Page 219 - Encyclopedia of Business and Finance

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Derivatives

have experienced significant losses with the use of deriva- financial instrument, which has opposite return
tives. However, their use has increased as efforts to control characteristics of the item being hedged, to offset
risk in complex situations are perceived to be wise strate- losses or gains.
gic decisions.
• A speculator enters the derivatives market in search
of profits, and is willing to accept risk. A speculator
SFAS 133’S DEFINITION OF A takes an open position in a derivative product (i.e.,
DERIVATIVE INSTRUMENT there is no offsetting cash flow exposure to offset
In 1998, the Financial Accounting Standards Board losses on the position taken in the derivative prod-
(FASB) issued Statement on Financial Accounting Stan- uct).
dards No. 133 (SFAS 133), Accounting for Derivative • An arbitrageur is a speculator who attempts to lock
Instruments and Hedging Activities, which is effective for
in near riskless profit from price differences by
companies with fiscal years beginning after June 15, 2000. simultaneously entering into the purchase and sale
SFAS 133 establishes new accounting and reporting rules
of substantially identical financial instruments.
for derivative instruments, including derivatives embed-
ded in other contracts, and for hedging activities. Deriva- Other participants include clearinghouses or clearing
tives must now be reported at their fair values in financial corporations, brokers, commodity futures trading com-
statements. Gains and losses from derivative transactions mission, commodity pool operators, commodity trading
must be reported currently in income, except from those advisors, financial institutions and banks, futures
transactions that qualify as effective hedges. exchange, and futures commission merchants.
According to Statement on Financial Accounting
Standards (SFAS) 133, a derivative instrument is defined
TYPES OF DERIVATIVE
as a financial instrument or other contract that represents
INSTRUMENTS
rights or obligations of assets or liabilities with all three of
Derivative instruments are classified as:
the following characteristics:
• Forward Contracts
• It has (1) one or more underlyings and (2) one or
more notional amounts or payment provisions or • Futures Contracts
both. Those terms determine the settlement amount • Options
of the derivative. An underlying is a variable (i.e.,
• Swaps
stock price) or index (i.e., bond index) whose mar-
ket movements cause the fair value market or cash Derivatives can also be classified as either forward-
flows of a derivative to change. The notional based (e.g., futures, forward contracts, and swap con-
amount is the fixed amount or quantity that deter- tracts), option-based (e.g., call or put option), or
mines the size of the change caused by the change in
combinations of the two. A forward-based contract obli-
the underlying; possibly a number of currency units,
gates one party to buy and a counterparty to sell an under-
shares, bushels, pounds, or other units specified in
lying asset, such as foreign currency or a commodity, with
the contract. A payment provision specifies a fixed
equal risk at a future date at an agreed-on price. Option-
or determinable settlement to be made if the under-
based contracts (e.g., call options, put options, caps and
lying behaves in a specified manner.
floors) provide the holder with a right, but not an obliga-
• It requires no initial net investment or an initial net tion to buy or sell an underlying financial instrument, for-
investment that is smaller than would be required eign currency, or commodity at an agreed-on price during
for other types of similar instruments. a specified time period or at a specified date.
• Its terms require or permit net settlement (SFAS
133, paragraph 6). Forward Contracts. Forward contracts are negotiated
between two parties, with no formal regulation or
exchange, to purchase (long position) and sell (short posi-
USERS OF DERIVATIVES
tion) a specific quantity of a specific quantity of a com-
The derivatives market serves the needs of several groups
modity (i.e., corn and gold), foreign currency, or financial
of users, including those parties who wish to hedge, those
who wish to speculate, and arbitrageurs. instrument (i.e., bonds and stock) at a specified price
(delivery price), with delivery or settlement at a specified
• A hedger enters the market to reduce risk. Hedging future date (maturity date). The price of the underlying
usually involves taking a position in a derivative asset for immediate delivery is known as the spot price.

196 ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION