A derivative is simply a financial instrument that derives its value from the movement in

commodity price, foreign exchange rate and interest rate of an underlying asset or
financial instrument. Actually, a derivative is an executory contract, meaning, it is not a
transaction but an exchange of promises about future action. On inception, derivative
financial instruments give one party a contractual right to exchange financial asset or
financial liability with another party under conditions that are potentially favorable, while
the other party has a contractual obligation to exchange under unfavorable conditions.
Expressed in the simplest terms, parties to the derivative financial instrument are taking
bets on what will happen the "underlying" financial instrument in the future.

There are four types of financial risk in connection with derivatives, namely:

1. Price risk is the uncertainty about the future price of an asset. Entities are exposed to
a price risk with respect to existing assets such as investments in trading securities and
assets to be acquired in the future such as purchase commitments and equipment to be
imported at a future date.

2. Credit risk is the uncertainty over whether a counterparty or the party on the other
side of the contract will honor the terms of the contract. Banks and other financial
institutions are usually exposed to a credit risk by granting loans to borrowers. There is
always the possibility of nonpayment of the loans.

3. Interest rate risk is the uncertainty about future interest rates and their impact on cash
flows and the fair value of the financial instruments. For example, a borrower with a
variable-rate loan is exposed to an interest rate risk by reason of the fluctuation of
interest rate in the future. Even a borrower with fixed-rate loan is also exposed to an
interest rate risk because there is always the possibility that interest rate will decrease in
the future.

4. Foreign currency risk is the uncertainty about future Philippine peso cash flows
stemming from assets and liabilities denominated in foreign currency.
Which of the following is not a derivative? = Regular way purchase or sale

All of the following are characteristics of a derivative financial instrument, except = The
instrument requires a large investment at the inception of the contract.

An example of a "notional" is = Number of barrels of oil

Which type of contract is unique in that it protects the owner against unfavorable
movement in the price or rate while allowing the owner to benefit from favorable
movement? = Option

It is a component of a combined or "hybrid'; contract that also includes a nonderivative

host contract with the effect that some of the cash flows of the combined contract vary
in a way similar to a stand-alone instrument. = Embedded derivative

It is an asset, liability, firm commitment, highly probable forecast transaction or net

investment in a foreign operation that exposes the entity to risk of changes in fair value
or future cash flows and is designated as being hedged. = Hedged item
Which of the following statements regarding accounting for derivatives is incorrect? =
Gains and losses resulting from speculation should be deferred.

Gains and losses on cash flow hedge are = Recorded as part of other
comprehensive income.

Derivatives derive their value from changes in a benchmark based on any of the
following, except = Discount on accounts receivable