Financial Reporting · Derivatives and Embedded Derivatives

Definition and Features of a Derivative under Ind AS 109

Updated 5 October 2026 · Fact-checked

Under Ind AS 109, a derivative is a financial instrument or other contract whose value changes with a specified underlying variable, needs no initial net investment or one much smaller than other similar contracts would need, and is settled at a future date. To solve questions, test all three features one by one.

Understand Definition and Features of a Derivative

A derivative is a contract whose value depends on something else. That something else is the underlying. It can be an interest rate, a share price, a commodity price, a foreign exchange rate, a price index, a credit rating or any other variable. For a non-financial variable, it must not be specific to a party to the contract.

The contract itself has no value of its own. Its value moves because the underlying moves. You and the other party agree today on terms, and the gain or loss comes later as the underlying changes.

Ind AS 109 gives three characteristics. First, the value changes in response to the underlying. Second, it requires no initial net investment, or an initial net investment smaller than would be required for other types of contracts with a similar response to market changes. Third, it is settled at a future date. A contract must meet all three to be a derivative.

A notional amount is the quantity, such as a number of units, a nominal sum or a number of shares, that is used with the underlying to work out the settlement. It is often not exchanged. In an interest rate swap, the notional principal is not paid. Only the interest difference is settled. Some contracts use a fixed payment or a payment that depends on the underlying instead of a notional amount.

Common examples are forwards, futures, options and swaps. A forward is a private contract to buy or sell at a fixed price on a future date. A futures contract is a standardised, exchange-traded forward with daily margin settlement. An option gives the holder a right, not an obligation. The holder pays a premium, which is small compared with the value of the underlying, so the second feature is still met. A swap exchanges cash flows on agreed dates.

Key rules to remember

Definition test (all three must hold): Derivative = Underlying-linked value + Little or no initial net investment + Settlement at a future date; If any one feature is missing, the contract is not a derivative under Ind AS 109.
Gain or loss on a forward purchase (long): Gain/(loss) = (Spot or forward price at settlement − Contract price) × Quantity; The seller (short) has the opposite result. Use the notional quantity.
Payoff to option holder (call): Payoff = Maximum of (Market price − Strike price, 0) × Quantity; Net result for the holder = Payoff − Premium paid. The writer's result is the opposite.
Payoff to option holder (put): Payoff = Maximum of (Strike price − Market price, 0) × Quantity; Premium paid is a cost to the holder at inception.
Net settlement in a swap: Net amount = (Rate A − Rate B) × Notional amount × Period; Only the net difference is paid. The notional amount is usually not exchanged.

How to solve Definition and Features of a Derivative questions

Use this method for any question that asks whether a contract is a derivative or how it behaves.

1Read the facts and list the contract terms: price, quantity, dates, premium or margin, and how it is settled.
2Identify the underlying variable. Check that it is a financial or other variable and that a non-financial variable is not specific to one party.
3Test feature 1: does the value change with the underlying? Say how.
4Test feature 2: is there no initial net investment, or one much smaller than needed for a similar-response contract? Compare premium or margin with the full value of the underlying.
5Test feature 3: is settlement at a future date? Note that net settlement or an exchange of the asset both count.
6State the conclusion. If all three are met, it is a derivative. Name the type: forward, future, option or swap.
7Link to accounting: derivatives are generally measured at fair value, with changes in profit or loss unless hedge accounting applies.

Quickest way: Three-question tick test

When to use it: Use it in MCQs and short case scenarios when you have about two minutes.

Ask: what moves the value? If nothing external moves it, stop. It is not a derivative.
Ask: how much was paid on day one compared with the exposure? Full payment means it is not a derivative.
Ask: when is it settled? If it is settled today, it is not a derivative.
Three ticks mean derivative. Write one line for each tick in a written answer.

