Derivatives and SPEs

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Derivatives and SPEs
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SPEs or VIEs

• Very often used to engage in off balance sheet
  financing.
• Enron scandal (several hundred SPEs, no
  consolidation) used to hiding losses

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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.

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SPEs or VIEs

• Interim Change Same rule, but outside
  investment requirement raised to 10
• New Rule (FIN 46R) Risk and reward model. -

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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

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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.

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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

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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 -gt
  at time of settlement, spot price is 35 a ton.
  Who wins, who loses?

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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

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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.

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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.

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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

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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

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Exercise 17-20 Net interest expense on 6/30/03
is

1. 6,000
2. 3,000
3. 3,350
4. 2,850

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Exercise 17-20 Net interest expense on 12/31/03
is

1. 6,000
2. 3,000
3. 3,350
4. 2,850

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Exercise 17-20 This interest swap is considered a

1. Speculative hedge
2. Fair value hedge
3. Cash flow hedge
4. Interest rate hedge

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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

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Options - Examples

• Stock options
• Futures (option to buy/sell commodities or
  currency, for example

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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

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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?

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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

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Exercise 17-19 The effect on net income on
3/31/02 was

1. A gain of 3,000
2. An unrealized holding gain of 3,000
3. A gain of 2,900
4. An unrealized holding gain of 2,900
5. No effect

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Answers

• Slide 14 D
• Slide 15 C
• Slide 16 B
• Slide 22 D