Risks of Derivatives

There are certain risks associated with derivative contracts:

1. Market Risk: Derivatives are exposed to movements in the underlying asset prices. If the market moves against the predicted direction, investors can incur significant losses. This risk is inherent due to the volatile nature of markets.

2. Counterparty Risk: As derivatives involve two parties (buyer and seller), there is a risk that one party might default on its obligations. Counterparty risk increases the potential for financial loss if the other party fails to fulfill the terms of the derivative agreement. This mostly happens in case of the forward contracts where no third party is involved in monitoring the trading.

3. Liquidity Risk: Certain derivatives lack liquidity which makes it difficult to trade them quickly at a fair price. Illiquid markets can result in wider bid-ask spreads and may lead to difficulties in executing trades.

4. Operational Risk: In the derivatives contracts, sometimes certain errors might occur in the processing or exercising phase, technological failures, or other operational issues that can lead to financial losses. Operational risk is associated with the infrastructure and processes supporting the transactions.

5. Basis Risk: The basis risk occurs when the relationship between the derivative and its underlying asset diverges unexpectedly. Basis risk can occur due to differences in interest rates, maturities, or other factors, leading to unexpected financial outcomes.

6. Interconnection Risk: There is a risk association in the relationship or interconnection between the different derivatives contracts and the dealers (e.g., banks). As per analysts, if only one party is involved (a major bank) that deals with the derivatives, might cause a snowball effect or chain reaction that would disturb the stability of the overall financial market.

Derivatives are a form of special financial instrument where the value of these instruments is derived from an underlying asset or an index. As the name goes, derivatives are linked to some form of financial instrument, indicator, or commodity. Some commonly used assets include stocks, bonds, commodities, currencies, and market indices. Initially, these underlying assets are created using any individual security or a combination of securities. As the value of these securities changes, the value of the derivatives also keeps changing. Derivatives are those complex instruments used in trading risk in the financial markets by either hedging, speculating, or arbitraging. Derivatives form the basic concept under consideration in financial engineering. The primary purpose of derivative contracts is to generate profit by speculating the future value of the underlying asset.

Geeky Takeaways:

• Derivatives are financial contracts where the value is determined based on the underlying stocks, bonds, commodities, or certain market indices. In simple words, predicting and agreeing to a future value of an underlying asset.
• These financial contracts are used by hedgers, speculators, arbitrageurs, and margin traders for risk management, hedging, speculation, and arbitrage among different markets.
• Derivatives are traded in two platforms either via over-the-counter (OTC) trading or via a standardized exchange.
• These contracts can take either simple or complicated forms of options, futures, forwards, swaps, or warrants.