Derivatives transactions involve significant potential risks. The risks that may arise in connection with a particular transaction depend on the terms of the transaction and on the circumstances of both you and your counterparty. Generally speaking, all derivatives transactions involve some combination of the following potential risks:
Market risk is the risk that the value to you of a transaction will be adversely affected by various market factors, such as (a) fluctuations in the level of one or more market prices, rates or indexes, (b) changes in volatility levels of market prices, rates or indexes, (c) variances in the correlations or other relationship between various market factors, and (d) the level of liquidity in the market or related markets for the relevant transaction.
Credit risk is the risk that a counterparty will fail to perform its payment or other obligations to you when due. Credit risk can also arise if a counterparty is downgraded by rating agencies, causing the value of obligations it has issued to decline in value.
Funding risk is the risk that you or your counterparty will not have adequate cash available to fund current obligations, which might occur because of mismatches in cash flows due from or to your counterparties in derivatives transactions or related hedging, trading, collateral or other transactions, or delays in payment.
Operational risk is the risk that you will incur losses because of (a) inadequacies in your internal systems or your controls for monitoring and quantifying the risks and contractual obligations associated with derivatives and related transactions, recording and valuing the transactions, or detecting human error, or (b) systems or management failures.
Transaction risk consists of risks that may arise based on the terms of a specific transaction. Highly customized derivatives transactions, in particular, may present heightened liquidity risk and introduce other significant risk factors of a complex character. Highly leveraged transactions may experience substantial gains or losses in value as a result of relatively small changes in the value or level of an underlying or related market factor. Unusual or extreme changes in market factors may affect the value of a transaction and the risks associated with it in ways that are not taken into account in most available systems for modeling transaction risk.
Pricing risk is the risk that the price and other terms on which you may enter into or terminate a derivatives transaction may not represent the best price or terms available to you from other sources, because the terms of derivatives transactions are individually negotiated. In addition, it may be difficult to establish an independent value for an outstanding derivatives transaction. Valuations performed in connection with requirements for posting collateral or other credit support in connection with a transaction do not necessarily reflect the value of the transaction for any other purpose.
Amendment and Termination Risk
Amendment and termination risk is the risk that arises as a result of the fact that an derivatives transaction may be modified or terminated only by mutual consent of the original parties, which will be subject to agreement on individually negotiated terms. Accordingly, it may not be possible for you to modify, terminate or offset your obligations or your exposure to the risks associated with a transaction before its schedule termination date.
Financial risk may arise if changes in the value of a derivatives transaction or portfolio of transactions may have a material adverse effect on your financial condition under the accounting principles applicable to you. You should consider how any proposed transaction will be reflected in your financial statements and in the reports you make to your shareholders and others, and how it may affect your ability to comply with financial covenants contained in any credit agreements or other agreements to which you are a party.
Compliance risk is the risk that (a) you will incur additional costs and expenses in order to comply with the laws and regulations applicable to derivatives transactions, (b) compliance with such laws and regulations will result in additional administrative and operational burdens on your business, and (c) failure to comply with such laws and regulations could subject you to the risk of litigation and the imposition of civil and criminal penalties.
The foregoing does not purport to disclose all of the risks and other material considerations associated with derivatives transactions. You should not construe this statement of general risks as business, legal, tax or accounting advice or as modifying applicable law. You should consult your own business, legal tax and accounting advisers with respect to proposed derivatives transactions and verify that each transaction is consistent with your policies and objectives. You should refrain from entering into any derivatives transaction unless you fully understand the terms and risks of the transaction, including the extent of your potential risk of loss, and are willing to accept those risks.