Financial Management for Nonprofit Organizations, 3rd Edition

APPENDIX 14ADERIVATIVES CHECKLIST

A derivative is an investment or other financial instrument whose value is dependent on, or derived from, another asset. It is a risk transfer tool. For example, you may protect against an adverse movement in a foreign currency by purchasing a forward contract, futures contract, or an option on that currency. Formally, a financial derivative is:

… a financial instrument that changes in value in response to an underlying share, interest rate etc. and creates the rights and obligations that usually have the effect of transferring between parties to the instrument one or more of the financial risks inherent in an underlying. For example, a share option allows the holder the option to benefit if the share price of the underlying share increases above the option's strike price, and places an obligation on the issuer of the option to supply the shares at the strike price, if the holder exercises the option. A key characteristic of derivatives is that they require little or no initial net investment and will be settled at a future date. Common examples are options, forwards and interest rate swaps.¹

Major types of derivatives are options, forwards, futures, and swaps. Although only a modest number of nonprofits outside the healthcare sector have used derivatives as part of their financial management processes – mostly swaps to lower or reduce the variability of interest expense – a number of endowments and foundations have lost money in investment ...