Question

What is a derivative in accounting?

Answer 1

A financial derivative is a liability or an asset whose value is derived from a market price or rate of the underlying.Common underlying assets include investment securities, currencies, interest rates and other market instruments. It is a financial instrument whose value changes in relation to changes in a variable, some of which are credit rating, interest rate or foreign exchange rate.

There are two broad categories of derivatives: option-based contracts and forward-based contracts:-

1.Option-based derivative contracts

Option-based derivative contracts provide the holder with the option, but not the obligation, to exercise the contract. The party that sells the option may be referred to as the option writer; the party that buys the option is the option holder. An option holder exercises its option when it is in the money (i.e., economically worthwhile), but not when it is out of the money.

2.Forward contracts Forward derivative contracts require the payment of the agreed-upon forward price in exchange for the underlying asset on or before a maturity date.

There are three primary ways of negotiating and trading derivatives:

1.Over-the-counter(OTC) derivatives

2.Centrally-cleared derivatives

3.Exchange-traded derivatives

An entity is required to measure derivative instruments at fair value.All fair value gains and losses are recognized in profit or loss except where the derivatives qualify as hedging instruments in cash flow hedges or net investment hedges.