Derivatives

Derivatives A. Derivatives are financial instruments that “derive” their values from some other security or

index. (TA-1)B. They are extensively used to hedge against various risks, particularly interest rate risk. C. Hedging means taking a risk position that is opposite to an actual position that is exposed

to risk. (TA-2)1. Interest rate futures are derivative contracts often bought and sold to hedge against

risk. They allow a firm to sell (or buy) a financial instrument at a designated future date, but at today’s price.

2. Interest rate swaps hedge risk by exchanging fixed interest payments for floating rate payments, or vice versa, without exchanging the underlying principal amounts. Interest rate swaps are the most frequently used derivatives. (TA-3)

3. A forward contract is similar to a futures contract but (a) calls for delivery on a specific date, (b) is not traded on a market exchange, and (c) doesn’t call for a daily cash settlement for price changes in the commodity underlying the contract.

4. An option on a financial instrument is a derivative that permits its holder either to buy or to sell the instrument at a specified price and within a given time period, without the obligation to exercise the option.

D. All derivatives, no exceptions, are carried on the balance sheet as either assets or liabilities at fair value. When the fair value changes, a gain or loss occurs. (TA-4) 1. If the derivative is not designated as a hedging instrument, or doesn’t qualify as one,

the gain or loss is recognized immediately in earnings. 2. If the derivative is used to hedge against exposure to risk, the gain or loss is either

recognized immediately in earnings along with an offsetting loss or gain on the item being hedged or

a. deferred in “comprehensive income” until it can be recognized in earnings at the same time as earnings are affected by a hedged transaction.

3. Which way depends on whether the derivative is designated as a fair value hedge, cash flow hedge, or foreign currency hedge.

E. When a derivative designated as a fair value hedge is adjusted to reflect changes in fair value, the resulting gain or loss is included currently in earnings. At the same time, though, the loss or gain from changes in the fair value, due to the risk being hedged, of the item being hedged also is included currently in earnings. (TA-5) (TA-8)

F. When a derivative designated as a cash flow hedge is adjusted to reflect changes in fair value, the resulting gain or loss is 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. The effect is matching the earnings effect of the derivative with the earnings effect of the item being hedged - the reasoning that supports hedge accounting. The portion of the gain or loss due to “ineffective” hedging is reported in earnings immediately. (TA-6)

G. A foreign currency hedge can be a hedge of foreign currency exposure of: (TA-7)1. a firm commitment – treated as a fair value hedge.2. an available-for-sale security – treated as a fair value hedge.3. a forecasted transaction – treated as a cash flow hedge.4. a company's net investment in a foreign operation - the gain or loss is reported in other

comprehensive income as part of the cumulative translation adjustment.H. To qualify as a hedge, the hedging relationship must be “highly effective” in achieving

offsetting changes in fair values or cash flows. Hedge accounting must be terminated for hedging relationships that no longer are highly effective. (TA-9)

I. The loss (gain) on a hedged item would not exactly offset each other if the hedging arrangement is ineffective. The effect would be a greater (or lesser) amount recognized in earnings for the swap than for the note. Without an exact offset, earnings would be affected caused by hedge ineffectiveness.

J. Fair value changes unrelated to the risk being hedged are ignored.

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DERIVATIVES

Derivatives are financial instruments that “derive” their values or contractually required cash flows from some other security or index.

Derivative financial instruments have become the key tools of risk management.

The most frequently used derivatives are:

o Financial futures

o Forward contracts

o Options

o Interest rate swaps

Derivatives can manage or hedge companies’ exposures to risk, including interest rate risk, price risk, and foreign exchange risk.

TA-1

DERIVATIVES USED TO HEDGE RISK

Hedging means taking a risk position that is opposite to an actual position that is exposed to risk.

The effectiveness of a hedge is influenced by the closeness of the match between the item being hedged and the financial instrument chosen as a hedge.

A futures contract allows a firm to sell (or buy) a financial instrument at a designated future date, at today’s price.

A forward contract is similar to a futures contract but 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.

An option gives its holder the right either to buy or to sell an instrument, say a Treasury bill, at a specified price and within a given time period.

Interest rate swaps exchange fixed interest payments for floating rate payments, or vice versa, without exchanging the underlying notional amounts. Over 70% of derivatives are interest rate swaps.

TA-2

INTEREST RATE SWAP

Swap of annual payments on $100,000 notional amount; fixed interest rate: 10% ($10,000)

fixed 10%

floating %

Floating rate: 9% at time of first payment ($9,000); Company A pays Company B $1,000

TA-3

Company B

Company A

ACCOUNTING FOR DERIVATIVES

All derivatives, no exceptions, are carried on the balance sheet as either assets or liabilities at fair value.

