A derivative is a financial instrument whose value is based on or derived from the value of something else (an "underlying"). That underlying can be the value of another financial instrument, a commodity, an index, an asset, or a debt instrument. Examples of derivative financial instruments include futures, forward, swap, and option contracts; interest-rate caps; and fixed-rate loan commitments.
Types of Derivatives
- A forward contact is an agreement between buyer and seller that requires the delivery of some commodity at a specific future date at a price agree to today (called the "exercise price").
- Future contacts are very similar to forward contacts, except that the terms of the contract has been standardized and they are traded actively on future exchanges. Futures are sometimes referred to as liquid forward contacts because futures trade separately.
- An option contract between two parties--the buyer and the seller--gives the buyer ("option holder") the right, but not the obligation, to purchase from or sell something to the option seller ("option writer") at a date in the future at a price agree to at the time the option contract is exchanged.
- A swap is an arrangement by which two parties exchange cash flows over a period of time. The two most common types of financial swaps used by companies are (1) currency swaps, and (2) interest rates swaps. Swaps are typically settled at a net of the difference between the two sources of cash flow. For example, company A has variable rate debt currently at 6% payable to B. A wants to ensure that their interest payments neither decrease or increase. Therefore, they enter into a "interest rate swap" for fixed interest payments from another financial institution, called C at 6%. If later the interest rate on the variable rate debt increases to 7%, A will pay B the 7% but will be reimbursed by C for the 1% difference. If the variable rate decreases to 5%, A will pay B 5% and an additional 1% to C. A is guaranteed to pay %6 and essentially betting that the interest rate rises. C is ensuring that A pays 6% and is betting that the interest rate falls. The swap, as can be seen in the example, is settled at a "net" amount.
- Baker, Theodore E. Christensen. "Chapter 11: Multinational Accounting: Foreign Current Transactions and Financial Instruments" In Advanced financial accounting . S.l.: Mcgraw Hill Higher Educat, 2011. 554-557.