Risks[edit]

See also: List of trading losses

The use of derivatives can result in large losses because of the use of leverage, or
borrowing. Derivatives allow investors to earn large returns from small movements in the
underlying asset's price. However, investors could lose large amounts if the price of the
underlying moves against them significantly. There have been several instances of
massive losses in derivative marets, such as the following:
!merican "nternational #roup $!"#% lost more than &S'() billion through a
subsidiary over the preceding three *uarters on credit default swaps $+DSs%.
,-./ The &nited States 0ederal 1eserve 2an announced the creation of a
secured credit facility of up to &S'). billion, to prevent the company's
collapse by enabling !"# to meet its obligations to deliver additional
collateral to its credit default swap trading partners.,-3/
The loss of &S'4.5 2illion by Soci6t6 #6n6rale in 7anuary 588) through mis9
use of futures contracts.
The loss of &S'3.: billion in the failed fund !maranth !dvisors, which was
long natural gas in September 5883 when the price plummeted.
The loss of &S':.3 billion in the failed fund Long9Term +apital ;anagement
in (<<).
The loss of &S'(.- billion e*uivalent in oil derivatives in (<<- and (<<: by
;etallgesellschaft !#.,-4/
The loss of &S'(.5 billion e*uivalent in e*uity derivatives in (<<. by 2arings
2an.,-)/
&2S !#, Swit=erland's biggest ban, suffered a '5 billion loss through
unauthori=ed trading discovered in September 58((.,-</
This comes to a staggering '-<.. billion, the ma>ority in the last decade after the
+ommodity 0utures ;oderni=ation !ct of 5888 was passed.
Counter party risk[edit]
Some derivatives $especially swaps% e?pose investors to counterparty ris, or ris arising
from the other party in a financial transaction. Different types of derivatives have
different levels of counter party ris. 0or e?ample, standardi=ed stoc options by law
re*uire the party at ris to have a certain amount deposited with the e?change, showing
that they can pay for any losses@ bans that help businesses swap variable for fi?ed rates
on loans may do credit checs on both parties. However, in private agreements between
two companies, for e?ample, there may not be benchmars for performing due diligence
and ris analysis.
Large notional value[edit]
Derivatives typically have a large notional value. !s such, there is the danger that their
use could result in losses for which the investor would be unable to compensate. The
possibility that this could lead to a chain reaction ensuing in an economic crisis was
pointed out by famed investor Aarren 2uffett in 2ershire Hathaway's 5885 annual
report. 2uffett called them 'financial weapons of mass destruction.' ! potential problem
with derivatives is that they comprise an increasingly larger notional amount of assets
which may lead to distortions in the underlying capital and e*uities marets themselves.
"nvestors begin to loo at the derivatives marets to mae a decision to buy or sell
securities and so what was originally meant to be a maret to transfer ris now becomes a
leading indicator.$See 2ershire Hathaway !nnual 1eport for 5885%
The different types of riss associated with derivative instruments are as follows:
+redit 1is : These are the usual riss associated with counterparty default and
which must be assessed as part of any financial transaction. However, in "ndia the
two ma>or stoc e?changes that offer e*uity derivative products have Settlement B
Trade #uarantee 0unds that address this ris
;aret 1is : These are associated with all maret variables that may affect the
value of the contract, for e.g. ! change in price of the underlying instrument.
Cperational 1is : These are the riss associated with the general course of
business operations and include:
Settlement 1is arises as a result of the timing differences between when
an institution either pays out funds or deliverables assets before receiving
assets or payments from a counterparty and it occurs at a specific point in
the life of the contract.
Legal 1is arises when a contract is not legally enforceable, reason being
the different laws that may be applicable in different >urisdictions 9
relevant in case of cross border trades.
Deficiencies in information, monitoring and control systems, which result
in fraud, human error, system failures, management failures etc. 0amous
e?amples of these riss are the Dic Lesson case, 2arings' losses in
derivatives, Society #eneral's debacle etc.
Strategic 1is : These riss arise from activities such as:
Entrepreneurial behavior of traders in financial institutions
;isreading client re*uests
+osts getting out of control
Trading with inappropriate counterparties
Systemic 1is : This ris manifests itself when there is a large and comple?
organi=ation of financial positions in the economy. FSystemic risF is said to arise
when the failure of one big player or of one clearing corporation somehow puts all
other clearing corporations in the economy at ris. !t the simplest, suppose that
an inde? arbitrageur is long the inde? on one e?change and short the futures on
another e?change. Such a position generates a mechanism for transmission of
failure 9 the failure of one of the e?changes could possibly influence the other.
Systemic ris also appears when very large positions are taen on the CT+
derivatives maret by any one player. Deither of these scenarios is in the offing in
"ndia. Hence it is hard to visuali=e how e?change traded derivatives could
generate systemic ris in "ndia.
other ( is
1. Issuer default risk
"n the event that a derivative product issuer becomes insolvent and defaults on their listed
securities, investors will be considered as unsecured creditors and will have no
preferential claims to any assets held by the issuer. "nvestors should therefore pay close
attention to the financial strength and credit worthiness of derivative product issuers.
2. Uncollateralised product risk
&ncollateralised derivative products are not asset baced. "n the event of issuer
banruptcy, investors can lose their entire investment. "nvestors should read the listing
documents to determine if a product is uncollateralised.
3. Gearing risk
Derivative products such as derivative warrants and callable bullBbear contracts $+22+s%
are leveraged and can change in value rapidly according to the gearing ratio relative to
the underlying assets. "nvestors should be aware that the value of a derivative product
may fall to =ero resulting in a total loss of the initial investment.
. !"piry considerations
Derivative products have an e?piry date after which the issue may become worthless.
"nvestors should be aware of the e?piry time hori=on and choose a product with an
appropriate lifespan for their trading strategy.
#. !"traordinary price $ove$ents
The price of a derivative product may not match its theoretical price due to outside
influences such as maret supply and demand factors. !s a result, actual traded prices can
be higher or lower than the theoretical price.
%. &oreign e"c'ange risk
"nvestors trading derivative products with underlying assets not denominated in Hong
Gong dollars are also e?posed to e?change rate ris. +urrency rate fluctuations can
adversely affect the underlying asset value, also affecting the derivative product price.
(. Li)uidity risk
The E?change re*uires all derivative product issuers to appoint a li*uidity provider for
each individual issue. The role of li*uidity providers is to provide two way *uotes to
facilitate trading of their products. "n the event that a li*uidity provider defaults or ceases
to fulfill its role, investors may not be able to buy or sell the product until a new li*uidity
provider has been assigned.
*. +arket risk
Derivative Hroducts may also be e?posed to the economic, political, currency, legal and
other riss of a specific sector or maret related to the single stoc, baset of stocs,
inde?, currency, commodity or futures contract that it is tracing