What is a Risk?
Risk means potential uncertainty regarding deviation from expected earnings or outcome. Risk tests the volatility an investor wants to take in order to achieve a benefit from an investment.
Risks come from different situations and are of different types. We have liquidity risk, sovereign risk, risk of insurance, business risk, and risk of default. Specific risks exist because of the uncertainty resulting from specific factors that influence an investment or a situation.
Business, counterparty, liquidity, and interconnection risks are the key risks associated with the trading derivatives. Derivatives are investment securities consisting of a contract between the parties whose value derive from and depend on the value of a financial asset that underlies it. Among the most commonly traded derivatives are futures, options, differential bonds, or CFDs, and swaps.
In any investment, market risk applies to the general risk. Investors make decisions and take positions based on assumptions, technical analyses, or other variables that lead to some conclusions about how an investment is likely to be performing. An important part of investment analysis is to determine the likelihood of profitability of an investment and to evaluate the risk/reward ratio of potential losses to potential gains.
Counterparty risk, or credit risk of a counterparty, occurs if one of the parties involved in a derivatives transaction, such as the buyer, seller, or supplier, defaults on the contract. This risk is higher in the markets of over-the-counter, or OTC, which are much less regulated than ordinary exchanges.
Liquidity risk is applicable to investors preparing to close a derivative trade before maturity. These investors need to determine whether closing the trade is difficult, or whether current bid-ask spreads are so broad that they represent a significant expense.