There are several risks inherent in financial transactions and asset liability positions. Derivatives are risk shifting devices; they shift risk from those ‘who have it but may not want it’ to ‘those who have the appetitie and are willing to take it.

The three broad types of price risks are:

(a) Market Risk: Market risk arises when security prices go up due to reasons affecting the sentiments of the whole market. Market risk is also referred to as ’systematic risk’ since it cannot be diversified away because the stock market as a whole may go up or down from time to time.

(b) Interest rate risk: This risk arises in the case of fixed income securities, such as treasury bills, government securities, and bonds, whose market price could fluctuate heavily if interest rates change. For example, the market price of fixed income securities could fall if the interest rate shot up.

(c) Rxchange rate risk: In the case of imports, exports, foreign loans or investments, foreign currency is involved which gives rise to exchange rate risk.

To hedge these risks, equity derivatives, interest rate derivatives, and currency derivatives have emerged.