
The trading of derivative securities represents a large portion of the shares that change hands in the financial markets. Investment firms, stock exchanges, and other financial institutions make attractive profits from trading these contracts. Investors can use derivative securities to hedge certain investment bets by taking as much risk as a firm or individual deems appropriate. Also, derivatives trading requires some forecasting about future prices, and may promote more efficiency in the markets.
Risk Management
At its core, the integration of derivative securities into an investment portfolio is about managing risk and attempting to profit. Although these securities can be highly sophisticated, derivatives are also designed to allow traders to compartmentalize risk. Derivative contracts can be divided into tranches with varying degrees of risk. Investors can buy and sell different tranches of derivative products based on the risk assigned to each tranche. In doing so, the investor can determine how much risk is acceptable in the event that the trade falters.
Type
There are different types of derivatives from which investors can choose to trade, all of which obtain a value based on some underlying security, such as a stock or a debt instrument. Options are a type of derivative that grant investors a choice to buy or sell a financial security by a later date for a predetermined price. An advantage is the flexibility inherent in these derivatives because investors are not obligated to follow through with a trade over the duration of an options contract.
Profits
Major stock exchanges that facilitate derivatives trading can earn a substantial amount of profits from this business. According to a 2011 article on the Bloomberg website, two such exchanges, the Deutsche Boerse and the New York Stock Exchange Euronext, agreed to merge. Combined, the derivatives businesses of these two exchanges is worth approximately $24.7 billion, the article states. Derivatives trading is a key profit driver at the NYSE Euronext and is responsible for approximately 50 percent of the exchange's bottom-line growth.
Influence
The underlying debt securities that give value to credit derivatives contracts are rated by industry agencies. If the assigned rating is misguided, it could lead to massive losses in the financial markets. Losses stemming from the trading of derivative securities that were riskier than expected caused some to blame these products for the financial crisis of 2008. An advantage from the fallout is that market participants gained greater awareness of the systemic risk that inappropriately rated derivatives may pose to the global economy. Subsequently, investors began seeking greater transparency in the markets.
References
- Bloomberg; NYSE-Deutsche Boerse Merger Is Free With Derivatives: Real M&A; Michael Tsang, et al; February 2011
- Department of Mechanical Engineering Massachusetts Institute of Technology. "Modeling, Valuation and Risk Management of Assets and Derivatives in Energy and Shipping," Page 2. Accessed June 24, 2020.
- World Federation of Exchanges. "WFE IOMA 2018 Derivatives Report," Page 7. Accessed June 24, 2020.
- Bank for International Settlements. "Statistical Release: OTC Derivatives Statistics at End June 2019," Page 1, Footnote 2. Accessed June 24, 2020.
- Great Britain: Parliament: House of Lords: European Union Committee. "The Future Regulation of Derivatives Market: Is the EU on the Right Track?, 10th Report of Session 2009-10, Report With Evidence," Page 81. The Stationery Office, 2010.
- Barclay Hedge. "What Is a Hedge Fund?" Accessed June 24, 2020.
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- The White House of President Barack Obama. "Wall Street Reform: The Dodd-Frank Act." Accessed June 24, 2020.
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- Kiichiro Yagi, Nobuharu Yokokawa, Hagiwara Shinjiro, and Gary Dymski. "Crises of Global Economy and the Future of Capitalism: An Insight Into the Marx's Crisis Theory," Page 104. Routledge, 2013.
- United States Government Accountability Office. "Review of Federal Reserve System Financial Assistance to American International Group, Inc." Accessed June 24, 2020.
- Corporate Finance Institute. "What Is a Forward Contract?" Accessed June 24, 2020.
- Corporate Finance Institute. "Futures Contracts." Accessed June 24, 2020.
- San Jose State University Department of Economics. "Options, Forward Contracts, Swaps and Other Derivative Securities." Accessed June 24, 2020.
- Brookings Institution. "The Dangers of Derivatives." Accessed June 24, 2020.
- The Options Guide. "Futures Margins." Accessed June 24, 2020.
- Harvard Law School Forum on Corporate Governance. "Why Re-Regulating Derivatives Can Prevent Another Disaster." Accessed June 24, 2020.
- U.S. Securities and Exchange Commission. "The World's Largest Hedge Fund Is a Fraud." Accessed June 24, 2020.
Writer Bio
Geri Terzo is a business writer with more than 15 years of experience on Wall Street. Throughout her career, she has contributed to the two major cable business networks in segment production and chief-booking capacities and has reported for several major trade publications including "IDD Magazine," "Infrastructure Investor" and MandateWire of the "Financial Times." She works as a journalist who has contributed to The Motley Fool and InvestorPlace. Terzo is a graduate of Campbell University, where she earned a Bachelor of Arts in mass communication.