Risks of Derivatives

Implicit leverage

The implicit leverage in derivatives contracts gives them much more risk than their cash market equivalents. Just as we have shown regarding the leverage of an equity investment on margin, a lower cash requirement to enter a trade increases leverage. Futures margins, according to the CME Group, are typically in the 3% to 12% range, indicating leverage of 8:1 to 33:1. With required cash margin of 4%, a 1% decrease in the futures price decreases the cash margin by 25%.

A lack of transparency in derivatives contracts and securities that combine derivative and cash market exposures (structured securities) may lead to situations in which the purchasers do not well understand the risks of derivatives or securities with embedded derivatives.

Basis risk

Basis risk arises when the underlying of a derivative differs from a position being hedged with the derivative. For a manager with a portfolio of 50 large-cap U.S. stocks, selling a forward with the S&P 500 Index as the underlying (in an amount equal to the portfolio value) would hedge portfolio risk, but would not eliminate it because of the possibility that returns on the portfolio and returns on the index may differ over the life of the forward. Basis risk also arises in a situation where an investor’s horizon and the settlement date of the hedging derivative differ, such as hedging the value of a corn harvest that will occur on September 15 by selling corn futures that settle on October 1. Again the hedge may be effective but will not be perfect, and the corn producer is said to have basis risk.

Liquidity risk

Derivative instruments have a special type of liquidity risk when the cash flows from a derivatives hedge do not match the cash flows of the investor positions. As an example, consider a farmer who sells wheat futures to hedge the value of her wheat harvest. If the future price of wheat increases, losses on the short position essentially offset the extra income from the higher price that will come at harvest (as intended with a hedge), but these losses may also cause the farmer to get margin calls during the life of the contract. If the farmer does not have the cash (liquidity) to meet the margin calls, the position will be closed out and the value of the hedge will be lost.

Counterparty credit risk

We have discussed counterparty credit risk previously. Here we note additionally that different derivatives and positions have important differences in the existence or amount of counterparty risk. The seller of an option faces no counterparty credit risk; once the seller receives the option premium there is no circumstance in which the seller will be owed more at settlement. On the other hand, the buyer of an option will be owed money at settlement if the option is in the money; thus, the buyer faces counterparty credit risk. In contrast, both the buyer and seller of a forward on an underlying asset may face counterparty credit risk.

In futures markets the deposit of initial margin, the daily mark-to-market, and the guarantee of the central clearinghouse all reduce counterparty risk. With forwards there may be no guarantees, or the terms of the forward contract may specify margin deposits, a periodic markto-market, and a central clearing party to mitigate credit risk.

Systemic risk

Widespread impact on financial markets and institutions may arise from excessive speculation using derivative instruments. Market regulators attempt to reduce systemic risk though regulation, for example the central clearing requirement for swap markets to reduce counterparty credit risk.