Derivative

What it means

A derivative is a financial instrument whose value derives from another asset or indicator, known as the underlying. It may be an exchange rate, interest rate, commodity price, share or index. The derivative does not own the underlying; it merely gains or loses on its movements.

The most common types are forwards, agreements on a future trade at today’s price, options, which give a right but not an obligation to trade, and swaps, in which the parties exchange payments, such as an interest rate swap. Futures are standardised forwards traded on an exchange.

Derivatives serve two opposite purposes. In hedging a company uses them to reduce a risk it already has, such as currency risk from exports. In speculation it deliberately takes on risk hoping for a profit. The same instrument can be insurance one time and a bet the next.

How it works in practice

Slovak companies mostly meet derivatives as exporters or importers hedging exchange rates, as borrowers hedging interest on larger loans and as buyers of energy or raw materials. Before entering into one, the bank assesses whether the company understands the risks and often requires collateral or a limit.

In the accounts derivatives are measured at fair value at the reporting date. For hedging derivatives, under certain conditions changes in value go to equity and reach the result only together with the hedged transaction. If the conditions are not met, changes go straight to the result and make profit and loss swing.

For tax, changes in the fair value of derivatives generally feed into the tax base according to how they are booked. For each derivative we therefore need the bank’s valuation at 31 December and the contract showing whether it hedges a specific transaction.

What to watch out for

The biggest losses occur when a derivative meant as a hedge actually hedges nothing, for example when a company hedges more volume than it really exports, or when the deal being hedged falls through. The insurance then becomes pure speculation.

Beware of complex structured products that banks present as attractive. They often contain sold options that cause unlimited losses if the rate moves sharply. Before signing we recommend asking what happens in an extreme market move and requesting scenarios.