Category: 

What is a Derivative Security?

Article Details
  • Written By: CPW
  • Edited By: Jay Garcia
  • Last Modified Date: 20 October 2014
  • Copyright Protected:
    2003-2014
    Conjecture Corporation
  • Print this Article
Free Widgets for your Site/Blog
In Laos and China, deep-fried scorpion is a popular street food.  more...

November 26 ,  1789 :  Thanksgiving Day was celebrated in the US for the first time.  more...

A derivative security, also known as a derivative stock, is a financial instrument whose price is dependent on one or a number of underlying financial assets. In itself, the derivative 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. The value of the security is dictated by the value of the underlying asset, which is usually a stock, a commodity, a bond, currency, interest rates or markets indexes. Derivative securities usually are valued by using a version of the Black-Scholes Option Pricing Model.

A derivative security is 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 from a range of motives. Among these other players stand most prominently the 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.

Ad

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 germane to 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.

There are a number of different types of derivative security, but they fall broadly into one of the following categories: Forward Contracts, Options, Future Contracts, and Swaps. However, these various derivative security types are more familiarly classified as either forward-based (future contracts, futures, and swap contracts) or option-based (call or put option).

Combinations of the forward-based and option-based derivative securities are not unknown however. A forward-based derivative agreement 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.

Ad

More from Wisegeek

You might also Like

Discuss this Article

everetra
Post 3

@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.

hamje32
Post 2

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.

Post your comments

Post Anonymously

Login

username
password
forgot password?

Register

username
password
confirm
email