What are elements of a derivative?
Consider the following elements of a derivative:
1 . A derivative has one or more underlyings. An underlying is an observable variable such as a specified interest rate, or commodity price, or foreign exchange rate.
2 . A derivative has one or more notional amounts. A notional amount is a number of currency units, bushels, shares, or other units specified in the contract.
3 . A derivative sometimes requires no initial investment. The firm usually acquires a derivative by exchanging promises with a counterparty, such as a commercial or investment bank. The exchange of promises is a mutually unexecuted contract.
4 . Derivatives typically require, or permit, net settlement, which means that when the counterparties settle the derivative contract, one of the contracting parties pays the other the fair value of the contract. Because many derivatives require no initial investment, that is, no initial cash payment to the counterparty, measurement at acquisition cost makes little sense for these instruments. That is, a derivative may have zero initial cost, but potentially large positive or negative fair values later. Both U.S. GAAP and IFRS require that firms record derivatives at their fair values on the balance sheet date.
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