What makes something a derivative
- One or more underlyings and a notional amount
- Little or no initial net investment relative to contracts with similar response to market changes
- Terms that require or permit net settlement
All derivatives are recorded on the balance sheet at fair value. The question is always where the change in fair value goes.
The three hedge types
| Hedge type | Hedges against | Gain/loss on the derivative |
|---|---|---|
| Fair value hedge | Changes in the fair value of a recognized asset/liability or firm commitment | Earnings — offset by the loss/gain on the hedged item, also in earnings |
| Cash flow hedge | Variability in cash flows of a forecasted transaction or variable-rate item | OCI, reclassified to earnings when the hedged transaction affects earnings |
| Net investment hedge | Currency exposure of a net investment in a foreign operation | OCI (cumulative translation adjustment) |
IMPORTANT: Without hedge designation and documentation at inception, all changes in a derivative's fair value go straight to earnings. Hedge accounting is an election with strict documentation and effectiveness requirements — it is never automatic.
EXAMPLE: A company with variable-rate debt enters an interest rate swap to pay fixed and receive variable. This hedges cash flow variability → cash flow hedge → changes in the swap's fair value go to OCI and are reclassified to interest expense as the interest payments occur.
Common derivative instruments
- Forward — customized private contract to buy/sell at a set price on a future date
- Future — standardized, exchange-traded, marked to market daily through a clearinghouse
- Option — the right, not the obligation, to buy (call) or sell (put)
- Swap — exchange of cash flow streams (e.g., fixed for variable interest)
EXAM TIP: Ask what is being hedged. Hedging a value that's already on the balance sheet → fair value hedge → earnings. Hedging future cash flows that aren't recorded yet → cash flow hedge → OCI.