A recent cascade of studies has focused on the risks associated with derivatives.
The studies, conducted by international financial experts and U.S. federal regulators, generally conclude that the risks thus far appear manageable.
What are these risks? How are they measured? How are they being managed? U.S. federal regulators are concerned about the extent to which derivatives may contribute to "systemic risk," or the risk that the default of a major counterparty firm or some other disruption in the derivatives market will spill over into other financial markets and ultimately affect the entire global financial system. Their concerns arise in part from the fact that derivatives further the linkages between the stock, bond, currency, and other financial markets.
In addition, derivatives are subject to the same kinds of risks as other financial products - credit, market, liquidity, settlement, and legal risks, according to the studies.
Credit risk is the risk that a counterparty in a derivatives transaction will fail to fulfill its obligations under the contract, thereby causing the other party to suffer a loss.
Typically, the credit exposure to the holder of a derivatives contract is measured by the replacement Cost of that contract. Credit risk can be monitored by marking to market derivatives contracts on a daily basis.
Participants in the derivatives market can limit credit risk by dealing with reputable counterparty firms that have high credit ratings, according to the studies.
They can also participate in netting arrangements, which govern the procedures to be taken if the counterparty defaults. A netting arrangement would specify how derivatives transactions are to be settled or liquidated, and would require the failed counterparty to take the net value of its payments and receipts from multiple transactions with the same party.
Market risk is the risk that the market will change and adversely affect the value of a derivative product. Hedging can reduce market risk, but it can also increase credit risk to the extent a firm covers, rather than unwinds, its existing position by taking on a new position with a new counterparty.
Liquidity risk is the risk that a derivative product or position cannot be sold or covered without a substantial loss. Hedging techniques can hamper liquidity by triggering sales or purchases when prices fall or rise.
Settlement risk is the risk that an operational problem, such as a computer malfunction, or a more serious problem, such as the default of a counterparty, will disrupt the payments that are to be made under a derivatives contract.
Legal risks include a variety of risks, such as whether a state or local government has the authority to participate in a derivatives transaction, whether the transaction meets securities and tax law requirements, and whether netting arrangements are legally enforceable.