When the fair value changes, a gain or loss occurs.

How we account for the gain or loss depends on how the derivative is used.

1. If the derivative is not designated as a hedging

instrument, or doesn’t qualify as one, the gain or loss is

recognized immediately in earnings.

2. If the derivative is used to hedge against exposure to

risk, the gain or loss is either

recognized immediately in earnings along with an offsetting loss or gain on the item being hedged or

deferred in “comprehensive income” until it can be recognized in earnings at the same time as earnings are affected by a hedged transaction.

Which way depends on whether the derivative is

designated as a (a) fair value hedge, (b) cash flow hedge,

or (c) foreign currency hedge.

TA-4

FAIR VALUE HEDGES A change in either prices or interest rates can cause a change

in the fair value of an asset, a liability, or a commitment to buy

or sell assets or liabilities.

If a derivative is used to hedge against the exposure to changes

in the fair value, it can be designated as a fair value hedge.

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.

o When the derivative is adjusted to reflect changes in fair

value, the other side of the entry is recognized as a gain

or loss to be included currently in earnings.

o At the same time, the loss or gain from changes in the

fair value (due to the risk being hedged) of the item

being hedged also is included currently in earnings.

o So, to the extent the hedge is effective, the gain or loss

on the derivative will be offset by the loss or gain on the

item being hedged. TA-5

CASH FLOW HEDGES

If a derivative is used to hedge against exposure to changes in

cash inflows or outflows of an asset or liability or a forecasted

transaction, it can be designated as a cash flow hedge.

When the derivative is adjusted to reflect changes in fair

value, the other side of the entry is recognized as a gain or

loss to be deferred as a component of other comprehensive

income - included in earnings later, at the same time as

earnings are affected by the hedged transaction.

Comprehensive income includes net income itself and

changes in elements of the balance sheet that the FASB feels

don’t (yet) belong in net income:

o foreign currency translation adjustmentso unrealized gains and losses on available-for-sale

securitieso minimum pension liability adjustments

The portion of the gain or loss due to “ineffective” hedging is

reported in earnings immediately.TA-6

FOREIGN CURRENCY HEDGES

The possibility that foreign currency exchange rates might

change exposes many companies to foreign currency risk.

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 cumulative translation adjustment.

TA-7

ILLUSTRATION INTEREST RATE SWAPS

Wintel Semiconductors issued $1 million of 18-month, 10% notes

payable to First Bank on January 1, 2013. Wintel is exposed to the risk that

general interest rates will decline, causing the fair value of its debt to rise.

To hedge against this fair value risk, the firm entered into an 18-month

interest rate swap agreement on January 1.

The swap calls for the company to receive payment based on a 10%

fixed interest rate on a notional amount of $1 million and to make payment

based on a floating interest rate tied to changes in general rates. Cash

settlement of the net interest amount is made semi-annually at June 30 and

December 31 of each year with the net interest being the $50,000 fixed

interest ($1 million x [10% x ½]) and the difference between the floating

interest rate times $1 million at those dates.

Illustration A-1

TA-8

Floating settlement rates were 9% at June 30, 2013, 8% at December 31,

2013, and 9% at June 30, 2014, and December 31, 2014. Net interest

receipts can be calculated as shown below. Fair values of both the

derivative and the note resulting from those market rate changes are

assumed to be quotes obtained from securities dealers.

1/1/2013 6/30/2013 12/31/2013 6/30/2014

Fixed rate 10% 10% 10% 10%Floating rate 10% 9% 8% 9%

Fixed payments ($1 million x [10% x ½]) $50,000 $50,000 $50,000Floating payments ($1 million x ½ floating rate) 45,000 40,000 45,000Net interest receipts $ 5,000 $10,000 $ 5,000

Fair value of interest rate swap 0 $ 9,363 $ 9,615 0

Fair value of note payable $1M $1,009,363 $1,009,615 $1M

Illustration A-1

TA-8 (continued)

When the floating rate declined from 10% to 9%, the fair values of both the derivative (swap) and the note increased. This created an offsetting gain on the derivative and loss on the note. Both are recognized in earnings the same period (June 30, 2013).

January 1, 2013Cash ..................................................................... 1,000,000

Notes payable ......................................................... 1,000,000To record the issuance of the notes.

June 30, 2013Interest expense (10% x ½ x $1 million)................... 50,000

Cash ..................................................................... 50,000To record interest.

Cash ($50,000 – [9% x ½ x $1 million]).................. 5,000Interest expense....................................................... 5,000

To record the net cash settlement.

Interest rate swap ($9,363 - 0).................................... 9,363Holding gain - interest rate swap ........................... 9,363

To record change in fair value of the derivative.

