Derivatives

Chapter 16

Robinson, Munter and Grant

Robinson, Munter & Grant

Chapter 16 2

Learning Objectives

• Distinguish between financial and derivative instruments

• Accounting hedges

• Accounting models

• Impact on net income and comprehensive income

• Fair value disclosures

Chapter 16 3

Financial Instruments

• Cash

• Evidence of an ownership interest in another entity

• Contract that binds two parties– Obligates delivery/exchange of cash or

another financial instrument, and– Conveys right to receive/exchange cash or

another financial instrument

Chapter 16 4

Derivative Instruments

• At least one underlying (variable)

• One or more provisional amounts or payment provision or both

• No initial net investment or smaller initial net investment than would be required for other types of contracts

• Terms require or permit net settlement

Chapter 16 5

Common Types of Derivative Instruments

• Swaps: Counterparties change position relative to underlying

• Options: Right to buy or sell underlying asset

• Forwards: Obligation to buy or sell an underlying

Chapter 16 6

Common Types of Derivative Instruments

• Futures: Exchange-traded forward contract

• Caps, Floors, Collars: Zero dollar-cost options that place limits on movement of the underlying asset

• Combination of the above elements

Chapter 16 7

Investment Return Example

• Shares of XYZ currently worth $100 each

A: buy 1,000 shares of XYZ for $100,000

B: enter forward contract to acquire 1,000 shares for $100 in 6 months

• In six months, price of XYZ

1) Increases to $150

2) Decreases to $50

Chapter 16 8

Investment Return Example

Share purchase Forward contract

$150 $50,000 gain

50% ROA

$50,000 gain

Infinite ROA

$50 $50,000 loss

(50%) ROA

$50,000 loss

(Infinite) ROA

Chapter 16 9

Holding Derivative Instruments

• Speculative investments are not designed to manage market or credit risks.

• Hedging instruments are part of an entity’s process of managing credit or market risk.

Chapter 16 10

Risk of Accounting Loss

Composed of:1. Credit risk: that other party may not

perform in accordance with the terms of the contract

2. Market risk: that changes in market conditions may make a financial asset less valuable or a liability more burdensome

3. Risk of theft or physical damage

Chapter 16 11

Risk of Accounting Loss

• Maximum recorded loss the company could reflect in the financial statements

• Not a measure of economic loss– Lost future revenues, for example

• An accounting hedge derivative is used to manage the risk of accounting loss

Chapter 16 12

Derivatives and Hedging

• Fair value hedges – Against changes in the fair value of hedged

• Cash-flow hedges– Variability of future cash flows

• Net investment hedges– Foreign investee

Chapter 16 13

Fair Value Hedge Accounting

• Against changes in the fair value of an existing asset or liability, or and unrecorded commitment

• Gain or loss is included in income– Perfect hedging would result in no net gain or

• Hedged item must be marked-to-market

Chapter 16 14

Fair Value Hedge Accounting

• Hedging ineffectiveness is recognized in earnings immediately– For qualifying fair value hedges

• Qualifying fair value hedge: change in derivative is 80-125% of the change in the hedged item

Chapter 16 15

Fair Value Hedge Accounting• Overhedge: Absolute value of the change

in the derivative is greater than the opposing change in the fair value of the hedged item

• Underhedge: Absolute value of the change in the derivative is less than the opposing change in the fair value of the hedged item

Chapter 16 16

Fair Value Hedge Derivative Criteria

• Extensive formal documentation of hedge

• Expected to be highly effective– Assessed at least every 3 months

• Written option to hedge an asset or liability must provide at least as much potential for gain as exposure to loss

Chapter 16 17

Fair Value Hedge Hedged Item

• Must be specifically identified– All or part of an asset, liability or commitment– Single item or portfolio or similar items

• Risk of accounting loss exists– Credit or market risk

Chapter 16 18

Fair Value Hedge Accounting treatment

• Gain/losses related to both derivative and hedged item are recorded income– Ideally, they would offset each other– Placement within income statement varies– Company must disclose where reported

• Carrying amount of hedged item is marked-to-market

Chapter 16 19

Fair Value Hedge Discontinue when…

• Hedging criteria no longer met

• Derivative expires, is sold, terminated or exercised

• Entity removes the designation of the fair value hedge

Chapter 16 20

Cash-Flow Hedge Accounting

• Mitigate against variability of future cash flows

• Classify gains and losses as related to– Effective (offsetting movement in hedged

transaction) hedging, or

– Ineffective hedging• Over- or under-hedge

Chapter 16 21

Cash-Flow HedgeHedging Criteria

• Extensive formal documentation of hedge– Including plans to assess effectiveness

• Expected to be highly effective– Assessed at least every 3 months

• Written option to hedge an asset or liability must provide at least as much potential for gain as exposure to loss

• Regarding interest receipts, hedging instrument must link existing asset and liability

Chapter 16 22

Cash-Flow HedgeHedged Transaction

• Must be specifically identified– Single item or group of items with same risk

exposure

• Occurrence of forecasted transaction is probable

• Transaction must be with external party• Risk of accounting loss exists

– Credit or market risk

Chapter 16 23

Cash-Flow HedgeAccounting treatment

• Effective portion– Other comprehensive income

– Recognized in income when related transaction affects earnings

• Ineffective portion– Overhedge is in earnings

– Underhedge is deferred in other comprehensive income

• Anticipated losses on hedged transaction are recognized in income immediately

Chapter 16 24

Cash-Flow Hedge AccountingExample

Derivative Increase $100 Increase $90

Hedged item

Decrease $95 Decrease $95

Recognize $5 gain now, defer $95 gain in other comprehensive income

Defer $90 gain

Underhedge is not immediately recognized

Chapter 16 25

Cash-Flow Hedge Discontinue when…

• Hedging criteria no longer met• Derivative expires, is sold, terminated or

exercised• Entity removes the designation of the cash-

flow hedgeAnd move accumulated gains/losses from

balance sheet to income statement

Chapter 16 26

Net Investment Hedge Accounting

• Hedge against the changes in the exchange rate impacts on the net investment of a foreign investee

• Gain/loss is included in other comprehensive income

– Part of cumulative translation adjustment– A component of Equity

Chapter 16 27

Disclosure of Fair Value for Financial Instruments

• Companies must disclose fair value of financial instruments in statements

– Or approximation thereof

• Values come from a variety of financial markets• Absent a financial market, fair values may be

calculated

Chapter 16 28

Fair Value for Financial InstrumentsMarkets

• Exchange market– Information readily available– Closing prices commonly used

• Dealer market– Dealers trade for their own accounts– Bid and ask prices are more readily available than

closing prices

Chapter 16 29

Fair Value for Financial InstrumentsMarkets and Other measures

• Brokered market– Brokers do not trade for their own account– Match buyers and sellers

• Principal-to-principal market– Little, if any, public information – Must use best estimate of fair value

• Other measures include discounted cash flows and pricing models

Chapter 16 30

Summary

• Financial and derivative instruments

• Fair value hedge

• Cash-flow hedge

• Net investment hedge

• Income statement and balance sheet impact

• Value of financial instruments

Derivatives

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