Lesson 3 of 6 · 12 min
Risks 1: implicit leverage and lack of transparency
The small cash outlay that makes derivatives efficient also builds in heavy leverage, and the flexibility to combine them can create exposures that stakeholders do not fully understand.
In short
- A small initial outlay for a large exposure means high implicit leverage: small moves in the underlying become large percentage gains or losses on the cash put up.
- Leverage makes speculative use easier and raises the chance of financial distress.
- Sold options can expose the seller to losses far larger than the premium received.
- Counterparty exposure from leverage is controlled with risk management, daily marking to market, collateral, limits and central counterparties.
- Lack of transparency: combinations of derivatives, and structured notes with embedded derivatives, add complexity and may cost more, be less liquid and be less transparent than the stand-alone derivative.
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