Risks Involved in Financial Derivatives

The risk involved in financial derivatives:

1) Insolvency Risk: The insolvency risk is the probability, for the issuer of the transferable security, that the debtor wilt no longer be able to meet its commitments.

The quality of the issuer of transferable security is very important as the issuer is responsible for the repayment of the initial capital.

2) Interest Rate Risk: The interest rate risk is the risk associated with a change in interest rates in the market resulting in a drop in the financial instrument price.

In the case of fixed-rate investments, such as bonds, the interest rate risk is expressed by the probability that a change in rates will not result in a change in the market price of the bond and, therefore, in a capital gain or loss.

3) Liquidity Risk: The liquidity risk is the probability, for the investor, of encountering difficulties when recouping the whole initial capital invested before the fixed maturity (if there is one). The liquidity of an investment is affected by a number of factors, namely:

  1. The volume of transactions on the market in which the product is traded: prices fluctuate more in a limited market where a large order can result in a significant price variation. The bigger the market, the lower the liquidity risk,
  2. The costs associated with leaving an investment,
  3. The time required to recoup funds (payment risk).

4) Volatility Risk: The volatility risk is the probability that the price of a variable yield investment will fluctuate more or less severely, resulting in a capital gain or loss. Investors will book a capital loss if the price drops and a capital gain if it rises.

5) Exchange Risk: When investing in a currency other than the euro, there is inevitably an exchange or currency risk. The exchange risk is the probability that an adverse trend in the currency being invested in will reduce the return of the investment.

If the trend in the currency is adverse, the return will be eroded following the shortfall in profit due to the conversion to the euro. If the trend is positive, the investment will enjoy a “normal” return, as well as a capital gain due to the favorable exchange rate.

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