1. Derivatives and SPEs

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

3. 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.

4. SPEs or VIEs Interim Change: Same rule, but outside investment requirement raised to 10% New Rule (FIN 46R): Risk and reward model. -

5. 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

6. 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.

7. 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

8. 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?

9. 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

10. 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.

11. 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.

12. 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

13. 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

14. Exercise 17-20: Net interest expense on 6/30/03 is A.$6,000 B.$3,000 C.$3,350 D.$2,850

15. Exercise 17-20: Net interest expense on 12/31/03 is A.$6,000 B.$3,000 C.$3,350 D.$2,850

16. Exercise 17-20: This interest swap is considered a A.Speculative hedge B.Fair value hedge C.Cash flow hedge D.Interest rate hedge

17. 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

18. Options - Examples Stock options Futures (option to buy/sell commodities or currency, for example

19. 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

20. 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?

21. 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

22. Exercise 17-19: The effect on net income on 3/31/02 was A.A gain of $ 3,000 B.An unrealized holding gain of $ 3,000 C.A gain of $2,900 D.An unrealized holding gain of $ 2,900 E.No effect

23. Answers: Slide 14: D Slide 15: C Slide 16: B Slide 22: D