Key Risks Associated with Derivatives

In this section, we will explain the risks involved in derivative products. These are (1) Counterparty Risk, (2) Investment Risk of the Underlying Asset, (3) Early Redemption & Potential Capital Loss Risk, (4) Liquidity Risk, (5) Interest Rate Risk, and (6) Leverage Risk.
(1) Counterparty Risk
Derivative products are issued by third parties, such as listed companies or financial institutions, which we usually refer to as “issuers”. If these organizations encounter financial problems and this leads to a decrease in their credit rating, or if they collapse because of solvency problems, the derivative products’ values will be affected and may even lose all value.
(2) Investment Risk of the Underlying Asset
The prices of derivative products’ depend on the value of their underlying assets. Normally, fluctuations in the underlying assets’ price will directly affect the prices of their derivative products.
(3) Early Redemption & Potential Capital Loss Risk
Regardless of whether the investor chooses to redeem early, or the issuer has to terminate the products because of early redemption, this action may cause the investor to lose money because they may receive an amount less than they invested. Therefore, attention should be paid to the early redemption provision, and consider if it would affect the amount you invest.
(4) Liquidity Risk
Generally speaking, this risk is related to whether or not the derivative products can be easily sold and converted into cash. Before expiry, some derivatives products may be harder to sell and subsequently converted into cash. If it is not possible to sell them, you will have to wait until the derivative products reach their expiry date before you can get your funds back. If your funds have to be ready to use at any time, please pay special attention to this risk.
(5) Interest Rate Risk
The fifth risk is the Interest Rate Risk. Any derivative
products are ultimately exchanging an “asset” and “money”, or exchanging two currencies. The fact is that “money” is necessarily linked to interest rates; therefore, interest rate changes will affect the prices of derivative products.
(6) Leverage Risk
Consider that although you may only observe small movements in the stock market (or foreign exchange market), their derivative products’ prices may exhibit more drastic changes