Financial derivatives operate through contracts in which consideration is made over some assets. Even though the basis of a financial derivative is a contract, a variety of types of derivatives works in different ways. A forward is for example an agreement that establishes rights and obligations for sale of property at a future time and at a pre specified price. It therefore works as a binding agreement to sell. It may yield benefits or losses to either party based on future market prices of the involved asset. An option on the other hand offers a financial property owner the right to trade in an asset at a given future date and price but does not input a liability to sell. A swap however operates by exchanging obligations over an asset (Stulz, 2005).
One of the major risks in financial derivatives is poor valuation of the assets. Overvaluation or undervaluation shifts profits or losses to either party even under constant economic conditions. There is also an involved risk of lack of demand for a derivative due to lack of interested parties. Uncertainty is also an identified risk in financial derivatives that undermines hedging. Similarly, inability to identify and fully understand financial derivatives and their involved risks is also a threat to dealing in financial derivatives (Stulz, 2005).
Financial derivatives therefore work by transferring interest or establishing rights to transfer interest that are derived from an asset. The derivatives that are executable at a specified date and consideration are however associated with a number of risks that includes uncertainty, misevaluation, and inadequate information involved perils
Stulz, R. (2005). Financial derivatives. The Milken Institute Review. Retrieved from: http://www.cob.ohio-state.edu/fin/faculty/stulz/publishedpapers/milkeninstitute_pubpaper.pdf