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Derivative Security definition

An asset type that gets a bad name perhaps because they're just beyond the understanding of the news media and general population.
  1. Define - Define derivative securities.
  2. Context - Use derivative security in a sentence.
  3. Quiz - Test your knowledge.
by Paul Alan Davis, CFA, January 1, 2019
Updated: January 1, 2019
Payoffs for derivative securities are often non-linear which makes them more difficult to model.

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Derivative Security

Beginner

A Derivative Security is an investment like an options or futures contract that 'derives' it's value from another asset such as a stock, bond or currency.

Likely the simpleist example of a Derivative Security is a call option on a stock. With a call option, the buyer has the right to buy a stock at a specified 'strike-price' for a period of time. The seller is obligated to sell at that price. If the stock price does not move in favor of the buyer by the expiration date then the option expires worthless and the buyer has lost the premium paid. As a result the payoff of a derivative like an options contract is not linear.

Derivative Securities are commonly used at institutional firms and banks as a risk management tool. So firms use derivatives to offset the risk of future changes in the price of commodities, equities, interest rates and currencies.

Synonym: financial derivatives

In a Sentence

Kay:  Couldn't your client use a derivative security  to protect him from downside risk?
Jim:  Yes, but I'd have to explain it so he understands it. That's the downside.

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Quiz

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Starbucks might be long coffee futures to lock in known prices to make its future operating income more stable. | True or False?

True

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