Derivatives

Definition

A derivative is a financial instrument whose value is dependent on or derived from an underlying asset, commodity, currency, economic variable, or financial instrument. The main types of derivatives are futures contracts, forwards, swaps, and options. These instruments are used in various markets, including derivatives markets and over-the-counter (OTC) trading, to hedge risks, speculate on price movements, or engage in arbitrage.

Types of Derivatives:

Futures Contracts: Agreements to buy or sell an asset at a future date at a predetermined price.
Forwards: Customized contracts between two parties to buy or sell an asset at a specified future date for a price agreed upon today.
Swaps: Contracts in which two parties exchange cash flows or other financial instruments.
Options: Contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price within a certain time frame.

Derivatives can be standardized and traded on exchanges or customized and traded OTC. The latter often lacks transparency, which was a contributing factor in the 2008 financial crisis.

Examples

Futures Contract: A wheat farmer enters a futures contract to sell 1,000 bushels of wheat at $5 per bushel in three months. The actual price of wheat might be higher or lower at the time of delivery, but the contract locks in a known price.
Option Contract: An investor purchases a call option on a stock that gives them the right to buy shares at $50 each within the next month. If the stock price rises above $50, the investor can exercise the option to buy at the lower price.
Swap: Two companies agree to swap monthly interest payments on $1 million loans, with one paying a fixed rate and the other paying a floating rate.

Frequently Asked Questions

What is the main purpose of derivatives?

Derivatives are primarily used for hedging risks, speculating on future price movements, or arbitrage opportunities.

What is the difference between a forward contract and a futures contract?

A forward contract is a customized agreement traded OTC, whereas a futures contract is standardized and traded on an exchange.

Are derivatives risky?

Derivatives can carry significant risk, especially when used for speculation or leveraged trading. However, they can also mitigate risk when used for hedging.

What was the role of derivatives in the 2008 financial crisis?

Complex derivative products, particularly those lacking transparency, contributed to the financial collapse by spreading and amplifying financial risks.

How are derivatives accounted for in financial statements?

Under the Financial Reporting Standard Applicable in the UK and Republic of Ireland (Section 12) and International Accounting Standard (IAS) 39, the fair value of derivatives must be disclosed in financial statements and recognized in the profit and loss.

Underlying Asset: The asset that provides value to the derivative, such as stocks, bonds, commodities, or currencies.
Hedge Accounting: An accounting method that matches the gains and losses of a derivative with the transaction being hedged to reduce volatility in financial statements.
Fair Value: The price at which an asset or liability can be traded in an orderly transaction between market participants.
Collateralized Debt Obligation (CDO): A complex structured finance product backed by a pool of loans and other assets.
Credit Default Swap (CDS): A derivative that offers insurance against the default of a borrower.
Structured Finance: Financial instruments created to provide funding or risk management for complex financial transactions.
Credit Derivative: A derivative whose value is derived from the credit risk on an underlying asset.

Online Resources

Suggested Books for Further Studies

“Options, Futures, and Other Derivatives” by John C. Hull
“Derivatives Markets” by Robert L. McDonald
“Fundamentals of Futures and Options Markets” by John Hull
“The Derivatives Handbook” by Robert J. Schwartz and Clifford W. Smith, Jr.

Accounting Basics: “Derivatives” Fundamentals Quiz

### What is a derivative? - [ ] A type of stock - [ ] A bond - [ ] A real estate property - [x] A financial instrument whose value depends on an underlying asset > **Explanation:** A derivative is a financial instrument whose price is derived from the value of an underlying asset such as a commodity, currency, or another financial instrument. ### Which of the following is not a type of derivative? - [ ] Futures contract - [ ] Forward contract - [ ] Swap - [x] Stock option > **Explanation:** While stock options are a type of derivative, general stocks themselves are not categorized as derivatives. Futures, forwards, and swaps are primary types of derivatives. ### What is the primary use of derivatives? - [ ] Real estate investment - [ ] Manufacturing goods - [x] Hedging risks and speculating price movements - [ ] Storing value > **Explanation:** Derivatives are mainly used for hedging risks, speculating on asset price movements, or engaging in arbitrage. ### In which market are standardized derivatives typically traded? - [x] Exchange-traded markets - [ ] Foreign currency market - [ ] Property market - [ ] Secondary market > **Explanation:** Standardized derivatives are typically traded on exchange-traded markets, which provide greater transparency and regulation. ### How are customized derivatives usually traded? - [ ] Stock exchanges - [x] Over-the-counter (OTC) - [ ] Auction houses - [ ] Property market > **Explanation:** Customized derivatives are usually traded over-the-counter (OTC), where the terms of the contract can be tailored to the specific needs of the involved parties. ### What played a significant role in the 2008 financial crisis? - [ ] Real estate decline - [ ] Global oil prices - [x] Unregulated and complex derivative products - [ ] Bonds mismatches > **Explanation:** Unregulated and complex derivative products, such as credit default swaps and collateralized debt obligations, significantly contributed to the financial collapse in 2008. ### What is a swap? - [ ] A share in a company - [ ] An asset ownership transfer - [x] A contract to exchange cash flows or other financial instruments - [ ] An equity transaction > **Explanation:** A swap is a financial derivative contract in which two parties agree to exchange cash flows or other financial instruments, such as interest rate payments or currencies. ### What is the purpose of hedge accounting? - [ ] To inflate profits - [ ] Tax evasion - [x] To reduce financial reporting volatility by aligning derivative gains/losses with the transaction being hedged - [ ] Increasing overall debt > **Explanation:** Hedge accounting aims to reduce financial reporting volatility by aligning the gains and losses of a derivative with the transaction being hedged. ### Why do businesses use options? - [ ] For internal accounting - [x] To gain the right to buy or sell assets at a predetermined price - [ ] As a replacement for stocks - [ ] For employee benefits > **Explanation:** Businesses use options to gain the right, but not the obligation, to buy or sell assets at a specified price within a certain time frame, often utilized for hedging or speculative purposes. ### What is 'fair value' in the context of derivatives? - [ ] The original purchase price - [ ] A taxed value estimate - [x] The price at which an asset or liability can be traded in a market transaction between willing participants - [ ] An estimation by the company's CFO > **Explanation:** Fair value is the price at which an asset or liability can be traded in an orderly transaction between market participants.

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