Derivative Instruments

Derivative Instrument

  • Derivatives are financial instruments
  • They derive their value from an underlying asset price or index
  • Their primary purpose is to create rights and obligations to facilitate the transfer of risks between the party wanting to transfer and the party with the risk appetite willing to take on the risk
  • Usually used as a hedging instrument for managing risks

Definition of a derivative

  • A derivative is a financial instrument or other contract with all three of the following characteristics:
  1. its value changes in response to the change in a ‘underlying’;
  2. it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts; and
  3. it is settled at a future date

Examples of certain underlying

  • The following are some examples of underlying

– Interest Rate
– Security price
– Commodity price
– Index like Dow Jones, Sensex, Nifty
– FX rate
– Credit rating provided by an agency
– Non-financial variable like weather

Key features of derivative

  • Where the underlying is a non-financial variable, then it should not be specific to a party to be a derivative – else it would become an insurance contract
  • A derivative can have more than one underlying – for example a cross currency interest rate swap has a FX rate as one variable and interest rate as another variable

Non-financial assets

Non-financial assets

  • Inventories, plant and machinery, properties and other intangible assets are examples of non-financial assets that are not financial instruments
  • Such assets even if it is held as an investment (as opposed to stock-in-trade) are not regarded as financial instruments
  • A contract to deal with non-financial asset at a specified price at a specified future date is also not a financial instrument
  • Thus commodity contracts that provide for settlement only by the receipt or delivery of a non-financial item are not financial instruments
  • However, contracts to buy or sell non-financial items that can be settled net or by exchanging financial instruments, or in which the non-financial item is readily convertible to cash, are within the scope of IAS 32 as if they were financial instruments
  • Right to exercise a future benefit in the form of receiving goods or services is not a financial asset e.g., pre-paid expenses – as there is no right to receive cash or any other financial asset

Financial Instrument – Financial Asset & Financial Liability

Financial Instruments

  • Any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity
  • For example, a receivable of one entity (financial asset) will represent a payable (financial liability) of another entity
  • An equity instrument (or security) is a financial asset for an investor holding the instrument and is equity of the issuer of the instrument

Financial asset

  •  Cash
  • Equity instrument of another entity
  • A contractual right

– to receive cash or another financial asset from another entity
– to exchange financial assets or financial liabilities with another entity under conditions that are potentially favorable to the entity
– (example: purchased call or put options)
• A contract that will/may be settled in the entity’s own equity instruments and is
– A non-derivative resulting in receiving a variable number of the entity’s own equity instruments
– A derivative that will/may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of entity’s own equity instruments

Financial liability

  • A contractual obligation

– to deliver cash or another financial asset to another entity
– to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity
– (example: written call or put options)

  • A contract that will/may be settled in the entity’s own equity instruments and is

– A non-derivative resulting in delivering a variable number of the entity’s own equity instruments
– A derivative that will/may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of entity’s own equity instruments

Written options – Financial liability

  • A written call option represents the obligation, if exercised, to sell an item at a specific price
  • A written put option represents the obligation if exercised, to purchase an item at a specified price
  • Contractual basis
  • The rights and obligations of financial assets and financial liabilities are the result of certain contractual provisions underlying these
  • An entity’s tax liability for example does not meet the ‘contractual basis’ test and hence is not a financial instrument
  • Cash, even though is not formed out of a contractual basis is still a financial asset as it is specifically included in the definition

Derivative Instruments

Derivative Instrument

  •  Derivatives are financial instruments
  •  They derive their value from an underlying asset price or index
  •  Their primary purpose is to create rights and obligations to facilitate the transfer of risks between the party wanting to transfer and the party with the risk appetite willing to take on the risk
  • Usually used as a hedging instrument for managing risks

Definition of a derivative

  • A derivative is a financial instrument or other contract with all three of the following characteristics:
  1. its value changes in response to the change in a ‘underlying’;
  2. it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts; and
  3. it is settled at a future date

Examples of certain underlying

  • The following are some examples of underlying
  1. Interest Rate
  2. Security price
  3. Commodity price
  4. Index like Dow Jones, Sensex, Nifty
  5. FX rate
  6. Credit rating provided by an agency
  7. Non-financial variable like weather

Key features of derivative

  • Where the underlying is a non-financial variable, then it should not be specific to a party to be a derivative – else it would become an insurance contract
  • A derivative can have more than one underlying – for example a cross currency interest rate swap has a FX rate as one variable and interest rate as another variable

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