Risk and reward?

Chapter 1: Intro

The biggest risk in any financial transaction is that you get it wrong. Do your research, look at charts of past performance, read the financial press on risk management – in short, know the risks that you’re taking. It’s vital to minimise these, because there are many other risks that can also trip you up and leave you nursing losses.

Chapter 2: Defaults and counterparty risk

One piece of good news is that much of the risk of default by a counterparty in a transaction has now been mitigated by clearing houses. This means that many derivatives trades, which involve holding securities until the expiration of a contract, are now cleared safely – using sufficient collateral posted up-front, to avoid default.

Chapter 3: Inadequate collateral

Institutional investors are required to set up margin accounts to trade many derivatives. This acts as up-front collateral to cover potential losses on the contract. The biggest danger is that a bet goes badly wrong and there is not enough collateral to cover it. Again, this risk has now been eased by the regulatory obligation to use clearinghouses in much derivatives trade.

Chapter 4: Tighter regulation

Investing in derivatives is now more transparent than it has ever been. Many derivative products came under intense scrutiny because of the global financial crisis, and are now more tightly regulated.

The call to bring more products on to exchanges and the introduction of clearing houses appears to have made the trading environment much safer.

The biggest risk for retail investors is to misunderstand the market of the underlying asset or financial instrument on which their derivative investment is based.