Derivative is a special type of financial instrument. It is a contract between two or more parties which has the following characteristics:
- It requires no or minimal initial investment
- It derives its value from changes in an underlying item (such as foreign currency exchange rate, commodity price, market interest rate etc.)
- It will be settled at a future date
Derivatives are classified and measured as fair value through profit or loss (FVTPL) financial instruments. Depending on the movements in values of the underlying item, a derivative can be a financial asset at FVTPL as well as a financial liability at FVTPL.
Here are some common examples of derivative contracts.
A forward contract is a tailor-made contract between two parties to buy or sell an underlying item on an agreed future date at a specified price. For e.g. a forward contract to purchase specified amount of foreign currency after 6 months at an agreed exchange rate or price.
Futures are ready-made contracts between two or parties to buy or sell an underlying item on an agreed future date at a specified price. Futures are like forward contracts, but the forward contracts are highly customized whereas futures are not. Futures are ready-made contracts which are usually traded in markets as well.
Options are contracts that give the holder of the contracts an option to buy or sell an underlying item (such as shares of a company) on an agreed date at a specified price. Here, there is an option given to the holder of the contract, whereas in forward and future contracts, there is a contractual obligation to buy or sell the underlying item.
Let’s see the following example to understand how accounting of derivatives is done.
Example – Derivatives
On 1 December 20×1, a company in Pakistan enters into a forward contract with a Bank to buy $50,000 after three months at an exchange rate of PKR 150/1 USD. How will this contract be recorded in the books of account considering the following additional information?
- Exchange rate on 31 December 20X1 is PKR 145/1 USD
- Exchange rate on settlement date, i.e. 1 March 20X2 is PKR 160/1 USD
On 1 December 20×1, forward contract is signed but as there is no initial investment, therefore nothing is recorded at this date. At year end and at settlement date, following entries will be made based on changes in the spot rates of the underlying foreign currency, i.e. USD exchange rate.
Uses of derivatives
Derivative contracts are used for any of the following two purposes:
- Speculation: to earn speculation gains by trading in derivatives.
- Hedging: to minimize uncertainty and risks of potential losses due to unfavorable movements in exchange rates or market prices of specific items.