Derivative securities are financial instruments that derive their value from an underlying asset, security, or index. The value of these instruments fluctuates based on the changes in the price or level of their underlying assets. Common types of derivative securities include options, futures, forwards, and swaps.
Types of Derivative Securities
Options
Options are contracts granting the holder the right, but not the obligation, to buy or sell an asset at a predetermined price on or before a specific date.
Call Options
Call options provide the holder the right to purchase an underlying asset at a specified strike price before the option expires. This is often used when investors predict the price of the underlying asset will increase.
Put Options
Put options give the holder the right to sell an underlying asset at a specific strike price before the option’s expiration. This is used when investors anticipate a decline in the underlying asset’s price.
Futures Contracts
A futures contract is a standardized agreement to buy or sell an asset at a future date and at a predetermined price. Unlike options, both parties in a futures contract are obligated to execute the contract at expiration.
Forward Contracts
Forward contracts are similar to futures but are customizable and traded over-the-counter (OTC). They are agreements for future transactions involving the purchase or sale of an asset at a predetermined price.
Swaps
Swaps involve the exchange of cash flows or other financial instruments between parties. Common swaps include interest rate swaps and currency swaps.
Applicability and Uses of Derivative Securities
Derivative securities serve various purposes in financial markets, including hedging, speculation, and arbitrage.
Hedging
Hedging helps manage financial risk by using derivatives to offset potential losses in investments. For example, a farmer might use futures contracts to lock in prices for crops.
Speculation
Speculators use derivatives like options and futures to bet on the future direction of markets, aiming to profit from price movements.
Arbitrage
Arbitrage involves exploiting price discrepancies between different markets or forms of a security to secure risk-free gains.
Historical Context
Derivative securities originated from ancient times but gained significant popularity with the establishment of organized exchanges in the 20th century. The Chicago Board Options Exchange (CBOE), founded in 1973, and the introduction of financial futures at the Chicago Mercantile Exchange (CME) in 1972 marked critical milestones in the evolution of derivatives.
Comparison with Other Financial Instruments
Equity Securities
Equity securities, such as common and preferred stocks, represent ownership in a company. Unlike derivatives, their value does not depend on other securities, making them primary securities.
Bonds
Bonds are fixed-income securities representing loans made by investors to borrowers, typically corporates or governmental entities. Their values are influenced by interest rates and credit risk but are not derivatives.
Related Terms
- Underlying Asset: The financial instrument upon which a derivative’s value is based, such as stocks, bonds, commodities, currencies, or interest rates.
- Strike Price: The specified price at which the holder of an option can buy (for a call) or sell (for a put) the underlying asset.
- Expiration Date: The date on which an option or futures contract becomes void, and the right to exercise it no longer exists.
FAQs about Derivative Securities
Q: What are the risks associated with derivatives?
A: Risks include market risk, credit risk, and leverage risk. These instruments can lead to significant losses if not managed correctly.
Q: How are derivatives traded?
A: Derivatives can be traded on exchanges, like futures and options, or over-the-counter (OTC), such as forwards and swaps.
Q: What role do derivatives play in the economy?
A: They enhance market efficiency, provide liquidity, enable price discovery, and allow for risk management.
References
- Hull, J. C. (2018). Options, Futures, and Other Derivatives. 10th ed. Pearson.
- Jarrow, R. A., & Turnbull, S. M. (2000). Derivatives Securities. 2nd ed. South-Western College Pub.
- Chicago Mercantile Exchange, resources and publications.
Summary
Derivative securities are vital financial instruments whose value is directly linked to underlying assets, enabling functions like hedging, speculation, and arbitrage. By offering insights into the future price movements and providing risk management tools, derivatives play a crucial role in global financial markets. Understanding the nature, types, and applications of derivatives is fundamental for navigating modern finance.
