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Derivatives – Financial instrument

Derivatives – Financial instrument

Derivatives: A derivative is a financial instrument which derives its value from some

other financial price. This ‘other financial price’ is called the underlying.

The most important derivatives are futures and options. Here we will discuss derivatives as financial derivatives and embedded derivatives.

Derivatives – Financial instrument

Before discussing the different derivatives, you should understand the various risks associated with them. The different types of derivative risks are:

(a) Credit risk: Credit risk is the risk of loss due to counterparty’s failure to perform on an obligation to the institution. Credit risk in derivative products comes in two forms:

(i) Pre-settlement risk: It is the risk of loss due to a counterparty defaulting on a contract during the life of a transaction. The level of exposure varies throughout the life of the contract and the extent of losses will only be known at the time of default.

(ii) Settlement risk: It is the risk of loss due to the counterparty’s failure to perform on its obligation after an institution has performed on its obligation under a contract on the settlement date. Settlement risk frequently arises in international transactions because of time zone differences. This risk is only present in transactions that do not involve delivery versus payment and generally exists for a very short time (less than 24 hours).

Derivatives – Financial instrument

(b) Market risk: Market risk is the risk of loss due to adverse changes in the market value (the price) of an instrument or portfolio of instruments. Such exposure occurs with respect to derivative instruments when changes occur in market factors such as underlying interest rates, exchange rates, equity prices, and commodity prices or in the volatility of these factors.

Derivatives – Financial instrument

(c) Liquidity risk: Liquidity risk is the risk of loss due to failure of an institution to meet its funding requirements or to execute a transaction at a reasonable price. Institutions involved in derivatives activity face two types of liquidity risk : market liquidity risk and funding liquidity risk.

(i) Market liquidity risk: It is the risk that an institution may not be able to exit or offset positions quickly, and in sufficient quantities, at a reasonable price. This inability may be due to inadequate market depth in certain products (e.g. exotic derivatives, long-dated options), market disruption, or inability of the bank to access the market (e.g. credit down-grading of the institution or of a major counterparty).

(ii) Funding liquidity risk: It is the potential inability of the institution to meet funding requirements, because of cash flow mismatches, at a reasonable cost. Such funding requirements may arise from cash flow mismatches in swap books, exercise of options, and the implementation of dynamic hedging strategies.

(d) Operational risk: Operational risk is the risk of loss occurring as a result of inadequate systems and control, deficiencies in information systems, human error, or management failure.

(e) Legal risk: Legal risk is the risk of loss arising from contracts which are not legally enforceable (e.g. the counterparty does not have the power or authority to enter into a particular type of derivatives transaction) or documented correctly.

(f) Regulatory risk: Regulatory risk is the risk of loss arising from failure to comply with regulatory or legal requirements.

(g) Reputation risk: Reputation risk is the risk of loss arising from adverse public opinion and damage to reputation.

Derivatives – Financial instrument

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