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Copyright © 2007 by The McGraw
-
Hill Companies, Inc. All rights reserved.


Derivatives

Appendix A



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2

Derivatives

Derivatives are financial instruments that
“derive” their values from some other security
or index. They serve as a form of ‘insurance”
against risk.

Financial
Futures

Forward
Contracts

Options

Interest
Rate
Swaps

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Derivatives Used to Hedge

Hedging

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

Assume a company has a
large amount of
outstanding debt that has a
floating (variable) interest
rate. If interest rates
increase, this could pose a
substantial cost to the
company in the form of
increased interest
payments.

The company might
choose to
hedge

its
position by entering into a
transaction that would
produce a gain of roughly
the same amount as the
potential loss if interest
rates do, in fact, increase.

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Financial Futures

A
futures contract

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

Treasury
Bond

Treasury
Bill

Commercial
Paper

Certificate
of Deposit

Fair value risk

is that the
investment’s value might
change.

Cash flow risk

is the risk of
having to pay more cash or
receive less cash.

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Financial Forward Contracts

A
forward contract
differs from a
futures contract in three ways.

1.
A forward contract calls for delivery on a specific date,
whereas a futures contract permits the seller to decide
later which specific day within the specified month will
be the delivery date (if it gets as far as actual delivery
before it is closed out).

2.
Unlike a futures contract, a forward contract usually is
not traded on a market exchange.

3.
Unlike a futures contract, a forward contract 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.

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Options

Options

frequently are purchased to
hedge exposure to the effects of
changing interest rates.

Options give the holder the right
either to buy or sell a financial
instrument at a specified price and
within a given time period.
The
holder has no obligation to exercise
the option.

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Foreign Currency Futures

Foreign loans have an added
element of risk of changes in
foreign exchange rates
. Foreign
exchange risk is often hedged in
the same manner as interest rate
risk.

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Interest Rate Swaps

Interest rate swaps

exchange fixed
interest payments for floating rate
payments, or vice versa, without
exchanging the underlying principal
amounts.

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Accounting for Derivatives

All

derivatives are
reported on the balance
sheet as either assets
or liabilities at fair
(market) value.

Accounting for the
gain or
loss

on a derivatives
depends on how it is used.

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Accounting for Derivatives

Non
-
hedge Derivatives

Immediately recognize
gain and loss in earnings

Hedge Derivatives

1.
Immediately recognize gain
and loss in earnings along
with an offsetting loss or
gain on the item being
hedged or

2.
Defer in comprehensive
income until it can be
recognized in earnings at
the same time as earnings
are affected by a hedged
transaction

Gain or Loss
on Derivatives

The treatment of gains and losses
for hedge derivatives depends on
whether the derivative is
designated as a (a) fair value
hedge, (b) cash flow hedge, or (c)
foreign currency hedge.

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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.

This means that, to the extent the
hedge is effective in serving its
purpose, the gain or loss on the
derivative will be
offset

by the loss or
gain on the item being hedged.

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Cash Flow Hedges

A gain or loss from a
cash flow hedge

is
deferred as Other Comprehensive
Income until it can be recognized in
earnings along with the earnings effect
of the item being hedged.

When the derivative is adjusted to reflect changes in fair
value, the other side of the entry is a gain or loss to be
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.

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Foreign Currency Hedges

A foreign currency hedge can be a hedge of foreign currency
exposure of:

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 unrealized gains and losses from foreign
currency translation.

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Hedge Effectiveness and Ineffectiveness

Hedge
Effectiveness

A high correlation exists between
changes in the fair value or cash
flows of the derivative and of the
item being hedged, not
necessarily a specific reduction
in risk.

Hedge
Ineffectiveness

Results in part of the derivative
gain or loss being included in
earnings.

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Fair Value Changes Unrelated to the Risk
Being Hedged

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

Note then that although we always mark a derivative to
fair value, the reported amount of the item being hedged
may not be its fair value. We mark a hedged item to fair
value only to the extent that its fair value changed due to
the risk being hedged.

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Disclosure of Derivatives and Risk

Extensive disclosure requirements provide information that includes:

1.
Objectives and strategies for holding and issuing derivatives.

2.
A description of the items for which risks are being hedged.

3.
For forecasted transactions: a description, time before the
transaction is expected to occur, the gains and losses
accumulated in other comprehensive income, and the events
that will trigger their recognition in earnings.

4.
Beginning balance of, changes in, and ending balance of the
derivative component of other comprehensive income.

5.
The net amount of gain or loss reported in earnings
(representing aggregate hedge ineffectiveness).

6.
Qualitative and quantitative information about failed hedges:
canceled commitments or previously hedged forecasted
transactions no longer expected to occur.

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Extended Method for Interest Rate Swap
Accounting

SFAS 133

permits a short
-
cut method for
accounting for interest rate swaps that
support the assumption of
“no
ineffectiveness.”

If a company can conclude that the swap
will be highly effective in offsetting
changes in the fair value of the debt, the
company can use the changes in the fair
value of the swap to measure the offsetting
changes in the fair value of the debt.

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End of Appendix A