment, which can tie up significant capital resources.
C
Derivatives can induce liquidity crises due to (rating) downgrade triggers, necessitating firms to meet unexpected cash demands during critical periods.
D
Derivatives might expose firms to foreign exchange risk, especially when the underlying assets are denominated in different currencies.