Risks of derivatives
Investing in derivatives, like any other form of investment, involves various risks. There is always a chance of losing your investment.
When do you have to deal with derivatives?
In daily life we often deal with derivatives such as a CFD and without being aware of it we also use them ourselves. After all, derivatives are ‘derivative products’ that represent an underlying value. This value is determined by a certain event or indirectly by a change in value somewhere else. For example, you can take an option on a house and thereby fix the purchase price. In agriculture, just like with derivatives, price agreements are also made, but then about the harvest with a manufacturer. Likewise, you can consider the fire insurance of a house as a kind of derivative.
What risks are associated with derivatives in particular?
The leverage effect and the liquidity risk are the biggest risks that derivatives entail. By using leverage when buying derivatives, you can take large positions with a relatively small capital. This means that not only the possible profits will be relatively large, but also the possible losses.
Liquidity risk comes into play when a position taken in derivatives leads to a loss and the associated payment obligation. A good example are derivatives linked to pension funds. For example, derivatives of pension funds can get a negative value. This is the result of unfavorable developments in the financial market and a high increase in interest rates and/or a large fall in the euro exchange rate.
The pension fund then builds up a debt towards the other party involved in the transaction in question. Then collateral must be arranged immediately by means of a sum of money or government bonds. The well-known fact that money cannot always be released immediately from the investments made also applies to a pension fund. In economic difficulties, bankruptcy may be looming if a pension fund is no longer able to meet its payment obligation in full. That is why having sufficient liquidity is an important point of attention for anyone who chooses derivatives as an investment form .
Compare brokers and start investing in derivatives
Are you excited about investing in financial derivatives after reading this article? Compare brokers that offer derivatives and find the broker that suits you best!