Accounting for investments in derivative financial instruments

Example: A company enters into a call option contract on January 2, 2007, with Baird investment Co., which gives it the option to purchase 1,000 shares referred to as the notional am

Appendix 17A: 

Accounting for Investments in Derivative Financial Instruments

ASC 815 (FAS 133)

Understanding derivatives  

a Forward Contract:

Gives holder the right and obligation to purchase

an asset at a preset price for a specified period of

time.

Example:

Dell enters into a contract with a broker for delivery of 10,000 shares of Google stock in three months at its

current price of $110 per share =>

$1,100,000

Dell has received the right to receive 10,000 shares in

three months and incurred an obligation to pay

$110 per share at that time.

Understanding derivatives  

b Option Contract:

Gives the holder the right, but not the obligation, to buy

share at a preset price for a specified period of time.

Example:

Dell enters into a contract with a broker for an option

(right) to purchase 10,000 shares of Google shares at its

current price of $110 per share

The broker charges $3,000 for holding the contract open for two weeks at a set price

Dell has received the right , but not the obligation to

purchase this stock at $110 within the next two weeks.

Concept of Derivative Instruments

The forward contract and the option contract both involve a

future delivery of stock.

The value of each of these contracts relies on the underlying asset –the Google stock.

Therefore, these financial instruments (the FORWARD and the OPTION contracts) are known as derivatives because

they derive their value from values of other assets

(e.g., Google stocks or other stocks or bonds or commodities)

Or, their value relates to a market –determined indicator

(e.g., interest rates or the S&P’s 500 index).

Who uses derivatives?

a Producers and consumers: Hedgers

Example:

Heartland –Large producer of potatoes

McDonald –Large consumer of potatoes (French fries)

The objective is not to gamble on the outcome or to profit

but to lock in a price at which both of them obtain

an acceptable profit.

Both companies, the producer and the consumer, are hedgers.

They hedge ( protect ) their positions to ensure an acceptable

financial outcome.

b Speculators and arbitrageurs: Speculators

The objective is to gamble on the outcome or to profit based

on the outcome.

Why use derivatives?

-Changes in the price of jet fuel:

Delta, Continental, United….

-Changes in interest rates:

Citigroup, AIG, BoA…

-Changes in exchange rates:

GE, GM, Cisco …

Accounting guidelines for derivatives ( ASC 815 )

a Recognized as assets and liabilities

b Reported at fair value.

c UNREALIZED Gains and losses from speculation in

derivatives recognized in income immediately .

d UNREALIZED Gains and losses from hedge transactions

reported in accordance with the type of hedge

either in OCI or income

Derivative financial investment - Speculation

Call option:  Gives the holder the right, but not the obligation ,

to buy shares at a preset price ( strike price or exercise price ).

A company (speculator) can realize a gain from the increase

in the value of the underlying share with the use of a Call

Option – a derivative.

Example: A company enters into a call option contract on

January 2, 2007, with Baird investment Co., which gives it the

option to purchase 1,000 shares ( referred to as the notional amount ) of Laredo stock at $100 per share On January 2nd, the Laredo shares are trading at $100 per share The option

expires on April 30, 2007 The company purchases the call

option for $400

If the price of Laredo stock increases above $100, the

company can exercise this option and purchase the

shares for $100 per share

If Laredo’s stock never increases above $100 per share, the

call option is worthless

Derivative financial investment - Speculation

Accounting entries:

(1) To record purchase (option premium) of call option:

Call Option 400 Cash 400

The option premium consists of two amounts:

Intrinsic Value & Time value

*Option premium = Intrinsic value + Time value ;

(a)Intrinsic value = Preset strike price - Market price

On January 2, the intrinsic value is ZERO because the market price equals the preset strike price.

(b)Time value is estimated using an option-pricing model

It reflects the possibility that the option has a fair value greater than zero WHY?

Because, there is expectation that the price of Laredo shares

will increase above the strike price during the option term

On January 2, the time value of the option is $400.

Derivative financial investment - Speculation

(2) FYE Adjustments: March 31, 2007:

a To record increase in intrinsic value of option:

On March 31, 2007, Laredo shares are trading at $120 per share.

Therefore, the Intrinsic Value of the Call Option is now:

Derivative financial investment - Speculation

(b) To record decrease in time value of the option:

On March 31, 2007, a market appraisal indicates that

the time value of the option is $100.

