Business and Personal Finance Dictionary

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• DERIVATIVES
  
  1. Financial instruments whose value depends upon the values of underlying assets, interest rates, currency exchange rates, or indexes. Various authorities define derivative instruments in broad, inclusive terms or narrow, exclusive terms. It is a common misconception that all derivatives are high-risk, speculative instruments. Large financial institutions use derivatives for hedging. Options, futures, swaps, and swaptions are common derivatives used for hedging purposes. All CMOs are derivatives. There are many derivative instruments, and new ones are developed often. See underlying. 2. In FAS 133, FASB defines derivatives narrowly. With some exceptions, FAS 133 defines a derivative instrument to be any financial instrument or other contract that has all three of the following characteristics: A. The financial instrument or contract has both: 1. One or more underlyings. 2. One or more notional amounts or payment provisions or both. B. The financial instrument or contract either does not require an initial investment or requires an initial net investment that is "smaller than the amount that would be required for other types of contracts that would be expected to have a similar response to changes in market factors." C. The terms of the financial instrument or contract either 1. Require or permit net settlement. 2.Provide that the contract can be readily settled net by a means outside the contract. 3.Provide for delivery or an asset that puts the recipient in a position not substantially different from net settlement. Mainly as a result of FASB’s second requirement, financial instruments such as CMOs and structured notes that are commonly called derivatives are not derivatives as defined by FASB. See FAS 133.
  
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