n It’s a financial instrument that has a value determined by the value of something else [underlying assets]
n The underlying can be a stock , bonds, commodity like corn, wheat…or other assets.
Why do we use derivatives?
n Derivatives are useful in risk management.
n It help in smooth the fluctuations caused by various types of risk, such as:
Ø Risk relative to interest rate
Ø Exchange rate
Ø Financial instrument and commodity price
n The main purpose of derivatives is to transfer risk from one party to another, that is to provide insurance.
n In derivatives transactions one party’s loss is always another party’s gain
n It improve the overall performance in the economy.
Two major ways of using derivatives
Derivatives used in
hedging
§ It is a transaction that reduce the risk of an investment
§ An attempt to offset exposure to price fluctuation
§ Here derivative can be considered as a type of insurance
speculation
§ Speculators enter the derivative market in search for profit and are willing to accept risk
§ they bet on price movement
§ A speculator expect that price of the product will increase so the fair value of forward contract increase
Basic principles in accounting for derivatives
n According to FASB derivatives are assets and liabilities
n Are reported at their fair value in financial statements
n Recognize any gain or loss resulting from speculation in derivatives in income
n Gains or losses resulting from hedge transaction depend on the type of the hedge
Major types of derivatives
Types of derivatives
n Swaps
-predetermined contract in which we exchange stream of cash flow
-it is a transaction between two parties in which the first party promise to make a payment to the second party and the second party promises to make a simultaneous payment to the first party
n Forwards
- a contract to buy or sell an assets at a future date
- change the underlying assets instead of cash flow
Examples for using derivatives
n Producers and consumers
producer consumer
expect the price expect the price
of potatoes will decrease will increase
n Both of them signs a forward contract
n In this case the consumer and the producer are hedgers because they enter the market to reduce the risk
n Futures
- an agreement between a buyer and a seller to exchange an assets at a preset price for a specified period of time
- a future is a forward contract that has been standardized and sold through an organized exchange
In futures
seller is obligated to deliver the assets to the buyer on specified future date
this date called the settlement or the delivery date
n Suppose there is a futures contract for the purchase of $1000 ounces of silver for $7 per ounce
n Seller : guarantees delivery of 1000 ounces for $7000 on the delivery date
n Buyer : is obligated to pay $7000 on the delivery date for 1000 ounces of silver
n Suppose price rises to $8 per ounce: the seller needs to pay $1000 to the buyer so the buyer still only pays $7000
n If price falls to $6, the reverse happens: the buyer needs to pay the seller $1000 to ensure that the seller receives $7000
n Hedging and speculation with futures:
n Producers and users of commodities use futures extensively to hedge their unwanted risks
– Farmers, oil drillers (producers) sell futures contracts for their commodities and insure themselves against price declines
– Food processing companies, oil refineries (users) buy futures contracts to insure themselves against price increases
n Speculators try to use futures to make a profit by betting on price movements:
– Sellers of futures bet on price decreases
– Buyers of futures bet on price increases
n An investor only needs a relatively small amount to purchase a contract that is worth a great deal
n Options
give holder the right but not the obligation to sell or buy a security
n Two types of options
- call option
- put option
Types of derivatives- options
Call option:
the holder have the right but not the obligation to buy a security or any type of assets at a fixed price within a fixed period.
- The preset price in the contract called Strike Price
Call option
n If asset price is higher than the strike price
– Option is in the money
n If asset price is exactly at the strike price
– Option is at the money
n If asset price is below the strike price
– Option is out of the money
n Obviously would not exercise an option that is out
of the money
n Put option
a right to sell an asset at a predetermined price on or before a specific date
n If asset price is lower than the strike price
– Option is in the money
n If asset price is exactly at the strike price
– Option is at the money
n If asset price is higher than the strike price
– Option is out of the money
Payment on option
n The payment on option called Option Premium
option premium= intrinsic value +time value
Intrinsic value
the difference between market price and
strike price.
Time value
reflect the possibility that the option’s fair value will increase
Using options
n Options transfer risk, and are used for
– Hedging
– Speculating
n A hedger is buying insurance
– Buying a call option ensures that the cost to you of buying an asset in the future will not rise
– Buying a put option ensures that you will be able to sell your asset in the future at a predetermined price
Using options
n Options are widely used for speculation
- Purchasing a call option allows a speculator to bet that the price of the underlying asset will rise
- Purchasing a put option allows a speculator to bet that the price of the underlying asset will fall
Characteristic of derivatives financial instrument
n has one or more underlying ,eg, specified interest rate , security price commodity price.
n Has an identified payment provision , the change in stock price multiply by the number of share ( national amount)
n Requires little or no investment at the inception of contract.
n Requires or permits net settlement .
-Investor generally do not have to sell or buy underlying assets to settle the option and realize gain
Derivatives used for hedging
n It is a technique that attempt to reduce risk
n Derivatives are used to offset the negative impact of changes in interest rates or foreign currency exchange rates
n Allow risk about the price of underlying assets to transferred from one party to another
Types of hedge
n Fair value hedge
n Cash flow hedge
Fair value hedge
n Derivatives can be used to hedge the exposure to changing in fair value of financial assets or liability like debt securities
q several types of fair value hedge
§ interest rate swap
- to hedge the risk that change in interest
rate will impact the fair value of debt
obligation
- the exchange of a fixed rate loan to a floating
rate loan.
