Risks in the Derivative Market

Derivatives are a longstanding form of financial contract that is distinct from a bond, yet it capable of including bonds. It is an explicit agreement between two parties, which creates unique conditions. A stock or bond, by comparison, has a uniform condition set by its type. Because derivatives can be purchased and redeemed by a third-party, it is a target for speculators.

The derivative market is open to random buyers, just like any bond market. The problem and opportunity is every derivative is unique. A person might end up having to juggle hundreds of different agreements if he is a professional trader. On the other hand, each contract might be worth a substantial amount of money or be equivalent to thousands of stock. When a person buys a contract, they gain ownership of the specified property or the specified payment.

A derivative might get around normal trading rules and allow a person to manipulate stock and assets in ways that they otherwise not be able to be sold. People make derivative contracts to sell a product at a fixed price or to lend in exchange for fixed payments. This is common in asset loans, such as cars and homes. If these deals become greater than market prices or revenues, then derivatives can become hot commodities.

A person who purchases a derivative speculates that the terms are preferable to present market value. If that is the case, then they could either reap the dividends or resale a steeply appreciated commodity. On the other hand, the same contract could fall below present market value and therefore become impossible to sell. A trader risks being stuck with a substandard arrangement for the sake of a speculation.

It is easy to manipulate derivatives and take huge risks while often evading laws designed to limit speculation. This was one of the reasons why the housing market built a bubble. Speculation drew in money and created artificially low borrowing conditions. Too much money was applied to the same asset, and the market correction caused a lot of people to lose money. Technically, the money is just tied into deflated housing value, but that money is therefore trapped.

A person who can reasonably predict a market trend can make excellent money by manipulating derivatives. On the other hand, they might be stuck with a substandard asset until the market becomes more favorable. The derivative market prefers someone with experience in their target.

Written by