Chapter 17 Lecture Notes 2

Chapter 17 Lecture Notes 2 - Accounting for Derivative...

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1 Accounting for Derivative Instruments: Chapter 17, Appendix A Derivatives Controversy Why Use Derivatives? Understanding Basic Derivatives Accounting for Basic Derivatives Speculation Accounting Hedge Accounting Fair Value Hedge Cash Flow Hedge Chapter focuses on derivative financial instruments.
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2 Increasing Importance and Role of Derivatives The use of derivatives has grown exponentially in recent years The total value of derivatives outstanding is estimated to be $127 trillion – up from $3 trillion in 1990 Demand for market risk management was created in mid 1970’s as interest rate risk, foreign currency price risk, and commodity price risk exploded U.S. breaking of Brenton Woods Accord, which had pegged currency exchange rates to the U.S. Dollar Oil price volatility post-OPEC control in 1970’s
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3 Who Uses Derivatives, and Why? Producers and Consumers Manage Risk (through Hedging) Commodity price risk Interest rate risk Foreign currency price risk Lock in future payment/price, reduce uncertainty, reduce volatility Speculators and Arbitrageurs Speculate Seek profits
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4 Derivatives Controversy Warren Buffett: “Derivatives are financial weapons of mass destruction. … The dangers are now latent – but they could be lethal.” Alan Greenspan: “[Derivatives] have especially contributed, particularly over the past couple of stressful years, to the development of a far more flexible, efficient and resilient financial system than existed just a quarter-century ago.” Randall Dodd (Director, Derivatives Study Center): “It’s a double-edged sword. … Derivatives are extremely useful for risk management, but they also create a host of risks that expose the entire economy to potential financial market disruptions.” Source: Washington Post, 3/6/03
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5 What are Derivatives? Derivatives – A generic term used to describe a wide variety of financial and commodity instruments whose value depends on or is derived from the value of an underlying asset/liability, reference rate or index.
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6 Differences between Traditional and Derivative Financial Instruments A derivative instrument has (1) one or more underlyings and (2) an identified payment provision . An underlying is a specified interest rate, security price, commodity price, index or prices or rates, or other market-related variable. The derivative instrument requires little or no investment at the inception of the contract. The derivative instrument requires or permits net settlement.
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7 Features of Traditional and Derivative Financial Instruments
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8 Common Derivatives Forwards (tailored) / Futures (standard specifications) Options (call/put) Swaps Hybrids / Embedded derivatives
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9 Forwards / Future Contracts Obligate one party to “buy” and another to “sell” an underlying instrument or commodity at a future date The holder has a right AND an obligation, to buy
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This note was uploaded on 09/16/2011 for the course ACCOUNTING 325 taught by Professor Stubbs during the Spring '11 term at Rutgers.

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Chapter 17 Lecture Notes 2 - Accounting for Derivative...

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