What are Derivative Securities

It is common for stockholders to purchase derivative securities in order to protect their investments from fluctuation in stock value. When an investor purchases a derivative security, he/she will be required to pay the issuer for the exchange of risk and the added assurance that he/she receives.

The price of derivative security will vary based upon the company an investor purchases this protection from, as well as on the type of derivative securities he/she purchases. An investor may choose to purchase exchange traded derivatives from an organized and regulated exchange. Another option that an investor possesses is to purchase over the counter derivatives. Each of these types of derivative securities has different benefits and detriments associated with them. Likewise, each of these investment protections will place a different type of financial burden upon an investor.

It is common for an investor to dedicate a large portion of his/her financial assets to the purchase of stocks. Therefore, it is logical for an individual to utilize financial resources to purchase derivative securities that will protect his/her investment. However, it is important for investors to gain an understanding of appropriate prices for derivative securities, as many investors often end up overpaying for this protection. This is especially true when an inexperienced individual purchases an over the counter derivative.

Banks and investing companies will often attempt to exploit the inexperience of new investors by charging them more money than they should be paying for a derivative security. In order to avoid this, it may be helpful for an individual to understand a little bit about how the cost of a derivative security is calculated.

Issuers utilize the Black-Scholes Model in order to develop an appropriate cost for stock derivatives. First developed by Robert Merton, Myron Scholes, and Fisher Black in 1973, the Black-Scholes Model continues to be employed regularly and is essential to the sale and purchase of stock derivatives. There are many different variations on this mathematical model. However, each of these models functions on the same premise—that the price of derivative security is regulated inherently by the value attached to the underlying stock.

The Black-Scholes Model takes into account all of the important aspects of stock trading and the nature of the stock market. An issuer will incorporate the expiration date, interest rate, strike price, and volatility into the equation that is utilized to determine derivative cost.

There is also an equation that is used to calculate European call option, and a separate equation utilized to find European pull option. When an investor uses these calculations to determine a suitable option price, he/she will also be required to utilize two separate equations to calculate parameters.

All of these equations can be found online, accompanied by thorough explanations regarding the proper way to apply these equations. Many online resources will also provide investors with access to examples of how to effectively utilize this model. Therefore, an investor may determine whether or not he/she is receiving an acceptable price for a derivative security.

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