This gives the company an unrealized loss of $300:

$300 = $400 - $100

The company records this change in time value as follows:

Unrealized Holding Gain or Loss—Income 300

Derivative financial investment - Speculation

(4) To record the settlement of the call option contract with Baird on April 1, 2007:

On April 1, 2007, the company exercises the call option

(simultaneously buys and sells) and records the settlement

of the call option with Baird as follows:

Cash (120,000 – 100,000 = net cash) 20,000

Loss on Settlement of Call Option 100

Derivative financial investment - Speculation

Effects of the call option on net income:

Date Transaction Income (Loss) Effect

March 31, 2007 Net increase in value of call option $19,700 April 1, 2007 Settle call option (100)

Total net income $19,600

Derivative financial investment - Speculation

Financial statement reporting:

(1)Call option is reported as an asset at fair value

(2) Any gains or losses (unrealized or realized) are

reported in income.

Put Option

An option contract giving the owner the right,

but not the obligation, to sell a specified amount

of an underlying security at a specified price

(STRIKE PRICE) within a specified time

A put becomes more valuable as the price of

the underlying stock depreciates (falls) relative

to the strike price.

This is the opposite of a call option.

Derivatives Used for Hedging –FV Hedge

$10 until March 2008 (usually the third Friday of the month)

If shares of Taser fall to $5 and you exercise the option, you can purchase 100 shares of Taser for $5 in the market and sell the shares to the option's writer for $10 each, which means you make $500 = (100 x ($10-$5)) on the put option

Note that the maximum amount of potential profit in this

example ignores the premium paid to obtain the put option

Exercise 20

Exercise 19 (HW) Exercise 21 (HW)

Three basic characteristics of Derivative Instruments(FAS 133)

1 The instrument has one or more underlyings and an

identified payment provision.

2 The instrument requires little or no investment at the

inception of the contract.

3 The instrument requires or permits net settlement.

Three basic characteristics of Derivative Instruments(FAS 133)

The interaction of the underlying , with the face amount or the

number of units specified in the derivative contract (the notional amounts), determines payment.

Example:

The underlying is the stock price of Laredo stocks

The value of the call option increased in value when the value of the Laredo stock increased.

Payment Provision = Change in the stock price x Number of Shares

Three basic characteristics of Derivative Instruments(FAS 133)

2 The instrument requires little or no investment at the

inception of the contract.

Example:

The company paid a small premium to purchase the call option –

an amount much less than if purchasing the Laredo shares as a

direct investment.

3 The instrument requires or permits net settlement.

Example:

The Laredo stock Call Option allows the company to realize a

profit on the call option without taking possession of the shares

This Net Settlement feature reduces the transaction costs

associated with derivatives

Derivatives Used for Hedging

Hedging is the use of derivatives to reduce Price risk, interest rate risk and exchange rate risk.

(1) Interest rate risk is risk that changes in interest rates will

negatively affect the fair-values or cash flow of interest

sensitive assets and liabilities

(2) Exchange rate risk is the risk of foreign exchange rates

negatively affecting profits

SFAS 133 (ASC 815) establishes accounting and reporting

standards for derivative financial Instruments used in hedging activities

The FASB allows two types of hedges:

a Fair Value Hedges;

b Cash Flow Hedges.

Derivatives Used for Hedging –FV Hedge

a Fair value hedge:

A derivative used to hedge (offset) the exposure to

changes in the fair value of a recognized asset or liability,

or of an unrecognized commitment

In a perfectly hedged position, the gain or loss on the

fair value of the derivative equals and offsets that of the

hedged asset or liability.

(1) Interest rate swaps: Used to hedge the risk that changes

in interest rates will have a negative impact on fair value

of debt obligations

(2) Put options:  Used to hedge the risk that an equity

investment will decline in value

Derivatives Used for Hedging –FV Hedge

Hayward does not intend to actively trade this

investment It consequently classifies the Sonoma

investments as available-for-sale (AFS)

On December 31, 2006, Sonoma shares are trading at

$125 per share.

Derivatives Used for Hedging –FV Hedge

Following the rules of FAS 115, Hayward records AFS securities at

AFS Securities 2,500 <=(125–100)*100

Unrealized Holding Gain (loss) –Equity 2,500

Derivatives Used for Hedging –FV Hedge

Accumulated other comprehensive income

Unrealized Holding Gain (loss) $2,500

Derivatives Used for Hedging –FV Hedge

(d) Hedge Derivative:

Hayward is exposed to the risk that the price of the Sonoma stock will decline To hedge this risk , Hayward locks in its gain on Sonoma investment by purchasing a put option on 100 shares of Sonoma

stock.

