What is a Derivative Part 2 - Notionals and Initial Net Investment

I left off last week with notionals and requirement contracts. Most of what I wrote about last week and again this week (and probably the next week) is more applicable to commodity derivatives rather than financial derivatives like interest rate hedges and foreign exchange hedges. This is due to the fact that the financial derivatives are very easily identified as derivatives. There isn't any controversary around them because they contractually net settle (This will be discussed next week).

I wanted to make clear that just because you find a notional in a requirements contract, does not mean the contract is a derivative. It only satisfies one of the characteristics of a derivative. We still have two more to discuss: initial net investment and net settlement.

So, on to finding hidden notionals. The default clause is another way that your traders or finance people can sneak in a notional. Most default clauses state that the entity defaulting has to make the non-defaulting entity whole. Basically, an entity has to buy out of the contract that they have defaulted on, to disincentivize them from defaulting. In a requirements contract, you don't have a notional, so there isn't any forward value in the contract that a defaulting entity would need to buy out. Therefore, sometimes a default clause will make reference to historical data or a minimum amount the non-defaulting party will be compensated. These types of additions to the default clause (while protecting the entity in the case of default), creates a notional for the contract, and possibly causes the contract to be a derivative.

Another issue with determining whether a contract has a notional, is the minimum and/or maximum clause. These clauses will state that the customer is required to take a least a certain amount of the product under contract or that they can only take up to a certain amount of the product. A minimum purchase requirement means that a notional exists. The entire amount of the requirement contract's volume will not be a derivative, just the minimum requirement volume. A maximum purchase requirement does not establish a notional because the notional could be anywhere between zero and the stated maximum amount.

One clause that precipitated a long conversation, was a clause in a solar power purchase agreement that stated if the solar farm did not produce a certain amount of power, then the seller would have to pay a penalty. Some felt this was a minimum volume amount and created a notional. Others felt that it was just a penalty clause and did not require the seller to produce a certain amount of power. They would just have to pay a penalty if they didn't. Since this requirement was on the seller and did not require the buyer to purchase a minimum amount, it was decided that this did not create a notional in the contract and kept the contract from being a derivative.

As I said before, notionals are tricky. If you have a question on them, you should talk to your auditors to be sure you are on the same page. You don't want to restate some financials over a notional.

Lastly for today, we have the second characteristic of Initial net investment. As a reminder, this is defined as an amount smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors. This is one of the most garbled and nonsense clauses in the FASC codification. Basically, it is stating that if you prepay a contract, you don't have a derivative, because there isn't any risk involved. You have already paid for everything. The question then because what does "smaller than would be required mean". I had to research this question because someone questioned whether a premium on an option would preclude the option from being a derivative. In one of the Big 4 Accounting firms (I don't remember which one) derivative guides, I found a statement that the premium has to be more than 90% of the value of the contract to fail this characteristic. I have not seen a contract that failed this characteristic. It would be rare to find a contract that was excluded from derivative rules because it failed initial net investment.

Next week, we will discuss the final characteristic of net settlement. If you thought notionals were confusing, then you should buckle up because it is going to be a bumpy ride.

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