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.
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.
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.
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.
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.
- Thinkstock/Comstock/Getty Images