What are the main risk associated with derivatives trading
Since its emergence as an organised sector of financial trade, the trade in Derivatives has seen tremendous growth. Such a rapid pace of growth has often led to the trade outpacing its regulation. The speculative nature and confusion due to its complexity have drawn the ire of critics. The in-depth knowledge of complex financial mechanisms required for this kind of trade often leaves unwary traders vulnerable to several risks arising from various circumstances involving the trade. These risks are categorised according to the circumstances in which they occur.
- Counterparty risk refers to the likelihood of one party of a Derivatives contract failing to meet their obligation to fulfil the contract or refusing to do so.
- Counterparty risks are higher on Derivatives traded on Over Counter (OTC) markets.
- Counterparty risk can be mitigated by trading through exchanges that require maintaining margin deposits from both parties and are much more regulated.
- Market risk refers to the general risk of financial loss due to fluctuations in the market. That can be further divided into interest rate risk, price risk and exchange rate risk.
- Interest rate risk refers to the possibility of financial loss due to fluctuations in interest rates of Derivatives such as Swaps.
- Exchange rate risk is the financial loss due to fluctuations in exchange rates of products such as foreign currency.
- Price risk refers to the possibility of financial loss due to price fluctuations of underlying assets of Derivatives such as Futures, Forwards and Options.
- Liquidity risk is the probability of financial loss due to early exercise of Derivatives.
- It generally applies to companies whose assets have low liquidity, i.e. they cannot be easily turned into cash for short term use.
- Working risk is the risk of financial loss due to disruption of the business's day-to-day working.
- Working risk occurs due to faulty procedures and policies, employee errors, failure of tech systems, criminal activity and new technology.
- When Derivatives are measured according to inaccurate paradigms, they are priced incorrectly. Loss resulting from this is called paradigm risk.
- Legal risk occurs due to legal obstacles that result in the default by one or more parties being unable to sign, enforce or fulfil a contract.
- Agency risk arises when an intermediary who makes a trade on Derivatives on behalf of an individual or institution, called a principal, makes trade contrary to the principal's interests.
- Leverage risk refers to the slight change in price that one party may use to its benefit at the cost of loss to another party. That can also be called arbitrage risk.
- Derivatives as financial instruments have long had a reputation of volatility. This reputation has led to a widespread perception of Derivatives as vulnerable.
- Systemic risk refers to the possibility of a country or global economic failure due to a loss of the Derivatives trade.
- Clearance risk refers to the failure of one party to fulfil an agreement despite their willingness to do so due to unforeseen circumstances.
- Clearance risk occurs in international trade usually.
Additional read: How to Manage Risk While Trading in Derivatives
Derivatives trade can be quite risky, as we see above. However, these can be mitigated with informed practices and careful consideration of such risks, just like any other form of trade prevalent in modern finance. Ultimately it is up to the investors and traders to consider and avoid risks.
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