Derivatives
Kyle Ashcraft, CPA · 2019 CPA Exam Scores · 95 FAR · 98 BEC · 91 REG · 90 AUD
A derivative is any financial instrument whose value is based on some underlying investment. Stock options are the clearest example: an option's price moves because the underlying stock's price moves.
What is a stock option?
When you buy a stock option, you're buying the right — not the obligation — to buy or sell a stock at a set price on a future date. If you want exposure to a stock four months from now, you can buy an option today instead of buying the stock itself.
What's the difference between a call and a put option?
- Call option — the right to buy shares at a future date
- Put option — the right to sell shares at a future date
What are the exercise price and the option premium?
The exercise price (also called the strike price) is the price locked into the option contract. If the exercise price is $70 and you hold a call option, you can buy the stock for $70 on the exercise date no matter what it's actually trading for.
The option premium is what you pay upfront to buy the option itself — separate from whatever you'd later pay to exercise it. For accounting purposes, options are measured at fair value.
An option's price only exists because the stock's price exists. That dependency is what makes it a derivative — the option contract itself has no value in isolation, only relative to the stock it's tied to.
Want the full BEC framework?
My free CPA 101 course covers the study approach I used to score 90+ on every CPA exam section.
More on corporate finance
Kyle Ashcraft, CPA scored 90 or above on every section of the CPA exam in 2019, including a 98 on BEC. He is the founder and sole instructor of Maxwell CPA Review, a complete CPA review course covering all six sections, where he creates every lecture, textbook and study outline himself.
The exercise price (i.e., strike price) is the price that the stock options allow you to either buy or sell the stock for at a future date. If the exercise price is $70 and you purchased a call option, then you’re allowed to buy the stock for $70, no matter what its actual price is. The stock option premium is what you pay to actually buy the stock option. For accounting purposes, we use the fair value of the options.