What Are the Main Risks Associated With Trading Derivatives?

Derivatives are investment instruments that consist of a contract between parties whose value derives from and depends on the value of an underlying financial asset. However, like any investment instrument, there are varying levels of risk associated with derivatives.

Among the most common derivatives traded are futures, options, contracts for difference (CFDs), and swaps. This article will cover derivatives risk at a glance, going through the primary risks associated with derivatives: market risk, counterparty risk, liquidity risk, and interconnection risk.

Market Risk

Market risk refers to the general risk of any investment. Investors make decisions and take positions based on assumptions, technical analysis, or other factors that lead them to certain conclusions about how an investment is likely to perform.

While there is not a surefire way to protect against market risk, as all are vulnerable to changes in the market, knowing how much a derivative is impacted by market fluctuations will help investors choose wisely. In reality, an important part of investment analysis is determining the probability of an investment being profitable and assessing the risk/reward ratio of potential losses against potential gains.

Counterparty Risk

Counterparty risk, or counterparty credit risk, arises if one of the parties involved in a derivatives trade, such as the buyer, seller, or dealer, defaults on the contract. This risk is higher in over-the-counter, or OTC, markets, which are much less regulated than ordinary trading exchanges.

A regular trading exchange helps facilitate contract performance by requiring margin deposits that are adjusted daily through the mark-to-market process. The mark-to-market process makes pricing derivatives more likely to accurately reflect current value. Traders can manage counterparty risk by only using dealers they know and consider trustworthy.

Liquidity Risk

Liquidity risk applies to investors who plan to close out a derivative trade prior to maturity. Overall, liquidity risk refers to the ability of a company to pay off debts without big losses to its business. To measure liquidity risk, investors compare short-term liabilities and the company's liquid assets. Firms that have low liquidity risk are able to quickly turn their investments into cash to prevent a loss.

Liquidity risk is also important for investors interested in derivatives to consider. Such investors need to consider if it is difficult to close out the trade or if existing bid-ask spreads are so large as to represent a significant cost.

Interconnection Risk

Interconnection risk refers to how the interconnections between various derivative instruments and dealers might affect an investor's particular derivative trade. Some analysts express concern over the possibility that problems with just one party in the derivatives market, such as a major bank that acts as a dealer, might lead to a chain reaction or snowball effect that threatens the stability of financial markets overall.

The Bottom Line

Like any other investment, derivatives' risk levels are calculated through a mixture of evaluation of the market risk that all investments are susceptible to, counterparty risk if a party involved in the trade defaults, liquidity risk of the actual companies being invested in, and interconnection risk between various derivatives. Whether used for risk management or to grow an investment, they are one of the most popular instruments in financial markets today.