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Derivatives

Derivatives. Chapter 16 Robinson, Munter and Grant. Learning Objectives. Distinguish between financial and derivative instruments Accounting hedges Accounting models Impact on net income and comprehensive income Fair value disclosures. Financial Instruments. Cash

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Derivatives

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  1. Derivatives Chapter 16 Robinson, Munter and Grant

  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 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: • Credit risk: that other party may not perform in accordance with the terms of the contract • Market risk: that changes in market conditions may make a financial asset less valuable or a liability more burdensome • 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 item • 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 loss • 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 Chapter 16

  25. Cash-Flow HedgeDiscontinue when… • Hedging criteria no longer met • Derivative expires, is sold, terminated or exercised • Entity removes the designation of the cash-flow hedge And 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 Chapter 16

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