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The Advantages of Tearing Up Derivative Contracts & Counterparty Risk

Original post by Michael Wolfe of Demand Media

When you make a significant number of investments, particularly investments that hinge on changes in the interest rate, you may choose to purchase derivatives contracts as a means of insuring yourself against additional risk. Derivatives can be purchased as a form of insurance, but they can also be purchased or sold as a speculative investment. However, there are several advantages to tearing up such contracts and not buying or selling them.

Derivative Contracts

While a derivative contract that has already been issued cannot be torn up until it has expired -- this would constitute a breach of contract -- you can choose to metaphorically tear them up by choosing to neither buy nor sell them. In such a case, you are essentially choosing to not speculate using financial instruments that involve counterparty risk. Perversely, although derivative contracts are meant to lower risk, this technique can actually lower your risk.

Valuation

One of the main difficulties with derivative contracts is that they can be exceedingly difficult to evaluate. This is true for several reasons. First, the market for some kinds of derivatives can be extremely illiquid, leading to unclear price signals. In addition, the underlying assets to which the value of a derivative is pegged will often be in flux. Getting rid of derivatives saves an investor this uncertainty.

More Profit Potential

When your choose to purchase a form of counterparty risk as an insurance policy -- for example, a swap may be purchased as a means of hedging an investment --you may receive a piece of mind, but you are also having the profit he stands to make from the investment against which you are hedging deeply cut into. By tearing up derivatives contracts, you are avoiding this cut.

Less Risk

During the credit crisis of 2008, some investors discovered that the derivatives which they had believed to be relatively safe investments were, in fact, nearly worthless -- or, even worse, made them liable to pay huge sums of money to another party. This is because of large, unexpected shifts in the market that the derivative holders didn't foresee. Eschewing derivatives altogether protects an investor from this sort of exposure.

                   

References

  • "Economics"; Roger A. Arnold; 2009
  • "Managing Financial Risk'; Charles W. Smithson; 1998

About the Author

Michael Wolfe has been writing and editing since 2005, with a background including both business and creative writing. He has worked as a reporter for a community newspaper in New York City and a federal policy newsletter in Washington, D.C. Wolfe holds a B.A. in art history and is a resident of Brooklyn, N.Y.

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