• Explanation

Financial instruments Cash, ownership interest in an entity, or a contract that (1) represents a potential financial liability for one party by imposing an obligation and (2) represents a potential financial asset for the other party by conveying a right. Examples include cash, accounts and notes receivable, accounts and notes payable, derivatives, stocks, and options. include cash, ownership interests (Choice B) in an entity (eg, stock), and contracts.  Contracts create both an obligation to transfer and a corresponding right to receive one or more financial instruments (eg, derivatives, debt) between two parties (Choice A).

Derivatives Financial contracts that derive their value from the performance of some underlying asset such as a share of stock, a commodity, or a currency. are a type of financial instrument (ie, contract) whose value is derived from an underlying asset.  They are always reported at fair value The price received to sell an asset or transfer a liability from an orderly transaction between market participants on a specific date. (Choice D).  Investors generally purchase derivatives for hedging A risk management strategy employed to offset losses in investments by taking an opposite position in a related asset. (reducing risk), arbitrageArbitrage is the riskless sale of an asset at a higher price and the simultaneous purchase of the same asset or an equivalent asset at a lower price. Since the transactions are simultaneous, arbitrage implies riskless profit. (taking advantage of market pricing differences), or speculation Investment in stocks, property, or other financial instruments in the hope of gain but with the risk of loss. (betting on the market).

Derivatives have the following characteristics (NUNS).

• No net investment:  There is either no initial net investment or an initial net investment that is smaller than would normally be required for a similar market instrument.
• An underlying and a notional amount:  The notional amount is the number of units and the underlying is the factor that affects the derivative's value (price, interest rate, exchange rate).  In a forward exchange contract, the notional amount would be the number of foreign currency units (FCUs) and the underlying would be the future exchange rate.
• Net settlement:  The derivative is settled in a net amount.  A holder of a forward exchange contract does not actually buy or sell the FCUs, but instead receives or pays the difference between the contracted exchange rate and the market rate.

Things to remember:
A derivative is a financial instrument that has the following characteristics: no net investment, an underlying and a notional amount, and net settlement.