Nature and Use of Derivative Instruments
A derivative is a financial instrument that derives its value from some other financial instrument or observable market prices, such as stock prices, interest rates, currency exchange rates, commodity prices, and the like. For example, an option to purchase a share of stock (an option contract) derives its value from the market price of the stock. A commitment to purchase a certain amount of foreign currency in the future (a forward contract) derives its value from changes in the exchange rate for that currency. Firms typically use derivative instruments (option, forward, and swap contracts) to hedge the risk of losses from changes in market prices, interest rates, foreign exchange rates, and commodity prices. The general idea is that changes in the value of the derivative instrument offset changes in the value of an asset or a liability or changes in future cash flows, thereby neutralizing the economic loss.
Refer to Scenario 1. Firm A wants to neutralize the effect of changes in the market value of the note payable caused by changes in market interest rates. It engages in one type of derivative instrument, a swap contract, with a notional value of $100,000 with its bank. In effect, the swap allows Firm A to swap its fixed-interest-rate obligation for a variable-interest-rate obligation. That is, in the swap contract, Firm A agrees to pay the bank a variable rate of interest on $100,000, and in exchange the bank will pay Firm A a fixed rate of interest (8%). The market value of the note will remain at $100,000 as long as the variable interest rate in the swap is the same as the variable rate used by the supplier to revalue the note while it is outstanding. The swap causes Firm A’s interest payments to vary as the variable interest rate changes, but it locks the value of the note payable at $100,000.
A derivative is a financial instrument that derives its value from some other financial instrument or observable market prices, such as stock prices, interest rates, currency exchange rates, commodity prices, and the like. For example, an option to purchase a share of stock (an option contract) derives its value from the market price of the stock. A commitment to purchase a certain amount of foreign currency in the future (a forward contract) derives its value from changes in the exchange rate for that currency. Firms typically use derivative instruments (option, forward, and swap contracts) to hedge the risk of losses from changes in market prices, interest rates, foreign exchange rates, and commodity prices. The general idea is that changes in the value of the derivative instrument offset changes in the value of an asset or a liability or changes in future cash flows, thereby neutralizing the economic loss.
Refer to Scenario 1. Firm A wants to neutralize the effect of changes in the market value of the note payable caused by changes in market interest rates. It engages in one type of derivative instrument, a swap contract, with a notional value of $100,000 with its bank. In effect, the swap allows Firm A to swap its fixed-interest-rate obligation for a variable-interest-rate obligation. That is, in the swap contract, Firm A agrees to pay the bank a variable rate of interest on $100,000, and in exchange the bank will pay Firm A a fixed rate of interest (8%). The market value of the note will remain at $100,000 as long as the variable interest rate in the swap is the same as the variable rate used by the supplier to revalue the note while it is outstanding. The swap causes Firm A’s interest payments to vary as the variable interest rate changes, but it locks the value of the note payable at $100,000.
Refer to Scenario 2. Firm B wants to protect its future cash flows against increases in the variable interest rate to more than the initial 8% rate. It also engages in a swap contract with a notional value of $100,000 with its bank. In effect, the swap allows Firm B to swap its variable-interest-rate obligation for a fixed-interest-rate obligation. That is, in the swap contract, Firm B agrees to pay the bank a fixed rate of 8% interest on $100,000, and in exchange the bank will pay Firm A a variable rate of interest. The swap fixes the firm’s annual interest expense and cash expenditure to 8% of the $100,000 note, which eliminates Firm B’s risk of interest rate increases. By engaging in the swap, however, Firm B cannot take advantage of decreases in interest rates to less than 8%, which it could have done with its variable-rate note. In this example, the swap locks in Firm B’s interest payments on the note, but the value of the note to the supplier will vary as the variable interest rate changes.
Banks and other financial intermediaries structure derivatives for a fee to suit the needs of their customers. Thus, the nature and complexity of derivatives vary widely. We focus our discussion to the interest rate swap contracts in the two scenarios to illustrate the accounting and reporting of derivatives. Consider the following elements of a derivative:
Banks and other financial intermediaries structure derivatives for a fee to suit the needs of their customers. Thus, the nature and complexity of derivatives vary widely. We focus our discussion to the interest rate swap contracts in the two scenarios to illustrate the accounting and reporting of derivatives. Consider the following elements of a derivative:
- A derivative has one or more underlyings. An underlying is the specified item to which the derivative applies, such as an interest rate, a commodity price, a foreign exchange rate, or another variable. Interest rates are the underlying in the two scenarios.
- A derivative has one or more notional amounts. A notional amount is the number of units (dollar amounts, foreign currency units, bushels, barrels, gallons, shares, or other units) specified in a contract. The $100,000 face value of the noteis the notional amount in the two scenarios
- A derivative may or may not require an initial investment. The firm usually acquires a derivative by exchanging promises with a counterparty, such as a commercial or investment bank. The acquisition of a derivative is usually an exchange of promises, a mutually unexecuted contract.
- Derivatives typically require, or permit, net settlement. For example, Firm A in Scenario 1 will pay the supplier the 8% interest established in the fixed-rate note. If the variable interest rate used in the swap contract decreases to 6%, the counterparty bank will pay Firm A an amount equal to 2% (8% – 6%) of the notional amount of the note, $100,000. Paying interest of 8% to the supplier and receiving cash of 2% from the counterparty results in net interest cost of 6%. If the variable interest rate increases to 10%, Firm A still pays the supplier interest of 8% as specified in the original note. It would then pay the counterparty bank an additional 2% (10% – 8%), resulting in total interest expense equal to the variable rate of 10%.
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