Financial Accounting and Reporting-CPA Practice Exam

What must a derivative instrument have to meet the definition?

1. Large initial net investment

2. No payment provisions

3. One or more underlyings

4. No settlement for cash

The correct answer is: One or more underlyings

A derivative instrument must have one or more underlyings to fulfill the definition of a derivative. The "underlying" refers to a variable such as interest rates, commodity prices, foreign exchange rates, or other financial instruments that the value of the derivative is tied to. The presence of underlyings establishes the relationship between the derivative and the underlying asset or index, allowing the derivative's value to fluctuate based on changes in the underlying variable. In financial terms, underlyings are crucial because they provide the basis for the potential future cash flows that the derivative can generate. Derivatives are often used for hedging risk or speculation, and the underlying is essential for determining how these instruments will perform as market conditions change. Without an underlying, the instrument would lack the necessary component to qualify as a derivative. Other choices do not align with the essential characteristics of derivatives. For instance, while derivatives can require an initial investment, a large initial net investment is not a requirement to define derivatives. Similarly, payment provisions can exist in derivatives, and settlement can occur in various forms, including cash settlements, which means that the absence of payment provisions or the stipulation of no cash settlement does not define a derivative. Hence, the correct answer, which highlights the requirement of