17a - De fining De rivative s Financial instruments that...

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Defining Derivatives Defining Derivatives Financial instruments that derive their value from values of other assets (e.g., stocks, bonds, or commodities). Three different types of derivatives: 1. Financial forwards or financial futures. 2. Options. 3. Swaps.
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Who Uses Derivatives, and Why? Who Uses Derivatives, and Why? LO 9 Explain who uses derivative and why. Producers and Consumers Speculators and Arbitrageurs
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Basic Principles in Accounting for Derivatives Basic Principles in Accounting for Derivatives LO 10 Understand the basic guidelines for accounting for derivatives. Recognize derivatives in the financial statements as assets and liabilities. Report derivatives at fair value. Recognize gains and losses resulting from speculation in derivatives immediately in income. Report gains and losses resulting from hedge transactions differently, depending on the type of hedge.
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LO 11 Describe the accounting for derivative financial instruments. Example of Derivative Financial Instrument-Speculation Illustration: Assume that a company purchases a call option contract from Baird Investment Co.,on January 2, 2010, when Laredo shares are trading at $100 per share. The contract gives it the option to purchase 1,000 shares (referred to as the notional amount) of Laredo stock at an option price of $100 per share. The option expires on April 30, 2010. The company purchases the call option for $400 and makes the following entry on January 2, 2010. Call Option 400 Cash 400 Option Option Premium Premium
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Example of Derivative Financial Instrument-Speculation The option premium consists of two amounts. Illustration 17A-1 Intrinsic value is the difference between the market price and the preset strike price at any point in time. It represents the amount realized by the option holder, if exercising the option immediately. On January 2, 2010, the intrinsic value is zero because the market price equals the preset strike price. LO 11 Describe the accounting for derivative financial instruments.
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Example of Derivative Financial Instrument-Speculation The option premium consists of two amounts. Illustration 17A-1 Time value refers to the option’s value over and above its intrinsic value. Time value reflects the possibility that the option has a fair value greater than zero. How? Because there is some expectation that the price of Laredo shares will increase above the strike price during the option term. As indicated, the time value for the option is $400. LO 11 Describe the accounting for derivative financial instruments.
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Additional data available with respect to the call option: On March 31, 2010 , the price of Laredo shares increases to $120 per share. The intrinsic value of the call option contract is now $20,000. That is, the company can exercise the call option and purchase 1,000
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This note was uploaded on 04/06/2011 for the course ECON 3332 taught by Professor Craig during the Spring '11 term at Rensselaer Polytechnic Institute.

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17a - De fining De rivative s Financial instruments that...

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