Derivative instrument

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1. Risk management - hedging.

A derivative instrument or contract is one whose value and other characteristics are derived from those of another asset or instrument (sometimes known as the Underlying Asset).

Derivative instruments are widely used by non-financial corporates for hedging purposes.


Example

A share option is a type of derivative contract, allowing the holder to buy shares at a certain predetermined strike price.

The value of the share option derives from the current price of the related underlying share, relative to the option strike price.


For instance, say we hold a call option to buy shares at a strike price of $50, and the option is very close to its expiry date.

If the shares are trading at $90, our option to buy at $50 is valuable.

The option holder could exercise their option, paying $50 per share, and then sell the shares for $90 each, making a profit of $40 per share.

So the option itself is valuable.

We could sell the option for - roughly - $40 (per share).


On the other hand, if the share price were only $20, it wouldn't be rational to exercise an option to buy shares for $50.

It would be irrational to do that, because the shares are cheaper to buy in the market for $20 each.

Accordingly, the option isn't valuable at present.


The value of the option is being driven by - among other things - the share price.


2. Financial reporting - IFRS 9 - US GAAP.

Contracts defined as derivative instruments must normally be "fair valued" at each financial reporting end date.

This can lead to greater volatility in reported corporate profits (earnings).

The greater the number of contracts that are categorised as derivative instruments, the greater the potential for increased volatility in reported profits.


Under International Financial Reporting Standards (IFRS) 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 specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘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 that would be expected to have a similar response to changes in market factors.
(3) it is settled at a future date.


There are a number of technical differences between the identification of derivative instruments under US GAAP, compared with IFRS.

The most important difference between IFRS 9 and US GAAP is that, to be characterised as a derivative instrument under US GAAP, the contract must generally reference a notional principal amount.

The consequence of this difference is that a larger number of contracts are classified as derivative instruments under IFRS 9, compared with US GAAP.

(Source Ermelindo Varela R.A, AMCT, FRM - Renewable Energy: is a level playing field out of reach for IFRS preparers? - 25 June 2024.)


See also


Other resources

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