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What is a derivative and what is hedging?

A derivative is a type of financial instrument whose value is based upon the value of an underlying asset, index, rate or reference point. One of the main reasons for entering into derivative transactions is for the purpose of hedging. Hedging is a method of reducing a party's existing or future exposure to a risk of an adverse movement in a variable. For example, under a credit agreement, a borrower may borrow amounts at a floating rate of interest. That borrower may enter into an interest rate swap to hedge its exposure to a risk of a rise in that interest rate.

Derivatives are frequently used to support (or 'hedge') a loan, for example by swapping a floating interest rate under the facility agreement into a fixed rate.

For more information on derivatives, see Practice Notes:

1. •

   The nature of financial derivatives

2. •

   Types of derivatives, and

3. •

   Financial derivatives—netting

How are derivatives documented?

Derivatives