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5 Major Risks in Derivatives Faced by Participants

Created on 30 Nov 2023

Wraps up in 7 Min

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Updated on 06 Feb 2024

5 Major Risks in Derivatives Faced by Participants

Before delving into today's article, let's draw insights from a study conducted by the Securities Exchange Board of India (SEBI).

The study focused on the "Analysis of Profit and Loss of Individual Traders Dealing in Equity F&O Segment." The primary objective was to scrutinise the trading activities of individual investors concerning the net profit/loss incurred by them in the equity F&O segment, specifically for the fiscal years 2019 and 2022.

Now, let's cast our eyes on the following images and peruse the highlighted text for a glimpse into the findings of this study.

Loss makers and profit makers of Derivatives.

Now take a look at this 👇 

Loss makers and profit makers of Derivatives. Insider by Finology

While the images speak for themselves, it's crucial to underscore that the evident magnitude of losses signals a significant level of risk.

The stock market is a big game- like cricket or something where you either hit a six or miss the ball. It's a bit like that in the financial world, where things can go up or down real quick. Now, let's talk about derivatives; it's like playing a special game within the big game. It's fun, but there are tricky parts, like solving a puzzle. These financial instruments, often compared to a double-edged sword, can amplify gains but also expose participants to a host of risks. 

In this article, we're going to look at these tricky parts, the things that can go not-so-great when you're playing this financial game.

Decoding Derivatives 

Before we dive into the risky business, let's understand what derivatives are. They are like financial contracts, and their value depends on something else, like a stock, an index, or a rate. Now, these financial tools, called futures and options, are the special tricks. They can help you play it safe or go big on gains. But here's the thing- they can make your wins bigger, but they can also make your losses bigger. 

Let's begin by checking out the 5 big risks you need to watch out for when you're trading in derivatives.

1. Counterparty Risk: The Domino Effect of Defaults

In the finance game, counterparty risk is a bit like making a deal with someone, and there's this constant worry that they might not hold up their end of the bargain. It's the risk that your financial buddy in the deal might drop the ball, and that could mean money troubles for you.

This risk shows up in all sorts of financial transactions, like loans or agreements where you're supposed to swap cash or assets down the line. Think of derivatives; those are agreements to exchange money or assets in the future. If one party can't deliver, the other might take a hit.

Now, the finance pros have got some tricks up their sleeves to deal with this risk. They might ask for collateral (like a security deposit), make margin calls (basically checking in on things), or do credit assessments (evaluating if the person is financially reliable). Think of it like your friend leaving their favourite toy as a guarantee until the swap happens.

There's also something called central clearing houses. These are like the guardians of finance, stepping in to make sure both sides of the deal stick to their promises. It's a way to lower the risk and prevent a financial mess.

And, oh boy, did we learn a lesson during the 2008 global financial crisis! Big financial players had trouble keeping their promises, and it caused a real stir in the money world. So, keeping an eye on counterparty risk is crucial to avoid those financial hurdles.

2. Price Risk: Riding the Rollercoaster of Market Fluctuations

In the finance world, price risk is like walking a tightrope because it's all about the potential for losing money when the prices of things you've invested in start doing the cha-cha. Investors, businesses, and traders are in the spotlight here, feeling the heat of prices going up and down for stuff like stocks, bonds, commodities, you name it.

Why does this risk party happen? Well, blame it on the market, economic vibes, geopolitics, and other outside factors. Things like interest rate changes, shifts in supply and demand, or surprise global events can throw prices into a dance routine.

To navigate this dynamic landscape, financial experts have some savvy strategies. They might spread their investments around (like not putting all your eggs in one basket), and use fancy tools called derivatives (think options or futures contracts) to hedge their bets. And, of course, they're constantly monitoring the market and economic indicators, akin to financial detectives on the lookout.

3. Liquidity Risk: Navigating the Murky Waters of Market Exit

Liquidity risk reminds me of the backstage drama in the financial world. This is the risk that things might get messy when you're trying to buy or sell stuff quickly and at a fair price. Imagine you've got this cool collectable, and suddenly, it's a hassle to find a buyer without taking a hit on the price.

What stirs up this drama? Well, it's a mix of market vibes, the specific nature of the asset, and the general economic scene. If something isn't traded much or there aren't many folks looking to buy or sell, that's when liquidity risk struts onto the stage.

Now, this risk isn't picky- it can mess with various financial instruments like stocks, bonds, and derivatives. When the market gets jittery, or things are uncertain, liquidity can do a disappearing act. Suddenly, it's harder to make trades, and the gaps between what buyers are offering and what sellers are asking for (bid-ask spreads) get wider.

