At Sonn Law Group, our top-rated securities fraud lawyers are committed to promoting investor education. While derivative securities are often mentioned in financial media, many investors have major questions regarding how these complex financial products actually work. Here, we answer three frequently asked questions that investors have about derivative securities.
Derivative Securities: Frequently Asked Questions (FAQs)
What is a Derivative Security?
A derivative security is a complex financial product with a price that is tied to the value of some type of underlying asset(s). More specifically, a derivative is a contract that is tied to an underlying asset. As the name suggests, this financial product ‘derives’ its value from the fluctuations in the underlying asset.
However, the derivative holder does not technically own the asset itself, at least not directly. As derivatives are not hard physical assets, but merely a contract, they will have a defined holding period and a limited lifespan.
What are the Most Common Types of Derivatives?
In the modern world, there are a seemingly endless amount of different types of derivatives available on the market. These derivatives are made up of a wide variety of different underlying assets, and are structured in different ways, often for a very narrow purpose.
You will find derivative securities made up of common stocks, bonds, commodities, global currencies, market indices and much more. The four most common types of derivative securities are as follows:
- Forward contracts: The most simple type of derivative securities offered are forward contracts. This type of derivative is nothing more than an agreement to sell something on a future date, at a price that is to be determined today. For example, a person might hold 100 shares of Stock A, valued at $50 today. With a forward contract, that person could sell those shares on a specified future date at a different price that is agreed upon by the two parties. Notably, with forward contracts there is no intermediary.
- Futures contracts: Futures contracts are similar to forward contracts. They also mandate the future sale of an asset at a price that is to be determined today. The difference between futures contracts and forward contracts is that futures contracts use intermediaries, and they are listed on market exchanges. This eliminates much of the friction in the transaction, including most counter-party credit risk.
- Options contracts: Options contracts comprise another very popular type of derivative security. The major difference between options contracts and futures contracts is that options do not bind both of the parties to buy/sell an asset at a future date. The options holder is paying a premium to get the choice (the option) to purchase an asset at a predetermined price at a later point in time.
- Swaps: Finally, swaps are another popular, though somewhat more complex, type of derivative securities. Swaps allow investors to exchange certain cash flow streams. A very common example involves swapping a fixed interest rate return for a variable interest rate return. For the most part, swaps are not traded on exchanges.
Are Derivative Securities Appropriate for Retail Investors?
Whether or not derivative securities are appropriate for you depends on many different factors. Though, as a general rule, you should not invest in complex financial products that you do not truly understand. If your broker recommends that you add derivative securities to your account, you have a right to have the investment opportunity clearly explained to you before you make a final decision. Do not be pressured into buying a financial product that you are not comfortable with holding.
Ultimately, derivative securities vary widely. Some derivatives are highly risky, while others are relatively safe. Some derivatives are straightforward financial contracts, and others are almost mind bogglingly complex. Of course, as with any investment, there are risks. With derivatives, sometimes the risks are very high.
Your registered investment advisor has a professional duty to make sure that any derivatives you purchase are well-suited for your unique needs as an investor. If you have lost money because of a bad derivative investment, you should consult with an experienced unsuitable investments attorney immediately. You may be able to hold your financial advisor liable for your losses.
Contact Our Investor Protection Lawyers Today
If you lost a substantial amount of money investing in derivative securities, particularly if you feel that you did not understand the investment, we can help. Please contact our team today to request your free, no risk case evaluation. At Sonn Law Group, we take on all investor losses claims using contingency fee agreements. That means that we do not get paid unless we help you obtain financial relief for your losses.