Derivatives: The Risks You Need to Know About

Derivatives took the centre stage in the 2008 financial crisis. Keywords and terms were thrown around – Lehman Brothers, mortgage, bankruptcy, and structured products, just to name a few. No matter which angle people look at the situation from, the financial crisis was brought by risks that could have been avoided.

No investor wants to get caught in ugly situations such as the 2008 financial crisis. A lot of investors lost most of their money, while some were able to survive the situation. How did these people know what to do? How did they see the risks?

What is a derivative?

A derivative is a financial contract. This contract’s value depends on its underlying asset’s performance. If the underlying asset’s price goes up, the value of the contract goes up as well. Pretty simple when you look at it in this manner, but it’s more complicated than it may seem.

Derivatives are attractive to businesses and investors because derivatives allow them to lessen investment risks by entering a derivatives contract.

How can derivatives be used to lessen risk?

Derivatives can reduce losses if used properly. For example, an investor with a huge portfolio of bonds can protect her portfolio by entering a derivatives contract. When this derivatives contract goes up as the bond market falls, it will cut the losses for the investor for this short-term volatility.

Basically, derivatives can be used to hedge on one of your current positions. If one of them is failing, entering a derivatives contract can still give you positive profits.

These are the kinds of risks that derivatives can lessen:

Commodity Risks

Businesses enter futures contracts to reduce the risk related to the volatility of commodity prices. This contract fixes the present price a business is willing to pay in the future. At the other side of the contract, the seller is obliged to sell the commodity at the specified price and date.

This means that if the price on the specified date is higher than the fixed price, the buyer was able to save money. However, if the price is lower, the buyer lost money and the seller gained more.

Have you ever wondered why your favourite coffee shop changes prices from time to time?

Coffee is a commodity. A coffee shop runs on coffee bean supplies. However, coffee supply is unpredictable. Coffee businesses worry about uncontrollable factors. In this case, it’s the weather. To maximise profits, a coffee business can smoothen the risks involved in coffee beans by entering a futures contract with coffee bean suppliers.

Stock Market Risk

Derivatives are also used to decrease the risks of volatile stock market prices. This works with two types of option contracts – calls and puts. The call options owner has the right to buy an asset at a specific price and specific date in the future. It works like Commodity Risks.

Interest Rate Risk

Companies can offset risks related to floating-rate debts by going into derivatives for an interest-rate swap. Swaps are a series of exchanges over an extended period of time. Companies do this to manage risk due to volatile interest rates.

You’re probably familiar with foreign exchange stalls in airports. When you go on a vacation, you will have to exchange your money for the local currency. When you go home, you may still have some notes of that currency left.

Instead of changing it back to your own currency, you can opt to wait for your currency to become stronger versus the currency that you have. By doing so, you will essentially get more money. You have lessened the risk of losing money you initially exchanged on the first day of your vacation.

Credit Risk

Companies are built not solely on the money of their owners but also the money of some lenders. In a sense, if you are investing in a company that has debt, you are also owners of that debt. Investors who own debts of a company are exposed to credit risk.

Credit risk is the possibility for the company to default on the debt, making you lose your money as an investor. Investors lessen this risk by entering into credit default swaps. They hedge their investments by entering positions into the company’s corporate bonds.

To understand derivatives better, you can look at it in this way: Entering derivatives is a way for you to diversify risk or transfer some of your deployed money to safer places. By doing so, you will lessen the possibility of losing money.

If derivatives lessen risks, why are they perceived as risky investments?

Just like anything, if used too much, it becomes dangerous.

In 2002, Warren Buffett sent a letter to Berkshire Hathaway shareholders, saying that derivatives were “financial weapons of mass destruction.”

According to Buffett, the reasons behind his statements were the abundance of credit risk and the lack of collateral to save possible losses. True enough, these became painfully evident during the 2008 financial crisis.

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What are the types of risks in derivatives?

Derivatives are notorious for a reason. Before entering derivatives, check out these risks first and see if you and your portfolio can handle them.

Market Risk

This refers to the general risk in any kind of investment. Investors base their decisions on different factors – technical analysis, fundamental analysis, and assumptions. Some even base it on luck – which is also a kind of risk.

An essential part in investing is knowing your risk-reward ratio and acknowledging that there will always be market risk. As an investor, you have to ask: What are the risks involved in this investment? If I risk this much, how much will I gain? Is my risk-reward ration worth pursuing? What kinds of investing mistakes am I prone to if I go through with this?

Derivatives, just like any type of investment, are prone to market risks. Remember that derivatives rely on the performance of another market. Thus, it carries the risk of that specific market as well.

Counterparty Risk

Counterparty risk happens when one side of a derivatives trade – whether it’s the buyer or seller – defaults on the contract. Basically, it’s the risk of not having anyone to trade with anymore.

This is highly evident in over-the-counter contracts that are not regulated properly. This played a vital role in the 2008 financial crisis with the housing market wherein people who couldn’t afford houses were allowed to take loans on unreasonable grounds. Eventually, these borrowers had to default on the agreement. If this happens on a massive volume, you get the 2008 financial crisis.

Liquidity Risk

Liquidity risks are present for investors who want to finish a trade before its maturity. However, doing so presents large bid-ask spreads and may lead to inefficient, large costs.

Interconnection Risks

Remember that derivatives rely on its underlying assets’ performance. Aside from its assets, it is also affected by external grounds. External factors and all the assets in a derivative are all inevitably interconnected.

One market can greatly affect what happens to another market, and that market affects another market, and so on. If an investor is in this situation, it is possible for her to lose her whole investment.

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What can you do to lessen the risks involved with derivatives?

It’s good to know that during a crisis, some investors were able to save their money because they were aware of the risks involved in different types of markets. Derivatives are not entirely bad investments. Just like any kind of investment, derivatives can be used to lessen risk. However, if abused on a massive scale, it can cause risks that can lead to history-changing events like the 2008 financial crisis.

If you want to invest in derivatives, you must first be aware of all the risks involved – the good and the bad. There are good risks and there are bad risks. Make sure that you only enter good risks that will strengthen your investment portfolio.

Ultimately, bad derivatives are only bad because they are unregulated. Never enter derivatives contracts without having a centralised counterparty who will manage the trades between the buyer and the seller. You need this central entity to ensure that no matter what happens, someone on the other side will complete the transaction.

Risk is part of any kind of investment. There is no way to eliminate risks, but you can always lessen them. Remember: The more you learn, the more you earn. So, take time to learn a lot about derivatives and its underlying assets. You may just hit the jackpot with them, or they can ruin everything for you. At the end of the day, the decision will always be yours.

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