Financial pros have their backstage tricks to deal with this. They balance having stuff that's easy to turn into cash with other things that might take a bit longer. 

Following that is the...

4. Legal or Regulatory Risk: Navigating the Legal Minefield

Legal or regulatory risk is the unexpected plot twist. It's the chance of facing financial losses or setbacks because of changes in laws, regulations, or legal actions. This risk pops up because the rules of the game, set by the law and regulators, can change, affecting how businesses operate and how they're seen in the legal scene.

Now, this risk wears different hats:

👉 Compliance Risk: The risk of failing to comply with existing laws and regulations, resulting in legal penalties, fines, or other enforcement actions.

👉 Reputational Risk: Adverse legal actions or regulatory scrutiny can harm an entity's reputation, affecting its relationships with customers, investors, and the public.

👉 Policy and Legislative Risk: Changes in government policies or the introduction of new laws and regulations can impact businesses, industries, and markets.

👉 Litigation Risk: The potential for legal actions, lawsuits, or disputes that may lead to financial losses or damage to an entity's reputation.

👉 Enforcement Risk: The risk associated with regulatory authorities enforcing compliance through investigations, audits, or other regulatory measures.

How do businesses and money wizards deal with this? They stay in the loop about legal changes, set up strong rule-following systems, and have legal experts on speed dial. Keeping open lines with regulators helps, too.

Now, let's switch gears a bit. When you dive into derivatives trading, contracts might not always stand strong when unexpected stuff happens. Legal or regulatory risk here is all about the uncertainty of whether these contracts will hold up.

Imagine a scenario where a new rule makes parts of a derivative contract invalid. That's not just a headache for the folks involved; it adds a dash of unpredictability to the market. Regulators, like the SEBI, step in to lay down rules that aim to keep things clear and lower the legal risks in the derivatives market. 

5. Operational Risk: Dodging the Bullets of Fraud and Inadequacy

Operational risk is the risk of financial loss resulting from inadequate or failed internal processes, systems, people, or external events. Unlike other types of risks, operational risk is not solely related to market fluctuations or credit issues but encompasses a broad range of factors that can disrupt or impact the normal functioning of an organisation.

Key components of operational risk include:

👉 Internal Processes and Systems: Inadequacies or failures in an organisation's internal processes and systems can lead to operational risk. This may include errors, fraud, or system breakdowns.

👉 People Risk: Human factors, such as employee errors, misconduct, or inadequate training, contribute to operational risk.

👉 External Events: Events beyond an organisation's control, such as natural disasters, political instability, or cyberattacks, can pose operational risks.

👉 Legal and Regulatory Compliance: Failure to comply with laws and regulations can result in legal actions, fines, and reputational damage, contributing to operational risk.

👉 Technology Risk: Reliance on technology introduces the risk of system failures, cybersecurity threats, and data breaches.

👉 Supply Chain Risk: Disruptions in the supply chain, whether due to geopolitical factors, economic issues, or natural disasters, can impact operations.

Risk mitigation strategies may include implementing robust internal controls, enhancing cybersecurity measures, diversifying supply chains, and conducting regular risk assessments. Financial institutions and businesses often have dedicated risk management functions to address and monitor operational risks proactively.

Derivatives trading isn't just about numbers and charts; it's a battlefield where operational risks lurk in the shadows. From fraudulent activities to inadequate documentation and improper execution, operational risks can manifest in various forms.

Consider the infamous case of the National Spot Exchange Limited (NSEL) scam in India. The exchange's failure, attributed to operational lapses and fraudulent practices, left investors grappling with substantial losses. This episode underscores the importance of robust operational frameworks and vigilant oversight to shield participants from the perils of operational risk.

If you want to read about Enterprise Risk Management, then click here.

The Bottom Line

In the world of derivatives, being careful and thorough is crucial. Counterparty risk, price risk, liquidity risk, legal or regulatory risk, and operational risk are the challenges traders face. Real-world incidents show how these risks can seriously affect financial well-being. Understanding, acknowledging, and actively managing these risks is a must for those using derivatives to build wealth.

Stay sharp, be smart, and you might uncover financial resilience at the end of the risk-filled journey.

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Sakshi Dhakre

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Sakshi is an adventurous spirit who enjoys both the intellectual stimulation of Finance and the sensory experiences of good food and nature’s beauty. She has a passion for delving into complex financial topics and distilling them down into easy-to-understand insights. When she's not poring over financial reports, you might find her exploring a new corner of the city, trying out new restaurants and cuisines or admiring the beauty of the night sky.

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