Holding loss - hedged note......................................... 9,363Notes payable ($1,009,363 – 1,000,000)................ 9,363

To record change in fair value of the notes due to interest.

The net interest settlement on June 30, 2013, is $5,000 because the fixed rate is 5% (half of the 10% annual rate) and the floating rate is 4.5% (half of the 9% annual rate).

Illustration A-1

TA-8 (continued)

December 31, 2013Interest expense .................................................... 50,000

Cash (10% x ½ x $1,000,000)......................................... 50,000To record interest.

Cash ($50,000 – [8% x ½ x $1 million])........................... 10,000Interest expense .................................................... 10,000

To record the net cash settlement.

Interest rate swap ($9,615 - 9,363)...................................... 252Holding gain - interest rate swap..................................... 252

To record the change in fair value of the derivative

Holding loss - hedged note.................................................. 252Notes payable ($1,009,615 – 1, 009,363)........................ 252

To record the change in fair value of the notes due to interest

The fair value of the swap increased by $252 (from $9,363 to $9,615).

Similarly, we adjust the note’s carrying value by the amount necessary to

increase it to fair value. This produces a holding loss on the note that

exactly offsets the gain on the swap. This result is the hedging effect that

motivated Wintel to enter the cash flow hedging arrangement in the first

place.

Illustration A-1

TA-8 (continued)

At June 30, 2014, Wintel repeats the process of adjusting to fair value both the derivative investment and the notes being hedged.

June 30, 2014Interest expense ......................................................... 50,000

Cash (10% x ½ x $1,000,000)................................ 50,000To record interest.

Cash ($50,000 – [9% x ½ x $1 million]).................. 5,000Interest expense....................................................... 5,000

To record the net cash settlement.

Holding loss - interest rate swap ................................ 9,615Interest rate swap ($0 – 9,615)................................ 9,615

To record the change in fair value of the derivative

Notes payable ($1,000,000 – 1,009,615).................... 9,615Holding gain–hedged note...................................... 9,615

To record the change in fair value of the notes

Note payable ......................................................... 1,000,000Cash ......................................................... 1,000,000

To repay the loan

Illustration A-1

TA-8 (continued)

EFFECTS ON BALANCES

Swap Notes Jan. 1, 2013 1,000,000

June 30, 2013 9,363 9,363Dec. 31, 2013 252 252June 30, 2014 9,615 9,615

1,000,000_______________ _______________

0 0

Income Statement ( ) June 30, 2013 (50,000) Interest expense – fixed payment

5,000 Interest expense – net cash settlement9,363 Holding gain – interest rate swap

(9,363 ) Holding loss – hedged note(45,000) Net effect – same as floating interest payment

Dec. 31, 2013 (50,000) Interest expense – fixed payment10,000 Interest expense – net cash settlement

252 Holding gain - interest rate swap (252 ) Holding loss – hedged note

(40,000) Net effect – same as floating interest payment

June 30, 2014 (50,000) Interest expense – fixed payment5,000 Interest expense – net cash settlement9,615 Holding loss - interest rate swap

(9,615 ) Holding gain – hedged note(45,000) Net effect – same as floating interest payment

Illustration A-1

TA-8 (continued)

HEDGE EFFECTIVENESS

To qualify as a hedge, the hedging relationship must be highly effective in achieving offsetting changes in fair values or cash flows.

An assessment of this effectiveness (generally means a high correlation) must be made at least every three months and whenever financial statements are issued.

Hedge accounting must be terminated for hedging relationships that no longer are highly effective.

HEDGE INEFFECTIVENESS

The loss and gain will not exactly offset each other if the hedging arrangement is ineffective.

Because there would not be an exact offset, earnings would be affected, an effect resulting from hedge ineffectiveness.

Even if a hedge is highly effective, all ineffectiveness is recognized currently in earnings.

FAIR VALUE CHANGES UNRELATED TO RISK BEING HEDGED

Fair value changes unrelated to the risk being hedged are ignored.

TA-9

Suggestions for Class ActivitiesProfessional Skills Development Activities

The following are suggested assignments from the end-of-chapter material that will help your students develop their communication, research, analysis, and judgment skills.

Communication Skills. Communication Cases A-2 requires group interaction. Real World Cases A-1 and A-3 are suitable for student presentation(s). Questions A-6 and A-7 create good class discussions.

Research Skills. In their professional lives, our graduates will be required to locate and extract relevant information from available resource material to determine the correct accounting practice, perhaps identifying the appropriate authoritative literature to support a decision. Research Case A-3 and A-4 provide an excellent opportunity to help students develop this skill.

Analysis Skills. Communication Case A-2 and Real World Case A-3 provide opportunities to develop analysis skills.