Derivative risks: leverage, basis, liquidity, counterparty and systemic

Why do derivatives carry implicit leverage?

The low upfront cash that makes derivatives attractive is the source of their biggest danger. Controlling a large exposure with a small deposit gives a high degree of implicit leverage , even when the user borrows nothing.

$$L = \frac{E}{M}$$

Here E is the exposure (notional value) and M is the cash committed (margin or premium). The return on the cash committed is the price move multiplied by that multiple.

$$R = \frac{E}{M} \times g$$

High leverage invites speculative use : a trader can take a big position with little capital, and losses can arrive fast. The same logic applies to sold options, where the seller can face a loss far larger than the premium received. Markets limit the damage with daily marking to market, collateral, position limits and central counterparties.

What do the other risks look like?

Risks of derivativesthe price of the benefits

• Speculative use Memorize implicit leverage: small outlay, large exposure
• Lack of transparency Use it complex positions few stakeholders understand
• Basis risk Memorize the hedge and the exposure differ in value
• Liquidity risk Memorize the hedge and the exposure differ in cash-flow timing
• Counterparty credit risk Memorize the other side fails to perform
• Systemic risk Memorize leverage and links spread stress across the market

Derivatives give access to exposures that cash markets do not, and the price is complexity. Lack of transparency means stakeholders may not understand the exposure. The risk grows when derivatives are combined or embedded in other securities. Structured notes are debt instruments with one or more embedded derivatives built to achieve an issuer’s or investor’s objective. A note sold to individual investors can cost more, be less liquid and be less transparent than the stand-alone derivative inside it. The investor in a note also bears the issuer’s credit risk on the whole note.

How do basis risk and liquidity risk differ?

Hedgers expect a derivative to offset the exposure closely. Two things can go wrong, and the exam tests the distinction.

• Basis risk is a divergence in value. The derivative references something similar to, but not the same as, the exposure: a broad index against a regional bank-stock portfolio, a different market reference rate, a credit default swap (CDS) spread on an issuer against its actual bond.
• Liquidity risk is a divergence in cash-flow timing. Daily settlement of futures takes cash out each day, while the hedged item may not pay until later. A hedger who cannot meet a margin call has the position closed out and must cover the loss.

	Basis risk	Liquidity risk
What differs	value	timing of cash
Example	jet fuel hedged with crude oil futures	coffee merchant needs margin cash before its stock of beans is sold
Question to ask	do hedge and exposure move together?	does cash arrive when it is needed?

Exam tip A hedge that is right on value but wrong on timing is a liquidity problem, not a basis problem.

Who bears counterparty credit risk?

Counterparty credit risk is the chance that the other side fails to perform. Unlike a loan, where the exposure is the amount lent plus interest, a derivative’s exposure swings with the underlying price, so it needs frequent monitoring.

Counterparty credit riskdepends on the instrument and the market

• Purchased option Memorize only the buyer, once the premium is paid
• Forward Memorize both sides, since either may end up owed money
• Futures and cleared swaps Use it reduced by daily settlement, margin and the clearinghouse

A purchased option shows the pattern. The buyer has paid the premium and depends on the seller to perform if the option finishes in the money. The seller has the premium and has no further claim on the buyer, so the seller bears no credit risk. A forward is different: it can end up in the money for either side, so each party bears the other’s credit risk.

Market type matters too. Daily settlement on exchange-traded contracts cuts credit risk sharply, and exchanges can raise margin or ask for intraday margin on volatile or concentrated positions. In over-the-counter (OTC) markets the credit terms are agreed privately, from no collateral at all to margining similar to futures.

What is systemic risk?

Systemic risk is the risk that excessive risk taking and leverage in derivative markets spread stress across the financial system. Many firms may suffer the same losses at once, or fail to pay each other, and the effect reaches well beyond the firms that took the risk. Heavy derivative use contributed to the stress of the 2008 financial crisis. Reforms since then include central clearing of standardized swaps with futures-like margin, which standardizes and reduces counterparty credit risk.

Go deeper Why structured notes can cost more

A structured note bundles a bond and one or more options. The issuer prices in its own costs and profit, the note rarely trades in a deep market, and an investor selling early may lose any premium paid above face value. To judge a note, compare everything the investor gives up (the premium over face value plus any principal at risk) with the premium on the stand-alone option, then adjust for the extra credit risk and lower liquidity.

Go deeper How margin calls turn into liquidity risk

A futures hedge that is right in value can still hurt. Suppose the hedged commodity sits in a warehouse and will be sold in three months, while the futures lose money each day. The loss on the futures is matched by a gain in the value of the stock, but the gain is not cash until the sale. Raising the margin cash in the meantime can force asset sales at poor prices, which is how a sound hedge can fail.