Derivatives and hedging

July 8, 2014

Derivative accounting is a complex subject filled with complicated transactions, financial statement presentations, and disclosures. In this article, we’ll scratch the surface of the derivative field and hedging activities, which are integrally related to derivatives.

1. What is a derivative?

For derivatives, the definition is in the name - they are financial instruments that “derive” their value from something else. This underlying asset needs to be easily measurable. It can be anything from a stock to an exchange rate to a bushel of wheat. As the value of the underlying asset changes, so does the value of the derivative instrument. Here are a few examples of derivatives you might encounter in the financial world:

Options - A call option grants the right to purchase an asset for a particular price sometime in the future. If the asset’s market price goes up, the call option’s value also goes up because it can be exercised at a price lower than the market price. A put option, on the other hand, allows the sale of an asset at a particular price. The holder of a put option hopes for the price to go down so that he can sell the asset for greater than market value. Option holders are not required to use the derivative, so an option usually costs some money upfront.

Forward contracts and futures - These instruments allow a company to buy or sell a particular asset in the future at a particular price. Unlike options, forwards and futures are contracts with an obligation to perform. As a quick example, if you sign a forward contract to buy euros in 30 days, and the price of a euro goes down in the next month, you’ll end up paying more than you would have without the contract. On the other hand, you would benefit if the price of a euro goes up. These contracts require no money upfront because the parties are exposed to the risk of loss on the contract.

Swaps - A swap is a contract most often associated with interest rates. One party pays a second party based on a fixed rate of interest while the second party pays the first based on a variable rate of interest. The change in variable interest rates in the general marketplace determines who comes out ahead on the swap contract.

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