Interest rate swap
Fair value hedge
§ put option
-the right but not the obligation to sell an
underlying at a particular price
-if the price of underlying decrease the
value of the option contract increase
Fair value hedge
n For fair value hedge
Ø change in fair value of the derivative flow directly to income
Ø change in fair value of hedged items recorded also in income
Ø Record the unrealized holding gain or loss in income
Example – fair value hedge
n On April 1 ,2006 , Hayward co. purchases 100 shares of sonoma stock at $100 per share , it classify them as available-for-sale
April 1, available-for-sale securities 10,000
cash 10,000
n The value of Sonoma shares increase during 2006 to $125
security fair value adjustment (AVF) 2500
unrealized holding gain or loss-Equity 2500
n To hedge against the risk that price of Sonoma stock will decline , Hayward purchase a put option on 100 shares of Sonoma stock on January 2,2007. with a strike price of 125 per share
Jan 2 ,2007 no entry
market price of stock= strike price in the contract
example
n At December 31 ,2007. when the price of Sonoma stock decline to $120 per share
Dec 31,2007 unrealized holding gain or loss-income 500
security fair value adjustment (AFS) 500*
* the special accounting for hedged items ( available-for-sale securities) in fair value.
n To record the increase in fair value of put option
Dec 31,2007 put option 500
unrealized holding gain or loss- income 500
example
Balance sheet
Assets
Available for sale securities 12000
Put option 500
Income statement
Other income
unrealized holding gain
-put option $500
Unrealized holding loss
-available-for-sale securities ( 500)
Cash flow hedge
n Derivatives can be used to hedge change in future cash flow arising from existing assets or liabilities or from forecasted transaction
n Example of cash flow hedge
future contract
gives the holder the right and the obligation to purchase an assets at a specified price on a specified future date
n For cash flow hedge
Ø derivatives accounted at fair value in balance sheet
Ø gain or loss recognized in equity as part of other comprehensive income
Cash flow hedge example
n Assume x company anticipated purchasing of 1000 metric ton of aluminum in January 2007
n To hedge the risk it might pay if higher price in 2007 , it enter into a future contract on September 1, 2006.
n As a result of this contact
- it has the right to receive 1000 metric tons of aluminum
- has an obligation to pay $1550 per ton ( spot price)
On sep 1, 2007. no entry
Fair value hedge example
n At Dec 31 , 2006 . Price of aluminum increase to $1575 per ton
Dec 31 future contract 25,000
unrealized holding gain or loss- equity 25,000
n In January 1 2007, purchase of 1000 metric ton of aluminum for $1575 per ton
aluminum inventory 1,575,000
cash 1,575000
At the same time , settlement on future contract
Dec 31 cash 25,000
future contract 25,000
Cash flow example
n When the company processes the aluminum into cans , total cost 1,700,000, and sell them for 2,000,000 in July 1 , 2007.
July 2007. cash 2,000,000
sales revenue 2,000,000
cost of good sold 1,700,000
inventory 1,700,000
n To reduce cost of good sold
July 2007 unrealized holding gain or loss-equity 25,000
cost of good sold 25,000
Other reporting issues
n Embedded derivatives
hybrid securities :
have characteristic of both debt and equity
combine traditional and derivatives instruments.
For example
convertible bond that consist of
Ø debt security referred to as host security
Ø conversion option referred to as embeded derivatives
n Companies must account for embedded derivatives as they do for other derivatives
Qualifying hedge criteria
Special hedge accounting allowed for hedging relationship that meet the following criteria
• Documentation, risk management, and designation
• The company expects the hedging relationship to be highly effective in achieving offsetting changes in fair value or cash flow
• Special hedge accounting is necessary only when there is a mismatch of the accounting effects for the hedging instrument and hedged items under GAAP
Disclosure provision
v Primary requirement for disclosures
• Disclose the fair value and related carrying value of financial instruments in financial statements
• Distinguish between financial instruments held for purposes other than trading
• Disclose the objective for holding or issuing derivatives ( speculation or hedging)
• Do not combine or net the fair value of separate financial instruments
• Display as a separate classification of other comprehensive income net gain or loss on derivatives designated in cash flow hedge
• Provide quantitative information about market risks of derivatives
Comprehensive hedge accounting example
n Use of interest rate swap
- the most common type of swaps
- the exchange of a fixed rate loan to a floating rate loan
- to hedge the risk that change in interest rate will impact the fair value of debt obligation
Interest rate swap
Interest rate swap example
n On January 2, Jones company issues $1,000,000 of 5 years, 8% , bonds
Jan 2,2007 cash 1,000,000
bonds payable 1,000,000
n On January 2, to protect against the risk of loss Jones enter into a 5 years interest rate swap contract
n As a result of this contract
- Jones will receive fixed payment at 8%
- Jones will pay variable rate based on the market rate in effect, that was in the inception of contract 6.8%
Jan 2, 20007 no entry
Interest rate swap example
n Jones make interest payment at the end of 2007
Dec 31, 2007 interest expenses 80,000
cash(8% *1,000,000) 80,000
n As a settlement payment of the swap contract on first interest payment date
Dec 31, 2007 cash 12,000
interest expenses 12,000
n A market appraisal indicates that the value of swap contract increased $40,000
Dec 31,2007 swap contract 40,000
unrealized holding gain or loss ـــ income 40,000
n Interest rates have declined , so the value of related liability increase
Dec 31, 2007 unrealized holding gain or loss – income 40,000
bonds payable 40,000
Financial statement presentation
Balance sheet
current assets
swap contract $40,000
long-term liabilities
bonds payable $1,040,000
n Record the derivative at its fair value in the balance sheet
n Adjust the hedged item (bond payable ) to fair value
Income statement
interest expenses
($80,000 – 12,000) $ 68,000
other income
unrealized holding gain
-swap contract $40,000
unrealized holding loss
-bond payable (40,000)
Net gain _$0_
n Record any gain or loss related to derivatives in income
n Record any gain or loss related to hedged item in income