The primary risks associated with trading derivatives are market, counterparty, liquidity and interconnection risks. Derivatives are investment instruments that consist of a contract between parties whose value derives from and depends on the value of an underlying financial asset. Among the most common derivatives traded are futures, options, contracts for difference, or CFDs, and swaps.
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Market Risk-Market risk refers to the general risk
in any investment. Investors make decisions and take positions based on
assumptions, technical analysis or other factors that lead them to
certain conclusions about how an investment is likely to perform.
Liquidity Risk-Liquidity risk applies to
investors who plan to close out a derivative trade prior to maturity. Such
investors need to consider if it is difficult to close out the trade or if
existing bid-ask spreads are so large as
to represent a significant cost.
Counterparty Risk-Counterparty risk, or counterparty
credit risk, arises if one of the parties involved in a derivatives trade, such
as the buyer, seller or dealer, defaults on the contract.
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This risk is
higher in over-the-counter, or OTC, markets,
which are much less regulated than ordinary trading exchanges.
A regular
trading exchange helps facilitate contract performance by requiring margin
deposits that are adjusted daily through the mark-to-market process.
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