A type of financial instrument that has financial securities (such as stocks, bonds, and contracts) as underlying. Per se, the derivative financial instrument is a more complex financial instrument that takes the form of contracts whose performance yet depends on that of certain underlying assets or arrangements/ mechanisms such as options, swaps and investments in convertible debt.

A derivative is principally a notional construct that will generally have no value attached to it when it is purchased or held (i.e. when a party enters into the contract). This is because the contract will derive its value from an underlying asset- that is, its performance in the market or as to the relationship between the two parties involved. One of the most basic forms of derivative is a forward foreign currency contract (FX forward), in essence a forward contract, that involves the trading of a certain pair of currency transacted now and will take place in the future.  If a entity enters into a forward foreign currency contract, say, one month before its year-end to sell foreign currency one month after its year-end, then on the date the contract is concluded, the contract will usually have a fair value of zero. Over the next two months, foreign exchange rates are likely to change give rise to a value for the forward foreign currency contract and it is this value that will have to be reflected on the balance sheet with changes in that value from one accounting period to the next being routed through income statement/ profit or loss.

Settlement style of the underlying dictates accounting treatment of such instruments. In other words, derivative financial instruments may gives one party a choice over method of settlement (e.g., the issuer or the holder can choose cash or physical settlement: net in cash or by exchanging underlying securities for cash). Such instruments are classified as a financial asset or a financial liability unless all of the settlement alternatives would result in it being an equity instrument.

An example of a derivative financial instrument with a settlement option that is a financial liability is a share option that the issuer can choose to settle net in cash or by exchanging its own shares for cash. Similarly, certain contracts to buy or sell a non-financial item in exchange for the entity’s own equity instruments can be settled either by delivery of the non-financial item or net in cash or another financial instrument. Such contracts are classified as financial assets or financial liabilities and not equity instruments.