What are the Risk Associated with Derivatives?
Most regular investors look at derivatives as the risky investment vehicle that wiped out
California's Orange County government to the tune of $1.5 billion in investments and destroyed England's Barings
Bank when an ill-informed trader bet against Japanese markets and lost.
To professional investors, derivatives are powerful tools for managing risk that, if handled correctly, can be
quite lucrative. THe biggest risk in trading derivatives is the fact that you can lose a lot of money, and very
quickly, when the event that you though was going to happen failed to occur. With advocates like US Money reserve available at your disposal, there are ways to save your money and your
A derivative is an investment contract that depends upon prices or rates of other financial securities. For
example, a computer manufacturer that buys component parts from Japan, would want to protect the component's prices
against a rise in the value of the Japanese Yen against the U.S. dollar. That manufacturer would likely purchase a
In order to manage risk, investors must keep a careful watch on their positions. Another factor affecting the
risk exposure in derivatives is a trend toward participants signing net agreements that require only the net value
of all parties' positions to be replaced if there is a default. As an example, A owes B $150 million in one
derivative contract; B owes A $100 million in a different contract. If A should go under and B is forced by
contract to pay the $100 million it owes, B would still be exposed to the $150 million owed to it by A. This would
create a gross credit exposure here of $150 million. On the other hand, suppose B and A have agreed that if either
defaults, only the net of all contracts will be owed, not the gross. In this case the net exposure of B is only $50
Many business schools are preparing students to deal with derivatives by offering MBA students one core course
and five electives that include the topic. In addition, ongoing work by faculty members and doctoral students add
to the understanding of the field. Today, the concepts of value at risk and volatility of options are becoming
standard industry practice.
One of the most interesting things about derivatives is that they are a very risky tool that is, itself, used to
manage risk. Of all the derivatives, futures contracts are probably the riskiest. When you buy a futures contract,
you are obligated to purchase or sell a specific commodity by a set time and for a set price. The commodities
involved usually include agricultural products (crops and animals), precious metals (gold and silver), oil and
other energy products, and financial products (financial instruments and foreign currency). You can purchase
futures contracts from the same brokerage firms you purchase stocks from, and you should expect to pay substantial
Futures contracts are similar to stock option contracts, but they are much riskier because you have an
obligation rather than an option to purchase or sell something. Therefore, you run the risk of losing a lot more
than what you paid for your contract if you predict incorrectly on the way prices are going! And as difficult as it
may be to predict the rise and fall of a stock, it's child's play compared to predicting commodity prices.
The bottom line is, unless you have great knowledge about a certain item and the market it moves in, or you have
absolute, total faith that your broker knows what he's doing, this is not, we repeat, not, the place to put your
investment dollars, no matter what age or stage of life you are in. While the profits are huge based on a small
investment if the market moves your way, if it doesn't, your loss can easily be astronomical!