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Outline the risks that can result from using derivatives.

FRM® Part I · Financial Markets and Products · Introduction to Derivatives · FRM1.FM.4.i

The idea

Derivatives transfer risk but create risks of their own. Counterparty credit risk is the chance the other side defaults when the contract has positive value to you. It is largest in OTC trades and is reduced by clearing, netting and collateral. Leverage magnifies market risk because a small margin controls a large notional. Basis risk arises when the hedge does not move one-for-one with the exposure, for example when it uses a different asset, maturity or grade. Liquidity risk includes funding risk from margin calls and the difficulty of closing a position. Model risk comes from valuing complex products with flawed assumptions, and operational risk from errors and unauthorised trading. Wrong-way risk occurs when exposure rises as the counterparty's credit quality worsens. A sound hedge can still cause a cash crisis.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which risk is the chance that the other party to an over-the-counter derivative fails to make a payment it owes?

  1. Basis riskWhy not: Basis risk is the mismatch between the hedge and the exposure, not default.
  2. Model riskWhy not: Model risk is loss from flawed valuation assumptions, not a counterparty failure.
  3. Funding liquidity riskWhy not: Funding liquidity risk is the inability to meet cash needs such as margin calls, not another party's default.
  4. Counterparty credit risk - correct

Credit exposure on OTC contracts arises when the contract has positive value to one side and the other side may default. Clearing, netting and collateral reduce it.

A harder one

A dealer values an illiquid, complex OTC option with an in-house model that assumes constant volatility, although observed market prices show a pronounced volatility skew. Which risk does this mainly illustrate?

  1. Counterparty credit riskWhy not: The issue is valuation, not the other party's ability to pay.
  2. Model risk - correct
  3. Basis riskWhy not: Basis risk is a hedge mismatch; nothing here involves hedging a different asset.
  4. Settlement riskWhy not: Settlement risk concerns failure at the time of delivery or payment, not valuation.

Complex products are valued by models, and wrong assumptions give wrong values and hedges. This is model risk, made worse when no liquid market prices exist to test the model.

The hardest tier

A firm holds 10,000 units of asset A worth 100 each and hedges by selling futures on a related asset B, one futures per unit of A. Over the hedge horizon, A falls to 92 and the futures price of B falls by 6.50. The net result of the hedged position is closest to:

  1. USD 0Why not: Assumes a perfect hedge, but A and B did not move equally, which is basis risk.
  2. USD -80,000Why not: Counts the loss on A only and ignores the gain on the short futures.
  3. USD -145,000Why not: Treats the futures as a loss of 65,000 as well; a short position gains when prices fall.
  4. USD -15,000 - correct

Loss on A = 8 x 10,000 = 80,000. Gain on short futures = 6.50 x 10,000 = 65,000. Net = -15,000. The leftover is basis risk from hedging with an imperfectly correlated asset.

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