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Derivative Securities Markets

Derivative securities (also called derivatives) are financial contracts whose values are derived from the values of underlying financial assets (such as securities). Each derivative security's value tends to be related to the value of the underlying security in a manner that is understood by firms and investors. Consequently, derivative securities allow firms and investors to take positions in the securities on the basis of their expectations of movements in the underlying financial assets. In particular, investors commonly speculate on expected movements in the value of the underlying financial asset without having to purchase the financial asset. In many cases, a speculative investment in the derivative position can generate a much higher return than the same investment in the underlying financial asset. However, such an investment will also result in a much higher level of risk for the investors.

Derivative securities are used not only to take speculative positions but also to hedge, or reduce exposure to risk. For example, firms that are adversely affected by interest rate movements can take a particular position in derivative securities that can offset the effects of interest rate movements. By reducing a firm's exposure to some external force, derivative securities can reduce its risk.

derivative securities (derivatives)

Financial contracts whose values are derived from the value of underlying financial assets.

Some investors use derivative securities to reduce the risk of their investment portfolio. For example, they can take a particular position in derivatives to insulate themselves against an expected temporary decline in the bonds or the stocks that they own.

Derivative securities are traded on special exchanges and through telecommunications systems. Financial institutions such as commercial banks and securities firms facilitate the trading of derivative securities by matching up buyers and sellers.

REVIEW QUESTION

RQ-11 Why are derivative securities purchased by investors?

foreign exchange market

A market consisting of large international banks that purchase and sell currencies to facilitate international purchases of products, services, and securities.

 
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