A critical characteristic of a derivative and the basis for its name is that the instrument derives its value from changes in the value of a related asset or liability. The rates or prices that relate to the asset or liability underlying the derivative are referred to as underlyings. The underlying may take a variety of forms, including a commodity price, stock price, foreign currency exchange rate, or interest rate. It is important to note that the underlying is not the asset or liability itself, but rather its price or rate. For example, the underlying in an option to buy a share of stock at a fixed price of $50 is not the stock itself; it is the $50 price of the stock, and it determines the value of the derivative.
Changes in the underlying price or rate cause the value of the derivative to change. For example, if the price of a stock underlies the value of an option to buy that stock, changes inthe price of the stock relative to the option price will cause the value of the option to change. If the underlying price of the stock changes from $50 to $52, then the option to buy at $50 has increased in value by $2 (one could buy the stock for $50 when it has a fair value of $52).
In order to fully value a derivative, one must know the number of units (quantity) that is specified in the derivative instrument. This is called the notional amount, and it determines the total dollar value of a derivative, traceable to movement or changes in the underlying. For example, if the option to buy stock for $50 increases in value because the underlying price of the stock moves from $50 to $52, the total magnitude of this increase in value depends on how many shares can be purchased under the terms of the option. If the option applies to 1,000 shares, then the total value of the option is $2,000 (a $2 change in the underlying price of $50 to $52 times a notional amount of 1,000 shares). The notional amount of a derivative might refer to so many bushels of a commodity, number of shares, foreign currency units, or principal amount of debt. Both the underlying price or rate and the notional amount are necessary in order to determine the total value of a derivative at any point in time.
Typically, a derivative requires little or no initial investment because it is an investment in a change in value traceable to an underlying, rather than an investment in the actual asset or liability to which the underlying relates. For example, if the price of a stock increases, the value of an option to buy that stock also increases. If one actually owned the stock, an increase in the price of the stock would also result in increased value. However, the important difference is that in order to experience the increase in value an option holder needs to make little or no initial investment, whereas the owner of the stock has to make a significant investment to acquire the stock in the first place.
Many derivatives do not require the parties to the contract, the counterparties, to actually deliver an asset that is associated with the underlying in order to realize the value of a derivative. For example, the option to buy a share of stock at a fixed price would allow the holder to sell the option rather than requiring the other counterparty to actually transfer stock to them at the option price. Assume that a stock is trading at $52 per share and that one holds an option to buy stock at $50 per share. The holder could sell the option for $2 or require the counterparty to sell them stock at $50. If the stock were purchased for $50, it could readily be converted into cash by selling at $52, thereby realizing a gain of $2.
The ability to settle the contract in exchange for cash, without actually buying or selling the related asset or liability, is referred to as net settlement. A derivative may be a separate, distinct financial instrument, or it may be embedded in another financial instrument. An embedded derivative has economic characteristics and risks that are not clearly and closely related to those of the host instrument. For example, a convertible bond is a host contract that also contains an embedded derivative. That derivative represents the option to convert the bond into common stock; its underlying is the price of the respective stock. The conversion feature’s economic value is more closely related to the underlying stock than the bond. If the embedded derivative meets certain criteria, it should be separated, or bifurcated, from the host contract and be accounted for as a separate instrument.