Trading in derivatives? Check these risk factors

If you are trading in equity derivates or want to trade in it then it is important for you to know what are the risks associated with it.

It can be noted that a derivative is an instrument whose value is derived from the value of one or more underlying, which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc.

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As per the information provided by BSE four most common examples of derivative instruments are Forwards, Futures, Options and Swaps.

Before planning to trade in derivates here are the different types of risks associated with derivative instruments which one needs to know and consider:

1. Credit Risk: These are the usual risks associated with counterparty default and which must be assessed as part of any financial transaction. However, in India the two major stock exchanges that offer equity derivative products have Settlement / Trade Guarantee Funds that address this risk, as per the information provided by BSE.

2. Market Risk: These are associated with all market variables that may affect the value of the contract, for e.g. a change in price of the underlying instrument.

3. Operational Risk: These are the risks associated with the general course of business operations and include:

Settlement Risk 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 Risk arises when a contract is not legally enforceable, reason being the different laws that may be applicable in different jurisdictions - 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.

4. Strategic Risk: These risks arise from activities such as entrepreneurial behavior of traders in financial institutions, misreading client requests, costs getting out of control, trading with inappropriate counterparties.

5. Systemic Risk: This risk manifests itself when there is a large and complex organization of financial positions in the economy. "Systemic risk" 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 risk.