Question

Write a 2-page paper in which you explain and analyze the different types of derivatives and how they affect financial statements. You are required to use at least two journal articles and follow proper APA format.

Answer 1

Derivatives are the financial instruments that derives its value from the fluctuations in the value of something other for example: if there is a derivative contract on a particular Stock lets say XYZ then the derivative contract value shall increase or decrease relatively with the increase or decrease in the value of XYZ Stock.

Derivatives are of 4 types basically

1. Forward Contracts

2. Future Contracts

3.Option Contracts

4. Swaps

1.Forward Contracts: These are the oldest and simplest form of derivatives in Forward contracts exchanges as  intermediary are not involved so the counter party default risk for the Forward contracts are high. Also before internet era it was very difficult to find the opposite party to enter into the Forward contracts. A forward contract is simply a contract between two parties to buy or to sell an asset at a specified future time at a price agreed today. Example

Mr. A enters into contract with a stock broker “B” on 1^st November 2018 for purchase of 1,000 XYZ steel shares at $ 200 on 1^st January 2019. In this case irrespective of the price on 1^st January 2019 Stock Broker “B” has to sell 1,000 shares of XYZ steel at $ 200 to Mr. A. In this case, if the price of the share is more than $ 200 on 1^st January 2019 then Mr. A” will be at profit other wise Stock broker “B” will be at profit.

2. Future Contracts: These are similar to the Forward Contracts apart from that exchange as the intermediary is involved in the Future Contracts so the counter party default risk is negligible. Buyer of contract is known as Long Position Holder whereas Seller is Known as Short Position Holder Example:

if the contract to purchase the shares of XYZ  steel is entered on a futures exchange (I.e clearing house) and both parties has to deposit some amount of money for honoring the contract, and then the contract is futures. Futures are nothing but a forward contract except that a third party is there in between to avoid the risk of denying honoring the contract.

3. Option Contracts: As the name suggest option contracts are the option in the hand of one party to buy/ sell on a certain date but it binds the other party. An options contract, binds one party whereas it lets the other party decide at a later date i.e. at the expiration of the option. So, one party has the obligation to buy or sell at a later date whereas the other party can make a choice. Further there are 2 types of options

1) Call Option 2) Put Option

Call Option is the right to buy at a given date at a Pre decided  price whereas Put Option is the obligation to sell at a given date at a Pre decided price

For example: Continuing the same example as in Forward Contract, In case of options Mr. A  purchased an option to “buy” (Call option) XYZ steel shares at $ 200 per share from Stock broker “B” at an option amount of $ 20 per share. In this case denial by “B” is not possible as Mr.A bought right but not obligation to buy the shares. On 1^st January 2019, if XYZ steel shares are operating at $ 100 then Mr. A is not obliged to buy the shares from “B” at $ 200.

So in this case Maximum loss for Mr. A is $ 20/ share and Maximum profit for stock broker “B” is $ 20/share. Profit of Mr.A  is unlimited and loss of stock broker “B” is unlimited.

There are various Models to calculate Option Price like  Black-Scholes model etc.

4. Swaps: Swaps are probably most difficult to understand in the financial markets. Swaps enable the participants to exchange their streams of cash flows. For instance, at a later date, one party may switch an uncertain cash flow for a certain one. The most common example is swapping a fixed interest rate for a floating one. Participants may decide to swap the interest rates or the underlying currency as well.

Accounting for Derivatives Instruments-

Under current international accounting standards an entity is required to measure derivative instruments at fair value or mark to market. All fair value gains and losses are recognized in profit or loss except where the derivatives qualify as hedging instruments in cash flow hedges or net investment hedges.

Now what is Fair value or mark to Market as per accounting standards?

It is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable and willing parties in an arm’s length transaction. Fair value does not take into consideration transaction costs incurred at initial acquisition or expected to be incurred on transfer or disposal of a financial Instruments.

So, these are the 4 basic types of derivatives. Modern derivative contracts include countless combinations of these 4 basic types and result in the creation of extremely complex contracts.