7.1 Types of derivatives

Derivatives are financial instruments that derive value from underlying assets, playing crucial roles in risk management and market strategies. They come in various forms, each with unique characteristics and applications in modern financial markets.

This topic explores the main types of derivatives: forwards, futures, options, and swaps. Understanding their differences, uses, and accounting implications is essential for grasping how these instruments shape financial landscapes and risk management practices.

Definition of derivatives

• Financial instruments deriving value from underlying assets, indices, or entities
• Crucial components in modern financial markets and risk management strategies
• Play significant roles in hedging, speculation, and arbitrage activities in Intermediate Financial Accounting

Key characteristics

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• Derive value from underlying assets (stocks, bonds, commodities, currencies)
• Require little or no initial investment compared to direct asset purchase
• Settlement occurs at a future date
• Can be used to transfer risk between parties
• Exhibit high leverage potential, amplifying gains and losses

Purpose and uses

• Hedge against potential financial risks (market, credit, interest rate)
• Speculate on price movements of underlying assets
• Arbitrage price discrepancies across different markets
• Enhance portfolio returns through strategic positioning
• Provide price discovery for underlying assets in efficient markets

Types of derivatives

Forward contracts

• Customized agreements to buy/sell an asset at a specific future date and price
• Traded over-the-counter (OTC) between two parties
• No standardization, allowing for tailored terms
• Settlement typically occurs at contract expiration
• Used extensively in foreign exchange and commodity markets

Futures contracts

• Standardized forward contracts traded on organized exchanges
• Require daily settlement (marking-to-market) to manage counterparty risk
• Highly liquid due to standardization and exchange-trading
• Commonly used in commodities, currencies, and stock indices
• Subject to regulatory oversight and margin requirements

Options

• Contracts granting the right, but not obligation, to buy (call) or sell (put) an asset
• Require payment of premium by option buyer to option seller
• Come in American (exercise anytime) and European (exercise at expiration) styles
• Used for hedging, income generation, and speculative strategies
• Offer non-linear payoff structures, limiting downside risk for buyers

Swaps

• Agreements to exchange cash flows based on different variables
• Typically involve periodic payments over the contract's life
• Often used to manage interest rate, currency, or commodity price risks
• Can be customized to meet specific needs of counterparties
• Commonly employed by corporations and financial institutions

Forward vs futures contracts

Similarities

• Both involve agreements to buy/sell assets at a future date for a predetermined price
• Used for hedging and speculative purposes in various markets
• Require no upfront premium payment (unlike options)
• Can result in delivery of the underlying asset at contract expiration
• Offer linear payoff structures based on price movements of underlying assets

Key differences

• Trading venue: Forwards trade OTC, futures on exchanges
• Standardization: Forwards customized, futures standardized
• Counterparty risk: Higher for forwards, lower for futures due to clearinghouse
• Settlement: Forwards at expiration, futures daily mark-to-market
• Regulation: Forwards lightly regulated, futures heavily regulated
• Liquidity: Forwards less liquid, futures highly liquid

Call vs put options

Rights and obligations

• Call options
  • Buyer has right to buy underlying asset at strike price
  • Seller obligated to sell if buyer exercises
• Put options
  • Buyer has right to sell underlying asset at strike price
  • Seller obligated to buy if buyer exercises
• Both types require premium payment from buyer to seller
• Options can be European (exercise at expiration) or American (exercise anytime)

Payoff structures

• Call options
  • Profit potential unlimited as underlying asset price rises
  • Maximum loss limited to premium paid for buyer
  • Break-even point: strike price plus premium
• Put options
  • Profit potential capped at strike price minus premium
  • Maximum loss limited to premium paid for buyer
  • Break-even point: strike price minus premium
• Both types offer non-linear payoffs, unlike forwards/futures

Common swap arrangements

Interest rate swaps

• Exchange fixed interest rate payments for floating rate payments
• Used to manage interest rate risk or speculate on rate movements
• Notional principal used for calculation purposes, not exchanged
• Common in corporate finance to align debt payments with cash flows
• Can involve same or different currencies (cross-currency interest rate swaps)

