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Derivative Securities Explained

Derivative Securities Explained

A derivative security is a financial contract between two parties for buying or selling a property, assets, commodity, or other security at a predetermined price within a specific time period. Generally, a derivative security is a contract representing a group of underlying assets. The most common underlying assets are bonds, stocks, commodities, currencies, market index and interest rates. The value of a derivative security is derived from or dependent on the performance of underlying assets or group of assets. These underlying assets are traded separately from the derivatives.

Derivative securities include future contract, forward contract, options and swap and other variants of these such as synthetic collateralized debt obligations and credit default swaps. These derivatives are used for hedging or gaining leverage. One tell-tale characteristic of a derivative security is that it does not securitize actual assets (like a mortgage-backed or other asset-backed security). It commoditizes a contingency that is related to the underlying assets – rather than actually monetizing the underlying assets.

A Little More About Derivative Securities

Derivatives are a type of security instrument that are generally publicly traded. Most derivative securities are traded over-the-counter (OTC) in personally-negotiated transactions between individuals. This type of sale or trade is largely unregulated. There are standardized derivatives traded on a public exchange specialized for derivatives or large public exchanges, such as the New York Stock Exchange. The OTC derivatives involve much greater risk than the standardized ones.

Derivatives originated several centuries back. Traditionally, while trading across the border, the traders needed to balance the exchange rates, as the value of currencies differ from one nation to another. Derivatives were introduced to solve this problem.

Derivatives have many uses in today’s market and are based on various types of transaction. Depending on the type of the derivative there are several purposes and usages. Derivatives are used for projecting the future price of any asset, avoiding the exchange rate issues, and hedging against changes in asset values. Here are some common examples of derivative securities:

  • Currency Future – Suppose, Justine, an Australian investor buys stock of an American company using US dollar. Now, Justine would be in a risk of exchange rates while holding that share. Justine can avoid the risk by purchasing currency futures (a derivative security). It would fix the exchange rate for selling the share in future and converting the money to the Australian dollar.
  • Future Contract – Here, one party agrees to sell an asset to the other on a fixed price within an agreed upon time period. For example, Mr. Burke possessed 15,000 stocks of a certain company in June 2017. He signed a future contract with Ms. Keen to avoid the risk of the stock of that company declining. Ms. Keen agreed to buy the stock after one year, speculating a rise in the price of that company’s stock. Now, if the price rises according to the speculation in June 2017, Ms. Keen makes a profit out of it, and if the price drops Mr.Burke gets extra bucks by selling it in a price higher than the present market.
  • Forward Contracts – These are basically the same a futures contract, but it is only traded over-the-counter and not on exchange.
  • Options – Options are a similar contract. The difference with future contract is here the parties have the right to buy (call option) or sell (put option) an asset on a fixed price on or before a future date, but they are not obligated. So here the transaction is optional and not mandatory.
  • Swap – A swap is most commonly used for trading loan terms. Here the two parties signing the contract, agree to swap their loan terms. Interest rate swap is where one goes from fixed interest rate loan to variable interest rate loan or the opposite. Someone with a fixed interest rate loan signs the contract with some having a variable interest rate loan, where other loan terms are similar. The loan will be in the original borrower’s name but both the parties are obligated to make the payment towards the other’s loan according to the agreement.

Note: A Mortgage-backed security (MBS) securitizing a group of underlying mortgage debts. Because the MBS represents ownership of an underlying asset – the assets are securitized. The security is not a derivative.

References for Derivative Securities

Academic Research on Derivative Securities

  • ·       Pricing and hedging derivative securities in markets with uncertain volatilities, Avellaneda, M., Levy∗, A., & Parás, A. (1995).  Applied Mathematical Finance2(2), 73-88. This paper proposes a model that offers a guide to pricing and hedging derivative securities. The authors offer a detailed, mathematical plan that constructs efficient hedges while capturing the importance of diversification in derivatives positions.
  • ·       Pricing and hedging derivative securities with neural networks and a homogeneity hint, Garcia, R., & Gençay, R. (2000). Journal of Econometrics94(1-2), 93-115. This work takes the usual Black-Scholes formula to the next level by running it through a neural network. This innovative approach to the classic formula offers a clear gain in pricing accuracy while producing a more stable hedging performance.
  • ·       Pricing interest-rate-derivative securities, Hull, J., & White, A. (1990). The Review of Financial Studies3(4), 573-592. This paper offers further insight into the extended performance of a pair of classic interest rate models. The Vasicek model and the Cox, Ingersoll, and Ross model are extended, and option prices are compared using Vasicek and other models.
  • ·       The impact of default risk on the prices of options and other derivative securities, Hull, J., & White, A. (1995). Journal of Banking & Finance19(2), 299-322. This paper shows the impact of default on risk on the prices of options and derivative securities by showing the values of these vehicles when the default risk is removed.
  • ·       One-factor interest-rate models and the valuation of interest-rate derivative securities, Hull, J., & White, A. (1993). Journal of financial and quantitative analysis28(2), 235-254. This paper provides multiple ways to model term structure. The mathematical process is presented in a step-by-step demonstration.
  • ·       Valuing derivative securities using the explicit finite difference method, Hull, J., & White, A. (1990). Valuing derivative securities using the explicit finite difference method. Journal of Financial and Quantitative Analysis25(1), 87-100. This paper provides a slight variation of the explicit finite difference method for valuing derivative securities. This research demonstrates this new approach by applying it as the authors value bonds under two different interest rate processes.
  • ·       Nonparametric pricing of interest rate derivative securities, Ait-Sahalia, Y. (1995).  (No. w5345). National Bureau of Economic Research. This paper examines a new method for pricing derivative securities that estimate the value without assuming parameters or frequency distribution.
  • ·       Optimal positioning in derivative securities, Carr, P., & Madan, D. (2001). This paper examines optimal positions for investors that have a discrete selection of securities to choose from. This self-contained model shows how internal market properties influence the makeup of investor portfolios.
  • ·       Pricing and hedging of derivative securities, Nielsen, L. T. (1999). OUP Catalogue. The author guides the reader through the mathematical and statistical processes that will allow them to understand the use of advanced probability mechanics in financial economics. Writing in a precise and rigorous style, this work will help the reader understand financial journals while giving them the tools to conduct their own analysis or research.
  • ·       Information, trade, and derivative securities, Brennan, M. J., & Cao, H. H. (1996). The Review of Financial Studies9(1), 163-208. This paper takes a look at Hellwig’s model. This model shows a few different ways of improving trading value by both informed and uninformed investors. The model continues until the trading becomes continuous until a state of maximum efficiency is achieved.
  • ·       Financial innovation and the role of derivative securities: An empirical analysis of the treasury STRIPS program, Grinblatt, M., & Longstaff, F. A. (2000).  the Journal of Finance55(3), 1415-1436. This paper takes a look at how innovation can affect financial markets. This is done by examing how investors use the popular Treasury STRIPS program. An examination of investor behavior and market change related to this program is also examined.

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