Derivatives and SPEs
SPEs or VIEs
• Very often used to engage in off
balance sheet financing.
• Enron scandal (several hundred
SPEs, no consolidation) used to
hiding losses
SPEs or VIEs
• Old Rules: as long as outside
investors had at least 4% equity –
no need to consolidate as long as
(ostensibly) they were in a control
position. In reality, parent
company ran the investment.
SPEs or VIEs
• Interim Change: Same rule, but
outside investment requirement
raised to 10%
• New Rule (FIN 46R): Risk and
reward model. -
Derivatives
Financial contract which derives its value
(changes value) based on the value
(change in value) of some underlying item.
Essentially: Bets
• Examples: Futures, Forward contracts
– Stock options
– Interest swaps
Derivatives
• A contract promising to buy/receive (or sell/pay)
something in the future.
• Initial cost is minimal, may lead to great reward
or loss.
• Example: Stock option: right to buy a share of
stock for $40. If at the time the option can be
exercised, market price for the stock is $60 =
$20 profit, option will be exercised. If market
price is $30 = no exercise.
Derivatives: Potato futures contract.
• 3 parties:
• Farmer grows potatoes, wants to lock in a price
in the future. Is worried that prices might fall.
Enters into a futures contract to sell potatoes at
$30 per ton in 120 days.
• McDonalds needs potatoes, worries prices may
rise. Buys futures contract to purchase potatoes
at $30 per ton in 120 days.
• Broker – middleman facilitates contracting.
Could be done directly, but not very practical
Potato futures contract II
• Time goes by. Spot market price for potatoes as
well as futures prices for potatoes CHANGE.
Speculators (“Arbitrageurs”) constantly buy and
sell contracts.
• Eventually, contracts are settled. May or may
not require delivering/taking possession of
potatoes. One party “wins”, one party “loses” ->
at time of settlement, spot price is $ 35 a ton.
Who wins, who loses?
Potato futures contract III
• At time of settlement, spot price is $ 27 a
ton. Who wins, who loses?
• Purpose of action described (for both the
farmer and McDonalds) is to “HEDGE” =
• Protect against future price declines
(increases) with only limited risk. They
actually need to sell/buy potatoes
Potato futures contract IV
• Arbitrageurs buy and sell contracts constantly –
this is what eventually results in the “market
(spot) price
• Arbitrageurs “Speculate” (polite way of saying
“gamble”) Their role is to “make prices” for many
types of financial instruments and commodities.
They do not EVER want to see potatoes (except
on a plate)
• The incur large amounts of risk, potential for
great rewards or losses.
Derivatives: Interest Rate Swap
• Company has $100,000 outstanding debt,
must pay fixed interest of 8% (4% twice a
year). $ 4,000
• Company believes interest rates will fall.
• Company buys an interest swap contract.
• Promises to pay a variable rate (LIBOR,
e.g.) and receive a fixed 4% twice a year.
• Underlying equal to the outstanding debt.
Interest Rate Swap II
• Variable rate: 3.8% = $3,800
• fixed interest = $ 4,000
• Settlement: Company receives (pays)
difference between fixed and variable rate
= $200
• Effective interest this period: $3,800
Interest Rate Swap III
• Journal entry:
Dr. Interest expense $3,800
Dr. Cash
$200
Cr. Cash (interest payable) $4,000
This is an example of hedging
Exercise 17-20: Net interest expense on
6/30/03 is
A.
B.
C.
D.
$6,000
$3,000
$3,350
$2,850
Exercise 17-20: Net interest expense on
12/31/03 is
A.
B.
C.
D.
$6,000
$3,000
$3,350
$2,850
Exercise 17-20: This interest swap is
considered a
A.
B.
C.
D.
Speculative hedge
Fair value hedge
Cash flow hedge
Interest rate hedge
Options
• Derivatives
• Enable the holder to buy stock (or
something else) at a predetermined price
• Require that the issuer of the option sell
the stock (other item) for a predetermined
price
Options - Examples
• Stock options
• Futures (option to buy/sell commodities or
currency, for example
Stock Options
• Call options – gives holder the right to buy
stock at a fixed price
– Bet that stock price will increase
• Put options – right to sell stock at fixed
price
– Bet that stock price will decline
Stock Options
•
•
•
•
•
May be issued as employee compensation
Problem: Valuation
Black-Scholes Option Pricing Model
Other possible models
Should options be recognized as
expenses by the issuing company?
Accounting for Derivatives
• FAS 133 – Fair value reporting required
• Difficult to determine value of some
derivatives
• Requires sophisticated models (i.e., Black
Scholes option pricing model)
• Based on a number of assumptions
• Therefore inherently subject to guesses,
estimates, revisions and controversies
Exercise 17-19: The effect on net
income on 3/31/02 was
A.
B.
C.
D.
E.
A gain of $ 3,000
An unrealized holding gain of $ 3,000
A gain of $2,900
An unrealized holding gain of $ 2,900
No effect
Answers:
•
•
•
•
Slide 14: D
Slide 15: C
Slide 16: B
Slide 22: D