Derivative instrument

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Elwintee

Senior Member
England English
As a financial ignoramus I should be grateful for a comprehensible definition of this phrase. I don't even know what a financial 'instrument' is, and I'm not sure what a 'security' is either. Both these words appear in the dictionary definition.
 
  • WyomingSue

    Senior Member
    English--USA
    A security is basically a stock or bond. A derivative is something that gets its value from its parts, for example a bag of groceries might be worth $20 because it contained a $3 gallon of milk, a $2 package of bread, and $15 of beef steak.
    So the financial wheeler-dealers take a bunch of things that have value (like mortgages or shares in Bahamian real estate) and package them up and resell the "grocery bag", also known as a a legal document or "instrument."
     

    WyomingSue

    Senior Member
    English--USA
    Glad to have helped. I thought more about my answer yesterday afternoon, and decided that I should add the following ... If I told a friend that the bag had $20 worth of groceries, he would pay me because he knows I am an honest person.
    In the financial world you don't always get a list of exactly what's in the derivative, and people buy and sell according to their best guess, and sometimes according to wild enthusiasms.
    Unfortunately, in the recent downturn, in the "grocery bag" the meat was turning green around the edges, the bread was stale, and the gallon jug of milk only had 1/2 cup left in it. Eventually some people noticed the bad smell!
     

    IParleFrench

    Senior Member
    English - USA
    As a financial ignoramus I should be grateful for a comprehensible definition of this phrase. I don't even know what a financial 'instrument' is, and I'm not sure what a 'security' is either. Both these words appear in the dictionary definition.
    Strictly speaking, a derivative is a security that derives its value from another "underlying" security. The underlying security has an inherent value due to a claim on something (like a stock or a bond does). A derivative security's value is determined by the value of the underlying security. It's confusing, I know.

    For example. IBM's stock might be trading at $100. You could have an "option" to purchase IBM for $120 any time in the next year. If IBM trades at $125 next month, your option is worth something, because you can buy the stock for $120 and turn around and sell it for $125 (when the stock is above $120, the option is called "in-the-money"). Even if IBM goes to $118 tomorrow, the option will be worth more than when the stock was at $100, because there would be a greater likelihood that the option would become in-the-money in the future.

    In the example above, the option is called a derivative, because its value is determined based on the value of an underlying security (the stock). The stock is not a derivative--it is a direct claim on the assets of the company. There are many types of derivatives; options are only one type. Some others are swaps, futures, and forwards.

    I hope this helps!
     
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    Thomas Tompion

    Senior Member
    English - England
    Just in case anyone is not clear what a bond is: think of it as a formal promise to pay sums, often fixed sums, at given dates in the future.

    Obviously if your rich uncle rings to say that he's going to give you a million pounds in five years' time, that is worth something now. You might even, if you were desperate for cash, sell it for four million now.

    It's important to remember that these sums don't alter with current interest rates. A fixed receipt in the future is worth what it's necessary to invest at current interest rates to receive that sum in the future, via compound interest, i.e. investing any profits as you go along. So interest rates operate, amongst other things, to link the value of present payments with that of future receipts.

    The further the receipt into the future, the less its present value, the smaller the sum you need to invest, at current interest rates, to receive the sum at that distant future date.

    And, most counterintuitive of all, the higher current interest rates, the lower the value of bonds, because, again, a smaller sum invested now would yield the value of the receipt at that future moment, because the fund grows more quickly at higher interest rates.

    This idea that a bond is composed of contractual receipts in the future is so difficult for some people to grasp that some countries (I won't say which) have issued bonds in the form of bundles of post-dated cheques for given sums at given dates, perforated, like a complicated stamp. The bond holder could tear a cheque out from the perforations when the date on that cheque was reached and take it to the bank to cash it, leaving the other cheques in the bond to be cashed later when they individually matured.
     
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