Derivatives Risk

From Financial Literacy Wiki

Derivatives risk is just a collective term for all risks involve in using derivatives. Risks associated with derivatives are similar to the risk of securities like market risk and liquidity risk. Derivatives also have credit risk or default risk. Since a derivative is a contract between two parties, there is a risk that one party may defaults.

Most of the unit trusts use derivatives for hedging and tactical asset allocation.

Unit trusts that invest in derivatives usually need to deposit a sum of money for initial margin in their derivatives' trading account. They are also required to, at a short notice, to put in additional deposits when the market moves against the investment position. With this in mind, if the fund managers did not make provision for these, some investments may have to be liquidated at a loss to meet the required margin in the account. This may affect the price of unit trust.

To limit the exposure to the risk mentioned above, there are investment controls and restrictions for the fund managers that are listed in prospectuses. For example, one control is that derivatives should be undertaken for the purpose of reducing risk or costs. For example, Page 16 of the Prospectus of UOB Gold and General Fund states:

"The manager shall only be permitted to use derivatives for the purpose of efficient portfolio management … when the conditions … are satisfied”

Another control is that the value of derivatives should not exceed a certain percent, usually 15 percent, of NAV stated in prospectuses of Country-Specific Unit Trusts. For instance, Page 31 of "Prospectus for Schroders International Choice Portfolio" states:

" The net aggregate value of contract prices of derivatives shall not exceed 15% of the Value of the Deposited Property…"