What is a Derivative? Part 1

Even though I am a bookkeeper (www.codexbookkeepingservices.com), In my prior life I worked with derivatives in the energy sector. A lot of derivatives. Derivatives are a rather confusing topic for people who don't work with them on a regular basis. I'm going to make several posts to help dissipate the confusion.

I was at a conference and the session was on new FASB guidance. We got to the topic of derivatives, and one of the participants asked, "What is a derivative?". The presenter froze, not because they didn't know what a derivative is, but because it is such a complicated subject and there are so many exceptions to every rule.

At its core, a derivative is a contract to purchase a commodity at a future date for a price that can be indexed to a forward market or a financial contract to lock in an interest rate or foreign exchange rate. (I thought that was going to be simpler to state until I started writing it. I almost froze like the presenter at the conference.)

FASC 815-10-15-83 defines a derivate as:

A derivative instrument is a financial instrument or other contract with all of the following characteristics:

1. Underlying, notional amount, payment provision. The contract has both of the following terms, which determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required:

   1. One or more underlyings

   2. One or more notional amounts or payment provisions or both.

2. Initial net investment.

   1. The contract requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.

3. Net settlement. The contract can be settled net by any of the following means:

   1. Its terms implicitly or explicitly require or permit net settlement.

   2. It can readily be settled net by a means outside the contract.

   3. It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

Price and Notional

An underlying is the price and a notional is the quantity. (remember UP underlying = price). You would think the price and quantity are easy to determine, and in most contracts you would be right.

The price may be stated as a reference to an index (stock market, commodity market, interest rate). To qualify as a price, the contract must state which index and when the price will be determined. (Such as "month end price" or "stock price on a certain day".) If the price is stated as the price of NYMEX capacity when the capacity is sold, the contract does not become a derivative until the capacity is sold. This in practice means the contract is not a derivative because it becomes a derivative at the exact moment of settlement and there isn't time to mark the contract to market.

The notional or quantity can be stated in many ways. But first, I want to tell you about requirement contracts because a lot of contracts are requirement contracts and they are not derivatives. A requirement contract is a contract that states the seller will sell all of the product an entity needs or the buyer states they will purchase all of the product an entity can produce. A good example is the implicit contract you have with your public utilities. The electric or water company has contracted to provide you with all the electricity or water that you need. Since you can't determine how much you are going to need until you need it, the quantity (notional) under the contract is undeterminable and the contract is not a derivative. Another example is a solar farm. You can't determine how much electricity will be produced until the shines and electricity is produced. Therefore, there is no quantity (notional) determinable under the contract. (As a side note, the solar farm owners are good at estimating the amount of electricity that is going to be produced from historical weather date.)

When does a requirement contract become a derivative? Early in my career, Ohio decided to deregulate their energy market thinking it would bring lower prices to the consumer. (It didn't.) To preserve its market share, the company I worked for started selling retail energy to commercial and industrial customers. My boss and I looked over all the contracts and determined they weren't derivatives because they were requirement contracts. We gave the retail energy people strict instructions to tell us if the contracts changed and we asked them every quarter end if the contracts had changed. They always told us no. When my company was bought out, the buying company looked at every contract and they were like, "hey these are derivatives." They had changed the contracts. They started adding the companies' historical usage as an addendum to the contract and this pulled the quantity into the contract. This falls under the theory of "Trust but verify", we did not verify, we just trusted.

Notionals are tricky. They can hide in addendums or default clauses or some random paragraph. You have to read the contracts carefully.

Next post I will talk more about notionals and about initial investment.

If you need a bookkeeper, I have a lot of experience in many different areas of accounting, so please email me at linda.cavanaugh@codexbookkeepingservices.com or visit my website at www.codexbookkeepingservices.com and let me make your work life a little easier.