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A corporation was a party to the following transactions during November and December of the current year. Which of these transactions is most likely to be defined as a derivative?
A. Based on its forecasted need to purchase 300,000 bushels of wheat in 3 months, entered into a 3-month forward contract to purchase 300,000 bushels of wheat to protect itself from changes in wheat prices during the period.
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Answer: A
Explanation:
A derivative is a financial instrument commonly used in hedging activities. Its value changes with the change in the underlying a specified interest rate, security price, foreign currency exchange rate, price index, commodity price, etc.). It requires little or no initial net investment compared with contracts having similar responses to changing market conditions, and it is settled in the future. The purchase of the forward contract as a hedge of a forecasted need to purchase wheat meets the criteria above. The forward contracts value will change with changes in the underlying the commodity price), requires little or no initial net investment the purchase is in three months), and settlement is in the future.
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