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.