Editing Derivative (finance) (section)

==Risks==
Derivatives are often subject to the following criticisms; particularly since the [[2008 financial crisis]], the discipline of [[Risk management]] has developed attempting to address the below and other risks – see {{slink|Financial risk management#Investment banking}}. 

===Hidden tail risk===
According to [[Raghuram Rajan]], a former chief economist of the [[International Monetary Fund]] (IMF), "...&nbsp;it may well be that the managers of these firms [investment funds] have figured out the correlations between the various instruments they hold and believe they are hedged. Yet as Chan and others (2005) point out, the lessons of summer 1998 following the default on Russian government debt is that correlations that are zero or negative in normal times can turn overnight to one – a phenomenon they term "phase lock-in". A hedged position "can become unhedged at the worst times, inflicting substantial losses on those who mistakenly believe they are protected".<ref>{{cite journal
  | author = Raghuram G. Rajan
  | title = Has Financial Development Made the World Riskier?
  | journal = European Financial Management
  | volume = 12
  | issue = 4
  | pages = 499–533
  | date = September 2006
  | ssrn = 923683
  | doi = 10.1111/j.1468-036X.2006.00330.x
  | s2cid = 56263069
 | author-link = Raghuram Rajan
 | doi-access = free
  }}</ref>
See the [[FRTB]] framework, which seeks to address this to some extent.

===Leverage===
{{Further|Leverage (finance)#Risk}}
{{See also|List of trading losses}}
The use of derivatives can result in large losses because of the use of [[leverage (finance)|leverage]], or borrowing. Derivatives allow [[investor]]s to earn large returns from small movements in the underlying asset's price. However, investors could lose large amounts if the price of the underlying moves against them significantly. There have been several instances of massive losses in derivative markets, such as the following:

:* [[American International Group]] (AIG) lost more than US$18 billion through a subsidiary over the preceding three quarters on [[credit default swap]]s (CDSs).<ref>{{cite news|last=Kelleher |first=James B.|url=https://www.reuters.com/article/newsOne/idUSN1837154020080918 |title='Buffett's Time Bomb Goes Off on Wall Street' by James B. Kelleher of Reuters |publisher=Reuters.com |date= September 18, 2008|access-date=August 29, 2010}}</ref> The United States [[Federal Reserve System|Federal Reserve Bank]] announced the creation of a secured credit facility of up to US$85&nbsp;billion, to prevent the company's collapse by enabling AIG to meet its obligations to deliver additional collateral to its credit default swap trading partners.<ref>{{cite news |last1=Andrews |first1=Edmund L. |last2=de la Merced |first2=Michael J. |last3=Walsh |first3=Mary Williams |date=September 16, 2008 |title=Fed's $85 billion Loan Rescues Insurer |work=The New York Times |url=https://www.nytimes.com/2008/09/17/business/17insure.html}}</ref>
:* The [[2008 Société Générale trading loss|loss of US$7.2 Billion]] by [[Société Générale]] in January 2008 through mis-use of futures contracts.
:* The loss of US$6.4 billion in the failed fund [[Amaranth Advisors]], which was long natural gas in September 2006 when the price plummeted.
:* The loss of US$4.6 billion in the failed fund [[Long-Term Capital Management]] in 1998.
:* The loss of US$1.3 billion equivalent in oil derivatives in 1993 and 1994 by [[Metallgesellschaft AG]].<ref>{{Cite journal | last = Edwards | first = Franklin  | title = Derivatives Can Be Hazardous To Your Health: The Case of Metallgesellschaft | journal = Derivatives Quarterly | issue = Spring 1995 | pages = 8–17 | year = 1995 | url = http://www0.gsb.columbia.edu/faculty/fedwards/papers/DerivativesCanBeHazardous.pdf }}</ref>
:* The loss of US$1.2 billion equivalent in equity derivatives in 1995 by [[Barings Bank]].<ref>{{Cite book | last = Whaley | first = Robert  | title = Derivatives: markets, valuation, and risk management | publisher = John Wiley and Sons | year = 2006 | page = 506 | url = https://books.google.com/books?id=Hb7xXy-wqiYC | isbn = 978-0-471-78632-0}}</ref>
:*UBS AG, Switzerland's biggest bank, suffered a $2 billion loss through unauthorized trading discovered in September 2011.<ref>{{cite magazine|url=http://www.businessweek.com/news/2011-09-15/ubs-loss-shows-banks-fail-to-learn-from-kerviel-leeson.html |archive-url=https://web.archive.org/web/20121030175804/http://www.businessweek.com/news/2011-09-15/ubs-loss-shows-banks-fail-to-learn-from-kerviel-leeson.html |url-status=dead |archive-date=October 30, 2012 |title=UBS Loss Shows Banks Fail to Learn From Kerviel, Leeson |magazine=Businessweek |date=September 15, 2011 |access-date=March 5, 2013}}</ref>

Derivatives typically have a '''large notional value'''. As such, there is the danger that their use could result in losses for which the investor would be unable to compensate. The possibility that this could lead to a chain reaction ensuing in an economic crisis was pointed out by famed investor [[Warren Buffett]] in [[Berkshire Hathaway]]'s 2002 annual report. Buffett called them 'financial weapons of mass destruction.' A potential problem with derivatives is that they comprise an increasingly larger notional amount of assets which may lead to distortions in the underlying capital and equities markets themselves. Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes a leading indicator.[http://www.berkshirehathaway.com/2002ar/2002ar.pdf (See Berkshire Hathaway Annual Report for 2002)]

===Counterparty risk===
Some derivatives (especially swaps) expose investors to [[Credit risk#Counterparty risk|counterparty risk]], or risk arising from the other party in a financial transaction. Counterparty risk results from the differences in the current price versus the expected future settlement price.<ref>{{Cite journal |last1=Wu |first1=Weiou |last2=G. McMillan |first2=David |date=2014-07-08 |title=The dependence structure in credit risk between money and derivatives markets: A time-varying conditional copula approach |url=https://www.emerald.com/insight/content/doi/10.1108/MF-07-2013-0184/full/html |journal=Managerial Finance |language=en |volume=40 |issue=8 |pages=758–769 |doi=10.1108/MF-07-2013-0184 |issn=0307-4358}}</ref> Different types of derivatives have different levels of counter party risk. For example, standardized stock options by law require the party at risk to have a certain amount deposited with the exchange, showing that they can pay for any losses; banks that help businesses swap variable for fixed rates on loans may do credit checks on both parties. However, in private agreements between two companies, for example, there may not be benchmarks for performing due diligence and risk analysis.