Derivative Securities Background

Hedges are contracts that seek to insulate companies from market risks—securities such as futures, options, and swaps are commonly used as hedges
 
Derivative securities, or simply derivatives are contracts whose value is derived from the value of another asset or economic item such as a stock, bond, commodity price, interest rate, or currency exchange rate
 
— they can expose companies to considerable risk because it can be difficult to find a derivative that entirely hedges the risks or because the parties to the derivative contract fail to understand the risk exposures 

Definitions

Futures contract—an agreement between two or more parties to purchase or sell a certain commodity or financial asset at a future date (called settlement date) and at a definite price. 

Swap contract—an agreement between two or more parties to exchange future cash flows. It is common for hedging risks, especially interest rate and foreign currency risks. 

Option contract—grants a party the right, not the obligation, to execute a transaction. A call option is a right to buy a security (or commodity) at a specific price on or before the settlement date. A put option is an option to sell a security (or commodity) at a specific price on or before the settlement date.

Derivative Securities

Qualitative Disclosures
Disclosures generally outline the types of hedging activities conducted by the company
and the accounting methods employed. 

Campbell Soup provides quantitative information relating to its interest rate and foreign exchange hedging activities in the MD&A section of the annual report. These disclosures are provided in Exhibit 5.8.

Analysis of Derivatives

  • Identify Objectives for Using Derivatives
  • Risk Exposure and Effectiveness of Hedging Strategies 
  • Transaction Specific versus Companywide Risk Exposure
  • Inclusion in Operating or Nonoperating Income

The Fair Value Option

Fair Value Reporting Requirements
Eligible assets and liabilities  - investments in debt and equity securities, financial instruments, derivatives, and various financial obligations. 
Not allowed: investment in subsidiaries that need to be consolidated,  postretirement benefit assets and obligations, lease assets/ obligations, certain types of insurance contracts, loan commitments; equity method investments under certain conditions.

Reporting Requirements
1. Carrying amount of the asset (or liability) in the balance sheet will always be at its fair value on the measurement date.
2. All changes in the fair value of the asset (or liability), including unrealized gain and losses, will be included in net income. 
3. Can choose to report the unrealized gain/loss portion differently from cash flow components or together.

Selective Application
Substantial flexibility exists to selectively apply the fair value option to individual assets or liabilities.

Analysis Implications

  • Reliability of fair value measurements 
  • Opportunistic adoption of SFAS 159
  • SFAS 159 allows considerable discretion to companies in choosing the specific assets or liabilities for which they exercise the fair value option.
  • An analyst needs to verify whether the fair value election has been opportunistic with an aim to window dressing the financial statements.
 

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