Accounting for Investments, Volume 2: Fixed Income Securities and Interest Rate Derivatives—A Practitioner's Guide

DERIVATIVES IN A FINANCIAL INSTRUMENT

A derivative instrument is a financial instrument, such as an option or futures contract, whose value depends on the performance of an underlying security or asset. Futures contracts, forward contracts, options, and swaps are the most common types of derivatives. Derivatives are generally used by institutional investors to increase overall portfolio returns or to hedge portfolio risk. A derivative is a financial instrument that does not constitute ownership, but a promise to convey ownership.

All derivatives are based on some underlying financial or non-financial item. For example, the underlying products could be any of the following:

• Equity shares: These include equity shares listed in the stock exchanges, index based on the equity market, etc.
• Commodities: These include grain, wheat, pepper, coffee, cotton, crude etc.
• Foreign exchange: This is buying and selling of foreign currency at the spot rates that are quoted by the inter banks.
• Bonds of various different varieties like Eurobonds, domestic bonds, fixed interest or floating rate notes, etc. Bonds are medium- to long-term negotiable debt securities issued by governments, government agencies, federal or state bodies, the World Bank, or companies. These bonds may be freely traded without reference to the issuer of the security if they are negotiable.
• Short-term money market negotiable debt securities such as T-bills issued by governments, commercial paper issued by companies or bankers ...