Types of Derivative Security

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Derivatives are used for speculation or to protect the value of a portfolio.
Derivatives are used for speculation or to protect the value of a portfolio. (Image: Jupiterimages/Goodshoot/Getty Images)

Derivative securities are investments or trading vehicles that derive their value from an underlying primary security such as stocks, bonds or currency. Derivatives can be used to speculate on the future values of the underlying instrument or to protect the values of an investment or loan portfolio. Derivatives trade on organized exchanges, and other types are set up between private parties.

Bonds

The most widely known type of derivatives on bonds are bond futures. Futures contracts are regulated securities trading on the commodity and futures exchanges. Futures are available against a wide range of U.S. government Treasury debt obligations. Government bond futures trading is a primary way to take a leveraged position on changing interest rates. Formal options trading on bonds consist of options that trade against the bond futures contracts. In the private, over-the-counter -- OTC -- market, repurchase agreements are a derivative on bond securities. A repurchase agreement is the sale of a bond with an agreement to buy it back in the future at a certain price.

Stocks

Stock options are the primary, exchange-traded derivative type for individual stocks. Put and call options on stocks allow traders to profit from rising or falling stock prices with a limited cost. Futures trading is limited primarily to futures on the major stock indexes. Stock warrants are an OTC derivative that function like long-term options. Warrants are usually sold in conjunction with another security offering to provide a "sweetener" to the deal.

Currency

Futures contracts for exchange rates between two currencies trade on the commodity and futures exchanges. A wide range of currency-pairs futures is available. A currency forward contract is a private, OTC derivative with features similar to a futures contract. Terms of futures contracts are set by the exchanges, while the terms of a forward contract are negotiated and agreed on by the two parties involved.

Interest Rates

The interest rate and money markets cover short-term interest rates and rates charged on bank loans. Most of the derivatives in these areas are traded OTC. Derivative types include interest rate swaps, rate caps and rate floors. One side of these contracts is looking for protection against changing rates and the other is providing the protection for a fee. In the futures markets, euro/dollar futures and some interest rate swap contracts are available.

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