Chapter 17a Derivatives
Accounting for Derivative Instruments
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Appendix 17A Accounting for Derivative Instruments
Until the early 1970s, most financial managers worked in a cozy, if unthrilling, world. Since then, constant change caused by volatile markets, new technology, and deregulation has increased the risks to businesses. In response, the financial community developed products to manage these risks. These products—called derivative financial instruments or simply, derivatives—are useful for managing risk. Companies use the fair values or cash flows of these instruments to offset the changes in fair values or cash flows of the at-risk assets. The development of powerful computing and communication technology has aided the growth in derivative use. This technology provides new ways to analyze information about markets as well as the power to process high volumes of payments.
Understanding Derivatives
In order to understand derivatives, consider the following examples.
Example 1—Forward Contract. Assume that a company like Dell believes that the price of Google's stock will increase substantially in the next three months. Unfortunately, it does not have the cash resources to purchase the stock today. Dell therefore enters into a contract with a broker for delivery of 10,000 shares of Google stock in three months at the price of $110 per share. Dell has entered into a forward contract, a type of derivative. As a result of the contract, Dell has received the right to receive 10,000 shares of Google stock in three months. Further, it has an obligation to pay $110 per share at that time. What is the benefit of this derivative contract? Dell can buy Google stock today and take delivery in three months. If the price goes up, as it expects, Dell profits. If the price goes down, it loses.
Example 2—Option Contract. Now suppose that Dell needs two weeks to decide whether to purchase Google stock.
It therefore enters into a different type of contract, one that
Page 1 of 22
Appendix 17A Accounting for Derivative Instruments
Until the early 1970s, most financial managers worked in a cozy, if unthrilling, world. Since then, constant change caused by volatile markets, new technology, and deregulation has increased the risks to businesses. In response, the financial community developed products to manage these risks. These products—called derivative financial instruments or simply, derivatives—are useful for managing risk. Companies use the fair values or cash flows of these instruments to offset the changes in fair values or cash flows of the at-risk assets. The development of powerful computing and communication technology has aided the growth in derivative use. This technology provides new ways to analyze information about markets as well as the power to process high volumes of payments.
Understanding Derivatives
In order to understand derivatives, consider the following examples.
Example 1—Forward Contract. Assume that a company like Dell believes that the price of Google's stock will increase substantially in the next three months. Unfortunately, it does not have the cash resources to purchase the stock today. Dell therefore enters into a contract with a broker for delivery of 10,000 shares of Google stock in three months at the price of $110 per share. Dell has entered into a forward contract, a type of derivative. As a result of the contract, Dell has received the right to receive 10,000 shares of Google stock in three months. Further, it has an obligation to pay $110 per share at that time. What is the benefit of this derivative contract? Dell can buy Google stock today and take delivery in three months. If the price goes up, as it expects, Dell profits. If the price goes down, it loses.
Example 2—Option Contract. Now suppose that Dell needs two weeks to decide whether to purchase Google stock.
It therefore enters into a different type of contract, one that