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DERIVATIVES

Appendix A. DERIVATIVES. Derivatives. Derivatives are financial instruments that “derive” their values from some other security or index. They serve as a form of ‘insurance” against risk. Financial Futures. Forward Contracts. Options. Interest Rate Swaps.

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DERIVATIVES

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  1. Appendix A DERIVATIVES

  2. Derivatives Derivatives are financial instruments that “derive” their values from some other security or index. They serve as a form of ‘insurance” against risk. Financial Futures Forward Contracts Options Interest Rate Swaps

  3. The company might choose to hedge its position by entering into a transaction that would produce a gain of roughly the same amount as the potential loss if interest rates do, in fact, increase. Derivatives Used to Hedge Hedging means taking a risk position that is opposite to an actual position that is exposed to risk. Assume a company has a large amount of outstanding debt that has a floating (variable) interest rate. If interest rates increase, this could pose a substantial cost to the company in the form of increased interest payments.

  4. Financial Futures A futures contract allows a firm to sell (or buy) a financial instrument at a designated future date, at today’s price. Treasury Bond Fair value risk is that the investment’s value might change. Treasury Bill Commercial Paper Certificate of Deposit Cash flow risk is the risk of having to pay more cash or receive less cash.

  5. Financial Forward Contracts A forward contract differs from a futures contract in three ways. • A forward contract calls for delivery on a specific date, whereas a futures contract permits the seller to decide later which specific day within the specified month will be the delivery date (if it gets as far as actual delivery before it is closed out). • Unlike a futures contract, a forward contract usually is not traded on a market exchange. • Unlike a futures contract, a forward contract does not call for a daily cash settlement for price changes in the underlying contract. Gains and losses on forward contracts are paid only when they are closed out.

  6. Options Options frequently are purchased to hedge exposure to the effects of changing interest rates. Options give the holder the right either to buy or sell a financial instrument at a specified price and within a given time period. The holder has no obligation to exercise the option.

  7. Foreign Currency Futures Foreign loans have an added element of risk of changes in foreign exchange rates. Foreign exchange risk is often hedged in the same manner as interest rate risk.

  8. Interest Rate Swaps Interest rate swaps exchange fixed interest payments for floating rate payments, or vice versa, without exchanging the underlying principal amounts.

  9. Accounting for Derivatives All derivatives are reported on the balance sheet as either assets or liabilities at fair (market) value. Accounting for the gain or loss on a derivatives depends on how it is used.

  10. Non-hedge Derivatives Immediately recognize gain and loss in earnings • Hedge Derivatives • Immediately recognize gain and loss in earnings along with an offsetting loss or gain on the item being hedged or • Defer in comprehensive income until it can be recognized in earnings at the same time as earnings are affected by a hedged transaction Accounting for Derivatives Gain or Loss on Derivatives The treatment of gains and losses for hedge derivatives depends on whether the derivative is designated as a (a) fair value hedge, (b) cash flow hedge, or (c) foreign currency hedge.

  11. Fair Value Hedges A gain or loss from a fair value hedge is recognized immediately in earnings along with the loss or gain from the item being hedged. This means that, to the extent the hedge is effective in serving its purpose, the gain or loss on the derivative will be offset by the loss or gain on the item being hedged.

  12. Cash Flow Hedges A gain or loss from a cash flow hedge is deferred as Other Comprehensive Income until it can be recognized in earnings along with the earnings effect of the item being hedged. When the derivative is adjusted to reflect changes in fair value, the other side of the entry is a gain or loss to be deferred as a component of Other Comprehensive Income and included in earnings later, at the same time as earnings are affected by the hedged transaction.

  13. Foreign Currency Hedges • A foreign currency hedge can be a hedge of foreign currency exposure of: • A firm commitment—treated as a fair value hedge. • An available-for-sale security—treated as a fair value hedge. • A forecasted transaction—treated as a cash flow hedge. • A company’s net investment in a foreign operation—the gain or loss is reported in Other Comprehensive Income as part of the unrealized gains and losses from foreign currency translation.

  14. Hedge Effectiveness and Ineffectiveness A high correlation exists between changes in the fair value or cash flows of the derivative and of the item being hedged, not necessarily a specific reduction in risk. Hedge Effectiveness Results in part of the derivative gain or loss being included in earnings. Hedge Ineffectiveness

  15. Fair Value Changes Unrelated to the Risk Being Hedged Fair value changes unrelated to the risk being hedged are ignored. Note then that although we always mark a derivative to fair value, the reported amount of the item being hedged may not be its fair value. We mark a hedged item to fair value only to the extent that its fair value changed due to the risk being hedged.

  16. Disclosure of Derivatives and Risk • Extensive disclosure requirements provide information that includes: • Objectives and strategies for holding and issuing derivatives. • A description of the items for which risks are being hedged. • For forecasted transactions: a description, time before the transaction is expected to occur, the gains and losses accumulated in other comprehensive income, and the events that will trigger their recognition in earnings. • Beginning balance of, changes in, and ending balance of the derivative component of other comprehensive income. • The net amount of gain or loss reported in earnings (representing aggregate hedge ineffectiveness). • Qualitative and quantitative information about failed hedges: canceled commitments or previously hedged forecasted transactions no longer expected to occur.

  17. Extended Method for Interest Rate Swap Accounting SFAS 133 permits a short-cut method for accounting for interest rate swaps that support the assumption of “no ineffectiveness.” If a company can conclude that the swap will be highly effective in offsetting changes in the fair value of the debt, the company can use the changes in the fair value of the swap to measure the offsetting changes in the fair value of the debt.

  18. End of Appendix A

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