Lesson 4 of 6 · All lessons in this module
- Benefit 1: transferring risk and creating new exposures
- Benefits 2–4: price discovery, operational and market efficiency
- Risks 1: implicit leverage and lack of transparency
- Risks 2: basis, liquidity, counterparty credit and systemic risk
- How issuers use derivatives: hedging and hedge accounting
- How investors use derivatives, and issuers versus investors
Lesson 4 of 6 · 13 min
Risks 2: basis, liquidity, counterparty credit and systemic risk
A hedge can fail because the derivative's value drifts from the hedged item (basis risk), because cash flows arrive at different times (liquidity risk), because the other side defaults (counterparty risk), or because leverage across the market feeds a crisis (systemic risk).
In short
- Basis risk: the derivative's value differs unexpectedly from the underlying or hedged item, often because it references a similar but not identical price or index.
- Liquidity risk: the derivative's cash flows come at different times from the hedged item's, e.g. daily margin calls before the hedged cash arrives.
- Counterparty credit risk: the other side may fail to pay. A call buyer faces the seller's risk; the seller faces none once the premium is paid. Both sides of a forward face each other's risk.
- Daily settlement on exchanges sharply reduces counterparty risk; OTC terms range from uncollateralised to futures-like margining.
- Systemic risk: excessive leverage and risk taking in derivatives can destabilise markets, as in 2008. Central clearing of swaps is one regulatory response.
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