Common mistakes in Definition and Features of a Derivative

Saying a derivative needs zero initial investment.
Students remember 'no investment' and ignore the rest of the wording.
Fix: Write 'no or little initial net investment'. An option premium is a payment, yet the contract is still a derivative.
Treating an outright purchase of shares as a derivative because the price moves.
Students focus only on feature 1.
Fix: Check feature 2. Buying shares needs full investment and fails the test.
Confusing notional amount with the amount actually paid.
The word 'amount' suggests cash changes hands.
Fix: Treat notional as a reference quantity used to compute settlement. In swaps it is not exchanged.
Saying forwards and futures are the same.
Both fix a price for a future date.
Fix: State the difference: forwards are customised over-the-counter contracts, futures are standardised exchange-traded contracts with daily margin and mark-to-market.
Ignoring that a non-financial underlying must not be specific to a party.
Students stop at the existence of an underlying.
Fix: If the variable is, for example, the sales of one party to the contract, check this condition before concluding.

Worked examples

Example 1

On 1 January, Meru Ltd enters a contract with a bank to buy US$ 1,00,000 on 31 March at ₹84 per US$. No money is paid on 1 January. The contract will be settled by delivery of the dollars. Is the contract a derivative? On 31 March the spot rate is ₹86. Compute the gain or loss.

Show the solution

Underlying: the INR/US$ exchange rate. The value of the contract changes as this rate changes. Feature 1 is met.
Initial net investment: nil. Feature 2 is met.
Settlement: on 31 March, a future date. Feature 3 is met.
All three features are met, so this is a derivative, specifically a forward contract.
Gain to Meru Ltd as buyer = (86 − 84) × 1,00,000 = ₹2,00,000.

Answer: The contract is a derivative (a forward). Meru Ltd has a gain of ₹2,00,000 at settlement.

Example 2

Kaveri Ltd buys 1,000 shares of Alpha Ltd at ₹500 each and pays ₹5,00,000 in full. Separately, it pays a premium of ₹20 per share for a call option on 1,000 shares of Beta Ltd with a strike price of ₹300, expiring in three months. The market price of Beta Ltd shares at expiry is ₹340. Which is a derivative? What is the net result of the option for Kaveri Ltd?

Show the solution

Alpha Ltd shares: the full price of ₹5,00,000 was paid at the start. There is no 'little or no' net investment and no future settlement. It is not a derivative.
Beta Ltd call option: the underlying is the Beta share price. Feature 1 is met.
Premium is ₹20,000 (20 × 1,000), far below the ₹3,00,000 (300 × 1,000) value of the underlying at the strike price. Feature 2 is met.
Settlement is at expiry in three months. Feature 3 is met. So the option is a derivative.
Payoff at expiry = (340 − 300) × 1,000 = ₹40,000, because the market price is above the strike.
Net result = 40,000 − 20,000 (premium) = ₹20,000 gain.

Answer: Only the Beta Ltd call option is a derivative. Its net gain to Kaveri Ltd is ₹20,000, and the Alpha Ltd shares are not a derivative.

Exam tips

In written answers, write the three characteristics as separate lines and apply each to the facts. This earns step marks.
In case MCQs, look for how much was paid on day one and when settlement occurs. These decide the answer quickly.
Learn one line each for forward, future, option and swap, including the forward vs futures difference, as it is frequently asked.
If a question asks about accounting, add that derivatives are generally measured at fair value through profit or loss unless designated in a hedge.

Practice questions from Derivatives and Embedded Derivatives

Definition and Features of a Derivative: frequently asked questions

What is the definition of a derivative under Ind AS 109?

It is a financial instrument or other contract within the scope of Ind AS 109 whose value changes with a specified underlying variable. It needs no or little initial net investment and is settled at a future date. All three features must be present.

What is the difference between a forward and a futures contract?

A forward is a customised contract between two parties, traded over the counter, usually settled at maturity. A futures contract is standardised, traded on an exchange and marked to market daily with margin. Futures carry less counterparty risk because of the exchange clearing mechanism.

What are the underlying and the notional amount?

The underlying is the variable, such as a price, rate or index, that drives the contract's value. The notional amount is the quantity or sum, such as units or a nominal principal, applied to the underlying to compute settlement. It is often not exchanged.

Is an option premium an initial net investment?

It is a payment, but it is small compared with the value of the underlying exposure. Ind AS 109 requires 'no or little' initial net investment, so an option still qualifies as a derivative.