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What Is a Derivative Security?

Updated May 17, 2024
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A derivative security, frequently called simply a “derivative” in the financial world, is an investment instrument that gets its value or ultimate price from the performance of some other instrument, often a stock, a bond, or a fixed fund. In a sense, then, the security is deriving its value from something else — hence, the name “derivative.” On paper, this sort of security is no more than an agreement between two contracted parties to buy or sell an asset at a fixed price on or before a date of expiration. It becomes valuable once the transaction is completed, and in the right circumstances can be very profitable. This sort of investment is often favored by investors because it allows them to avoid many of the risk of higher stakes investing, and can offer compelling returns in many cases. Still, like nearly all financial instruments, derivatives do carry some risk. Investors are usually wise to carefully research fund performance before investing, and consulting with a professional before purchase might also reduce the risk of loss.

Understanding Financial Derivatives Generally

Financial investments come in many different formats, and derivatives are usually somewhat unique in that they aren’t an asset in and of themselves. Things like stocks, bonds, and commodities, and even interest rates are often more easily understood because they more or less stand alone as independent holdings that can be valued and often bought or sold on their own. Derivatives, on the other hand, get their value from how these and other instruments perform. The value of the derivative is determined entirely based on the performance of the underlying asset, and the two are inseparable.

People invest in derivative securities much as they would invest in the stock or bond market generally. They can be bought and sold on most major financial markets, and often carry the potential of generating significant gains.

Types and Variations

Derivatives come in many different formats, but in general all fall broadly into one of the following categories: forward contracts, options, future contracts, and swaps. However, these various types are more familiarly classified as either forward-based , which is usually understood to include future contracts, futures, and swap contracts; or, alternatively, option-based, which is to say, a call or put option.

Combinations of the forward-based and option-based derivative securities are also possible. A forward-based derivative agreement, for instance, obliges a buyer to buy and a seller to sell with equal risk at a mutually agreed upon price and on a specified date or within an agreed time frame. Option-based agreements confer on the derivative stock holder a right to buy or sell an underlying asset at an agreed price during a specific time period.

Main Benefits

A derivative-heavy portfolio is often particularly appealing to those investors looking to offset or hedge their risk when investing, but a number of other financial players also take an interest in stock derivatives for various reasons. Perhaps most prominent are those speculators and arbitrators who are less interested in off-setting or hedging risk and are instead motivated by the prospective profit that stock derivative speculation can bring. Some other players who typically participate in the stock derivatives market are brokers, banks, financial institutions, and commodity trading advisers.

A typical example of risk off setting or hedging is when a foreign company buys derivative securities that stipulate a certain monetary exchange rate at a future date. This allows, for example, an American company purchasing stocks in a French company on a French bourse to offset the risks commonly associated with currency fluctuations by ensuring that a specified currency conversion back into dollars at a pre-arranged date is effected by means of a previously agreed upon stock derivative contract.

Potential Risks

Like almost all financial transactions, derivatives are not immune to risk, and some investors do lone money on them. When properly researched and executed they have the potential of bringing in often significant gains, but there is no guarantee and even the best laid plans sometimes fail. It’s usually wise for all investors to consider the risk and the likelihood of loss before investing, and to never invest more than can potentially be lost.

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Discussion Comments

By everetra — On May 29, 2011

@hamje32 - It depends upon which collapse you’re talking about. I think derivative trading was implicated in the stock market collapse of 1987, among other factors. Other later stock market crashes had to do with other things like “dot com,” bubbles, housing bubbles, etc.

As for security, all financial investing involves risks. Common examples of derivates are futures or options and these are very risky indeed, as they involve contracts to buy or sell at a price in the future. Prices could swing either way, of course, and so you expose yourself to risk that way.

By hamje32 — On May 26, 2011

Derivates are supposed to be used to hedge bets, to provide a certain amount of pricing security, according to this. However my understanding is that derivatives were risky financial instruments and were in fact responsible for the stock market collapse.

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