(Accounting for Forward Contracts)

Accounting for derivatives and hedging transactions

Derivatives – is a financial instrument or other contract that derives its value from the changes in value of some other underlying
asset or other instrument.

Characteristics of a derivative
A derivative is a financial instrument or other contract with all three of the following characteristics:
a. Its value changes in response to the change in an underlying
b. Requires no initial investment or a very minimal initial net investment and;
c. It is settled at a future date

Underlying – is a specified price, rate or other variable (e.g. interest rate, security or commodity price, foreign exchange rate,
index prices or rates).

After initial date of transaction, the value or settlement amount of a derivative is the amount determined by multiplying the
notional amount by the underlying.

Notional amount – is a specified unit of measure (currency, units, shares, pounds, etc).

Purpose of derivatives
a. To speculate (incur risk)
b. To hedge (to avoid risk)