Managing the complex risks hidden within derivative-heavy investment portfolios

Derivatives derive value from underlying assets like equities or bonds, but they introduce unique dangers. This video explains how investors manage the specific market and counterparty risks inherent in these instruments, moving beyond simple metrics to ensure robust portfolio protection.

Derivatives—including options, futures, forwards, swaps, and swaptions—are contracts between two counterparties governed by specific terms. While market risk tracks sensitivity to price movements in interest rates, inflation, or currencies, derivatives introduce a distinct counterparty credit risk. This occurs when one party defaults, forcing the other to face replacement risk.

To manage these exposures, regulators have introduced frameworks like IFRS 13 to improve accounting standards. While Value at Risk (VaR) is a standard tool for measuring market risk, it has known limitations. Consequently, regulators now advocate for a broader suite of metrics, requiring investors to tailor their risk management strategy to their specific funding and liability profiles.

Source: How do you risk manage portfolios that contain financial derivatives?