Currency swaps

• Exchange principal and interest payments in different currencies
• Used to access foreign capital markets or hedge currency risk
• Involve exchange of notional principals at initiation and maturity
• Help companies match foreign currency assets with liabilities
• Can combine with interest rate swaps for complex risk management

Commodity swaps

• Exchange fixed price payments for floating price payments on commodities
• Used by producers and consumers to hedge against price volatility
• Common in energy markets (oil, natural gas) and agricultural products
• Can be cash-settled or involve physical delivery of commodities
• Help stabilize costs/revenues for businesses dependent on commodity prices

Accounting for derivatives

Recognition criteria

• Derivative contracts recognized as assets or liabilities on balance sheet
• Initial recognition at fair value, usually the transaction price
• Subsequent recognition based on changes in fair value
• Recognition timing depends on trade date vs settlement date accounting
• Special considerations for embedded derivatives in hybrid contracts

Measurement principles

• Fair value measurement required for most derivatives
• Changes in fair value recognized in profit/loss unless hedge accounting applied
• Valuation techniques include market approach, income approach, and cost approach
• Consideration of counterparty credit risk in fair value measurements
• Disclosure of fair value hierarchy levels (Level 1, 2, or 3) required

Hedge accounting basics

• Optional accounting treatment to align timing of hedged item and hedging instrument
• Three types: fair value hedges, cash flow hedges, and net investment hedges
• Requires formal designation and documentation of hedging relationship
• Effectiveness testing required to qualify for hedge accounting
• Special accounting treatment for time value of options and forward points

Risk management with derivatives

Hedging strategies

• Use derivatives to offset potential losses in underlying positions
• Common strategies include delta hedging, portfolio insurance, and immunization
• Dynamic hedging involves frequent rebalancing of derivative positions
• Cross-hedging used when perfect hedge instruments unavailable
• Basis risk consideration crucial in designing effective hedges

Speculation vs hedging

• Speculation aims to profit from anticipated market movements
• Hedging seeks to reduce or eliminate existing risk exposures
• Speculators provide liquidity and price discovery in derivative markets
• Hedgers transfer unwanted risks to parties more willing to bear them
• Regulatory treatment and accounting implications differ for each purpose

Derivative valuation methods

Black-Scholes model

• Widely used for European-style option pricing
• Assumes geometric Brownian motion for underlying asset prices
• Incorporates factors: stock price, strike price, time to expiration, volatility, risk-free rate
• Closed-form solution for call and put option prices
• Limited by assumptions of constant volatility and no dividends

Binomial option pricing

• Flexible model suitable for American and European options
• Uses discrete-time framework to model possible price paths
• Allows incorporation of dividends and early exercise decisions
• Can handle complex option features and underlying asset behaviors
• Computational intensity increases with number of time steps

Regulatory environment

IFRS vs US GAAP

• IFRS 9 and ASC 815 govern derivative accounting under respective frameworks
• Both require fair value accounting for most derivatives
• Differences in hedge accounting rules and effectiveness testing
• US GAAP more prescriptive, IFRS more principles-based approach
• Convergence efforts ongoing but differences remain in specific areas

Disclosure requirements

• Extensive disclosures required for derivative instruments and hedging activities
• Qualitative disclosures on risk management objectives and strategies
• Quantitative disclosures on fair values, notional amounts, and gains/losses
• Tabular format presentations often required for clarity
• Enhanced disclosures for credit derivatives and credit-risk-related contingent features

Derivative markets

Over-the-counter (OTC)

• Bilateral trading between counterparties without exchange intermediation
• Allows for customization of contract terms to meet specific needs
• Generally less regulated than exchange-traded markets
• Higher counterparty risk due to lack of central clearinghouse
• Dominated by large financial institutions and sophisticated investors

Exchange-traded derivatives

• Standardized contracts traded on organized exchanges
• Central clearinghouse acts as counterparty to all trades
• Higher liquidity and transparency compared to OTC markets
• Subject to strict regulatory oversight and margin requirements
• Accessible to a wider range of market participants, including retail investors