Risks of Derivatives

Risks of Derivatives- Heavy investments are on the line when using derivatives. If not played with carefully, the firm may incur a huge loss. There are seven categories of risks associated with derivatives.

• Counterparty credit risk: Default by counterparty resulting in a financial loss to the other party. Credit risk is measured by the cost of replacing cash flows in the market and not by the notional amount of the contract.
• Price risk or market risk: The risk of change in the price of derivative which is related to the price risk of the underlying instrument.
• Settlement risk: Payment of funds by one party in a financial transaction to the other party before receiving its own cash or asset.
• Liquidity risk: Risk of default by counterparty and resulting loss.
• Operating risk: The risk of operating a commercial bank which arises an account of inadequate internal controls by the management of derivatives which are quite complex; the difficulty of valuation of derivatives which rely on sophisticated mathematical models and regulatory risk in terms of changes in accounting procedures, capital adequacy, restrictions on banking practices that may be imposed by regulators in view of the explosive growth of derivatives.
• Legal risk: In OTC instruments since rights and duties are not clearly defined.
• Aggregation risk: Occurs in derivative instruments in view of the number of markets and instruments and their interconnections. The risk to individual parties in such transactions is difficult to assess.

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