Derivatives
Chapter 16
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Learning Objectives
• Distinguish between financial and derivative instruments
• Accounting hedges
• Accounting models
• Impact on net income and comprehensive income
• Fair value disclosures
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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
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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
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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
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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
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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
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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
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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.
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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
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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
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Derivatives and Hedging
• Fair value hedges – Against changes in the fair value of hedged
item
• Cash-flow hedges– Variability of future cash flows
• Net investment hedges– Foreign investee
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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
loss
• Hedged item must be marked-to-market
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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Summary
• Financial and derivative instruments
• Fair value hedge
• Cash-flow hedge
• Net investment hedge
• Income statement and balance sheet impact
• Value of financial instruments