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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)
Company
A
 fixed 10% Company
B
 floating % 
Floating rate: 9% at time of first payment ($9,000); Company A
pays Company B $1,000
TA-3
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 adjustments
o unrealized gains and losses on available-for-sale
securities
o 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
Fixed rate
Floating rate
10%
10%
10%
9%
12/31/2013 6/30/2014
10%
8%
10%
9%
Fixed payments ($1 million x [10% x ½])
Floating payments ($1 million x ½ floating rate)
Net interest receipts
$50,000
45,000
$ 5,000
$50,000
40,000
$10,000
$50,000
45,000
$ 5,000
Fair value of interest rate swap
$ 9,363
$ 9,615
0
$1M $1,009,363 $1,009,615
$1M
Fair value of note payable
0
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, 2013
Cash
..................................................................... 1,000,000
Notes payable .........................................................
1,000,000
To record the issuance of the notes.
June 30, 2013
Interest expense (10% x ½ x $1 million) ...................
Cash .....................................................................
To record interest.
50,000
50,000
Cash ($50,000 – [9% x ½ x $1 million]) ..................
Interest expense .......................................................
To record the net cash settlement.
5,000
Interest rate swap ($9,363 - 0) ....................................
Holding gain - interest rate swap ...........................
To record change in fair value of the derivative.
9,363
5,000
Holding loss - hedged note..........................................
9,363
Notes payable ($1,009,363 – 1,000,000) ................
To record change in fair value of the notes due to interest.
9,363
9,363
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, 2013
Interest expense
....................................................
Cash (10% x ½ x $1,000,000) ........................................
To record interest.
50,000
50,000
Cash ($50,000 – [8% x ½ x $1 million]) ...........................
Interest expense
....................................................
To record the net cash settlement.
10,000
Interest rate swap ($9,615 - 9,363) ......................................
Holding gain - interest rate swap .....................................
To record the change in fair value of the derivative
252
Holding loss - hedged note ..................................................
Notes payable ($1,009,615 – 1, 009,363) .......................
To record the change in fair value of the notes due to interest
252
10,000
252
252
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, 2014
Interest expense ..........................................................
Cash (10% x ½ x $1,000,000)................................
To record interest.
50,000
50,000
Cash ($50,000 – [9% x ½ x $1 million]) ..................
Interest expense .......................................................
To record the net cash settlement.
5,000
Holding loss - interest rate swap ................................
Interest rate swap ($0 – 9,615)................................
To record the change in fair value of the derivative
9,615
Notes payable ($1,000,000 – 1,009,615) ....................
Holding gain–hedged note ......................................
To record the change in fair value of the notes
9,615
Note payable ..........................................................
Cash
..........................................................
To repay the loan
1,000,000
5,000
9,615
9,615
1,000,000
Illustration A-1
TA-8 (continued)
EFFECTS ON BALANCES
Swap
Jan. 1, 2013
June 30, 2013
Dec. 31, 2013
June 30, 2014
Notes
1,000,000
9,363
252
9,363
252
9,615
_______________
0
9,615
1,000,000
_______________
0
Income Statement  ()
June 30, 2013 (50,000)
5,000
9,363
(9,363)
(45,000)
Interest expense – fixed payment
Interest expense – net cash settlement
Holding gain – interest rate swap
Holding loss – hedged note
Net effect – same as floating interest payment
Dec. 31, 2013 (50,000)
10,000
252
(252)
(40,000)
Interest expense – fixed payment
Interest expense – net cash settlement
Holding gain - interest rate swap
Holding loss – hedged note
Net effect – same as floating interest payment
June 30, 2014 (50,000)
5,000
9,615
(9,615)
(45,000)
Interest expense – fixed payment
Interest expense – net cash settlement
Holding loss - interest rate swap
Holding gain – hedged note
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 Activities
Professional 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.