What is a derivative?
Let’s start by revisiting the definition of derivative products and list some of the most popular ones. A derivative is a financial security. Its value is derived from one or more underlying assets.
A derivative is essentially an agreement between two or more parties based on the previously mentioned assets. The price is determined by the oscillations in the underlying assets. Some of the most common underlying assets – or markets – are indexes, bonds, stock commodities, interest rates and Forex.
There are two ways to trade derivatives, each holding particular characteristics. The most common form of trading derivatives is over-the-counter (OTC). These are largely unregulated and can be considered to be riskier. The other option is to trade through an exchange. This option gives greater security and aims to provide a more organised and consistent experience.
The market risk
Market risk refers to the general risk on an asset or a portfolio to overall market price movements. These so-called movements include inflation, interest rates, currency, and equities.
Traders or investors will try to forecast the performance of a given asset. This forecast is based on their financial analysis, probability or other external factors that influence profitability. From those forecasts they are able to determine the risk/reward ratio of the potential gains versus potential loss.
The time risk
All derivative contracts have a pre-defined duration or expiry date. These contracts expire as soon as the defined duration limit drives them to term. If the investment doesn’t complete the expected goals within the duration limit, this can result in financial losses.
The leverage risk
Leverage allows a trader to make trades with a larger value than the originally invested capital. The use of leverage magnifies the effect – of either profit or loss – on the position’s value. For example, should the value of the underlying asset drop, that will result in the need to borrow funds to cover the loss.
Liquidity risks appear when an investor decides to end a trade before its full maturity. Treading down that path triggers important bid-ask spreads, which could incur significant costs or even lead to capital loss.
The counterparty risks
Counterparty risk arises if one of the parties involved in a derivatives trade does not live up to their contractual obligation. The faulting party could be the seller (like a bank), the dealer (such as a broker), or the buyer (like a trader).
The risk lies in the cumulative loss to the financial system from a counterpart that fails to deliver on its OTC derivative obligation. In other words, if one counterparty drops out or goes bankrupt. Derivatives contain by far the widest variety of counterparty risks as they are much less regulated than ordinary trading exchanges.
Continuously successful trading in derivatives can be tricky and requires both practice and focus. Before you dive into derivatives and risk management, you may want to test your knowledge. You can do so on our Investmate app. After all, it’s never a bad idea to refresh your knowledge of finance.