As recent years have shown us, the adoption of appropriate risk management processes is a vital part of maintaining a healthy derivatives market. And for all derivatives market participants—from major financial institutions to first-time individual investors—the crucial first step of an effective risk management strategy is simply understanding the different types of risk associated with derivatives trading.

Broadly speaking, the primary risks that accompany trading in derivatives fall into one of four different categories:

Market risk

stock exchangeAlso known as systematic risk, market risk is the general risk associated with any kind of investment; that is, the potential that an individual investor will experience losses as a result of factors that affect the performance of the financial markets overall. For example, a decline in the market that follows a major natural disaster is one instance of market risk; other common sources of market risk include recessions, changes in interest rates, or significant political changes or instability. Market risk cannot be eliminated, even through diversification, but it is possible to hedge against it. A thorough assessment of the risk/reward ratio, which involves balancing potential losses against potential gains, is an important part of market risk management.

Counterparty risk

A type or a sub-class of credit risk, counterparty risk arises when one of the parties in a derivatives contract defaults on the contract and is unable to honor its obligations to the other party. For example, when an investor purchases a put option in an over-the-counter (OTC) transaction, counterparty risk will be introduced if the markets plunge, thus sharply increasing the mark to market value of the put option. Another, simpler example is of an investor who buys a corporate bond from Company X: inherent within this transaction is the risk that Company X, for whatever reason, will not be able to pay the investor the nominal value of the bond at the agreed point of maturity.

All sorts of investors, large and small, experience counterparty risk, particularly those large institutional investors that use transactions such as swaps, equity put options, and other OTC-traded derivatives. The increased risk in OTC transactions arises from the fact that OTC markets have typically been far less strongly regulated than ordinary trading exchanges.

While counterparty risk has always been present, general public awareness of it increased sharply following the 2008 financial crisis. Since that time, institutions of all kinds have been working to increase and improve systems and methodologies for monitoring and, when necessary, mitigating counterparty risk. Many OTC market participants now adopt a structured approach to counterparty risk: a three-step process that involves careful initial selection of counterparties based on such criteria as credit rating and trading experience, the drafting of proper documentation, and appropriate collateral management.

Interconnection risk

A broader type of risk, whose effects were also seen in 2008, interconnection risk refers to the impact that today’s complex interconnections between various derivative instruments and their dealers might have on the particular derivative trade of an investor. Essentially, this type of risk refers to the possibility that when just one party in the derivatives market, such as a major bank acting as a dealer, encounters problems or challenges, a chain reaction or snowball effect could impact the overall stability of the financial market.

Liquidity risk

This type of risk stems from an investment’s lack of marketability, when it cannot be sold or bought quickly enough to minimize or prevent a loss. In other words, liquidity risk is the inability to convert a hard asset or a security to cash without a potentially significant loss of capital or income. It arises when a business or an individual holds a valuable asset that cannot be sold or traded at market value, due either to a lack of buyers or to an inefficient market where it is difficult to connect buyers with sellers.

dollarFor a basic example, consider the situation of an individual who needs to sell his $1 million home, but cannot find any interested buyers due to present market conditions. Liquidity risk would arise if the homeowner is in a position of having to sell the home, even at a significant loss, in order to meet near-term financial demands.

In derivatives markets, liquidity risk is typically reflected in large price movements or in unusually wide bid-ask spreads, which is the amount by which the ask price of an asset exceeds the bid; in other words, the difference between the highest price a buyer is willing to pay and the lowest price that a seller is willing to accept. One of the major challenges of liquidity risk is that it is often self-perpetuating: as liquidity risk increases, investors attempt to sell their holdings at any price, thus widening bid-ask spreads and causing liquidity risk to rise still higher.