What are derivatives?
Derivatives refer to the contracts whose value is derived from the value of an underlying financial instruments like stocks, bonds, currency, commodities and indices. They are used for various purposes like hedging against risk, speculating on price movements, or gaining exposure to different markets.
Derivatives Contracts can be traded on various Exchanges, and they allow investors to manage risk exposure or speculate on market movements. However, due to their leveraged nature, they can also amplify losses if the market moves against the position taken. These contracts are extensively used in financial market by investors, companies, and institutions to manage risk or gain exposure to different assets and markets.
RISK OF DERIVATIVES
Some of the key risks associated with derivatives includes:
- Market Risk: Derivatives are sensitive to changes in the value of the underlying assets. Market fluctuations, volatility, and unexpected price movements can lead to losses.
- Leverage Risk: Derivatives often allow investors to control a large position with a relatively small investment. While this can amplify profits, it also magnifies losses. Even a small adverse movement in the market can result in substantial losses.
- Liquidity Risk: Some derivative markets may lack sufficient liquidity, meaning it could be challenging to buy or sell contracts without significantly impacting their prices. This can make it difficult to exit positions quickly or at desired prices.
- Operational Risk: Errors in trade execution, technological failures, or inadequate processes within firms handling derivatives can lead to significant losses.
Understanding and managing these risks are crucial for investors and institutions involved in derivatives trading.
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