Hayward enters into a put option on January 2, 2007, and designates the option as a fair value hedge of the Sonoma investment This put option (which expires in two years) gives Hayward the option to sell

100 Sonoma shares at a price of $125

To record a purchase, assuming no premium paid:

January 2, 2007:

No entry required.

and its designation as a fair value hedge for the Sonoma investment.

*At inception: Exercise price equals the current market price

Derivatives Used for Hedging –FV Hedge

SPECIAL ACCOUNTING FOR THE HEDGED ITEM (FAS 133):

Once the hedge is designated, accounting for any unrealized gain or loss

on available for-sale securities is recorded in income , NOT in equity.

(e) On December 31, 2007, Sonoma shares are trading at $120 per share:

Unrealized Holding Gain (loss) -Income 500

AFS Securities 500

To record an increase in the value of the put option:

Unrealized Holding Gain or Loss—Income 500

Note: The decline in the price of Sonoma shares results in an increase in the

fair value of the put option The increase in fair value on the option offsets or hedges (protects) the decline in value on Hayward’s AFS security.

Derivatives Used for Hedging –FV Hedge

(f) Financial statement disclosure:

(i) Balance sheet:  Both the investment security and the put option are

reported at fair value.

Shareholders’ Equity

Accumulated other comprehensive income:

Unrealized Holding Gain (loss) $2,500

Derivatives Used for Hedging –FV Hedge

(f) Financial statement disclosure:

(ii) Income statement: any unrealized gain or loss on the investment security and the put option is reported under “Other Income” or “Other Expense.”

HAYWARD CO.

Income Statement (Partial) FYE December 31, 2007

Other Income

Unrealized holding gain (loss) –Put Option $ 500

Unrealized holding gain (loss) –AFS Securities (500)

Problem 18

Derivatives Used for Hedging –CF Hedge

Cash flow hedges

Cash flow hedges are used to hedge exposure to cash flow risk

Cash Flow risk arises from the variability in cash flows

Who uses Cash Flow hedge?

Producers and consumers.

Example:

Heartland –Large producer of potatoes

McDonald –Large consumer of potatoes (French fries)

The objective is not to gamble on the outcome or to profit

but to lock in a price at which both of them obtain an

acceptable profit.

Derivatives Used for Hedging –CF Hedge

Example:

In September 2006 Allied Can Co anticipates purchasing

1,000 tons of Aluminum in January 2007

Concerned that price for aluminum will increase in the

next few months, Allied wants to hedge the risk that it

might have to pay higher prices for aluminum in January 2007

As a result, Allied enters into an aluminum futures contract

(forward contract).

Derivatives Used for Hedging –CF Hedge

The underlying for this derivative is the price of aluminum

If the price of aluminum rises above $1,550, the value of the futures contract to Allied increases Because, Allied will be able to purchase the aluminum inventory at the lower price of $1,550 per ton.

Derivatives Used for Hedging –CF Hedge

Accounting Entries:

(1)Assume that in September 2006, the spot price equals the

strike price With the two prices equal, the futures contract has

no value

September 2006

No entry is necessary!

A memorandum indicates the signing of the futures contract and

its designation as a cash flow hedge for future purchase of

aluminum inventory.

Derivatives Used for Hedging –CF Hedge

SPECIAL ACCOUNTING:

The FASB allows special accounting for cash flow hedges.

Generally, FAS 133 requires companies to measure and

report derivatives at fair value on the balance sheet and

report gains and losses directly in net income.

However, FAS 133 allows companies to account for

derivatives used in cash flow hedges at fair value on the

balance sheet, but record gains and losses in equity , as part

of other comprehensive income.

Derivatives Used for Hedging –CF Hedge

Since Allied has not yet purchased and sold the

inventory, this gain is an Anticipated Transaction

In this type transaction,

a company accumulates in equity gains and losses on the futures contract as part of other comprehensive income until the period in which it sells the

inventory, thereby effecting earnings.

Derivatives Used for Hedging –CF Hedge

(2) To record increase in value of futures contract due to

increase in spot price:

At December 31, 2006, the price for January delivery of aluminum increases to $1,575 per ton.

December 31, 2006

Allied makes the following entry to record the increase in the

value of the futures contract.

Unrealized Holding Gain or Loss—Equity 25,000 *

*25,000 = ($1,575 – $1,550) x 1,000 tons

comprehensive income