Financial Accounting and Reporting-CPA Practice Exam

What does the value or settlement amount of a derivative depend on?

1. The asset's book value

2. The market price of the underlying asset

3. The multiplication of the notional amount and the underlying

4. The time until contract expiration

The correct answer is: The multiplication of the notional amount and the underlying

The settlement amount of a derivative is fundamentally based on the relationship between the derivative contract and the underlying asset it derives its value from. This typically involves the notional amount, which acts as a base for calculating the settlement. In many derivative instruments, such as options and futures, the value is determined by multiplying the notional amount by the difference between the market price of the underlying asset and the strike price or contract price. This multiplication creates the financial payoff that is realized at settlement. Considering the importance of the notional amount, it serves as a reference point for how changes in the price of the underlying asset directly impact the derivative's value. Therefore, the final settlement amount is critically dependent on both the notional amount and the performance of the underlying asset, which is captured in the product of these two elements. While the market price of the underlying asset and the time until contract expiration are important factors influencing a derivative's value and pricing, they do not alone define the settlement amount without the context of the notional amount's influence in the calculation.