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What are Derivative Instruments?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 30 September 2016
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Derivative instruments are any type of financial securities that depend on the performance of some type of underlying security in order to have any value. There are a number of investment opportunities that are structured in this manner, including different types of swaps, forward options, and futures. In some cases, derivative instruments can be an excellent means of maximizing return on an investment, as well as successfully hedging a financial portfolio.

Since derivative instruments depend on the strength of an underlying security or set of securities, it is important to assess the current status of those securities, as well as accurately project their future movement. For example, if a bond option carries a variable rate that is tied directly to the performance of an underlying stock, the investor would want to look closely at the past history of that stock. Along with the history, the potential investor should also consider the standing of the issuer within its particular industry, and assess the potential for that stock to increase in value during the life of the option. If the prospects seem attractive, investing in the derivative is likely to be a good idea.

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Just as with any type of investment activity, derivative instruments do carry some degree of risk. Any event or market movement that has an adverse impact on the value of the underlying security will also cause the instrument to lose value. This includes events such as political shifts, disaster situations like floods or hurricanes, or even changes in consumer demand that suddenly cause a serious drop in sales for the company that issues the underlying security. Fortunately, many of these factors can be accurately predicted, minimizing the potential for losing a great deal of money by investing in the derivative.

Derivative instruments are sometimes issued with the potential for the investor to eventually acquire shares of the underlying security. From this perspective, this means that an investment of this type can be an excellent way to hedge a portfolio against future purchases. Experienced investors often make use of hedging strategies of this type in order to maximize return while also increasing the scope and general value of the portfolio.

In order to identify derivative instruments that show promise of earning a significant return, it is a good idea to work closely with a broker who understands the nature of derivatives. This makes it easier to sort through the many options on the market, and focus on derivatives that are likely to help the investor achieve his or her personal financial goals. A competent broker is usually able to quickly identify strengths and weaknesses associated with the underlying security or securities, and accurately advise the investor of what to expect if the derivative is purchased.

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